Explained: Why tax on derivatives is a setback to HNIs, hedge funds, family offices?

High-net-worth individuals (HNIs), hedge funds, large overseas institutional investors, and family offices may have to pay more taxes on derivative gains from the next financial year which is being seen as a setback for the investors.

Finance Minister Nirmala Sitharaman extended the scope of 'bonus stripping' because it disallows squaring futures-market gains with cash equity losses.

In the Union budget, the government proposed to include share transactions under the ambit of 'bonus stripping', which was earlier applicable only to mutual fund units.

We spoke to Gaurav Bissa, Vice President at Trustline Securities to understand 'bonus stripping' in a simple language:

What is Bonus Stripping?

An investor would buy shares of a company which is soon going to issue bonus shares. Generally, these shares are bought before the record date but after the announcement made by the company.

As usual post the record date, the share price would be adjusted according to this corporate event i.e. bonus issue. Post adjustment of the stock price on the exchanges, the investor would sell the original holdings and thereby booking his loss.

Normally, the income tax department follows the first in first out (FIFO) approach to determine profit /loss. As a result of the above move, the investors would get two benefits out of this --

The short-term loss incurred after selling the original shares could be used to set off any other capital gain.

By selling the bonus shares after one year, the investor could claim the benefits of Long Term Capital Gain (LTCG) and pay 10% tax on the same.

The only issue is that since the bonus shares cost nothing so the entire amount would be charged to tax.

Example –

We can understand this with the help of one hypothetical example. For instance, XYZ Company shares were trading on the stock exchange at a price of Rs 1,000 apiece and the company announced a bonus issue in the ratio of 1:1as of 19th March 2019.

Thereafter, a smart investor bought 10,000 shares @ Rs 1,002.50 per share. Post the record date, share plunged to Rs 501 but the above investors was having  20,000 shares in his Demat account.

A few days later, that investor sold the original holdings of 10,000 shares at a price of Rs 505 per share and thereby booked a loss of Rs 49,75,000 as per tax laws.

The balance of 10,000 shares was received at zero cost and he held them for more than one year. Then he sold 10,000 bonus shares @ Rs 1,012.50 per shares i.e. Rs.  10,1,25,000 on 20th December 2020.

Tax Implications -

As per tax laws, the investor adjusted the loss of Rs 49,75,000 from the previous transaction against the entire gains of Rs 10,1,25,000.  

Net taxable gains were Rs 5,075,000. Capital gains payable were Rs 5,07,500 (10% of the said taxable gains) instead of Rs 1,012,500.

On top of that, the investor got a whopping return of 51% in one and half years on the amount initially invested.

Earlier, investors were able to reduce their capital gains liability by using a so tool called ‘bonus stripping’.

But now, the government has made an amendment to this tax framework and consequently, this tool becomes futile.

So now the big and smart investors can no longer use this loophole under the tax laws for their own advantage. Bonus Stripping will no longer be available from 1st April 2022.

(Disclaimer: The views/suggestions/advice expressed here in this article are solely by investment experts. Zee Business suggests its readers to consult with their investment advisers before making any financial decision.)