Income Tax

Overview of Bonus Stripping & Tax on Bonus Shares under ITA 1961

Dividend is a crucial source of income for stock investors over the long term, and one of the ways in which such dividend is paid out is through stock dividends, i.e., bonus shares. In the hands of investors, cash dividends are tax-free because the firm announcing the dividend pays dividend distribution tax on it, resulting in investors using the technique of Bonus Stripping. The article discusses the concept of bonus Stripping & Tax on Bonus Shares under ITA 1961^[1].

Meaning of Bonus Shares 

Bonus shares refer to the additional shares provided to the current shareholders by the company as a bonus in the event of the company’s inability to pay a dividend to its shareholders despite earning decent profits for the quarter. Such shares can only be issued by the company to its shareholders as per their stake in the same. 

Bonus Stripping: An Overview  

Bonus Stripping is a strategy adopted by investors for the purpose of reducing the tax burden under the IT Act 1961. Under this type of arrangement, an investor willing to reduce the tax burden applicable to his assessment purchases stocks before the record date & sells off the units post the record date, when the unit price becomes ex-bonus. Holding the units on the record date makes the person eligible for additional units declared by the company without paying any additional amount.

Advantages of Bonus Stripping

The advantages of bonus stripping are enlisted below –

• It is a great strategy for investors in the high tax bracket
• It enables the adjustment of the notional loss against STGS from stocks, debt funds, equity funds, FD interest deposits, gold and property
• It allows carrying forward the unadjusted loss to 8 financial years

Disadvantages of Bonus Stripping

 This strategy has some disadvantages as well, which are enlisted below-

• The bonus shares must be held for at least 1 yr in order to avoid the impact of tax since the acquisition price of bonus shares is zero.
• If the investor sells the bonus shares before the completion of 1 yr, then the same shall be taxed under short-term capital gains
• The bonus Stripping Strategy is not applicable if original shares bought ex-bonus are held for more than one year.
• The strategy is not feasible during bear markets or when markets are expected to see a correction

Bonus Stripping as per the Income Tax Act 1961

The provisions that keep a check on this strategy are provided under section 94(8) of the IT Act 1961, which states as under-

• Purchase or acquisition of units by the taxpayer within a period of 3 months before  the record date,
• Receipt or allotment of additional units to the taxpayer without any payment, based on holding of such units on the record date; and
• Sale or transfer of the original units by the taxpayer within a period of 9 months subsequent to the record date and holds the additional units.

Tax Position if Section 94(8) is Applicable

The provisions of section 94(8) become applicable only upon the satisfaction of the above-mentioned conditions; then, the loss arising on account of the sale of all or any such units would be ignored for computation income chargeable to the tax of the respective person. It must be noted by the taxpayers that the loss ignored would be assumed to be the cost of acquisition of such additional unit held by the person as on the date of such sale/transfer.

Stages of Bonus Stripping

• Setting up of a corporation to give bonus shares to existing shareholders, as per an investor.
• Purchase of the stock of the company by an investor
• Receipt of bonus shares on the basis of the issue ratio in a bonus issue.
• Sale of original shares at a lower price by the investor subsequent to the issue of bonus shares, resulting in a short-term capital loss
• Earning a long-term capital gain after the sale of shares after one yr by the investor

Amendments Proposed in Section 94(8) of the Income Tax Act

 The amendments proposed in Section 94(8) of the Income Tax act, is regarding the enforcement of the applicability of bonus stripping and dividend stripping provisions for securities and units also, vide Clause 25 of the Finance Bill 2022 (budget 2022-23), which is discussed below

• Section 94 of the Act consists of anti-avoidance provisions for dealing with transactions in securities and units of the mutual fund, which, inter-alia, include dividend stripping and bonus stripping.
• However, the current provisions 94(8) of the Act are not applicable to bonus stripping undertaken in the case of securities and to units of (InvIT) or (REIT) or (AIFs) as the definition of the term “unit” hasn’t been modified subsequent to the introduction of provisions relating to REITs, InvITs etc.
• Further, the current provisions of the Act, i.e. provisions pertaining to dividend stripping, do not apply to the units of new pooled investment vehicles like InvIT or REITs or AIFs.
• In lieu of the same, there has been a proposal to amend sub-section (8) of section 94(7)   regarding the prevention of tax evasion through bonus stripping to make the said provision applicable to securities as well.
• It is also proposed for amending the Explanation to the section to modify the definition of the unit to include units of business trusts, like InvIT, REIT and AIF, within the definition of units.
• This amendment will take effect from and will accordingly be applicable in relation to the assessment year 2023-24 and subsequent assessment years.
• It is worth noting that  ‘record date’ refers to the date as fixed by the company for entitlement of the holder of the unit for receiving income or additional units without any payment/consideration.

Conclusion

The acquisition and disposal of the shares weren’t made with the primary goal of avoiding taxes; the loss on bonus stripping can be offset under existing laws. If such stripping was done solely for the purpose of avoiding taxes, the assessing officer might attach cost on a proportionate basis to the original and bonus shares. Therefore it is important for the investor to have a thorough knowledge of this concept, its legality and its current status as the IT Act before making any decision.

Read Our Article: Some Common Penalties under Income-Tax Act, 1961