Bonus stripping? Be careful

Oct 19 2014,

 Since last week, Mumbai resident Rajendra Doshi has been buying four or five shares of Infosys Technologies daily. For, last week, the information technology services firm announced a 1:1 bonus issue. The company has not fixed a record date for the issue and Doshi aims to own at least 100 shares by the time one is announced.

Many savvy investors do likewise to make the most of public issues like a bonus or rights issue. The main advantage is abenefit. Due to a loophole, bonus stripping only in mutual fund schemes (not stocks) comes under the purview of of the Income Tax Act, 1961. It says an investor should have bought units of a scheme at least three months prior to a bonus and stayed invested for at least six months.

Sometime earlier, JM Financial Mutual Fund''''''''s Arbitrage Advantage Fund had collected Rs 5,000 crore (half of the MF inflows in July 2014) on the back of two types of tax benefit. The first was that after the Budget announcement change in tax treatment for debt funds. As a result, arbitrage funds came across as a better alternative, since gains from it were exempt from tax as it is an equity fund. Union Budget 2014 raised long-term capital tax on all debt funds to 20 per cent after three years. Earlier, withdrawal from debt funds attracted a long-term capital gains tax of either 10 per cent (without indexation) or 20 per cent (with indexation), whichever was lower, after one year.

Second, JM Arbitrage Advantage seems to have informally promised a on bonus stripping, though the management denied it.

The practice of buying stocks or mutual fund units to take part in a bonus issue, which allows them to book losses on the original investment value and then set it off is called bonus stripping. There can be two ways in which investors can take advantage of bonus stripping from a tax point of view, says Vaibhav Sankla, director of tax consultancy firm H&R Block.

Scenario 1
Assume an individual has been holding Infosys stocks for some time and the stocks are worth Rs 1 lakh today; he has bought it for say Rs 500 then. As the stock''''''''s current market price (CMP) is around Rs 4,000, the investor holds approximately 25 shares.

He would sell all the 25 shares at the CMP of Rs 4,000 each. Since the gains are long term in nature, the same would be tax exempt. Simultaneously, he would also purchase 25 shares at Rs 4,000 each. Both these transactions would be delivery based. These are carried out to provide a new ''''''''cost basis'''''''' of Rs 4,000 as against Rs 500 and make the shares ''''''''short term'''''''', explains Sankla.

As Infosys has announced a 1:1 bonus issue, the investor will get another 25 shares on the record date. Under the tax laws, the cost of the bonus shares is considered as zero.

On the ex-bonus date, that is the day after the bonus is distributed, the investor will own 50 shares costing Rs 2,000 each at the CMP.

If the investor sells half his holding ex-bonus (25 shares), at the CMP of Rs 2,000 each, he will book a of 50 per cent. This is so because he will earn Rs 50,000 as against his original cost of Rs 1 lakh. Tax loss = Rs 50,000. This loss of 50 per cent can be set off against any other long-term or short-term capital gains, adds Sankla. If you cannot set off the entire loss booked in one financial year, you can do so over the next seven.

Say the investor wants to maintain his portfolio holding. He can again buy as many shares he sold to book profit. If all these shares are sold after a year, the entire gains from the sale would be tax exempt. The disadvantage: You will incur a transaction cost, though that will be lot less than the tax advantage you get. Tax experts warn that sometimes the tax department could question if they notice shares sold in a year only to book a capital loss and adjust capital gains.

Scenario 2
Assume Doshi was sitting on short-term capital gains of Rs 50 lakh from the sale of a property. Short-term capital gains from sale of property cannot be deployed in another property or capital gains bonds. Such capital gains are added to income and taxed at the slab rate. Or, can be set off against other capital gains.

Assume Doshi buys Infosys shares worth Rs 1 crore before bonus shares are allotted. At a CMP of Rs 4,000, he will own 2,500 shares. Say he sells half his share holding (of 5,000 shares) ex-bonus. Again, as his cost of acquisition was Rs 1 crore, he will book a capital loss of 50 per cent as he will earn only Rs 50 lakh (2,500 x Rs 2,000) from this share sale. Doshi can sell the balance shares only after a year for tax exemption.

Given Doshi''''s owning equities, he can be worried that the price of his remaining holding could fall over the next year. If he doesn''''t want to take the risk, he will hedge the holdings in the for one year. A year from the allotment of bonus shares, he shall sell the remaining (bonus) shares, free of tax. He can also liquidate his futures position. However, he would be required to pay tax on gains from the futures holding at 30 per cent, says Sankla.

However, the tax and associated transaction cost would be much less than the tax savings on the capital losses booked. If the stock market value of the stock falls 10 per cent, the gain on the derivative side, the investor will pay 30 per cent of 10 per cent. Or, pay three per cent of the total holding. By the end of this month, Doshi could buy the November futures as on the last Thursday of a month, futures prices converge with the CMP, diluting the premium. The share futures price will not be exactly Rs 2,000 but at a premium of, say, Rs 200-300.

Caution
"Therefore, investors should always check the historic premium of stock futures. And, should not take a position in stock futures with very significant premium," says Manoj Nagpal, chief executive of Outlook Asia Wealth Advisors.

Bonus strippers mostly hedge their position through derivatives and, hence, should be careful about liquidity in the derivatives market. This could be a problem when there are a large number of bonus issues, adds Nagpal.

G Chokkalingam, managing director of Equinomics Research & Advisory, says investors tend to make money or accumulate wealth ex-bonus/ex-rights only if the company or fund house grows in tandem. "Some companies announce a only to support their market cap and investors lose money," he says. Three years earlier, he recalls, the Sundaram Finance stock was priced at Rs 500. It announced a 1:1 bonus over a year earlier and the stock quoted at Rs 1,270 ex-bonus. This means the stock went up 2,500 times. Similarly, eight months earlier, LG Balakrishna Brothers was at Rs 250-260. Three to four months earlier, it announced a 1:1 bonus and the stock moved up to Rs 640 or grew 1,200 times.

Going forward
Tax experts say if the General Anti Avoidance Rule comes into effect, the deadline for which is April 1, 2015, bonus strippers could be pulled up. The law says if any transactions does not have any commercial substance but results in lower tax, then the tax department can cancel the benefit and recalculate the tax. However, the threshold for this rule is tax benefit of Rs 5 crore or more.

Source: Business Standard

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