Bonus Stripping was a common practice amongst investors to save taxes on capital gains income. Bonus Stripping means buying shares of a company planning for a bonus issue and selling the original shares after receiving bonus shares to earn more profits and pay less tax. However, under Budget 2022, the government made an amendment to Section 94(8) of the Income Tax Act to stop the practice of Bonus Stripping. The amended provision shall be applicable from 1st April 2023. As a result, bonus stripping would not be an option to evade taxes anymore.
What is Bonus Stripping?
When an investor buys shares of a company that is planning to announce issues of bonus shares and sells the original shares after receiving shares under the bonus issue, this practice is known as Bonus Stripping. Here are the stages of bonus stripping:
- Investor has news of a company set to issue bonus shares to existing shareholders
- Investor buys shares of the said company
- Under the bonus issue, the investor receives bonus shares as per the bonus issue ratio
- Investor sells the original shares after the bonus issue at the reduced share price after the bonus and thus incurs a short term capital loss
- The investor sells the bonus shares after a year and thus earns a long term capital gain
Benefits of Bonus Stripping for the Investor
The investor gets the following benefits from bonus stripping:
- The STCL on the sale of original shares can be set off against other capital gains income, both STCG, and LTCG, and thus leads to a reduction in tax liability
- The LTCG on the sale of bonus shares is exempt up to INR 1 lac and taxable at a rate of 10%
- Out of the entire transaction, the investor ends up earning more profits and paying less tax on it
Example of Bonus Stripping
Mr. A came to know about the news of the bonus issue by Company XYZ. Mr. A buys 50 shares at INR 1000 thus having invested INR 50,000. Under the bonus issue with a ratio of 1:1, the company issues 50 shares to Mr. A as bonus shares. Mr. A now holds 100 shares valuing INR 1,00,000.
As a result of the bonus issue, the share price drops to INR 500. Mr. A sells the original 50 shares and incurs a Short Term Capital Loss (STCL) of INR 25,000. In the next financial year, Mr. A sells the bonus 50 shares at the rate of INR 1200 and earns a Long Term Capital Gain (LTCG) of INR 60,000 considering the cost of acquisition of bonus shares is zero.
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As a result of Bonus Stripping, Mr. A got the following benefits:
- Earned Net Profit of INR 35,000 on the entire transaction
- The STCL incurred on the sale of original shares was set off against other capital gains, both STCG and LTCG
- The LTCG of INR 60,000 is exempt from tax under Section 112A
- Earned profits without paying taxes
Budget Amendment – Section 94(8) of Income Tax Act
To avoid the practice of tax evasion using 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 kept a check on the bonus stripping transactions in the case of mutual fund units. Under Budget 2022, Section 94(8) was amended with effect from 1st April 2023. As per the amendment, the word ‘units’ shall be substituted by the word ‘securities and units’. Thus, this section now applies to both units of mutual funds and equity shares too.
As per Section 94(8), if:
- An investor buys mutual fund units within a period of 3 months prior to the record date of the bonus issue AND
- The investor sells all or any of the original shares within a period of 9 months after the record date of the bonus issue
Any loss incurred on the above transaction shall be ignored for the purpose of calculating capital gains. Thus, the investor will not be able to book the loss on such a sale transaction. Further, such loss would be considered as a purchase price for the bonus shares acquired.
In the above example, the STCL of INR 25,000 will be ignored for purpose of tax calculation. Mr. A will not be able to set off such a loss. Instead, INR 25,000 would be treated as the cost of acquisition for the bonus shares sold.
Bonus Stripping is the practice of buying shares of a company or units of a mutual fund with an intention to acquire bonus shares or units as a result of a bonus issue. The investor then sells the original shares or units to set off loss against other capital gains. Further, the investor sells bonus shares to earn long-term capital gains and pay tax at a reduced rate of 10%. This practice of earning profits from bonus issue but paying no tax or reduced tax on it is called bonus stripping.
Bonus Stripping is not legal in India. Section 94(8) of the Income Tax Act lays down conditions to check bonus stripping in the case of equity shares and units of mutual funds in India.
Under Budget 2022, an amendment was made to Section 94(8) of the Income Tax Act. The word ‘units’ was substituted by ‘securities and units’. Thus, Bonus Stripping in the case of both equity shares and units of mutual funds can now be restricted through Section 94(8). This amendment would come into effect from 1st April 2023.