Bonus Stripping: Meaning, Concept & Tax Implications

Companies and mutual funds have two ways to distribute their profits amongst their shareholders: (1) by distribution of Dividends and (2) By Issuance of Bonus Shares. Transactions of dividend distribution attract tax, so many companies and mutual funds distribute their profits by way of the issuance of additional shares/units without any cost to the recipient.

What is a Bonus Issue?

The bonus issue is done through profit appropriation (allocation). A company will distribute profits by issuing additional units instead of distributing the company’s profits by way of dividends. As such, a bonus issue has no tax implications on either the company issuing it or the recipient of bonus units. However, some investors smartly utilise a bonus issue as a tax planning tool. Let us see how this works.

The Concept of Bonus Stripping

Investors mainly indulge in bonus stripping as a mechanism to evade income taxes. Dividend stripping is another means to achieve this. However, bonus stripping is when the purchase or sale of units of a mutual fund is transacted in a manner that would result in short-term capital loss that can be adjusted against any other capital gains.

Bonus stripping is a technique whereby an Investor acquires units (referred to as original units) of the mutual fund sometime before the issuance of bonus units. Once the mutual funds issue bonus units, the Investor sells the original units and thereby incurs a loss on the original units. The investor keeps the bonus units with themselves for a period of 1 year so that they can avail themselves of the lower tax rate of 10%  (increased to 12.5% from FY 24-25) on long-term capital gains. Hence, investors enjoy two-fold benefits.

One benefit is the short-term capital loss on selling original units, which can be set off against any capital gains. The other is a concessional tax rate of 10% on the long-term gains made on the sale of the bonus units after one year.

Income tax Implications on Bonus Stripping

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:

• acquires units/shares within three months before the record date
• on which bonus units/shares are subsequently announced,
• and the original units/shares are sold within nine months from the record date

The loss incurred by the taxpayer on the sale of original units/shares will be ignored for the calculation of income tax (i.e., the taxpayer is not allowed to book the loss on such a sale transaction). However, such losses would be considered the Cost of Acquisition / Purchase Price for the bonus units/shares acquired.

It is important to note that until the Finance Budget 2022, the above-mentioned provision (Section 94(8)) was applicable only to mutual fund units. It did not apply to company shares. Now, it applies to units as well as shares.

Illustration

Let us understand the concept of bonus stripping by way of an example

• Mr. A identified that a mutual fund X will issue bonus units in the ratio of 1:1.
• Before the record date, he acquired 500 units (original units) of the mutual fund. On the date of Mr. A's acquisition, the price of the units was Rs.1000/-. Hence, the total acquisition cost for units was Rs.5,00,000/-.
• On the record date of a bonus issue, he will receive one bonus unit for every unit held. Hence, Mr A would receive 500 bonus units. After the bonus issue, the market value of the units will decline. Each unit will be worth Rs 500/- (i.e., half the original price as the bonus issue was in the ratio of 1:1). 
• Now, Mr. A sells the 500 original units at Rs. 500/—, which were purchased for Rs. 1,000/—per unit. Thus, he loses Rs.2,50,000 on the sale of the original units.
• Later, after a year, he sells the bonus units. Since the cost of acquiring bonus units is Nil, the entire proceeds received from the sale of bonus units would be his long-term capital gains.

In this case, Mr. A can first set off the short-term losses made from the original units held against the other long-term capital gains. Subsequently, if the capital gains remaining after set off are greater than Rs. 1 lakh, he would be taxed on them at the rate of 12.5%% only.

Hence in this scenario where an investor, Mr A, experiences a Short-Term Capital Loss (STCL) of Rs. 2.5 lakh in the specified bonus stripping transaction (i.e., purchase and sale of shares/units within the stipulated timeline). According to the amended Section 94(8), this loss will not be factored into tax calculations. Mr. A cannot offset this loss; instead, the entire Rs. 2.5 lakh will be considered as the acquisition cost for the bonus shares that were subsequently sold. Hence, it aims to curb the misuse of bonus-stripping strategies and enhance the tax system's integrity.  

To conclude, investors purchasing units/shares 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, an investment made with a long-term objective in mind would definitely be a safer bet.