Formula to Calculate Indexation Cost
Indexation can be defined as a technique which can be used to adjust the amount byways of a price index, so as to maintain the purchasing power after excluding the effect of inflation.
The formula to calculate indexation cost is represented as below,
Where,
- CII stands for Cost of Inflation Index
Step by Step Calculation of Indexation Cost
The steps to calculate the indexation cost are as per below:
- Step1: Find out the original cost of acquisition, including the cost of the transaction, which took place.
- Step2: Note down the Consumer Inflation Index for the year into consideration, which could be a year of sell, or any other year in consideration.
- Step3: Now, note down the base year’s Consumer Inflation Index.
- Step4: Multiply the Original Cost of acquisition with CII noted in step 2 and divide the same by CII noted down in step 3, and the resultant figure is the index value, which shall bring the value of an asset in the current period.
Examples
Example #1
The cost of X that was purchased in the year 2001 was $100,000. It is now 2019, and the prices of X have been increased. What is the current price of X provided that CII in the given year, i.e., 2019 is 214 and CII of the base year, which is 2001 here is 190? You are required to compute the current price of X.
Solution
We are given here the cost of acquisition, the CII for the year 2019, and CII for the year 2001. Hence, we can use the below formula to calculate the current price of X.
Below is given data for calculation of current price
Therefore, calculation of current price is as follows
= $100,000 x 214 / 190
Current price will be –
- Current Price =$112,631.58
Hence, the current price of X is $112,631.58 per Indexation.
Example #2
Country X has the system of taxing the individuals on the sale of an asset. It has also set up the policy when there is a sale of the asset, and if its being sells in a long term period, then there is a benefit of Indexation applicable. Mr. Kennedy’s resident of country X had purchased the land back in 1990 and has sold the land in the current year. He acquired that land for $153,680, including the cost of duties and other transaction costs. After almost a decade, he has sold this asset for $350,900. The capital gains are subject to 15%. Also, the CII for the year 1990 was 121, and the CII for the year of sale is 211. You are required to compute capital gain on the sale of the asset after applying for indexation benefit.
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Solution
Mr. Kennedy purchased the asset back in the year 1990 and has sold almost after a decade, and hence he would be subject to long term capital gain tax. In order to compute the tax, we need to first find out the capital gain, and for that, we need the index cost of acquisition.
Below is given data for calculation of Indexation
Therefore, Indexation Cost can be calculated using the above formula as,
= $153,680 x 211/121
Indexation will be –
- Indexation = $ 267,987.44
Capital Gain
- Capital Gain = 82912.56
Capital Gain Tax
- Capital Gain Tax = 12436.88
Now, we can calculate the gain which would be sale less index cost of acquisition which is $350,900 less $267,987.44 which would be $82,912.56
The long term capital gain tax is 15% and which would be applied to the gain, which we calculated above, i.e., $82,912.56 and 15% of the same would be $12,436.88.
Example #3
Y is a developed nation. It has a policy of taxing long term capital gain at 12.5% and short term capital gain tax at 17%. Also, the country allows indexation benefits for long term capital gain. Further, the country allows 9% long term capital gain flat if no indexation benefit is taken. Mrs. Carmella sold an asset for $15,000, which is subject to long term capital gain tax. When the asset was purchased for $10,000, the CII for the same has been calculated as 158, and CII for the year of sale is calculated as 177. You are required to evaluate whether Mrs. Carmella should opt for Indexation or pay long term capital gain tax, flat at 9%?
Solution
It is an interesting question where govt. is flexible with their taxpayers and allowing them to pick up the best option where they need to pay less tax.
Mrs. Carmella purchased the asset, and she is liable for long term capital gain tax. In order to calculate the tax, we need to first find out the capital gain and again to calculate the gain we need index cost of acquisition.
Use the following data for calculation of Indexation
Therefore, Indexation Cost can be calculated using the above formula as,
= $10,000 x 177/158
Indexation will be –
Indexation =$ 11,202.53
Capital Gain will be –
- Capital Gain = 3797.47
Capital Gain Tax will be –
- Capital Gain Tax = 341.77
Hence, the gain would be $15,000 less $11,202.53, which will be $3,797.47, and capital gain tax on the same would be 9% of the same, which is $341.77 capital gain tax.
Option II
Capital Gain Tax will be –
Capital Gain Tax =625.00
Pay capital gain tax @ 12.50% straight on gain of $5,000 ($15,000 less $10,000) which shall be $625.
Hence, the tax outflow is more in option II; the taxpayer should opt for an option I, which is with Indexation.
Relevance and Uses
Indexation is widely used in many of the countries for gauging the economic conditions. As stated earlier, this is the most commonly used measure for valuing the assets to current prices and, by proxy, for knowing the effectiveness of the economic policy of the government. The Indexation shall give the businesses, the government, and citizens a brief idea about the changes in the price of the assets in the economy and can act as a guide to making decisions about the whole economy. Indexation is used in the field of taxation and in other fields of finance to know the true value of the asset purchased from base year to the current period.
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