Anup Pragya from XYZ Financial Advisor mentioned that I can invest in this Mutual Fund which will issue additional bonus units and my tax liability will also be substantially reduced. This seemed like an acceptable and foolproof method of saving tax on my exit transaction.”, Mr. Mahesh Kamath told me.

“Sir, we believe that this investment is in the grey zone. Given the size of your transaction, I definitely think this will come up for Income Tax scrutiny and most likely dispute.”, I told Mr. Mahesh after much thought.

“Are you sure?”, said Mr. Mahesh

“There is one way to find out, Sir. Let’s ask XYZ Financial to send an email with their proposal.”, I replied.

The year was 2013 and this could have been IGR Consultants’s biggest new business transaction. Mr. Mahesh Kamath who had been our client with a portfolio of around 25 lakhs until then had decided to enjoy his golden years and sold his stake in his company. The capital that was generated, as a result, amounted to tens of crores. Now that kind of sum also leads to a sizeable tax liability which in Mr. Mahesh’s case was around 12.7 Cr even after investing under Sec 54 in Capital Protection Bonds and a New Dream House. It is not easy for the savviest of people to see a huge amount being taken by the taxman from your bank account. We look for ways to legitimately save the tax.

The advice by XYZ Financial Advisors, a leading financial institution, stoked the emotion to save tax but did so by stretching the boundaries of legitimacy of the allowable means. To this date, I can’t figure out how they got wind of the large transaction of Mr. Mahesh within a day. Pragya, a senior partner with a couple of Advisers, armed with Apple MacBook Pros, glossy brochures and polished slides made an impressive presentation to Mr. Mahesh on how they can manage his money with a slew of strategies and products that will generate outsized returns and double/triple his portfolio in record time. IGR Consultants was no match for this kind of competition. Our largest portfolio at that point was around 5 Cr.

One such strategy that XYZ Financial suggested was bonus stripping with an equity-like mutual fund. Bonus stripping had been a practice of wealthy investors of buying units of a mutual fund to take part in a bonus issue, which allowed them to book losses on the original value invested and then set it off against gains from other sources like a stake sale. The capital gains from bonus units, whose cost is taken as 0, became nil after one year as long-term capital gains on equity holdings were tax-exempt at that time.

On paper, this strategy looked perfectly fine but there was one problem. The information that the suggested mutual fund was going to issue bonus units was not public information. So, an investor putting a large sum of money in the scheme and then selling the units at a loss after the bonus issue claiming big tax savings was too big a coincidence for income tax authorities to ignore. Though there have been strict SEBI rules and regulations against insider trading, it seemed that neither the Adviser nor the Mutual Fund provider thought much of it. The gullible investors believed they were getting into a foolproof transaction, saving tax in an allowed legal manner by the system.

So, after two days I got a call from Mr. Mahesh. “Hello Anup, Pragya has sent me an email from her personal email ID confirming the strategy.” The usage of personal ID did not give me confidence that everything was in order.

I said, “Sir, you have earned this money after starting the company from nothing and hard work of more than 25 years. The most important thing for you in the future will be the peace of mind and a sleep-well portfolio. Besides, you can also take this tax payment as your contribution to society because not everyone is privileged to be in this position.”

Then I waited with bated breath because I had just staked a potentially large growth for IGR Consultants with my bold statement. There was an uncomfortably long silence on the other side of the phone.

Finally, I heard Mr. Mahesh speak, “Anup, you have given me a very important perspective today. I will not be using the bonus stripping strategy. I have also decided to not appoint XYZ Financial Advisors as my Adviser. IGR Consultants will manage my portfolio.”

All I could say at that time was, “Thank you Sir, for your trust in IGR Consultants.”

Thanks to Mr. Mahesh for trusting IGR Consultants with our judgement because within a year the practices related to bonus stripping caught regulatory attention and tax authorities disputed the transactions. Many investors were caught unaware and had to file cases and appeal to resolve the situation.

The Government and the Income Tax department came up with provisions under Section 94(8) in the 2018 budget to plug some of the loopholes in bonus stripping. Introduction of Long-Term Capital Gains Tax in the same budget also took away the sheen of bonus stripping.

Often, we all get tempted to stretch the rules and regulations so that we can benefit. It is never an easy choice but at IGR Consultants we have always erred on the side of caution. Risk Management is our way of working and being Fiduciary to our clients, our motto.

Make sure you have an Adviser who will let you tread the thin line between Right and Wrong carefully!