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Budget 2022 plugged the loophole of setting off of derivatives market profit with cash market losses

21 October 20224 mins read by Angel One
Budget 2022 plugged the loophole of setting off of derivatives market profit with cash market losses
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In Budget 2022, Finance Minister Nirmala Sitharaman proposed to extend the scope of bonus stripping to include share transactions under the umbrella. This will disallow the investors from setting off the derivatives market profits with cash market losses.

The step has been taken to plug the loophole that was being taken advantage of by many investors. Along with that, the government has also extended the provision related to bonus stripping to various other trusts and funds.

What is Bonus Stripping?

Upon learning that a company is about to issue bonus shares, investors used to buy the shares of that company. Later, upon issuance of bonus shares, investors used to sell the original shares and keep the bonus shares. As the price of the share falls after the bonus issue, they used to book short-term capital loss on the sale of such originally purchased shares. This short-term capital gain was utilised to set off other incomes.

Another benefit they derived from this arrangement was the low tax rate on bonus shares. If an investor held the bonus shares for more than a year, they can get the benefit of a reduced tax rate on long-term capital gain from such shares.

Who might get affected by this change?

Investors such as hedge funds, high net worth individuals (HNIs), foreign portfolio investors, and other large-scale investors are likely to get affected by this change. They might have to shell out more money on the taxes paid on profits earned from derivatives.

All the investors who utilised the bonus stripping to reduce the tax liability on gains earned from derivatives market income may get affected by this disallowance. Investors may find other ways of tax-planning.

Other Auxiliary Changes

Further, in the Budget documents, it was also registered that the bonus stripping rules were also extended to certain other investment assets like Infrastructure Investment Trusts (InvITs), Real Estate Investment Trusts (REITs), Alternative Investment Funds (AIFs), etc.

The Union Government has also tightened the dividend stripping rules which has a similar working mechanism. In the case of dividend stripping, investors sell shares upon learning about the dividend and use the short-term capital loss to set off against other income.


What are Alternative Investment Funds?

Alternative Investment Funds, commonly known as AIF, are a type of private fund that collects funds for sophisticated investors and pools them up. These investors can either be foreign or domestic. Later, these investment vehicles invest the pooled money according to their investors’ defined investment policy.

Are the tax rates for capital gains on equity and derivatives different?

Yes, the tax rate for capital gains on equity is 10% to 15% whereas the capital gains from derivatives are subject to a 30% rate of tax. This is because the equity market capital gains are taxed at a fixed rate based on whether it is a long-term profit or a short-term profit. On the other hand, derivatives market profits are considered as business income and therefore, are subject to tax as per the applicable tax rate to the assessee.

What are the benefits of bonus stripping?

Although the investors incur a short-term capital loss by selling the original shares, they receive two main advantages from this arrangement. One is additional bonus shares and the other is the ability to set off the short-term capital loss with other income. Investors also hold bonus shares for more than one year to get the benefit of reduced tax on the long-term capital gain from such sale of shares.

Disclaimer: This blog is exclusively for educational purposes and does not provide any advice/tips on investment or recommend buying and selling any stock.

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