Bonus stripping

A bonus issue creates no wealth. Give every unitholder one free unit for each one held and the same net assets are spread over twice as many units, so the NAV halves. The investor has twice as many units at half the price and is exactly as rich as before.

The tax system, however, looks at the original units in isolation and sees a unit bought at Rs 30 now worth Rs 15. Sell it and you appear to have made a Rs 15 loss — a loss that could be set against a real capital gain elsewhere, while the bonus units, which cost nothing, carry the value forward. That is bonus stripping, and it is manufacturing a deduction out of an accounting artefact.

The Income Tax Act blocks it with two time windows. If the original units were bought within 3 months before the record date and sold within 9 months after it, the loss cannot be set off against anything.

The disallowed loss is not destroyed. It is added to the cost of acquisition of the bonus units, which would otherwise be nil. So the relief is deferred to whenever those bonus units are actually sold, rather than granted now against an unrelated gain.

The rest of the set-off rules sit around this and are examined alongside it:

• A capital loss, short or long term, cannot be set off against any other head of income such as salary.
• Short-term capital loss may be set off against short-term or long-term capital gain.
• Long-term capital loss may be set off only against long-term capital gain.
• Unabsorbed capital loss may be carried forward for up to 8 years.

The workbook adds a line worth remembering for a judgement-flavoured question: even where the windows are cleared and the loss is technically allowed, the practice is discouraged. Investments should be made for the fundamental attributes of the scheme.

Disallowed when BOTH hold:

  purchase date  ≥  record date − 3 months
  sale date      ≤  record date + 9 months

Then:
  Cost of acquisition of bonus units
      = (normally nil) + the disallowed loss

An investor buys 10,000 units at Rs 30 on 5 June — an outlay of Rs 3,00,000. He also has an unrelated short-term capital gain of Rs 1,50,000 from an equity-oriented scheme this year, and would like to wipe it out.

The scheme announces a 1:1 bonus with a record date of 20 July. The NAV halves to Rs 15 and he now holds 20,000 units still worth Rs 3,00,000. On 10 January he sells the original 10,000 units at Rs 15 for Rs 1,50,000, booking a Rs 1,50,000 loss.

Test the two windows:

Both are breached, so the loss is disallowed:

Had he instead held the original units past 20 April — nine months and a day after the record date — the loss would have been available, and the Rs 30,000 would not have arisen. And had he never bought at all, he would be in exactly the same economic position, which is the honest description of what the exercise achieves.

Chapter 8 (Taxation), section 8.5, covers set-off of capital gains and losses and closes with bonus stripping and the Rs 30 / Rs 15 illustration. The near-certain question is the two windows — 3 months before the record date and 9 months after it — and the follow-up is what happens to the disallowed loss, the answer being that it becomes the cost of acquisition of the bonus units.

• 3 months before, 9 months after. Reversing the two, or applying both to the purchase, is the intended error.
• Both conditions must hold for the loss to be disallowed. Clear either window and the loss is allowed.
• The loss is not lost — it moves. It becomes the cost of acquisition of the bonus units, so the benefit is deferred, not cancelled.
• Bonus units ordinarily have a nil cost of acquisition. That is precisely why the disallowed loss has somewhere to go.
• A bonus issue creates no wealth. More units at a proportionately lower NAV is the same money; only the tax optics change.
• Capital loss can never be set off against salary or any other head. Long-term capital loss goes only against long-term capital gain; short-term loss goes against either. Carry forward is 8 years.
• No exit load is charged on bonus units or on units allotted on reinvestment of IDCW — a separate Chapter 7 rule that questions like to pair with this one.