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What is Bonus Stripping?

Recently, one of India's most admired companies viz. Infosys announced a 1:1 bonus issue. In other words, all those who are shareholders of Infosys as on the record date, will get one additional share for every share that they hold in the company... free of cost.

Beware! This is not a lottery. As I had warned earlier, don't be fooled by Bonus Shares.

However, there is another aspect to bonus shares that is being exploited by some savvy investors and smart tax advisers.

This involves some clever tax planning and is commonly referred to as Bonus Stripping.

Suppose you buy 100 shares of Infosys, which is presently trading at around Rs.4000. Your total investment is valued at Rs.4 lakhs (=100 *4000).

After the bonus shares are issued your shareholding will increase to 200. And, typically, the share price will drop by about 50% as the no. of shares in the market would have doubled.

So, after the bonus issue, Infosys will trade at around Rs.2000. Your investment would still be valued at Rs.4 lakhs (=200 *2000). Hence, effectively speaking, you neither gain nor lose anything from the issue of bonus shares.

Now, we come to the crux of the matter i.e. 'bonus stripping'.

Soon after the bonus, you sell 100 shares at Rs.2000. Since the tax laws work on First In First Out (FIFO) principle, your original 100 shares would be considered as sold. And you continue to hold the 100 shares you received as bonus.

You paid Rs.4 lakh to buy the original 100 shares.
Now you get back only Rs.2 lakh.
So, your (notional) loss = Rs.2 lakhs.

Since all this happens within a few months, i.e. less than one year, this becomes your Short Term Capital Loss (STCL).

This loss of Rs.2 lakhs can be
- adjusted against any other "taxable capital gains"
- either short term or long term
- that you may have made in your other investments (e.g. stocks, debt MFs, gold or property)
- during the financial year.

In this manner, you substantially cut down your tax liability. In case you haven't had any such taxable short-term / long-term capital gains during the year, you can carry forward the loss for eight years. So you get an opportunity to cut your tax in the future too.

This is what bonus stripping is all about.

Beware! There is a risk to this bonus stripping.

You are open to the risk of Infosys share price falling below Rs.2000. Thus, you will make a loss on the 100 bonus shares. This may wipe out all the tax that you would have otherwise saved. This is a real risk and you should be ready for it.

If you think you can avoid or minimize this by selling even the bonus shares... wait. If you sell these within a year, short term capital gains tax of 15% + cess etc. would become payable (tax on equity is nil only if the holding period exceeds one year). The cost of acquisition of bonus shares is zero. So the entire sales proceeds of Rs.2 lakhs would be taxable. This could nullify or reduce your intended tax savings.

Moreover, there is also the risk of tax authorities taking a view that the sole purpose of this transaction was 'tax avoidance'. Hence, they could disregard and disallow the same and ask you to pay the necessary tax liability.

Note: Because of FIFO principle, the mathematics of bonus stripping may not benefit you, if you are already an Infosys shareholder for more than a year.

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