Bonus stripping disallowance (Section 94(8))

Bonus stripping disallowance under Section 94(8) of the Income Tax Act 1961 is an anti-avoidance provision that prevents investors from generating artificial capital losses on mutual fund units by receiving bonus units (additional units allotted at nil cost) and then selling the original units at a loss. The mechanism is structurally analogous to dividend stripping under Section 94(7): bonus units, like IDCW distributions, reduce the NAV of the existing units without creating taxable income (bonus units are acquired at nil cost), and the resulting NAV decline in the original units can be engineered into a capital loss. Section 94(8) disallows the capital loss on the original units to the extent of the cost of the bonus units, which is notionally allocated from the loss on the original units.

Tax advice disclaimer. This article is for educational reference only and does not constitute professional tax or financial advice. Tax law changes frequently and individual circumstances vary widely. Readers should consult a qualified Chartered Accountant or tax adviser before making any investment or tax-filing decision.

The bonus stripping strategy

When a mutual fund issues bonus units (additional units allotted to existing unit holders at nil cost), the NAV per unit falls proportionately. For example:

• An investor holds 1,000 units at NAV Rs 100 = Rs 1,00,000 total value.
• The fund issues a 1:1 bonus. The investor now holds 2,000 units at NAV Rs 50 = Rs 1,00,000 total value.

The investor’s total holding value is unchanged. However, the original units are now worth Rs 50 each (vs the original cost of Rs 100 each). If the investor sells the original 1,000 units immediately:

• Sale: 1,000 x Rs 50 = Rs 50,000.
• Cost: 1,000 x Rs 100 = Rs 1,00,000.
• Capital loss: Rs 50,000.

This Rs 50,000 loss can be used to offset capital gains elsewhere, while the investor still holds 1,000 bonus units worth Rs 50,000 (total value unchanged at Rs 1,00,000). The investor has effectively crystallised a paper loss for tax purposes without actually losing any wealth.

Section 94(8) provisions

Section 94(8) provides that where:

1. A person acquires units in a mutual fund (the “original units”) and bonus units are allotted to that person within a period of three months before and nine months after the date of acquisition of the original units; and
2. The person sells or transfers the original units within nine months after the date of allotment of the bonus units; and
3. The cost of the bonus units as computed under Section 55(2)(a) (i.e., nil, since bonus units are received without payment) is taken into account;

Then any loss arising from the sale/transfer of the original units shall not be allowed under any provision of the Act, to the extent of the cost of the bonus units (which is nil, but the mechanism transfers the “cost” of the loss to the bonus units, effectively deferring the loss rather than disallowing it absolutely).

Technical effect of Section 94(8)

The practical operation of Section 94(8) is:

• The capital loss on the original units is not allowed at the time of sale.
• The disallowed loss amount is deemed to be the cost of acquisition of the bonus units.
• When the bonus units are eventually sold, the cost of the bonus units is enhanced by the previously disallowed loss amount, reducing the gain (or increasing the loss) on the bonus units.

This means Section 94(8) defers the loss, rather than permanently disallowing it (unlike Section 94(7), which outright disallows the dividend stripping loss). The investor will get the tax benefit of the loss when the bonus units are sold, not when the original units are sold.

Contrast with Section 94(7)

Application to mutual funds vs equity shares

Section 94(8) applies to both mutual fund units and listed equity shares. For mutual funds, bonus issues are relatively infrequent compared to listed company equity, where bonus issues are common. However, the provision is included in the mutual fund context because some fund houses have historically issued bonus units.

Time-window

The Section 94(8) window is:

• Original units acquired within three months before or nine months after the bonus allotment date.
• Original units sold within nine months after the bonus allotment date.

If the original units are held for more than nine months after the bonus allotment, Section 94(8) does not apply and the loss is fully allowed.

Interaction with holding period and STCG/LTCG

The holding period of the original units and the bonus units are computed independently. If the original units are long-term (held more than 12 months for equity funds) and Section 94(8) defers the loss to the bonus units, the deferred loss is treated as a long-term capital loss when the bonus units are eventually sold (provided the bonus units have also crossed the 12-month threshold). If the bonus units are sold within 12 months, the deferred loss contributes to STCG loss.

Reporting

Losses subject to Section 94(8) disallowance should be reported in Schedule CG of ITR-2 or ITR-3 with the disallowance clearly noted. The enhanced cost of bonus units (incorporating the deferred loss) must be tracked for future-year reporting. Reconciliation with the Annual Information Statement (AIS) ensures that the transaction dates and amounts are consistent.

See also

• Dividend stripping disallowance (Section 94(7))
• Equity mutual fund taxation in India
• STCG on equity MFs (Section 111A)
• LTCG on equity MFs (Section 112A)
• MF switch as a taxable event
• Capital gains tax in India
• AIS/TIS mapping for MF transactions
• ITR-2

References

1. Income Tax Act 1961, Section 94(8) – bonus stripping disallowance.
2. Income Tax Act 1961, Section 94(7) – dividend stripping disallowance.
3. Income Tax Act 1961, Section 55(2)(a) – cost of bonus assets.
4. Income Tax Act 1961, Section 2(42A) – short-term capital asset.
5. CBDT Circular on Section 94 anti-avoidance provisions.