Mutual Funds & Bonus Issue

A mutual fund that I have invested in has issued bonus units. What are the tax implications of this?

From the tax point of view, bonus units are conceptually similar to dividend stripping, but somewhat more complex. Bonus units that a fund issue is deemed to have been acquired at zero cost. Thus, whenever they are sold, the entire sale price is treated as capital gains. However, at the time of issue of bonus, the NAV of the fund drops in a proportion that is identical to the ratio at which bonus funds are issued. This fall in the NAV is a capital loss as far as the original units are concerned and it is here that tax benefits can be realised. The original units can be sold off with a capital loss, which can be used to set off other capital gains. The bonus units carry a high tax liability though since you will pay taxes on the entire sale price.

Here's an example. Suppose you hold 10,000 units of a fund whose NAV is Rs 15. You made the purchase less than a year ago at an NAV of Rs 12. If today you decide to sell these units, you will fetch Rs 1.5 lakh, out of which Rs 30,000 will be short-term capital gain. On this, you are likely to pay a tax of Rs 9,000—30 per cent of gains.

However, let's say now that the fund issues a bonus in the ratio of 1:2. This would transform your holdings from 10,000 units of Rs 15 NAV to 15,000 units of Rs 10 NAV, keeping your total investment intact at Rs 1.5 lakh. But that's the aggregate. For tax purposes, your holdings comprise 10,000 units that you acquired at Rs 12 and 5,000 units that you just acquired at zero price. Thus, the original short-term capital gain of Rs 30,000 has been changed into a short-term capital loss of Rs 20,000 on one account and a short-term capital gain of Rs 50,000 on the other.

Do note that unlike dividend stripping, bonuses are nominally a zero-sum exercise. If you were planning to sell your entire holdings, your tax liability would remain unchanged. If, on the other hand, you are willing to hang on to a part of your investment till it turns long-term, then bonus gives you an opportunity to sell off the original units separately and book a loss, and also defer taxation on the rest.