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What is cost inflation index?

The cost Inflation index is an indicator that is used for adjusting capital expenditures made on assets to account for inflation and arrive at their tax-deductible value. The cost inflation index is notified by the Indian government annually and it takes March 31, 2001 as the base year with an index value of 100. The index for each subsequent year indicates by what percentage the general price level has increased compared to the base year.

Why is the cost inflation index important?

The cost inflation index definition states that it is a metric used for adjusting the actual cost of a capital asset to account for inflation and arrive at its tax-deductible depreciation value under the Indian Income Tax Act. Thus, the cost inflation index plays an important role in computing tax depreciation allowances in India.

By indexing the actual cost of capital assets to account for inflation, the cost inflation index helps ensure fair treatment of taxpayers under the income tax laws. Without indexing, the depreciation deduction would become meaningless over time due to rising prices.

Cost inflation index example

Let us take an example to understand what is cost inflation index better.

Suppose a company purchased a machine for Rs. 1 crore in the financial year 2010-11. As per tax rules, it is entitled to claim depreciation of 15% of the actual cost every year. Without applying the cost inflation index, the depreciation would remain Rs. 15 lakhs (15% of Rs. 1 crore) every year till the whole amount is deducted over 6-7 years.

However, during this time period, inflation would have significantly eroded the value of Rs. 1 crore. Goods and services that could be bought for Rs. 1 crore in 2010 may cost over Rs. 1.5 crore today due to price rise.

Hence, the tax depreciation deduction would not properly offset the actual reduction in the value of the machine. To address this, the cost inflation index is applied. Let's assume the index for 2010-11 was 200 and for current year 2023-24, it is 300. Then, the indexed cost of the machine will be recomputed as Rs. 2 crore (Rs. 1 crore x 300/200).

Now the annual depreciation claim can be Rs. 30 lakhs (15% of Rs. 2 crore) instead of the earlier Rs. 15 lakhs. This adjustment provides meaningful tax relief to the taxpayer.

Over time, as inflation gradually increases production costs, the higher cost inflation index ensures businesses get a fair chance to claim tax deductions proportionate to the impact of inflation. This promotes certainty and relative stability in tax matters. It also encourages continued investment in capital assets knowing that tax rules support accounting for inflation.

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