Cost Inflation Index (CII) and its application in Mutual Funds

Hand turns a dice and changes the word “deflation” to “inflation”, or vice versa.

CBDT had notified Cost Inflation Index (CII) for the FY 22-23 (AY 23-24) as “331”, a rise of 4.4% year on year, 2nd high since FY16.

What is a Cost Inflation Index? Cost Inflation Index, also referred to as CII, is an index maintained and notified by Central Board of Direct Taxes, on an annual basis, according to Section 48 of the Income Tax act. It essentially measures the relative inflation that prevailed between two given Financial Years.

How CII is computed? According to the explanation given in Section 48 of IT act, CII of a financial year is notified by the central government, having regard to 75% of the average rise in CPI (Urban) index during the immediately preceding previous year. Since 1st April 2016 the comparison index has been changed to CPI (Urban).

Base Year shift for CII: Base year is the year from when the CII series is being published with the base value as 100. Earlier, the base year for CII used to be 1981-82. Budget 2017 proposed to amend the Base Year of CII from 1981-82 to 2001-02. The reason for base year changing the base year was to solve the difficulties and problems faced by taxpayers when valuing the properties bought before the 80s. It was equally difficult for the tax authorities to go by such reported valuations. Henceforth, for capital assets (properties) bought before 2001, Assessees can use the ‘Fair Market Value (FMV) as of Apr.2001’ or the ‘Actual cost of purchase’, whichever is higher.

CII and its applications: CII is primarily used to compute the inflation effect, also called indexation, on the gains during the sale of certain specified assets and investments such as property, debt mutual funds, certain specified listed debt securities, gold, unlisted shares, etc.

What is Indexation? Indexation is the process of improving ‘Original cost of acquisition’ of a capital asset, with that of inflation as measured by CII that prevailed during the holding period while calculating the capital gains. Since gains are the difference between sale value and the purchase cost, an improved cost of acquisition (as per CII) would likely result in lesser gains, and hence lesser tax outgo. Indexation benefit helps in ascertaining the capital gains after adjusting for inflation, to reflect a more realistic economic result.

How to calculate the Indexed cost of Acquisition / Purchase?

Indexed Cost of Acquisition or Purchase = Original Cost of Acquisition X [CII during the year of sale / CII during the year of purchase or 2001-02, whichever is later]

Table 1

Capital Gains: Gains arising out of sale of capital assets are called capital gains. Capital Gains can be oftwo types, Short-term and Long-term depending on the asset type and the holding period. There are stipulated holding period for different assets for the gains to qualify as ‘long-term’.

  • In the case of Property: Gains arising from the sale after two years (since April 2017) qualifies as long-term capital gains.
  • For Debt and non-equity mutual funds, gold, etc: Gains arising from sale after three years, qualifies as long-term.

Effective Use of CII in Mutual Funds with Indexation Benefits: (Non-Equity Oriented Schemes like Debt Funds, FMPs, Gold Funds, etc)

Below table illustrates the tax impact of income from FDs (interest) and Debt funds (Gains).

Table 2

Let’s assume, that an Individual invested Rs. 1,00,000 on 20.3.2017, in a Debt Fund (that is eligible for Indexation). She redeemed the investments on 09.04.2021 at Rs. 1,30,000. This resulted in a gain of Rs.30000 and CAGR of 6.68%. Gains are Long Term, as the investment was held for 49.4 months (more than 36 months).

In the case of FDs, the entire income (Rs.30000) is taxed at the Individual’s respective Tax Slabs (as applicable). Which means an assessee at 30% tax bracket would have a tax liability of around Rs.9000 and those in 20% tax Slab, around Rs.6000 (plus cess, etc).

Alternatively, Debt MFs are taxed after indexation, improving the cost of investment, at the pace of CII. This makes Debt mutual funds attractive over other fixed income investment options (i.e., those without Indexation benefits), over longer term.

In Debt funds, applying the indexation exercise, the indexed cost of investment becomes Rs.120076 and hence the taxable gain is Rs.9924 (instead of entire 30000) and tax liability works out to Rs.1985, which potentially brings down the tax liability by -34% for those in 10% tax slab; -67% for those in 20% tax bracket and by -78% for those in 30% tax bracket.

On a post-tax basis, the effective return (/ yield) in Debt fund stood at 6.28%, whereas in the case of FDs, it was 6.07% for those in 10% tax slab; 5.43% for those at 20% slab and 4.81% for those in the 30% slab.

CII trend from FY16 … CII has moderated due to the decline in the average CPI inflation and has been gradually rising for the last few years. Yet, Debt mutual fund Investors were able to reduce on the tax out go, due to the Indexation benefits it carries. During high inflation years, the tax advantages could be more (as CII would be higher), sometimes resulting in nil tax (like it happened during FY’10 to FY’15). Debt Mutual Funds has a good potential to maximize the post-tax net yield and returns by way of indexation benefits, and hence lesser tax outgo.

Extending the redemption date and availing additional year of Indexation benefit: As CII and indexation are applied and calculated on a financial year basis, Investors can avail additional year of indexation benefit by holding the investments and crossing over to another financial year (of course, subject to investor specific requirements and circumstances). Many informed investors do this.

Taking the same illustration, one could notice that the redemption took place on 09.04.2021 and since it falls in FY 21-22, investor was eligible to avail indexation for five years (FY17 to FY22).

Key points to keep in mind while investing in a debt scheme:

Debt MF offers advantages over other traditional fixed income products, but they also come with Market, Interest rate, Liquidity and Credit risks. As explained by us earlier at different occasions, primary factors one should consider while looking at debt funds are:

  • Credit quality of the portfolio: How much instruments in the portfolio, are rated AAA / Sovereign and others.
  • YTM: Yield to Maturity, as it is called is an important factor and that relatively changes with duration.
  • Average maturity and the modified duration: Which is relevant to understand the possible degree of fluctuations in case of interest rate changes (especially when rates are rising)
  • Interest rate scenario: Allocate funds in a staggered manner, if it is a rising rate scenario, as with subsequent increases in rates, one could get in at a better yield.
  • Concentration level in the portfolio – how much % weight the top holdings / sectors carry, single group or company exposure, and their credit standings, etc.
  • The scheme’s and the fund manager’s track record
  • Risk management processes adopted by the fund house, etc.

Target Maturity funds: Debt funds with target maturity strategy and that adopt roll-down strategy could be considered, as they will not have much of the risks arising due to interest rate rise, if investor hold the funds till it’s maturity.

It is highly advised that investors study and understand these factors thoroughly before investing.

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