Bonus stripping is a term used to structure a transaction of purchase and sale of shares of a listed company, which generates short-term loss which is set off against some other capital gains.
As we enter the Budget week speculation about Long Term Capital Gains tax (LTCG) or plugging the loophole around ‘Bonus Stripping’ becomes louder. Tax systems are complex and to keep it simple it leaves behind few opportunities, and if the government can plug this loophole, it could garner close to Rs15000-20000 crore in additional revenues, say experts.
To start with – what is bonus stripping and why has it become the talk of the town?
Bonus stripping is a term used to structure a transaction of purchase and sale of shares of a listed company, which generates short-term loss which is set off against some other capital gains.
This is achieved through acquiring shares of a listed company pre-bonus and selling original shares immediately and bonus shares after one year. Short term loss on original shares is set off against other capital gains and bonus shares are sold after one year to get a long-term capital gains exemption.
Most of the countries apart from India have a system of stock split rather than issue of bonus shares. “There is no other country in the world where bonus shares are valued at zero. It is only in India where we give this flexibility to rich investors to avoid paying capital gains tax.
You plug the loophole, you will get probably between Rs 15,000 crore and Rs 30,000 crore
It is a normal belief that there doesn’t exist ‘FREE Lunches’ and finding arbitrage opportunities are difficult but there exists one known as ‘Bonus Stripping’.
Tax systems are complex and to keep it simple it leaves behind few opportunities to save on it. As there is a tax haven on Long-Term Capital Gains, investors holding stocks, where bonuses are declared, have an opportunity to book a loss and set it off against other short-term gains.
It’s an ‘Open Secret’ and be assured the regulator knows it as well. It’s just the priority or lack of systems or lack of urgency which has kept it around for a long time. For a fair tax treatment, bonus stripping should be curbed and a probability exists of it popping up as an announcement in future.
Agarwal further added that LTCG would be a larger revenue source of taxes, however; regulating bonus stripping could be a fair approach immediately. With the challenge of lower tax avenues and higher spending, the odd remains in favor for an announcement of something to control this in the upcoming budget.
How does bonus stripping work?
Ashok Shah, Partner, NA Shah Associates explains bonus stripping with the help of an example:
• Suppose you haves short-term capital gains of Rs1,00,000 on sale of listed company shares
• On this, you would be required to pay capital gains of Rs15,000 (15%)
• Now you locate a company X, listed on the stock exchange, which is declaring bonus in the ratio of 1 bonus share for each share held. The market value of the equity shares of X is Rs. 1,000.
• After record date for bonus shares, the price of a share of X would drop to Rs. 500.
• If you do not desire to pay any capital gains tax, you buy 2,000 shares of X for Rs.2,00, 000 before the record date. On this, you will get 2,000 bonus shares after the record date.
• After the ex-bonus date, you sell 2,000 original shares of X for Rs. 500, realizing Rs. 1,00,000. As per Income tax rules, you get short-term loss of Rs1,00,000.
• You hold the 2,000 Bonus shares received by you for a period of one year and sell the shares for say Rs. 500 per share. For the purpose of computation of capital gains, the cost is taken at Rs. Nil but since long-term capital gains are exempt, you do not pay any tax.
• On an overall basis, against the cost of Rs.2,00,000, you have realized Rs. 2,00,000 making no gain or loss. But for tax purpose, you got short-term loss of Rs. 1,00,000 which you used to set off against short-term capital gains of Rs. 1,00,000 and you saved tax of Rs. 15,000.
Is Bonus stripping foolproof?
If you can prove that acquisition and disposal of the shares was not done with the main objective of tax avoidance, then as per current rules, you can set off the loss on bonus stripping.
If the main motive is tax avoidance or the transaction lacks commercial substance, Income tax department can invoke General Anti Avoidance Rules (if the quantum of tax advantage exceeds Rs. 3 crores).
Supreme Court in the case of Wallfort Stock and Shares Brokers in the context of dividend stripping had held that there was nothing illegal about dividend stripping. Thus, following the same analogy, even bonus stripping should be safe unless provisions of GAAR apply.
However, he cautions investors on resorting to Bonus stripping for claiming tax exemptions. “If you like the shares for long-term investment, then there is no harm in resorting to bonus stripping as it will amount to legitimate tax planning. But structuring the transaction solely as a tax avoidance tool is a risky affair.
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