Bonus stripping: How it works?
The term “bonus stripping” refers to the exercise of purchasing mutual fund units with the sole aim of making a participation into bonus issue scheduled ahead, and also allows them to book loses on the value invested originally. Thereafter, the loses are set off against the profits/gains booked from other sources.
Generally, bonus stripping was observed only in the case of fixed income funds, but lately even arbitrage funds has began indulging in it as well.
If an investor can make out in advance when the mutual fund is set to announce a bonus, he buys some units. For instance, if you know a mutual fund will be announcing bonus in the three months (coming), you can buy 100 units at a price of Rs 20.
NAV (net asset value) = PRICE/MUTUAL FUND UNIT
When the bonus is announced in the coming 3 months, NAV falls to the same extent as the bonus paid out.
For instance, bonus is about 85%, you get into your kitty 85 bonus units without any additional cost. Now, you have 185 units in total of the same fund.
NAV drops to Rs 10.81 from Rs 20, i.e. 100/185*20
Now, you can easily sell originally bought 100 units without losing any time, booking a loss of Rs 9.19/unit. The total for 100 units is Rs 919.
The loss can be set off against the profits/gains booked from other sources, SAVING ON CAPITAL GAINS TAX.
The bonus units (85 in number) should be kept invested for another nine months and sold only year later after you purchased original units. Mind you, it being an equity scheme, capital gains are zero if invested for more than a year. Therefore, you don’t pay any tax on sale of bonus units.
However, the strategy is perfectly fine, if there is no insider information leak or selective disclosure about the time of fund house going in for bonus or payment of dividends. But, if it’s done prior knowing the scheduled date, it becomes illegal and Sebi may come into picture.