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Sometimes companies issue fresh units to the existing shareholders without any consideration in exchange for the same. This practice is called as Bonus Issue.
Bonus issue is done by way of profit appropriation (allocation). A company will distribute profits by way of issuing additional units instead of distributing the company’s profits by way of dividend. As such, a bonus issue does not have any tax implications on either the company issuing it or on the recipient of bonus units. However, there are investors who smartly utilize a bonus issue as a tax planning tool. Let us see how this works.
Investors mainly indulge in bonus stripping as a mechanism to evade income taxes. Dividend stripping is another means to achieve the same. However, bonus stripping is a situation when purchase or sale of units of a mutual fund is transacted in a manner, which would result in short term capital loss that can be adjusted against any other capital gains.
In bonus stripping, the investors acquire units before the mutual fund company makes any bonus issue. Once they issue the bonus units, the investors sell the original units, which they had held earlier. This can lead to short term capital loss. Later, after one year, they dispose of the bonus units. Hence, investors enjoy two-fold benefits.
One benefit is the short term capital loss for the sale of original units, which is available for set off against any capital gains. The other is the benefit of a concessional rate of tax of 10% of the long term gains made on the same of the bonus units.
Let us understand the concept of Bonus stripping by way of an example
In this case, Mr A can first set off the short term losses made from original units held, against the long term capital gains made from the sale of bonus units. Subsequently, if the capital gains remaining after set off is greater than Rs 1 lakh, he would be taxed on it at the rate of 10% only.
As a check on the activity of bonus stripping, provisions under Section 94(8) of the Income-tax Act, 1961 were introduced into the statute books. According to this section, if a person:
the taxpayer will not be allowed to book the loss on such sale transaction. Moreover, such losses would be considered as the Purchase Price of the bonus units acquired.
It is important to note, the above-mentioned provision (Section 94(8)) is applicable only in case of mutual fund units. It is not applicable with respect to shares of a company.
To conclude, investors purchasing units with a very narrow idea of saving taxes and indulging in bonus stripping would get caught under the provisions of Section 94(8) of the Income-tax Act, 1961. Accordingly, investment made with a long term objective in mind would definitely be a safer bet.