As most investors might be aware, long term capital gains (LTCG) i.e. gains made post selling listed equity shares and equity oriented mutual funds at least one year after buying are now taxed at 10 per cent. However, that was not the case earlier. Prior to 2018, such LTCG was completely exempt from the tax proceedings. To protect the interests of investors who went in for listed equity shares prior to 2018, a grandfathering clause was announced by the Finance Minister during Budget 2018. Typically, a grandfather clause is a provision wherein an old rule continues to apply to some existing situations while a new rule applies to all future cases. Here, we look at how the grandfathering provision works in the case of taxing LTCG.
Tax implications
To compute capital gains, one basic thing is to calculate the difference of the stock price/NAV of a mutual fund at which the security is sold and the cost at which it was purchased. Typically, the cost of acquisition is considered as the one at which share was actually purchased, but if that would be the case, investors who purchased the security way before 2018 and have accumulated mounting gains by then would be facing the brunt of the new law.
Grandfathering comes to their rescue. Under grandfathering provisions, the deemed cost of acquisition shall be considered as the higher of (1) actual cost of buying and (2) lower of the market value on January 31, 2018, and price at which the security is sold. The difference between sale price and deemed acquisition cost is considered to compute long term capital gain or loss. Here are a few scenarios to illustrate this.
Let’s say you bought 1,000 shares of stock A worth ₹1,00,000 on July 1, 2018 (Scenario A in the table). The market value of those shares as on January 31, 2018, was ₹1,30,000 while you sold them for ₹1,60,000 on, say, July 11, 2023. Here the cost of acquisition will be considered as ₹1,30,000 (higher of ₹1,00,000 or ₹1,30,000) and thereby LTCG comes to ₹30,000 (1,60,000 – 1,30,000).
Now, considering another Scenario D, let’s say you bought 1,000 shares on July 1, 2016, worth ₹1,50,000. The market value of those shares on January 31, 2018, was ₹2,00,000 which, however, dipped to ₹80,000 when you sold the shares. In this case, ₹1,50,000 would be considered the cost of acquisition, resulting in long term capital loss of ₹70,000 (1,50,000 – 80,000).
You can compute in this manner for each of your equity stocks and equity oriented mutual funds sold in the year cited in the table. Consequently, if total long term capital gains come to more than ₹1,00,000, that excess amount over and above ₹1,00,000 will be taxed at 10 per cent.
Investor takeaways
In a nutshell, the grandfathering provisions attempt to protect investors’ gains from being taxed prior to the announcement of the new LTCG tax rules while at the same time, i an arbitrary loss situation is avoided as seen in Scenarios C,D and E.
It is important for investors who have made equity related investments to understand the grandfathering provisions as it can help them for tax planning purposes. While gains made before 2018 are not considered for taxation purposes long term capital losses when realised can be considered for the same. Hence, one can use tax loss harvesting concept and set off the realised long term losses against the gains. Do note that the long term capital loss can be set off only against LTCG while short-term capital losses are allowed to be set off against both LTCG and STCG and the losses can be carried forward till eight years for set-off.
While the grandfathered price (highest price at which a particular equity security traded on January 31, 2018) is readily available, ultimately it is the investor’s job to keep handy the actual cost of the equity securities acquired before 2018, be it equity SIPs, lumpsum equity MF investments or listed shares, for whichever they want to book gains/losses. In certain cases, they might have to take help from their broker or MF distributor.