Tax rules keep changing, and these changes can sometimes impact your tax liabilities. But what will happen if you have made any investment before the change in rules? Then how will you manage your tax liabilities? To manage such tax liabilities, the government has introduced the Grandfathering Rule.
In today’s blog post, we will give you an overview of the grandfathering rule, why it is applied and how it works through an example.
Grandfathering Meaning
Grandfathering in Income Tax is a provision specified by income tax authorities to protect certain gains made before a change in tax law from being taxed unfavourably under the new laws. Simply put, it allows taxpayers to retain a tax benefit on investments made before a specified date.
In India, it is particularly related to long-term capital gains on the purchase of equity and equity-related mutual funds. This was introduced when the government brought in LTCG on such investments in the Union Budget 2018.
Why is the grandfathering rule applied?
This rule is applied to protect against the adverse impact of changes in tax laws. The key reasons why it was introduced are as follows:
- Protecting Existing Investors: Investors who have accumulated significant gains on the purchases of equity and equity-related mutual funds before 1st Feb 2018; such gains were exempted till 31st Jan 2018.
- Fairness: Tax rules are changed over time. And the provision of grandfathering helps in ensuring that only eligible investments are considered for tax purposes.
- Smooth Transition: Once the new tax rules are implemented, the government tries to introduce such changes while reducing the impact on investors who already held such investments.
Rule Under Section 112A
Section 112A of the Income Tax Act 1961 defines the taxation of long-term capital gains arising from the sale of equity shares and equity-related mutual funds.
- Investments Covered Under Section 112A: The key investments covered under Section 112A are equity shares of a company that is listed on a stock exchange, units of an equity-oriented mutual fund, and units of a business trust.
- Tax Rules: The tax rate is 12.5% on eligible long-term capital gains exceeding 1.25 Lakh INR in a financial year.
- The Rule of Grandfathering: It is important for eligible investments acquired before 1st February 2018. Under Section 55(2)(ac).
How Grandfathering Works
The steps for how grandfathering works are as follows:
- Identification of Purchase Cost: The first step is to identify the original cost of acquisition of the investment. This is usually the amount an investor actually paid to purchase the shares or mutual fund units.
- Calculating the Fair Value: The next step is to identify the market value of the investment as on 31st January 2018. This date was introduced by the government to provide for the LTCG changes.
- Comparing the Fair Market Value: Once you identify the fair market value as of 31st Jan 2018, then you need to compare it with the actual sale price of the investment.
- Cost of Acquisition: Once the lower amount is identified, compare it with the initial cost. Then the cost of the acquisition formula needs to be implemented.
- Calculating Gain: The last step will be calculating the capital gain by deducting the cost of acquisition from the sale proceeds.
Formula of the Grandfathering Rule
The formula to calculate Capital Gain using the grandfathering rule is as follows:
Capital Gain = Sale Value – Indexed Cost of Acquisition
And the formula to calculate the cost of acquisition is as follows:
Indexed Cost of Acquisition = Cost of Acquisition * (CII of Year of Sale/CII of Year of Purchase)
Example of the Grandfathering Rule
Let’s understand the grandfathering rule through an example.
Mr A purchased shares of ABC Limited in 2016 for INR 1,00,000. By 31st January 2018, the value of such investment had increased to INR 3,00,000. The investor sold the shares in January 2026 for INR 5,00,000.
Read Also: Silver Taxation in India
Difference Between Grandfathering and Regular Capital Gain Calculation
The key differences between grandfathering and regular capital gain are as follows:
| Particulars | Grandfathering | Regular Capital Gain |
|---|---|---|
| Use | It is used only when the eligible investments were acquired before 1st February 2018. | Investments are calculated according to the applicable capital gains provisions. |
| Cost of Acquisition | The cost of acquisition is determined using the grandfathering formula. | It is generally based on the actual cost of acquisition. |
| Market Value | The fair market value is considered based on 31st January 2018. | Fair market value is not generally used to determine cost under regular capital gains. |
| Objective | The grandfathering clause is defined to protect eligible gains accumulated before the tax changes. | Calculates taxable capital gains according to applicable tax rules. |
Benefits of the Grandfathering Rule
The key benefit of the grandfathering rule is as follows:
- Protect Gains: The key benefit of the grandfathering rule is that it protects eligible gains accumulated up to 31st January 2018. As the government reintroduced LTCG tax on eligible equity investments in 2018, it helped prevent investors from being taxed on entire gains.
- Reduce Tax: The grandfathering rule can help investors reduce capital gains tax by lowering the cost of acquisition based on the prescribed formula.
- Fairness During Tax Changes: The laws related to tax over time can affect investments made under earlier rules. Grandfathering ensures that only eligible capital gains are considered for taxation.
Conclusion
On a concluding note, grandfathering is a key provision implemented by Income Tax authorities to protect the interests of investors from the impact of changes in capital gains provisions. The long-term capital gains tax was reintroduced by the government in 2018, and after that it became difficult for the investors who purchased equity shares and equity-oriented mutual funds before 1st February 2018 to calculate their cost of acquisition. This can reduce the tax liability of the investor arising because of changes in regulations. However, to understand its formula and the provisions defined under section 112A is important when making any calculation of capital gain; therefore, it is advisable to consult your investment and tax advisor.
Frequently Asked Questions (FAQs)
What is grandfathering?
The grandfathering rule in mutual funds is a provision introduced by income tax authorities to protect the interests of investors after long-term capital gains tax was reintroduced by the Government of India. It protects eligible capital gains accumulated before a specific date when tax law changes.
What is the cutoff date for the grandfathering rule in mutual funds?
The cutoff date for the mutual fund grandfathering rule is 31st January 2018. The rule is applicable to the eligible investments made on or before this specific date.
Name the investments that are eligible for the grandfathering rule?
The eligible investments that are eligible for the grandfathering rules include listed equity shares, units of equity-oriented mutual funds, units of trusts, etc.
Can we still use the grandfathering rule in mutual funds?
Yes, one can use the grandfathering rule in equity-oriented mutual funds, as it remains relevant when calculating capital gains on eligible investments acquired before 1st Feb 2018 and sold later.
How will the value be calculated if the sale price is lower than the fair market value on 31st January 2018?
According to the formula, it uses the lower of the sale consideration and the fair market value, and compares the amount with the original acquisition cost. This means the deemed cost can never exceed the sale price under the formula, and the calculation results in no capital gain.
