What is Bonus Stripping? How does it help in saving tax?

Before getting into ‘Bonus stripping’ let us understand the concept of ‘bonus issue’. Generally, a company provides dividends to shareholders as returns paid for investments. In some cases instead of issuing a dividend, the company would provide additional bonus shares to existing shareholders as compensation for profit appropriation which is termed as ‘Bonus Issue’.

For example, company A has an existing share capital of Rs. 5,00,000 distributed amongst 100 shareholders for a face value of Rs. 5,000 per share. The dividend payable for each shareholder is supposedly 5,000 Rs. per share but instead of paying Rs. 5,000 the company offers an additional share that values Rs. 5,000.

By making bonus issue to the shareholders, the company subtly saves itself from dividend distribution tax. The shareholders also utilize bonus issues as a way to passively reduce tax burden through a process called Bonus Stripping.

What is Bonus Stripping?

An investor buys shares in a company knowing that the company is set to make bonus issues to its existing shareholders and sells the original share after acquiring the bonus issue, This is called bonus stripping.

In a bonus stripping arrangement, the investor sells the original unit for a short term capital loss but gets his hands-on two kinds of benefits,

• He receives additional shares as a bonus issue and sells them after one year and claims the benefits of LTCG (long-term capital gain).
• The incurred short-term capital loss becomes eligible for a set-off, where he can adjust the loss with tax payable and get a certain tax exemption.

Same way, the bonus stripping arrangement is also plausible with mutual fund holders. The distributable surplus can be offered as bonus units to mutual fund holders, where he can exercise the bonus stripping arrangement and become eligible for tax adjustments for the short-term capital loss and get his hands on capital gain, post selling the bonus units.

How does bonus stripping work?

Let us help you understand bonus stripping with an illustration.

For example, a potential investor Ms. X is acknowledged that company A is set to make the bonus issue to its shareholders for the financial year 2021, on a 1:1 ratio.

Now, Ms. X buys 100 units of shares in company A, each unit valuing Rs. 1,000. Ms. X holds shares worth Rs. 1,00,000.

On the date of the bonus issue, the company issues 100 shares to Ms. X as bonus units. Now she holds the original units valuing Rs. 1,00,000 and bonus units valuing 1,00,000, so a total of Rs. 2,00,000.

It is inevitable that the market price for the shares reduce after the company makes the bonus issue. Now the shares value Rs. 500 each.

After acquiring the bonus shares, she sells the original units 100 shares for Rs. 50,000, incurring a short-term capital loss of Rs. 50,000.

In the next financial year, she sells the bonus units. As she has not bought the bonus units making any payment, the selling price is her long-term capital gain.

Bonus stripping in the Income-tax act

Bonus stripping is not legal in India, to avoid the occurrence of bonus stripping, the income tax act has enforced certain provisions that indirectly keep a check over such arrangement.

These provisions are found under section 94(8) of the Income Tax Act which specifies that,

• In order to claim a short-term capital loss, the acquired share units must be purchased 3 months prior to the date of bonus issue.
• The share units must be sold within 9 months, after the date of the bonus issue.

In such cases, shareholders are not entitled to book the loss on sale of shares and additionally, this loss will be considered as the purchase price of the bonus units acquired.

Risks involved in bonus stripping, that the shareholder must watch out

Bonus stripping could be a beneficial way to reduce the tax burden if you are worried about the tax rates for the capital gains on stock, property, or jewelry for a particular financial year.

Using bonus stripping as a tool can help you reduce the taxable amount to an extent, but it does involve tedious procedures and risks of complying with the restrictive provisions.

One of the major risks that might make you end in bane rather than boon is the possibility to be taxed for short-term capital gains.

The acquisition price of the bonus share is considered zero, in India. Selling them before one year from the date of bonus issue would attract 15% short-term capital gains tax.

Also, keep in mind that if the shares are held more than a period of one year, post the date of the bonus issue, it will be treated as long term capital loss