Don’t we all love the idea of saving taxes? The fervor reaches its peak during the budget session of the Parliament. It is during this time that everyone seeks avenues and means to save as much tax as possible. It is in this frenzy that many miss out on ways that are there in the system but are unknown to many. There are indeed innumerable ways to cut the tax burden. Investing in stocks, no matter how risky it is, has been one of the favorite avenues for individuals to gain wealth over a short period of time and cut down their tax footprint. Read on to find out how can you make a fortune without paying much to the authorities.
In this blog, we’ll talk about how one can save short-term capital gain tax on equities using “Bonus Stripping” – an innovative way to reduce tax outflow to the government that is generally adopted by smart and savvy investors.
Before we dig deeper, first let’s walk you through the following points that enumerate the tax provisions for gains on listed equities:
- Long-term capital gain tax on listed equities is NIL (holding period > 1 year); e.g., you buy 100 shares of TCS at INR 2,000 per share on Jan 1, 2016, and sell it on Jan 3, 2017, at INR 2,300 per share; in this case, the total gain of INR 30,000 is tax exempt
- Short-term capital gain tax of 15% on listed equities (holding period of up to 1 year); e.g., you buy 100 shares of RIL at INR 1,100 per share (including brokerage) on Jan 1, 2017; on the back of the JIO effect, the price per share reaches INR 1,400 in 3 months. You book profit and make a total gain of INR 30,000. Since the holding period is less than a year, you’ll have to shell out INR 4,500 as capital gain tax
“Bonus Stripping” to the rescue
- Zero in on a company that has declared a bonus issue: Company A with a share price of INR 1,000 announces a 1:1 bonus
- Buy shares of a company for an appropriate value: You should buy 60 shares cum-bonus worth INR 60,000
- After-bonus scenario: Generally, the price will adjust to around half of its cum-bonus value of INR 1,000, as the bonus ratio is 1:1. Also, you will now have 120 shares (60*2) of Company A. The total value of shares will remain at INR 60,000 (60 shares with an acquisition price of INR 1,000 +60 shares with an acquisition price of INR 0 (bonus shares are treated free of cost)
- Sell half the shares: Sell the 60 shares with an acquisition price of INR 1,000 at the current market price of INR 500. This will result in a loss of INR 30,000 (loss of INR 500 per share)
- Set off loss vs. short-term capital gain: This loss can be then set off against the short-term capital gain of INR 30,000 made on RIL stock
- Tax saved: In this process, you can save a total tax of INR 4,500
Sounds great, right? But there are certain challenges that also need to be understood in this strategy
- Investor must hold the shares received as bonus stock for at least 1 year. This is because the acquisition price of bonus shares is NIL and short-term capital gain will be imposed if you sell it before the transaction gets classified as long-term capital gain
- There is a risk of the share price of bonus stock plummeting and causing losses, e.g., suppose the price of company A stock falls to INR 200 in 1 year. This will lead to a loss of INR 18,000 (60*300). This is much more than the tax saved of INR 4,500
- It is advisable to invest in companies issuing bonus shares but with good fundamentals
With an increasing number of amateur investors entering the market, there’s a need to at least appraise them about this way of saving tax on wealth generated through stocks. To put it in a nutshell, bonus stripping is one of the best means to cut down tax on short- term capital gains. However, one needs to play smart in order to extract the most out of it.
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