Use Bonus Option of Mutual Funds to Save Tax

You might know about Growth and Dividend option while investing in mutual fund but very few of us are aware of the “Bonus” option offered by mutual funds. In this post I have written about what bonus options of mutual funds mean and how it can be used to save taxes!

What is Bonus option?

We take example of Arbitrage Mutual Fund which has Net Asset Value (NAV) of which is Rs. 20.

Below is example explaining Growth, Dividend and Bonus Option.

• NAV – Rs 20
• Investment Done – Rs 1,000,000
• Number of Units bought – 50,000
• Return for 1 Year 9%
• At end of 1 Year the the above investment would grow to Rs 10,90,000 but this would be paid in different ways depending on the option chosen.

For Growth option the NAV would increase by 9%, so the new NAV would be Rs 21.8 and your number of units remain at 50,000. So your fund value = 21.8 X 50,000 = Rs 10,90,000

In case of dividend option the fund can give entire profits as dividend. So in this case the fund might payout Rs 1.80 per unit as dividend. At the end you would have 50,000 units of the fund with NAV as Rs 20 and additional Rs 1.80 X 50,000 = Rs 90,000 as dividend. [Here I have ignored DDT for simple calculation]

In case of bonus option, suppose the fund declares bonus ratio of 2:1, which means that for every 2 units investors would get 1 additional unit. So the investor would get additional 25,000 units.
Total units after bonus = 75,000
NAV (after bonus) = Rs 21.8 X (2/3) = Rs 14.53 [as the NAV adjusts for bonus units]
Your maturity amount = 75,000 * Rs 14.53 = Rs 10,90,000

How Bonus units save Taxes?

We take the above example and show you how you can save taxes with time lines.

Below is the calculation:

Purchase Amount = Rs 20 X 50,000 = Rs 10,00,000 [on April 1, 2014]

NAV just before Bonus = Rs 21.8 [on March 14, 2015; assuming 9% returns in the period]

Bonus – 1 bonus unit for every 2 units held

NAV adjusted for bonus bonus = Rs 14.53 [on March 15, 2015]

Number of total units after bonus = 50,000 + 25,000 = 75,000

After the bonus is declared you can redeem your initial 50,000 units in the fund.
Redemption Amount = Rs 14.53 X 50,000 = Rs 7,26,667 [on March 16, 2015]

As the fund is sold within one year of purchase, it would lead to Short Term Capital Loss = Rs (10,00,000 – 7,26,667) = Rs 2,73,333

This short term capital loss can be adjusted against any Short Term or Long Term capital Gains from other assets in the financial year. Additionally if you cannot offset it fully in this financial year, you can carry forward this loss to next 8 years!

Next you can sell the remaining units after 1 year of bonus declaration.

So assuming 9% annual return

• NAV [on March 15, 2016] = Rs 15.84
• Redemption Amount = Rs 15.84 X 25,000 = Rs 3,96,033
• Purchase Cost = Rs 0 X 25,000 = Rs 0 [Bonus units are considered to have 0 purchase price for tax calculations]
• Since the redemption is after 1 year, the gains would be Long Term Capital Gains = Rs 3,96,033

As arbitrage funds are considered equity funds, long term capital gains are tax free!

Points to Remember:

• To be eligible for bonus units and claim tax benefit as above, you should be invested 3 months before the bonus record date and be invested for 9 months after record date
• The problem with the above strategy is the bonus declaration is not very frequent and it’s difficult to predict when the bonus would be announced
• A number of debt and arbitrage funds have started Bonus option in their funds in 2014
• There is no tax benefit in case the bonus is declared after 1 year of investment in Arbitrage Fund as then the losses are termed as Long Term Capital losses which cannot be offset against other gains.
• The above idea also works for companies offering bonus shares.
• In case of debt mutual funds, the above strategy would work if the bonus is declared within 3 years of purchase and the bonus units are sold after 3 years from bonus record date. In this case the later would generate long term capital gains which have lower tax than short term capital gains for people in higher tax bracket of 20% or more.
• Sale of Bonus units are not subject to exit Load

The above process of taking Tax Advantage is known as Bonus Stripping and is perfectly legal.