How change in base year for indexation from 1981 to 2001 affects you?

The Finance Minister, in his budget speech, made three significant announcements in terms of taxation of long term capital gains.

1. Change in holding period (for capital gains to qualify as long term capital gains) for real estate from 3 years to 2 years. Holding period for other capital assets has been left unchanged.
2. More options to be offered under Section 54EC in addition to NHAI and REC capital gains bond. You can invest up to Rs 50 lacs per financial year in such specified bonds under Section 54EC to avoid paying long term capital gains tax.
3. Base year for indexation changed from 1981 to 2001.

The impact of the first two announcements is quite intuitive. In this post, let’s try to under the impact of change in base year for indexation from 1981 to 2001.

Before we move on to how this change affects you, let’s first try to understand how indexation benefit helps you save capital gains tax.

How does Indexation help?

When you purchase an asset, a part of rise in the value of asset can be attributed to inflation.

Suppose Apple was an asset and today you can purchase 1 apple for Rs 100. Let’s say you can purchase 1 apple after 5 years for Rs 130. Apple is same. Just that value of money has eroded in five years.

Same happens to your capital assets too. A part of the rise in price of the asset will be because of inflation and a part due to wise decision making.

The Government, by letting you to index your purchase (acquisition) price, does not penalize you for price appreciation due to inflation.

For instance, you purchase a parcel of land in FY 2006 (August 2005) for Rs 5 lacs and sold it for Rs 12 lacs in FY 2013. Cost inflation index in 2005-2006 was 497 while in 2012-2013 was 939.

Therefore, the indexed cost of acquisition becomes Rs 5 lacs * 939/497 = Rs 10.74 lacs

Long Term Capital Gains = Sales price – Indexed cost of acquisition (and improvement)

Long Term Capital Gains = Rs 12 lacs – Rs 10.74 lacs = Rs 1.26 lacs

Long Term Capital Gain Tax = 20% * 1.26 lacs = Rs 25,125 (before cess and surcharge)

In absence of allowance for indexation, your capital gain would have been Rs 7 lacs and your long term capital gains tax liability would have been Rs 1.4 lacs.

Not difficult to see that indexation benefit has saved you a lot of tax.

Do note indexation benefit is available to long term capital gains. No such facility for short term capital gains.

How does change in Base year impact you?

Now you know,

Long Term Capital Gains = Sales price – Indexed cost of acquisition (and improvement)

Sales price is easy to figure out. After all, you just sold the asset.

For the Indexed Cost of Acquisition, you need to find out the Cost of Acquisition and inflate it to find Indexed Cost of Acquisition.

As per Section 55 of the Income Tax Act,

Cost of acquisition, where the capital asset became the property of the assessee before the 1st day of April, 1981, means the cost of acquisition of the asset to the assessee or the fair market value of the asset on the 1st day of April, 1981, at the option of the assessee;   

April 1, 1981 to be replaced with April 1, 2001 (from April 1, 2018 as per the budget announcement)

So, as per the existing law, if you acquired a capital asset before 1981, it is your discretion to choose the cost of acquisition. You can choose it to be the actual cost or the Fair Market Value as on April 1, 1981.

Of course, you will pick up the higher one. Sometimes, it is not possible to find the actual cost of asset especially for those properties that you have inherited.  In such cases, you have to go for FMV.

As per Section 48 of the Income Tax Act,

“indexed cost of acquisition” means an amount which bears to the cost of acquisition the same proportion as Cost Inflation Index for the year in which the asset is transferred bears to the Cost Inflation Index for the first year in which the asset was held by the assessee or for the year beginning on the 1st day of April, 1981*, whichever is later;

April 1, 1981 to be replaced with April 1, 2001 (from April 1, 2018 as per the budget announcement)

Once you have decided the Cost of acquisition, the Cost of Inflation Index comes (CII) into picture. If you purchase the property in FY1992, you will apply the CII value for FY1992.

Now that the base year has been changed from 1981 to 2001, you will have to apply CII value for FY 2001-2002 (from next year). CII for 1992 will not exist for taxation purposes.

Illustration

You purchased a property in August 1991 for Rs 10 lacs and sold it in FY2018 for Rs 70 lacs.

By the way, CII for FY2018 has not been announced. Let’s assume it is 1165.

