Bonus stripping in Income Tax Act refers to a strategy once used by investors to reduce capital gains tax by leveraging bonus issues in shares or mutual funds. However, after the amendment to Section 94(8) of the Income Tax Act by the Finance Act, 2022, such tax advantages have been largely curtailed. This article explains the concept of bonus stripping, the working mechanism, changes introduced by the law, and how investors should now approach bonus-based transactions.
The concept of Bonus Stripping
Bonus Stripping is a strategy commonly used by some investors to reduce the tax burden under the Income Tax. Under a Bonus Stripping Agreement, the person who wishes for a reduction of the tax burden applicable to his assessment purchases stocks prior to the record date and sells off the units after the record date, when the unit becomes ex-bonus.
In bonus stripping, the investors acquire shares or units of a mutual fund before the record date of a bonus issue. Once bonus units are issued, the investors sell the original units they had held earlier. This action typically results in a short-term capital loss, while the bonus units are retained for future sale, often at a concessional long-term capital gains tax rate after holding for at least one year. Later, they dispose of the bonus units.
As the person is holding the units on the record date, they are eligible for additional units declared by the company without payment of any additional amount. Due to Bonus Stripping, a person can get dual benefits: firstly, they receive additional units free of cost by holding units on the record date; secondly, they sell the original units after the record date at the ex-bonus price. Earlier, the loss incurred on the sale of the original units could be set off or carried forward, but under the amended law, this benefit is restricted.
Now, if an investor acquires shares or units within 3 months prior to the record date and sells all or part of the original holdings within 9 months after the record date, any capital loss on such sale is ignored for tax purposes and cannot be set off or carried forward immediately. Instead, this loss is treated as the cost of acquisition for the bonus units or shares received. This rule applies to both mutual fund units and listed company shares. Consequently, the immediate benefit of bonus stripping for tax set-offs has been limited, as such losses can no longer be booked immediately and are instead deferred to the eventual sale of the bonus units.
How Bonus Stripping Works?
- The investor purchases shares or mutual fund units just before the record date for the bonus issue.
- Bonus units or shares are allotted free of cost to those who hold units on the record date.
- After receiving the bonus units, the investor sells off the original units, usually at a reduced price.
- This sale creates a short-term capital loss, which, under earlier rules, could be set off against other capital gains to reduce overall tax liability.
- Later, the investor may sell the bonus units, often after one year, enjoying lower long-term capital gains tax rates.
Changes in Tax Law: Section 94(8)
Section 94(8) of the Income Tax Act was significantly amended by the Finance Act, 2022. Before April 2023, anti-avoidance provisions under this section applied only to units of mutual funds and did not cover shares. From 1st April 2023 onward, the scope has expanded to include both “securities and units,” covering listed equity shares, Exchange Traded Funds (ETFs), index funds, and open-ended mutual fund schemes.
Income Tax Implications on Bonus Stripping
If an investor acquires shares or mutual fund units within three months before the record date for a bonus issue, and sells any or all of the original shares/units within nine months after the record date, the resulting loss on the sale will be ignored for tax calculation. This means the investor cannot set off or carry forward such losses. Instead, these disallowed losses are treated as the acquisition cost of the bonus shares/units ultimately received.
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- The expanded Section 94(8) now applies to all taxpayers—individuals, firms, and companies—and includes not only mutual funds but also listed shares and other securities such as ETFs.
- Attempts to gain dual tax benefits through bonus stripping (set-off of short-term losses and concessional taxation of bonus units) are effectively blocked by these rules.
- The main objective is to prevent the artificial creation of tax-deductible capital losses and improve the integrity of the tax system.
- Taxpayers should recognize that any loss ignored under this law shall be assumed as the purchase cost of the bonus shares/units, deferring potential tax benefits to future sales rather than eliminating them.
Example
Suppose an investor buys 10,000 mutual fund units three weeks before the record date at ₹50 per unit and a 1:1 bonus is declared. If the investor sells the original units after the bonus issue at ₹35 per unit, a short-term capital loss is created. Under amended Section 94(8), this loss is ignored for immediate tax purposes and becomes the cost of the bonus units.
Conclusion
The recent regulatory changes have made bonus stripping an ineffective strategy for immediate tax avoidance on both mutual funds and listed shares. With the expanded scope of Section 94(8) of the Income Tax Act, investors can no longer claim short-term capital losses arising from such transactions for immediate set-off or carry forward. Instead, these losses are deferred and treated as the cost of acquisition of bonus units or shares, thereby limiting the dual tax benefits previously gained through bonus stripping.
As a result, investors should shift their focus away from artificial loss creation and short-term tax planning, and instead adopt investment decisions based on long-term financial objectives. The tax authorities vigilantly monitor bonus stripping arrangements to curb misuse and protect government revenue.
Ultimately, investors indulging in bonus stripping with the sole intent of saving taxes are likely to get caught under the purview of Section 94(8). Therefore, making investments with a genuine long-term perspective not only aligns with regulatory compliance but is also a safer and more prudent approach for sustainable wealth creation.
