Before 2018, we all knew long-term capital gains in equity were tax-free. But now – they are taxed at 10%. In a simple situation what if someone’s date of purchase of a certain equity MF unit is in 2015? Now, if this person sells in 2022, will his gain be calculated on his original price of 2015? Or something else? Here comes the Grandfathering Clause or Grandfathering rule of income tax.

Also download NAVs of 31 Jan 2018 & Share Prices of 31 Jan 2018 from below.

Definition of Grandfathering Clause

A grandfathering clause is a provision in which an old rule continues to apply to some existing situations while a new rule will apply to all future cases. Those exempt from the new rule are said to have grandfather rights or acquired rights or to have been grandfathered in.

In simple terms, grandfathering rule ensures that the tax levied on gains is prospective and is levied from the date of levy of such tax. This is done to protect the interest of taxpayers.

How Grandfathering Rule helps investors?

Long-term capital gains (LTCG) on the transfer of listed equity shares and equity-oriented mutual fund schemes were exempt from tax until the financial year 2017-18.

The Finance Act, 2018 reintroduced tax on LTCG on sale of listed shares and equity-oriented mutual fund schemes w.e.f. 1st April 2018, i.e. FY 2018-19 with a grandfathering clause.

As the LTCG was reintroduced on 1st February 2018, the CBDT (Central Board of Direct Taxes) allowed gains up to 31^st January 2018 to be grandfathered i.e. tax will not be paid on gains accrued till 31^st January 2018.

You will love to read this too GST Impact on Your Investments

To get the benefit of grandfathering clause, investors/taxpayers will have to ascertain the cost of acquisition of their investments based on a formula covered in Section 55 of Income Tax Act, 1961 which will ensure that the gains up to 31st January 2018 are grandfathered or are exempt from tax.

Grandfathering Clause Formula

The cost of acquisition is ascertained as below:

Value I- Fair Market Value (FMV) as of 31st January 2018 or the Actual Selling Price whichever is lower

Value II – Value I or Actual Purchase Price, whichever is higher

Long Term Capital Gain = Sales Value – Cost of Acquisition (as calculated above)

Tax Liability = LTCG of Rs 1 lac is tax-exempt in a year. So tax liability will be 10% (plus applicable surcharge and cess) on the amount after deducting Rs 1 Lac from the total tax gain.

Let us understand with an example:

Mr. ABC made a lump-sum investment of Rs. 30 lakh in shares of a listed company in June 2010. Its FMV as of January 31, 2018, was Rs. 50 lakh.

ABC redeems his entire investment in May 2019 for Rs.53 lakh netting a gain of Rs. 23 lakh.

However, due to the grandfathering clause, Mr. ABC’s taxable gain would be only Rs. 3 lakh i.e. Rs. 53 lakh – Rs 50 lakh. (Rs. 1 lakh will be exempt and Rs. 2 lakhs will be taxable)

Another Example:

XYZ had made another lump-sum investment of Rs. 15 lakh in shares of another listed company in February 2015. The FMV of the investment on January 31, 2018, was Rs. 4 lakh, and he sold all these shares in June 2019 for a sum of Rs. 10 lakh. In this transaction, XYZ incurred a loss of Rs. 5 lakh ( Rs. 10 lakh – Rs 15 lakh) calculated for tax purposes as per the above-mentioned formula.

You will love to read this too When is NRI Exempt from Filing Income Tax?

In this case, a loss of Rs 5 lakh can be carried forward for eight years and can be set off against long-term capital gains.

Thus, grandfathering clause ensures that the long-term capital gains up to 31st January 2018 are not taxable.