How the new 'bonus stripping' rule in Budget impacts investors

Investors were so far able to reduce their capital gains tax by using a tool called ‘bonus stripping’. But now this tool becomes unavailable as the government has made the entire exercise a futile one by making an amendment in the Income Tax Act, as announced in the Budget. Bonus Stripping will no longer be available from 1st April, 2022. Let us understand what this was all about.

What is Bonus Stripping?
An investor would buy shares of a company which was about to issue bonus shares to its shareholders. Generally, the shares were bought after the announcement but before the record date. Post the record date, the share price would drop to make adjustment for the ex-bonus price. At that time, the investor would sell the original shares and thereby book a loss, as the income tax department follows the first in first out (FIFO) method to determine profit/loss. The investor would get two benefits from this:

1. The short-term loss incurred after selling the original shares could be used to set-off any other capital gain.
2. By selling the bonus shares after one year, the investor could claim the benefit of Long Term Capital Gain (LTCG) and pay 10 per cent tax on the same. The only issue was that since the bonus shares had a cost of “0”, the entire amount would be charged to tax.

What an investor could achieve here is a tax arbitrage. For e.g., if the capital gains tax was 30 per cent for short-term gains, the investor was able to reduce his tax liability by 20 per cent by simply bonus stripping. However, the investor was also exposed to the risk of the share price going down. Let us examine this with an example.

How does Bonus Stripping work?
Let us take a real life example. Reliance Industries Ltd issued bonus shares in the ratio 1:1 on 6th September, 2017. This was announced on 21st July, 2017 and based on this information, an investor bought 100 shares @ Rs 1,616.1 on 24th July, 2017. Post the record date, the share price fell to Rs 818.9 per share on 7th September, 2017. On 11th September, 2017, the investor sold the original 100 shares at Rs 818.1 and thereby made a loss of Rs 79,800, as per income tax. The balance 100 shares received at zero cost were held for 1 year. Then, by selling these shares on 11th September, 2018 at Rs 1,238.45, the entire sale consideration of Rs 1,23,845 was tax free (the 10 per cent capital gains tax was introduced in the Budget from 1 April, 2018). The investor had a tax saving of approx. Rs 24,000 (30 per cent of Rs 79,800). If this transaction was done post 31 Jan 2018, it would attract a 10 per cent capital gains tax on Rs 1,23,845.

Amendment brought in this Budget
The current provision of sub-section (8) of section 94 of the Act contains an anti-avoidance provision to deal with bonus stripping transactions. The provision, as of now, is applicable only to mutual fund units. But in this Budget, the government has made an amendment to the definition to include even securities or ‘units’. So just by adding a word the entire definition has changed.

Way ahead
Now the Sec 94(8) rule which was introduced to curb this practice will be applicable to all the securities. Below is the extract of Sec 94(8):

The losses arising from such transactions will be ignored for the purpose of calculation of income for capital gain tax if -

• Investors who buy the units within a period of 3 months prior to the record date (date on which bonus is allotted).
• If such investor sells or transfers all or any of the original units within the period of 9 months after the record date.

Instead, the loss amount will be considered as the cost of acquisition for bonus shares.

For example, 1,000 shares bought @ Rs 100 on 2 Feb, 2022 so total value is Rs 1 lakh and bonus is given at 1:1 ratio (record date 15 Feb, 2022). So, after the bonus is received the investor has 2,000 shares for Rs 50 each. If the investor sells all his original 1,000 shares on 19 Feb, 2022 for Rs 50, his short term capital loss will be Rs 50,000 (Rs 1,00,000 less Rs 50,000). This loss of Rs 50,000 will be ignored for taxation purposes. Instead this Rs 50,000 will be considered as cost of acquisition for remaining 1,000 bonus shares.

(The author, Juzer Gabajiwala, is Director at Ventura Securities. Views are his own.)