Banking on bonus

Selling of bonus units in mutual funds before nine months can lead to more tax liability, but it does not apply to stocks.

In the last few months, the Securities and Exchange Board of India (Sebi) has come out with a slew of measures for mutual fund investors.

First, it announced that there will be no entry load for direct investors in mutual funds from January 4, 2008. This was quickly followed by another directive of no entry load and exit load on bonus units.

The latter guideline has brought the issue of bonus units in the limelight once again. This is because an amendment was made in the Income Tax Act, which prevents tax payers from "bonus stripping".

This provision mentions that if there is any loss when the investor redeems bonus units in the first nine months, the loss will not be considered as part of taxable income.

In fact, the loss will be treated as cost of buying the bonus units. The capital gain/loss on sale of bonus units will be calculated, considering this amount as the cost of bonus units, though the cost is zero. Let's understand this better with the following example

Suppose a mutual fund with a net asset value (NAV) of Rs 20 declares a bonus of 1:1 on April 1. The date of the issuance of this bonus is kept a month later. An investor, lured by this offer, purchases 1,000 units of the fund for Rs 20,000 in the month of April itself to get the bonus units in the next month.

When the bonus is allotted, the investor will have double (2,000) the number of units he originally purchased. That is, now he has 1,000 units that he has already purchased plus another 1,000 through the bonus. And, the cost of acquisition of these additional units is zero.

However, while the entry cost is zero, issuance of bonus would lead to a fall in the NAV to Rs 10. So now you have 2,000 units of the funds but the total value of the units stays at Rs 20,000.

Now, say the investor redeems 1,000 units for Rs 10,000. On the fact of it, it would seem as short-term loss because just a month back, 1,000 units were bought for Rs 20,000. Earlier, as per the law, this loss could be used to set-off capital gains, thereby reducing the tax liability.

Many investors took advantage of this loophole in the system. The process was referred to as "bonus stripping". However, the Income Tax Act has been amended now. The loss of Rs 10,000 will not be considered to be set off against any other capital gain.

Since making the loss totally ineligible for any tax relief would have been too harsh, the amended law provides that the ignored loss of Rs 10,000 would be treated as the cost of bonus units, even though the investor has not paid anything for them.

But it is important to remember that if the investor would have sold the bonus units in, say, July for Rs 11,000, thereby making short-term capital gains of Rs 1,000, he would be charged capital gain tax on this profit.

Now, the law requires fulfilment of two time limits, that is, purchase of the units within 3 months of the record date for issue of bonus units and sale of the original units within a period of 9 months from the record date. If any of these two dates are not applicable to the transaction, the investor will not have to pay any tax.

Thus, in our example, if the purchase of units had taken place say, January, which is more than 3 months prior to the record date in May, the loss of Rs 10,000 would be allowed to set-off. Selling off the units after December will also be treated similarly.

Tailpiece: The new section on bonus stripping applies to only units of Mutual Funds and not to shares of companies. Buying shares and selling them ex bonus, leading to a short-term capital loss, can still be set-off against "any" capital gains.

The writer is a chartered accountant