Bonus Stripping

Bonus stripping is a tax-saving strategy used by investors in India to reduce capital gains tax liability. It involves purchasing shares or mutual fund units before a bonus issue and selling the original units at a lower price after the bonus is issued. This creates a capital loss, which investors can offset against other capital gains, reducing their overall tax burden.

Under Section 94(8) of the Income Tax Act, bonus stripping applies to mutual funds and equity shares. However, tax authorities have placed restrictions to prevent misuse. The capital loss from the original units cannot be adjusted against capital gains if the bonus units are held for at least nine months. This provision prevents investors from artificially creating losses.

While bonus stripping can be beneficial, investors must ensure compliance with tax laws to avoid scrutiny. Consulting a tax expert before engaging in this practice is recommended for effective tax planning.

How does bonus stripping work

Bonus stripping is executed in three main steps: purchasing, receiving bonus units, and selling the original units. Investors buy shares or mutual fund units before a company announces a bonus issue. Once the bonus shares are issued, the market value of the original shares drops, creating an opportunity for tax optimisation.

After the bonus units are credited, investors sell the original units at a lower price, resulting in a capital loss. Under normal circumstances, this loss can offset capital gains from other investments, reducing overall tax liability. However, Section 94(8) of the Income Tax Act restricts this advantage. If investors retain the bonus units for at least nine months, the loss from selling the original units is disallowed for tax adjustment.

This provision ensures that investors do not artificially manipulate their tax liabilities. Proper planning is essential to use bonus stripping legally while benefiting from legitimate tax savings. Consulting a financial advisor can help investors structure their transactions efficiently.

Concept of bonus stripping

Bonus stripping is a tax-efficient investment technique that leverages bonus issues to generate capital losses. This strategy is commonly used in stock markets and mutual fund investments. When a company or fund announces a bonus issue, additional shares or units are distributed to existing shareholders, reducing the price of the original holdings.

The concept revolves around the fact that selling the original units at a lower price results in a capital loss. Investors use this loss to offset capital gains from other assets, minimising their tax burden. However, tax laws in India impose restrictions under Section 94(8) of the Income Tax Act. If an investor sells the original units but retains the bonus units for at least nine months, the capital loss cannot be set off against other gains.

Bonus stripping remains a popular tax planning tool, but it must be used within legal limits. Investors should carefully assess the holding period requirements and market conditions before employing this strategy.

Bonus stripping in the Income-tax Act

The Income Tax Act, 1961, governs bonus stripping under Section 94(8) to prevent misuse of this tax-saving strategy. The law applies to mutual funds and equity shares where investors purchase units before a bonus issue and sell the original holdings at a loss. Here are the key provisions of Section 94(8):

• Restriction on capital loss adjustment – If the investor holds the bonus units for at least nine months, any loss from selling the original units cannot be offset against capital gains.
• Applicability to mutual funds and shares – The provision applies to both equity shares and mutual fund units to prevent artificial loss creation.

By enforcing these rules, tax authorities ensure that investors do not exploit bonus stripping solely for tax reduction. Investors should plan transactions carefully to comply with regulations while optimising tax benefits.

Conclusion

Bonus stripping can be an effective tax-saving method when executed correctly within the framework of Indian tax laws. It allows investors to use capital losses to offset gains, reducing their tax liability. However, Section 94(8) of the Income Tax Act imposes restrictions to prevent artificial loss creation. Investors must be aware of the nine-month holding rule for bonus units to ensure compliance.

While bonus stripping is a legal tax planning tool, improper use can lead to tax disallowances and scrutiny. Investors should consult financial experts before employing this strategy to avoid tax complications. Understanding the rules and implications ensures tax efficiency without violating tax laws.

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