Investors could until now reduce their capital gains tax using a tool called “bonus stripping”. But now, this tool becomes unavailable since the government has made the whole exercise futile by making an amendment to the Income Tax Act, as announced in the budget. Bonus Stripping will no longer be available from April 1, 2023. Let’s understand what it was all about.


What is Bonus Stripping?

An investor would buy shares of a company that was about to issue bonus shares to its shareholders. Typically, shares were purchased after the announcement but before the record date. After the record date, the stock price would fall to adjust to the ex-bonus price. At that point, the investor would sell the original shares and thus record a loss, as the tax department follows the first-in, first-out (FIFO) method to determine profit/loss. The investor would derive two advantages:

1. The short-term loss incurred after the sale of the original shares could be used to offset any further capital gains.
2. By selling the free shares after one year, the investor could claim the benefit of Long-Term Capital Gain (LTCG) and pay 10% tax on the same. The only problem was that since the free shares had a cost of “0”, the entire amount would be taxed.

What an investor could achieve here is tax arbitrage. For example, if the capital gains tax was 30% for short-term gains, the investor could reduce his tax liability by 20% simply by stripping the bonuses. However, the investor was also exposed to the risk of a decline in the share price. Let’s examine this with an example.


How does Bonus Stripping work?

Let’s take a concrete example. Reliance Industries Ltd issued free shares in ratio 1:1 on September 6, 2017. This was announced on July 21, 2017 and based on this information, an investor purchased 100 shares at Rs 1,616.1 on July 24 2017. Publish record date , the share price fell to Rs 818.9 per share on September 7, 2017. On September 11, 2017, the investor sold the initial 100 shares at Rs 818.1 and thus suffered a loss of Rs 79,800, according to income tax. The balance of 100 shares received at zero cost was kept for 1 year. Then, by selling these shares on September 11, 2018 at Rs 1,238.45, the entire sale consideration of Rs 1,23,845 was tax exempt (10% capital gains tax was introduced in the budget from April 1, 2018). The investor realized a tax saving of approx. Rs 24,000 (30% of Rs 79,800). If this transaction were made after January 31, 2018, it would incur a capital gains tax of 10% on Rs 1,23,845.


Modification made in this budget

The current provision of subsection (8) of section 94 of the Act contains an anti-avoidance provision to deal with premium stripping transactions. The provision, to date, only applies to mutual fund units. But in this budget, the government made a change to the definition to even include titles or “units”. So just by adding one word, the whole definition changed.


Way forward

From now on, the Sec 94(8) rule which was introduced to curb this practice will apply to all titles. Below is the excerpt from Sec 94(8):

Losses resulting from such transactions will be disregarded for purposes of computing income for capital gains tax if –

• Investors who buy the shares within 3 months before the record date (date on which the bonus is awarded).
• If this investor sells or transfers all or part of the original shares within 9 months after the record date.

Instead, the amount of the loss will be considered the cost of acquiring the free shares.

For example, 1,000 shares bought at Rs 100 on Feb 2, 2022, so the total value is Rs 1 lakh and the bonus is awarded at a ratio of 1:1 (record date Feb 15, 2022). Thus, once the bonus has been received, the investor has 2,000 shares for Rs 50 each. If the investor sells all his original 1,000 shares on 19 February 2022 for Rs 50, his short-term capital loss will be Rs 50,000 (Rs 1,00,000 minus Rs 50,000). This loss of Rs 50,000 will be ignored for tax purposes. Instead, these Rs 50,000 will be considered as an acquisition cost for the remaining 1,000 free shares.


(The author, Juzer Gabajiwala, is a principal at Ventura Securities. Opinions are his own.)