This is truly a bonus for investors who wish to dodge from being taxed heavily. Especially small investors, who have turned pale worrying about to soften the tax blows on their gains, post Budget 2002-03. This budget rendered the dividend income earned on mutual funds tax-unfriendly. In other words, depending on the income tax slab an individual falls under, he'll be taxed on his dividend income. Thanks to public outrage, the finance minister was forced to provide some relief: income from all sources, including dividend income, is now eligible for section 80L deduction (upto Rs 9,000) of the IT Act. Not enough to reduce your tax liability significantly.
Traditionally, one of the most common ways of tackling tax burden has been to book capital losses against capital gains, even for mutual funds. In the latter's case, a bonus option works out to be a low-risk, tax-efficient investment to manage short-term and long-term capital gain tax liability, wherein the distributable profits of the fund are capitalised in the form of bonus units. The first fund to offer such an option was JM Mutual fund, which introduced this in its open-ended Income fund in March 2002. Since the fund declared a bonus before fiscal-end investors had an opportunity to defer their capital gain tax-liability.
Following in JM's footsteps is Pioneer ITI Mutual. Recently acquired by Franklin Templeton Investments, this AMC has introduced a bonus plan for all its debt schemes: Income Builder Account (IBA), Monthly Income Plan (MIP), Gilt Fund, Short-term Income Plan and Treasury Management Account (TMA). This is in addition to the existing growth and dividend options of these schemes. This AMC has positioned the bonus option as a grand incentive for investors with less than 1-year investment horizon.
Here is an account of how you can use the bonus option to reduce the tax burden:
Suppose you invest a sum of Rs 10 lakh in the bonus option of a fund at NAV of Rs 20. So you have 50,000 units in your account in the beginning. Assuming that the fund is likely to declare a bonus of 1:1 (1 unit for every 1 unit you hold.). Now while the value of your investment stays the same (Rs 10 lakh), you hold twice the number of units (1 lakh) and the NAV gets reduced to Rs 10. So, if you redeem your original units at reduced NAV, you book a short-term loss of Rs 5 lakh. This, in turn, can be offset against a capital gain, if any standing in your books. Therefore, you don't have to pay any capital gains tax in the current fiscal. The balance units, i.e., 50,000, are now worth Rs 5 lakh. By redeeming the bonus units at the end of the next financial year, you pay a tax of 10.5% (inclusive of the surcharge) on your long-term capital gains of Rs 5 lakh, assuming there is no appreciation in the value of your holdings (or NAV). The tax payable will then amount to Rs 52,500.
However, all this would be meaningless if the market watchdog, SEBI, decides to withdraw the tax status accorded to bonus issues. If that happens then it will be back to the drawing boards for AMCs who will have to design a new tax-friendly package to woo investors.
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