Before we dig into the concept of grandfathering introduced in Union Budget 2018, with respect to Long Term Capital Gains tax (LTCG) on equity shares, let us understand the meaning of capital gains and tax implications on them.
When do you pay capital gains tax?
We pay capital gains tax on assets like shares, property, gold etc. if they are sold at a profit. So, if you buy an apartment at Rs 25 lakhs and sell the same 10 years later at Rs 50 lakhs, you pay tax on the profit made of Rs 25 lakhs.
What is grandfathering when paying Long Term Capital gains tax?
Prior to the announcement of the Union Budget 2018, if an individual sold shares after one year at a profit, he was not subject to any tax on the profits. If you sold shares before 1 year, you would be paying a short-term capital gains tax of 15 percent of the profit. This means equity shares were subject to short-term capital gains tax (sold before 1 year at a profit), but no tax if shares were sold after 1 year at a profit.
The problem arose as every asset class including real estate, gold etc., were subject to long-term capital gains tax, but shares were not. To accord a fair treatment to all asset classes, Finance Minister Arun Jaitley decided to subject equity shares to 10 percent long-term capital gains tax. So, if you sold shares at a profit after 1 year or later you would now be subject to 10 percent tax with effect from April 1, 2018.
However, since the Union Budget comes into effect from April 1, 2018, and the Union Budget was delivered on Feb 1, 2018, there would be large-scale selling between Feb 1 and March 31, 2018, to avoid paying 10 percent capital gains tax.
Therefore, Grandfathering was introduced in the Union Budget 2018, wherein the cut-off date was fixed at Jan 31, 2018. This means your profits are protected until Jan 31, and no tax was payable on them.
Let us cite an example:
Say you bought shares worth Rs 1 lakh on Jan 1, 2016, and the value was Rs 1.5 lakhs as on Jan 31, 2018. If after Jan 31, you sell the shares at a value of Rs 1.75 lakhs (say for example on Feb 21), then you pay tax on Rs 25,000 only (value as on Jan 31 minus sale value as on Feb 21).
Had grandfathering not been introduced, you would be subject to capital gains tax on Rs 75,000 and not Rs 25,000.
However, if you sold the shares at a lower value then that prevailing on Jan 31, no tax is payable. However, you need to remember the value of these shares as on Jan 31, 2018.
This is why grandfathering was introduced, so as to protect your profits, at the same time prevent large-scale selling pressure in shares between Feb 1 (day of announcement) and April 1, 2018 (the day when LTCG becomes applicable).
Also, it was only logical you should not be paying tax, as LTCG was never applicable before the announcement of the Union Budget and hence price protection or grandfathering was a must.