Bonus Stripping in Mutual Funds
Bonus stripping is a tax avoidance strategy in mutual funds where an investor purchases units before a bonus unit allotment, allowing the original units' cost to be spread over a larger number of units, then sells the original (higher-cost-basis) units at a loss while retaining the bonus units, with Section 94(8) of the Income Tax Act blocking the loss claim.
Bonus stripping in mutual funds mirrors a similar practice in equity shares. When an AMC issues bonus units in a ratio (say 1:1, meaning one bonus unit for every unit held), the NAV is adjusted downward proportionally — a scheme with NAV of Rs 100 issuing a 1:1 bonus would see its NAV fall to approximately Rs 50, with the investor now holding twice the units. Economically, the investor's corpus is unchanged, but the cost of acquisition per unit, for tax purposes, changes in a way that could be exploited.
The mechanics of the old strategy: an investor holds, say, 1,000 units purchased at Rs 100 each (total cost Rs 1 lakh). After a 1:1 bonus, they hold 2,000 units with NAV of Rs 50 each. The tax-adjusted cost basis gets recalculated. If the investor then sells the original 1,000 units (or the first 1,000 units on a FIFO basis) at Rs 50, they would appear to book a loss of Rs 50 per unit (Rs 50,000 total), while still holding 1,000 bonus units at near-zero cost. This manufactured loss could offset other gains.
Section 94(8) of the Income Tax Act, 1961 addresses bonus stripping. Under this provision, if an investor: (a) acquires mutual fund units within three months before the bonus record date, and (b) transfers the original units within nine months after the bonus record date, then any capital loss arising on the original units to the extent that the market value of the bonus units is reduced from the acquisition cost of the original units shall not be allowed. The disallowed loss is added to the cost of acquisition of the bonus units, deferring the tax benefit to a future period.
In practice, bonus issues in mutual funds were never as common as in listed equities, and most major AMCs discontinued the practice of issuing bonus units over the 2010s, partly because SEBI's post-2006 guidelines allowed only growth, dividend (IDCW), and dividend reinvestment options — the bonus option gradually became a legacy feature used by very few schemes. With negligible bonus issues in the current mutual fund landscape, Section 94(8) has largely academic relevance for new investors.
For historical portfolios with legacy bonus units, the cost-basis computation can become complex, particularly when units were purchased across multiple dates straddling a bonus record date. In such cases, engaging a chartered accountant familiar with mutual fund taxation is advisable to correctly compute capital gains.