Bonus stripping under Section 94(8) of the Income Tax Act

Section 94(8) of the Income Tax Act 1961 is an anti-avoidance rule that prevents bonus stripping by disallowing capital losses when securities or mutual fund units are purchased shortly before and sold shortly after a bonus issue. The rule is the parallel to Section 94(7) which addresses dividend stripping. Both rules operate to align tax treatment with economic substance and prevent artificial loss creation.

For Indian mutual fund investors, Section 94(8):

• Disallows capital losses arising from bonus-stripping patterns.
• Applies to bonus issues by companies and to bonus unit allotments by mutual funds.
• Specifies timing windows (3 months before bonus, 9 months after).
• Limits short-term tax-arbitrage opportunities.

This article covers the rule mechanics, the timing windows, the application to mutual funds, and the tax-planning compliance considerations.

Bonus stripping mechanism

What bonus stripping was

Before Section 94(8), investors could attempt bonus stripping:

1. Buy securities/units shortly before a bonus issue.
2. Receive bonus units at no incremental cost.
3. Sell original units after the bonus (ex-bonus price typically lower).
4. Claim capital loss on the sale.
5. Retain the bonus units, effectively converting investment into bonus units while booking a tax-deductible loss.

The artificial loss creation provided tax benefit without economic loss.

Why Section 94(8) was introduced

Section 94(8) was introduced (effective April 2005, with subsequent refinements) to:

• Align tax treatment with economic substance.
• Prevent structural tax arbitrage.
• Strengthen the anti-avoidance framework parallel to Section 94(7).

Section 94(8) rule mechanics

Timing windows

Section 94(8) triggers when:

• Securities/units purchased: Within 3 months before the record date for bonus issue.
• Original securities/units sold: Within 9 months after the record date.

If both conditions met, capital losses on the sale are disallowed to the extent corresponding to the bonus units retained.

Computation

If Section 94(8) applies:

• Capital loss disallowed: To the extent of bonus units retained.
• The cost basis of the bonus units retained is treated as the loss amount (effectively transferring the loss to the bonus units’ future redemption).

Example:

• Purchase 100 units at Rs 50 each on 1 Feb 2024 (Rs 5,000 total).
• 1:1 bonus on 1 Mar 2024 (100 additional units, total 200 units).
• Sell original 100 units at Rs 25 each on 1 Jun 2024 (Rs 2,500).
• Apparent capital loss: Rs 5,000 - Rs 2,500 = Rs 2,500.
• Section 94(8) disallows the Rs 2,500 loss.
• The Rs 2,500 cost basis transfers to the retained 100 bonus units (so their effective cost = Rs 25 each).

The investor doesn’t get to deduct the loss immediately, but the bonus units have a higher cost basis, reducing future capital gains.

Application to mutual fund bonus units

Historical relevance

Pre-2018, some Indian mutual funds occasionally issued bonus units (the AMC issuing additional units to existing investors without consideration). The bonus-stripping rule under Section 94(8) directly applied to such bonus issues.

Post-2018 trends

Bonus units in Indian mutual funds have become rare post the SEBI scheme categorisation framework. The category of bonus units in MFs is historical for most retail investors.

Continued relevance

Section 94(8) remains technically applicable to:

• Bonus issues by corporates (where individual investors hold shares).
• Any rare mutual fund bonus issues.
• Bonus issues from REITs/InvITs.

Compliance considerations

Record-keeping

Investors should maintain records of:

• Purchase dates and prices.
• Bonus issue record dates.
• Sale dates and prices.

Tax-filing implications

Where Section 94(8) applies:

• Compute capital loss net of disallowed portion.
• Add disallowed loss to the cost basis of retained bonus units.

Comparison with Section 94(7)

See also

• Mutual funds in India
• Dividend stripping (Section 94(7))
• Bonus units in MF
• Equity mutual fund taxation in India
• Debt mutual fund taxation (post-2023)
• Section 112A
• Section 111A
• IDCW
• Growth vs IDCW option

External references

• Income Tax Department of India
• Income Tax Act 1961

References

1. Income Tax Act 1961, Section 94(8).
2. CBDT circulars on Section 94(8) interpretation.
3. Finance Act amendments to Section 94(8).