Grandfathering
Also written Grandfathering clause
The Budget 2018 provision that kept long-term gains on equity funds accrued up to 31 January 2018 tax-free, by treating the value on that date as the base for computing taxable gain.
In plain language
Until the Union Budget of 2018, long-term capital gains on equity mutual funds were exempt from tax. The budget made them taxable. Done bluntly, that would have taxed gains investors had already earned while the exemption was in force — effectively taxation with retrospective effect.
To avoid that, the finance minister introduced what came to be known as the grandfathering of capital gains. Gains earned up to 31 January 2018 would not be taxable. For every equity mutual fund investment made before that date, the valuation as on 31 January 2018 becomes the base point, so only appreciation after that date is taxed.
The benefit was given, in the workbook's words, to ensure that the effect of the tax is only prospective and not retrospective.
The word also appears elsewhere in the workbook with a different sense: mutual fund holdings of AT1 and Tier 2 bonds already above SEBI's new limits were "grandfathered" — allowed to stay, with no further investment permitted. Same idea of protecting an existing position, different rule.
How it works
The workbook states the mechanism as: gains for tax are calculated by taking the higher of the purchase price or the NAV as on 31 January 2018.
Its illustration: an investor put Rs 1,00,000 into an equity-oriented fund in 2017, and the investment was worth Rs 2,00,000 on 31 January 2018.
| Scenario | Realised value | Taxable LTCG per workbook |
|---|---|---|
| 1 — sold on 9 February 2018 | Rs 1,80,000 | Zero, since the realised value is below the 31 January 2018 value |
| 2 — sold later | Rs 2,20,000 | Rs 20,000 (Rs 2,20,000 − Rs 2,00,000) |
Note what Scenario 1 does. Applying "the higher of purchase price or 31 January NAV" mechanically would give a cost of Rs 2,00,000 and a loss of Rs 20,000. The workbook instead treats the gain as zero. Grandfathering protects past gains from tax; in the workbook's own example it does not manufacture a loss out of a post-January fall below the grandfathered value. Where the two readings conflict, the worked scenario is the safer guide for a numerical question.
Grandfathering then combines with the current rules: after the grandfathered base is found, long-term gains from equity-oriented funds are taxed at 12.5 per cent above the Rs 1.25 lakh annual exemption (for redemptions on or after 23 July 2024).
The formula
Cost for LTCG (equity fund bought before 1 February 2018)
= higher of { actual purchase price , value on 31 January 2018 }
Taxable LTCG = Sale value − that cost
Workbook Scenario 1: if sale value < value on 31 January 2018
but > purchase price, taxable LTCG = zero
A worked example
Case A — a gain before and after the cut-off. Mr Rao invested Rs 2,00,000 in an equity fund in March 2016 at an NAV of Rs 40, getting 5,000 units. The NAV on 31 January 2018 was Rs 58. He redeems all units at Rs 75. The NAVs are illustrative.
| Without grandfathering | With grandfathering | |
|---|---|---|
| Sale value (5,000 × 75) | Rs 3,75,000 | Rs 3,75,000 |
| Cost used | Rs 2,00,000 (actual) | Rs 2,90,000 (5,000 × 58) |
| LTCG | Rs 1,75,000 | Rs 85,000 |
If this is his only long-term gain in the year, Rs 85,000 is within the Rs 1,25,000 exemption, so the tax is nil. Without grandfathering, Rs 50,000 would have been taxable at 12.5 per cent — Rs 6,250.
Case B — the 31 January value is below cost. Ms Sen bought 4,000 units at Rs 50 (Rs 2,00,000); the NAV on 31 January 2018 was Rs 45 (Rs 1,80,000). She sells at Rs 70 for Rs 2,80,000.
Cost = higher of Rs 2,00,000 and Rs 1,80,000 = Rs 2,00,000
LTCG = 2,80,000 − 2,00,000 = Rs 80,000
Grandfathering never pushes the cost below what she actually paid; it only lifts it where the market had already done so by the cut-off.
Why NISM asks about it
Chapter 8 (Taxation), section 8.2, explains grandfathering with the Rs 1,00,000 / Rs 2,00,000 investment and its two sale scenarios, alongside the Rs 1.25 lakh exemption. Expect the cut-off date (31 January 2018), the reason for the clause (to avoid retrospective taxation), and a numerical question built on the higher-of rule or on the workbook's scenarios.
Common exam traps
- Cut-off date: 31 January 2018. The budget that introduced the tax was 2018; do not confuse the date with 1 April 2018 or 23 July 2024.
- Only gains accrued up to the cut-off are protected. Appreciation after 31 January 2018 is taxable.
- Cost is the higher of actual price and 31 January 2018 value — never the lower.
- The workbook's Scenario 1 gives zero gain, not a loss, when the sale value falls between purchase price and the 31 January 2018 value. That is the workbook's own resolution; follow it in a numerical question.
- Its purpose is to prevent retrospective taxation, not to reduce the tax rate.
- "Grandfathered" AT1 and Tier 2 bond holdings in Chapter 7 are a different rule — excess holdings allowed to stay, with no fresh investment.
Where this is taught
- Series V-A · Chapter 8: Taxationintroduced here
- Series XIX-B · Chapter 9: Taxationintroduced here
- Series X-B · Chapter 11: Taxation of Equity Productsintroduced here
Related terms
- Net Asset ValueThe net assets of a mutual fund scheme divided by the number of units outstanding — what one unit of the scheme is worth on a given day, after every liability except the unitholders' own.
- Bonus strippingBuying units shortly before a bonus issue and selling the originals at the halved NAV to manufacture a capital loss — a loss the Income Tax Act disallows inside a defined 3-month and 9-month window.
- Equity-oriented fundA fund that puts at least 65% of its proceeds into listed domestic equity shares — the tax definition that unlocks the 12.5% long-term rate and the Rs 1,25,000 annual exemption.
- Long Term Capital GainThe gain on mutual fund units sold after the long-term holding period — 12 months for equity-oriented funds, 24 months for most others — taxed at 12.5% on equity funds above a Rs 1.25 lakh yearly exemption.
- Short Term Capital GainThe gain on mutual fund units sold within the holding period — 12 months or less for equity-oriented funds, 24 months or less for most others — taxed at 20% for equity funds and at slab rate otherwise.
- Bonus sharesAdditional shares issued free to existing shareholders in proportion to their holding — no tax at allotment, a nil cost of acquisition, and a fresh holding period from the allotment date.
- Section 87A rebateA tax rebate for resident individuals with total income below a threshold — up to Rs 12,500 (old regime, Rs 5 lakh), and under the new regime up to Rs 25,000 (Rs 7 lakh) or Rs 60,000 (Rs 12 lakh from FY 2025-26).
- FIFO methodThe rule that securities sold from a demat account are deemed to be those that entered the account first — which fixes both their period of holding and their cost of acquisition for capital gains.
- Parallel calculationFor land or buildings bought before 23 July 2024 but sold after, the requirement to compute tax two ways, 20% with indexation and 12.5% without, and pay whichever is lower.
- Unlisted equity sharesShares not listed on any recognised stock exchange in India: the long-term holding period is 24 months rather than 12, long-term gains are taxed at 12.50%, and short-term gains at normal rates.