In 2018, the Indian government introduced a tax on long-term capital gains (LTCG) for the sale of equity shares and mutual funds. Gains exceeding ₹1 lakh were to be taxed at 10%. To ensure fairness, the grandfathering clause was introduced to protect investors from being taxed on gains made before the implementation of the new rule. This clause applies to all equity shares and equity-oriented mutual funds purchased before 1 February 2018.

Key Aspects of the Grandfathering Clause

1. Exemption on Gains Until 31 January 2018

Any profits accrued from shares or mutual funds until 31 January 2018 are tax-free. The clause ensures that gains made prior to this date are not affected by the new LTCG tax law, as these were earned under the previous tax regime, which exempted LTCG from equity investments.

2. Cost of Acquisition (COA) Adjustment

To fairly calculate the taxable gains for shares purchased before 1 February 2018, the cost of acquisition (COA) is adjusted. The COA is determined as the higher of:

• The actual purchase price, or
• The market price on 31 January 2018, also called the Fair Market Value (FMV).

This adjustment allows investors to consider the market value of shares on 31 January 2018 as their cost, which reduces the taxable gains for shares that have appreciated significantly over time.

3. Fair Market Value (FMV) on 31 January 2018

The FMV is the highest traded price of a stock on 31 January 2018. If the stock was not traded on that day, the highest traded price on 30 January 2018 is used. For mutual funds, the FMV is the Net Asset Value (NAV) on 31 January 2018.

Detailed Example to Illustrate the Rule

Let’s consider an example to understand how the grandfathering rule works:

Scenario:

• Purchase Date: March 2016.
• Purchase Price: ₹12,000.
• FMV on 31 January 2018: ₹15,000.
• Sale Date: May 2018.
• Sale Price: ₹18,000.

Step 1: Determine the Cost of Acquisition (COA)

The COA is the higher of:

• The actual purchase price: ₹12,000.
• The FMV on 31 January 2018: ₹15,000.

Thus, the COA for tax calculation purposes is ₹15,000.

Step 2: Calculate Long-Term Capital Gains (LTCG)

LTCG is calculated as the difference between the sale price and the COA:

• LTCG = ₹18,000 - ₹15,000 = ₹3,000.

Step 3: Apply the Tax Rule

• Profits up to 31 January 2018 are exempt.
• The ₹3,000 gain is post-31 January 2018 and is taxable under the new rules if the total LTCG for the financial year exceeds ₹1 lakh.

If total LTCG exceeds ₹1 lakh, the taxable portion is taxed at 10% without indexation.

Why is the Grandfathering Rule Important?

The clause was introduced to protect historical gains. If the government had taxed gains made before the rule was announced, it would have been considered unfair, as investors had no prior knowledge of the tax implications when making their investments. By setting 31 January 2018 as a cut-off date and offering an FMV adjustment, the government provided a smooth transition into the new LTCG tax regime.

How It Works for Mutual Funds

For equity-oriented mutual funds, the same rules apply:

• The FMV is the NAV on 31 January 2018.
• Gains accrued after this date are taxable, but the COA can be adjusted to reflect the NAV on 31 January 2018.

Taxation Details Post Grandfathering

• Pre-31 January 2018 Gains: Fully exempt from tax.
• Post-31 January 2018 Gains: Taxed at 10% if total LTCG exceeds ₹1 lakh in a financial year.

This clause helps ensure fairness and prevent retroactive taxation, giving investors confidence in the market.

Summary

The grandfathering clause in Section 112A is a thoughtful measure designed to ensure that investors are taxed only on gains made after the introduction of the LTCG tax in 2018. By allowing the higher of the actual purchase price or the FMV on 31 January 2018 to be considered as the COA, the rule shields historical gains from tax liability while aligning with the new tax framework. This creates a balanced approach to long-term capital gains taxation, fostering trust and fairness in the Indian equity markets.