What is Bonus Stripping and how I am using this strategy to cut taxes?
I had to sell my mutual funds and stocks to purchase real estate property this year. However, I was having a short term capital gain due to selling mutual funds and stocks. I am planning to cut taxes on short term capital gains using Bonus Stripping as one of the strategy. Do you know that you can save tax or cut taxes for short term capital gain by adopting a simple strategy which his legal? What is this bonus stripping in shares is all about? What are the features of Bonus Stripping and what are its limitations?
What is bonus stripping in shares?
Bonus stripping in shares is an option where an investor buys shares of a company which announced bonus shares and sell them off after bonus date and book notional loss. This notional loss can be legally adjusted against any other capital gains for the year and we can cut/save tax. This bonus stripping in company shares is still in practice u/s 94 (8) of Income Tax Act 1961.
Bonus Strip explained with an example
Infosys announced a bonus issue few weeks back. Let us say Infy shares are quoting at Rs 4,000 (for easy explanation) per share and you purchased 100 shares @ Rs 4,000 costing Rs 4 Lakhs. Now on bonus date, shares of Infy would fall by 50% (1:1 bonus). Means the price would fall to Rs 2,000. However, you would get another 100 shares in your demat account. So you have a total of 200 shares, but the share price is Rs 2,000 per share. Total value of Rs 4 Lakhs remains same. However, if you sell 100 original shares out of this for Rs 2 Lakhs, it would indicate as notional loss of Rs 2 Lakhs (You brought 100 shares at Rs 4 Lakhs and sold 100 shares at Rs 2 Lakh). This notional loss can be adjusted against any other short term capital gain or long term capital gain from other sources. So, if you have capital gain of up to Rs 2 Lakhs from selling mutual funds or any other stocks, you can adjust this notional loss and you need not pay any short term capital gains tax.
Features of Bonus Stripping in shares
- You can legally sell such shares after ex-bonus date and adjust loss against any other capital gains. However, there are certain conditions to be fulfilled.
- Such notional loss can be adjusted against the short term capital gain or long term capital gain from stocks, equity funds, debt funds, gold and property.
- Unadjusted loss can be carried forward to 8 financial years.
- Good strategy for high tax bracket investors
- Good for those who are worrying about short term capital gains from debt funds as they would be treated as short term gains if sold within 3 years (as announced in recent budget this year).
What are the limitations of Bonus Stripping in shares?
- Investors have to hold bonus shares for at least 1 year to avoid such tax. Since the acquisition price of bonus shares is zero, if you sell them before 1 year, you need to pay 15% short term capital gain.
- Strategy does not work if you have shares for more than 1 year in your portfolio. Income tax law allows first in, first out principle. This is run on the principle that long term capital gain taxes are free after 1 year and loss of such investment, there is no provision to adjust.
- Investment in low quality stocks can wipe-off your capital itself.
- Strategy is not good during bear markets or when markets have reached and when stock markets are expected to see some correction.
- You can adjust such loss against any fixed deposit interest rate income in a year.
Bonus Stripping explained with various scenarios
Let us assume that Infy share is trading at Rs 4,000 and you bought 100 shares. Bonus is announced (1:1) and share price has fallen to Rs 2,000 on bonus date.
Scenario-1 – You have sold all shares (100 original and 100 bonus) within 1 year @ Rs 2,100
- Shares brought – Short term capital loss – (Rs 2,100 current rate – Rs 4,000 original price) x 100 shares = Loss of Rs 190,000
- Bonus shares sold within 1 year = Rs 2,100 current price – Rs 0 acquisition value of bonus shares x 100 bonus shares = Profit of Rs 210,000
- Short term capital gain = Rs 210,000 profit – Rs 190,000 of loss = Rs 20,000
- Short term capital gains tax = Rs 20,000 x 15% = Rs 3,000
Scenario-2 – Original shares sold within 1 year @ Rs 2,100 and bonus shares sold after 1 year from date of bonus issue
- Shares brought – Short term capital loss – (Rs 2,100 – Rs 4,000) x 100 = Loss of Rs 190,000
- Bonus shares sold after 1 year = Rs 2,100 – Rs 0 (bonus shares acquisition value is zero) x 100 = Profit of Rs 210,000. However, no capital gain as equity shares sold after 1 year are tax free
- Short term capital loss = Rs 190,000.
- This loss can be adjusted against other short term capital gains of stocks, mutual funds, gold or property. If you do not have any other capital gains, you can carry forward this to next 8 financial years and adjust them.
Conclusion: Bonus stripping is one of the best way to cut and save tax for short term or long term capital gain. However, this strategy should be used wisely to ensure that you do not end up making wrong steps. Buying blue chip stocks which announced a bonus issue would be better strategy. You should keep this mind that this strategy is legally valid only for the cases where bonus shares are sold after 1 year from the date of bonus shares allotment. Otherwise, you need to pay capital gains tax on bonus shares, where acquisition value is zero.
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What is Bonus Stripping and how I am using this strategy to cut taxes