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Bonus Stripping

by | May 6, 2024 | Income Tax, Income from Trading | 0 comments

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Important Keyword: bonus issue, bonus stripping, Section 94(8), tax evasion.

Bonus Stripping

A bonus offering, also referred to as a bonus allotment or bonus share offering, occurs when a corporation issues additional shares to its present stockholders at no additional expense. These bonus shares are distributed based on the proportion of shares each shareholder already possesses. Unlike raising capital, the primary objective of a bonus offering is to capitalize on the company’s reserves and surplus. By converting these reserves into share capital, the company increases the total number of outstanding shares without diminishing the ownership percentage of existing shareholders.

What is Bonus Stripping?

When an investor purchases shares of a company anticipating a forthcoming bonus share issuance and then sells the original shares post-receipt of the bonus shares, this strategy is termed as Bonus Stripping. Here’s how the process unfolds:

  1. The investor learns about an upcoming bonus share issuance by a company.
  2. Consequently, they acquire shares of the said company.
  3. Upon the bonus issue announcement, the investor receives additional shares as per the bonus issue ratio.
  4. Subsequently, they sell the initial shares post-bonus issuance at a reduced share price, incurring a short-term capital loss.
  5. The investor retains the bonus shares for over a year, leading to long-term capital gains.

Bonus Stripping was previously utilized by investors to mitigate taxes on capital gains income. However, with the amendment to Section 94(8) of the Income Tax Act introduced in Budget 2022, the government aims to curb this practice. The revised provision is set to be effective from April 1, 2023, thereby eliminating Bonus Stripping as a tax evasion strategy.

Benefits of Bonus Stripping for the Investor:

  1. Taxpayers can offset short-term capital losses from the sale of original shares against other capital gains, thereby reducing their tax liability.
  2. Long-term capital gains from the sale of bonus shares are exempt up to INR 1 lakh and taxed at a rate of 10% thereafter.
  3. Overall, investors stand to gain higher profits from the transaction while paying reduced taxes.

Example of Bonus Stripping:

Mr. A learns about Company XYZ’s plan to issue bonus shares. He purchases 50 units of mutual funds at INR 1000 each, investing INR 50,000. Upon the bonus issue announcement with a 1:1 ratio, Mr. A receives an additional 50 units as a bonus, making his total holdings worth INR 1,00,000. However, post-bonus issuance, the share price declines to INR 500, prompting him to sell the initial 50 shares. Subsequently, in the subsequent financial year, Mr. A sells the bonus 50 shares at INR 1200 each.

HoldingsNo. of SharesBuy PriceSale PriceProfit/LossGain type
Original Shares5050,00025,000(25,000)STCL
Bonus Shares50060,00060,000LTCG

Thus, in this scenario, Mr. A reaped the following benefits:

  1. Earned a net profit of INR 35,000 from the entire transaction.
  2. The short-term capital loss (STCL) incurred from the sale of original shares was utilized to offset other capital gains, including both short-term capital gains (STCG) and long-term capital gains (LTCG).
  3. The long-term capital gains (LTCG) amounting to INR 60,000 remained exempt from tax under Section 112A.
  4. Achieved profits without incurring tax liabilities.

Budget Amendment – Section 94(8) of the Income Tax Act

To combat tax evasion through Bonus Stripping, the finance minister introduced an amendment to Section 94(8) under Budget 2022.

The existing Section 94(8) of the Income Tax Act already monitored bonus stripping transactions concerning mutual fund units. With the Budget 2022 amendment, Section 94(8) extends its scope to cover both securities and mutual fund units, effective from April 1, 2023.

As per the revised Section 94(8), if:

  1. An investor purchases mutual fund units within three months preceding the record date of the bonus issue.
  2. The investor sells all or any of the original shares within nine months following the record date of the bonus issue.

Then, any loss incurred from such transactions will be disregarded for capital gains calculation. Consequently, the investor cannot claim a loss on such sales, and the loss amount will be considered as the purchase price for the bonus shares acquired.

In the earlier example, the STCL of INR 25,000 would not be factored into tax calculation. Instead, the loss of INR 25,000 would be considered the acquisition cost for the bonus shares.

Let’s illustrate this amendment with another example:

Nippon Mutual Funds declare a 1:1 bonus issue on its units on June 30, 2023. The record date for the bonus units is July 31, 2023. An investor purchases 10,000 original units on July 7, 2023, at INR 50 per unit. Subsequently, they sell 10,000 original units on November 15, 2023, at INR 35 per unit, and 7,000 units on November 20, 2023, at INR 35 per unit.

Hence, in this case, section 94(8) will apply and the calculation of capital gains will be as below:

ParticularsOriginal Units (10,000)Bonus Units (7,000)
Sales value3,50,0002,45,000
Cost of Acquisition5,00,0001,05,000
Short-Term Capital Gain/Loss(1,50,000)1,40,000

Note: The cost of acquisition of bonus shares = (STCL of original units) * Number of bonus shares acquired / Total number of original units sold = 1,50,000 * 7,000 / 10,000 = 1,05,000.

Here, according to Section 94(8), the short-term loss of INR 1,50,000 will not be considered while calculating the total income of the investor. Further, such losses cannot be set off or carried forward to future years.

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Official Income Tax Return filing website: https://incometaxindia.gov.in/

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