Finance Minister Nirmala Sithraman in Union Budget 2022-23 has taken away one of the popular tax planning mechanisms called bonus stripping.
From April 1, 2023, investors who previously used a technique known as bonus stripping to reduce their tax liability could no longer do so. It is because of a change in the Income Tax Act that was introduced in the Union Budget 22-23.
This article will look at bonus stripping and how it works.
What is Bonus Stripping, and how does it work?
Bonus stripping occurs when shares or mutual funds are purchased and sold in a way that results in a short-term capital loss that can help to offset capital gains.
So, in this scenario, an investor buys units or shares at a higher price to sell them at a lower price.
Let us take a simple example to explain bonus stripping.
Assume that an investor buys 100 shares of a corporation at Rs 100 per share. After some time, they publicly announce that they are going for a 1:1 bonus issue. As one share is now split into two shares, the share price of the company’s share gets priced to Rs 50. Now, the person has a total of 200 shares.
The person might sell the original 100 shares at Rs 50 each. As per the current rules, they can record this sale of shares as a loss because they bought a single share of the company at Rs 100 and sold it for Rs 50.
So, the investor can use the loss of Rs 5,000 (Rs.100*100â€“100*50) to offset any capital gains from other transactions.
We also need to keep in mind that the investor still owns the 100 shares they received as a bonus. They may stay invested for one year to take advantage of the LTCG tax on equity units, which is taxed at 10% on gains over Rs 1 lakh.
Budget bans Bonus Stripping
The Income Tax Act currently has a clause prohibiting the set-off of losses suffered through bonus stripping against other capital gains to deter investors from engaging in such practices.
According to Section 94 (8) of the Income Tax Act, if units are purchased within three months of the bonus issue’s record date and sell some units within nine months of the record date, the loss incurred shall be ignored. But till now, the anti-avoidance portion of section 94(8) only applied to mutual fund units.
With the latest budget announcement, in addition to mutual funds, the equity shares and units of InvITs, REITs and other alternative investment funds would also not be allowed to offset the losses arising out of the bonus issue against other gains.
The budget has also recommended revising the definition of units to incorporate units of new pooled investment vehicles such as InvITs, REITs, and AIFs.
Another similar concept is dividend stripping. Under dividend stripping, the investors hope to profit from capital losses resulting from post-dividend stock sales at a reduced price. However, as dividends are now taxed in the hands of the shareholder, dividend stripping is no longer relevant.
These changes will take effect on April 1, 2023, and will apply to the assessment years 2023-2024 and the following years.