Understanding Grandfathering Rules, Provisions: Impact And Importance

Grandfathering in income tax is a privilege granted to certain benefits or rights that were previously enjoyed prior to the change in tax rules. The grandfathering was implemented in the budget of 2018, as the government reintroduced the tax on some long-term capital gains (LTCG) arising from equity funds with the objective of raising revenue.

The provision meant that the gains from equity shares up to 31 January 2018 will be exempt from the new LTCG tax regime.

The rule of grandfathering is given to safeguard people and companies that have already invested in policies and plans as per the current rules of the same. Grandfathering rules indicate that any changes or additional rules will not affect the present policies and their benefits.  

This can be considered a tool used in budgeting, especially to maintain the stability and continuity of current programs and policies. It also avoids harming investors committed to policies based on past benefits and returns.

For example, a government can grandfather the existing pension systems. So, any changes would only apply to newly hired candidates, not current employees who have been promised retirement benefits.

Before Budget 2018, long-term capital gains on listed equity shares, equity-oriented mutual funds and units of business trusts were not taxable, except for certain excluded income.

LTCG tax on the specified equity investments was introduced by the government from 1st April 2018. The new regime has a base tax rate of 10% (without indexation) for LTCG above ₹1 lakh. But the government realised that there had been gains by investors which had been tax-free* under the previous regime.

This grandfathering clause income tax provision was, therefore, added to ensure that the gains of the investments up to 31 January 2018 were not reduced. The concept was to make sure that appreciation prior to the new tax regime is not taxed as a result of the new tax.

A special method was adopted with regards to the cost of acquisition of assets acquired before 1 February 2018. The calculation of the actual acquisition cost and the fair market value (FMV) on 31 January 2018, subject to the prescribed formula.

The grandfathering rule LTCG applies to eligible long-term capital assets acquired before 1 February 2018. It determines a special cost of acquisition so that the appreciation existing up to 31 January 2018 receives protection.

The grandfathering provision Section 112A works through the special cost mechanism under Section 55. For an eligible asset acquired before 1 February 2018, the cost is generally taken as the higher of:

• The actual cost of acquisition; or
• The lower of:
  • FMV as on 31 January 2018, and
  • The actual sale consideration. 

For listed securities, the FMV generally refers to the highest quoted price on a recognised stock exchange on 31 January 2018.

Budget 2024 changes to LTCG

Budget 2024 changed the LTCG tax rate for specified listed equity shares, equity-oriented mutual funds and business trust units covered under Section 112A. The rate was increased from 10% to 12.5%, while the annual exemption threshold was increased from ₹1 lakh to ₹1.25 lakh. The changes apply from 23 July 2024, subject to the applicable transitional provisions.

The current tax framework therefore needs to be considered separately from the original 2018 rules. The grandfathering mechanism, however, continues to determine the cost of eligible assets acquired before 1 February 2018. Current Income Tax Department material also reflects the ₹1.25 lakh Section 112A threshold and 12.5% rate.

Grandfathering: 2018 vs current LTCG framework

Calculating LTCG for shares acquired before 1 February 2018 involves determining the grandfathered cost before calculating the taxable gain.

Step 1: Check the acquisition date

First, establish whether the shares were acquired before 1 February 2018. If they were acquired on or after this date, the special grandfathering mechanism does not apply.

Step 2: Determine the actual purchase cost

Determine the cost amount of shares purchased. This is the actual price of acquisition.

Step 3: Find the FMV as on 31 January 2018

In the case of listed shares, calculate the prescribed FMV at 31 January 2018. This is normally done based on the highest quoted price on a recognised stock exchange on that day.

Step 4: Apply the grandfathering formula

Use the following calculation:

Grandfathered cost = Higher of:

• Actual acquisition cost; or
• Lower of FMV as on 31 January 2018 and sale consideration.

This prevents the entire increase in value from being treated as taxable LTCG when the investment had already appreciated before the new tax regime was introduced.

Step 5: Calculate the LTCG

Once the grandfathered cost has been determined:

LTCG = Sale consideration − Grandfathered cost − Eligible transfer expenses

The resulting LTCG is then considered under the applicable Section 112A provisions.

Simple example

Suppose shares were purchased before 1 February 2018 for ₹80 per share. Their FMV on 31 January 2018 was ₹120, and they were later sold for ₹160.

The grandfathered cost would be the higher of ₹80 and the lower of ₹120 and ₹160. Therefore, the grandfathered cost would be ₹120.

The LTCG would consequently be ₹160 − ₹120 = ₹40 per share, before considering eligible expenses.

The grandfathering benefit equity shares provision primarily protects gains on specified investments that were acquired before 1 February 2018 and fall within the relevant LTCG framework.

Listed equity shares

Listed equity shares can qualify when they meet the applicable conditions under Section 112A. The grandfathering mechanism determines their cost of acquisition using the prescribed 31 January 2018 FMV rules.

Equity-oriented mutual funds

Units of qualifying equity-oriented mutual funds acquired before 1 February 2018 can also be covered by the grandfathering mechanism, subject to the applicable Section 112A conditions.

Units of business trusts

Certain units of business trusts covered by the relevant LTCG provisions may also receive the benefit where the prescribed conditions are satisfied.

Important conditions

The benefit is not simply available because an investment was purchased before 2018. Investors should check:

• Whether the asset falls within the assets covered by Section 112A.
• Whether the investment was acquired before 1 February 2018.
• Whether the applicable STT and other statutory conditions are satisfied.
• Whether the transaction qualifies as a long-term capital asset under the applicable rules.
• The prescribed FMV as on 31 January 2018.

The grandfathering clause income tax framework is therefore primarily designed to protect pre-existing appreciation rather than provide a blanket exemption from LTCG tax. The underlying Section 112A framework and prescribed cost-of-acquisition rules determine how the benefit is applied.

The impact of grandfathering provisions differs on the situations in which it is used. For instance, the rules usually safeguard individuals and organisations already invested in a particular policy. And it offers continuity toward the benefits of current programs or policies.

Hence, if grandfathering rules don’t apply to an individual or Company, they will be liable to pay the new tax rates or have to comply with the new laws or modifications. This can lead to a reduction in benefits, instability, and uncertainty for such investors.

The impact of grandfathering provisions also differs based on the new laws and policies introduced and on the benefit or provision being grandfathered. Apart from gaining stability for investors, assessing the benefits and downsides of applying the grandfathering rules is important.

Investors must pay attention to grandfathering rules as they impact the taxation of their assets and the gains they will earn.

One of the important features of grandfathering rules is that the investments made before the legislation is adopted can be excluded or grandfathered in from the new tax policies or regulations. Hence, instead of being taxed at the latest and higher rate, the gains on excluded investments will be liable to lower previous tax rates.

The grandfathering rules offer stability and confidence to investors, especially in cases where the investors have made long-term investments based on the previous tax and gain rates, unaware of possible changes in taxation. So, grandfathering rules stimulate these long-term investments and ensure lower risk.

The grandfathering rule in income tax is a provision that excludes new taxation rules or provisions from current investment policies and their benefits. While grandfathering offers continuity and stability, it also safeguards individuals and companies that have invested in specific schemes based on its low tax rates or benefits.

However, the grandfathering provisions have harmful or beneficial effects on long-term capital gains and budgeting. Depending on how resource allocation takes place and what is the ultimate cost of the policies and programs in question.

Moreover, if one sells their holdings after 31 March, they can book their long-term losses. Earlier, there was no benefit provided if one incurred a loss on equity funds or stocks held over a year. But with grandfathering rules, it is allowed.