 Under the old base year of 1981

CII for 1992: 199

CII for 2018: 1165

Indexed Cost of acquisition: Rs 10 lacs * 1165/199 = Rs 58.54 lacs

Long Term Capital Gain = Rs 70 lacs – Rs 58.29 lac = Rs 11.45 lacs

LTCG Tax = 20% * 11.71 lacs = Rs 2.29 lacs

Under the new Base year of 2001

Though the new CII index has not been announced, it will likely be in similar ratios i.e. CII value of 426 in 2001 will become 100 and subsequent value will be adjusted accordingly.

Once the change is effected, there is no CII value for FY1992 (or it will be considered at 100, same as for 2001-2002).

You have two options now.

1. You can either consider your acquisition price in FY1992 (Rs 10 lacs) as your purchase price. However, there will be no indexation benefit for 10 years from 1992 to 2001 OR
2. You can consider Fair Market Value (FMV) as on April 1, 2001 as your purchase price. Finding out FMV can be tricky. You can find out transaction price of similar properties in 2001 or you can take assistance of a valuer. If you use too high a value for FMV, your IT assessing officer may have problems.

You will choose the higher one.

If property prices have grown faster than CII (from 1992 to 2002), there is a clear benefit. You can take FMV as the purchase price. Otherwise, you stand to lose.

CII in 1991-1992 was 199. In 2001-2002, it was 426. With CII, property prices would have gone up to Rs 21.4 lacs.

There are two scenarios.

1. FMV on April 1, 2001 is Rs 25 lacs. (> 21.4 lacs through CII)

Indexed Cost of acquisition= Rs 25 lacs * 1165/426 = Rs 68.36 lacs

Long Term Capital Gain = Rs 70 lacs – Rs 68.36 lacs = Rs 1.64 lacs

Long Term Capital Gains Tax = 20% * 1.64 lacs = 0.32 lacs

Under old regime, you were paying 2.29 lacs as tax. You are benefiting from the change in tax rule.

2. FMV on April 1, 2001 is Rs 15 lacs. (< 21.4 lacs through CII)

Indexed Cost of acquisition= Rs 15 lacs * 1165/426 = Rs 41.02 lacs

Long Term Capital Gain = Rs 70 lacs – Rs 41.02 lacs = Rs 28.97 lacs

Long Term Capital Gains Tax = 20% * 28.97 lacs = Rs 5.79 lacs

This is much greater than Rs 2.29 lacs in the previous regime. Hence, your tax liability has increased.

Though I do not have any data to back my statement, I believe that property prices have risen sharper than the CII. Hence, you are more likely to benefit from this change in tax rule.

If you purchase the property after 2001, there is no impact on you.

This change in base year is not only for real estate transactions. It is for all the capital assets such as debt, gold, equity etc (wherever indexation is applicable).

The analysis is same for other investments too. If the appreciation in price has been higher than increase in CII, you will have to pay lower tax (as compared to that with base year as 1981). Or else, you will have to pay greater capital gains tax.

Let’s consider the impact on other assets.

Debt/Debt Mutual Funds

Quite beneficial.

If you have been holding debt MF units before 2001, you can simply choose the Fair Market Value (FMV) as on April 1, 2001.

Fair market value for a debt mutual fund is not difficult to determine. You can simply check the NAV as on April 1, 2001. Essentially, any capital gain before April 1, 2001 becomes tax-free for you.

It is another matter altogether whether you have been holding the same debt funds since 2001.

However, I don’t think there will be many such investors.

Equity/Equity Mutual Funds

There is no impact on taxation of equity/equity mutual funds as long term capital gains are exempt from tax.

Gold

If the gold price declined between your date of purchase and the April 1, 2001, you can consider your actual purchase price of cost of acquisition.

Or else if the gold went up between your purchase date and April 1, 2001, you can consider FMV on 2001 as your acquisition price.

Disclaimer

I am not a tax expert.  Though I have taken utmost care in doing my research, Income Tax Act has many clauses/sub-clauses which I may have skipped and hence my interpretation of the Income Tax Act may be incorrect. You are advised NOT to base any decision on the contents of this post. This post is not a substitute for professional advice. You must consult a Chartered Accountant before you take any decision.