What is Bonus Share and Bonus Stripping? And Tax on Bonus Share Under Income Tax Act

Introduction

Dividends are one of the most important sources of income for stock investors over the long term. Dividends are paid out in two ways: cash dividends and stock dividends (Bonus shares). In the hands of investors, cash dividends are tax-free because the firm announcing the dividend pays dividend distribution tax on it. As a result, the technique of Bonus Stripping is used by investors to save money on taxes. To address this, the government amended Section 94(8) of the Income Tax Act in Budget 2022 to prohibit the practice of Bonus Stripping. In this article information on Tax on Bonus Share and Bonus Stripping concept is explained.

What is Bonus Share?

They are fresh shares that are issued to current shareholders at no expense to them. It is usually allocated according to the proportion of an investor’s current holdings. Bonus shares are a company’s accrued earnings that are converted into shares rather than dividends. A Bonus Issue of Shares is another name for this technique.

Benefits of Issue of Bonus Share

• It helps in Increasing the Liquidity Base

When a company’s price per share is quite high, investors find it difficult to purchase fresh shares. As a result, investors are given bonus shares. When the number of shares in a company grows, it puts downward pressure on the stock price and lowers the price per share. This improves the share’s marketability and liquidity, as well as retail participation.

• Helps company in Saving Tax

Companies must pay dividend distribution tax on cash payouts, resulting in lower returns for investors. There is no dividend distribution tax in the case of bonus shares. Now let’s have a look at “What is Bonus Stripping?” And the new amendments made on Tax on Bonus Share.

What is Bonus Stripping?

Bonus stripping is mostly used by investors to avoid paying taxes. Dividend stripping is another method for accomplishing the same goal. Bonus stripping, on the other hand, occurs when a mutual fund’s units are purchased or sold in a way that results in a short-term capital loss that can be offset by other capital gains.

Bonus stripping occurs when investors purchase units before the mutual fund company issues a bonus. The investors sell the original units that they had previously held once the bonus units are issued. This can result in a loss of capital in the short term. They dispose of the bonus units after one year. As a result, investors win in two ways.

One advantage is the ability to deduct a short-term capital loss from the selling of original units from any capital gains. The other advantage is that long-term gains on the bonus units are taxed at a reduced rate of 10%.

Stages of Bonus Stripping

• A corporation is set to give bonus shares to existing shareholders, according to an investor.

• An investor purchases stock in the company.

• The investor receives bonus shares based on the bonus issue ratio in a bonus issue.

• After the bonus is issued, the investor sells the original shares at a lower price, resulting in a short-term capital loss.

• After a year, the investor sells the bonus shares and earns a long-term capital gain.

Tax on Bonus Share under Income Tax Act

In Budget 2022, the finance minister proposed an adjustment to Section 94(8) to prevent tax cheating through Bonus Stripping.

In the case of mutual fund units, the existing Section 94(8) of the Income Tax Act kept a lid on bonus stripping activities. Section 94(8) of the Budget of 2022 was changed to take effect on April 1,2023. The word ‘units’ will be replaced with the phrase’securities and units’ as a result of the alteration. As a result, this provision now applies to both mutual fund units and equity shares.

If the following conditions are met, Section 94(8) applies:

• An investor purchases mutual fund units within three months of the bonus issue’s record date.

• The investor sells all or part of the initial shares within 9 months of the bonus issue’s record date.

For the purposes of calculating capital gains, any loss sustained on those described above transactions will be ignored. As a result, the investor will be unable to book a loss on such a sale. Furthermore, such a loss would be treated as a purchase price for the bonus shares.

Information on Tax on Capital Gain

Gains from the sale of equity and debt mutual funds are taxed differently. Equity funds are those that have more than 65 percent of their asset inequities.

Example to Understand Tax Treatment on Bonus Share

Mr. H can offset the short-term losses from original units held against the long-term capital gains from the sale of bonus units in this situation. If the capital gains after set off are larger than INR one lakh, he will only be taxed at a rate of 10%.

Conclusion

If it can be demonstrated that the acquisition and dispose of the shares were not done with the primary goal of avoiding taxes, the loss on bonus stripping can be offset under existing laws. If bonus stripping was done solely for the purpose of avoiding taxes, the assessing officer may attach cost on a proportionate basis to the original and bonus shares.