Taxation rules for bonus share and stock split

Companies pay dividends to share the earnings. They do it in two ways, either as bonus share (also known as stock dividend) or cash dividend. In case of cash dividend, cash is paid to the shareholders after the companies’ pays dividend distribution tax. However, the tax implication of bonus share is not so clear for many investors. This article will try to explain the tax implication and how it works in bonus share. We will also discuss the tax implication in case of share split.

Bonus share

Bonus shares are also known as free shares even though this is misleading. A share is not a hard currency as such but a certificate which depends on the earning and the portion of earning (also known as EPS) for its value. For example, suppose a company has earned 100 crore as profit and it has 1 crore shares outstanding, the earning per share (EPS) will be Rs. 100. This also means your share is ideally earning Rs 100 every year, with some growth.

Now if the company announces bonus share in the ratio of 1:1, means investors will get 1 extra share for every 1 share they hold, the number of shares outstanding will be 2 crore. This will reduce the EPS to Rs. 50. This means your share will earn Rs. 50 per year with some growth. But since you own 2 shares now because of bonus share, your earning will be Rs 100.

Certainly, you will pay much less for a share that earns Rs 50 than a share that earns Rs. 100.

If this is so, what is the use of bonus share?

The use of bonus share is twofold.

It helps improve liquidity of the stock.

When companies issue bonus shares, the number of shares in the market goes up. Since there is more number of shares, the price of shares comes down. Usually, a low price of shares increases its liquidity or trading volume because of the general feeling that the stock is now available at “cheaper” price.

It saves taxes for investors

Bonus shares save taxes both for the company and the investor. These shares are treated like any other share where you pay taxes only when you sell them and earn a profit. If you have sold them before 12 months of getting it, you have to pay short term capital gain taxes. If you sell it after a year of getting it, there is no tax on the gain. The cost of bonus share for the calculation of profit is taken as zero. This explains why bonus shares are considered free shares.

Let’s take an example to calculate the tax. We will only consider short term capital gain taxes.

Investor status

Number of shares bought on 1st Jan 2011

100

Share price when purchased (on 1st Jan 2011)

300

Bonus shares received (on 1 May 2011)

1 to 1

Total number of shares in the account

200

Suppose the investor sells 100 shares on 1st Dec, 2011 at Rs 310 per share. Since this is short term gain. He or she will have to pay taxes on the gain 100 * (310-300) = Rs 1000. The tax rate is 15%.

Now suppose the investor sells other 100 shares on 1st Mar, 2012 at Rs 310 per share. Since the sale happened before 1 year of issuance of bonus share, he or she will have to pay short term capital gain tax at 15% of the profit. However, in this case the tax liability will be different. As explained earlier, the acquisition price of bonus share is taken as zero. Hence the short term capital gain will be 100 * (310 – 0) = Rs 3100 and you will have to pay tax on the gain of Rs 3100.

If you sell them after a year, you don’t have to pay taxes on capital gain. This is where the advantage of bonus share comes in for investors.

A note on bonus stripping

When bonus shares are issued, the price of shares falls. Hence there may be opportunity to sell the original shares and book notional loss. This loss can be offset against short term capital gains to save taxes. At the same time, you have the bonus share with you anyway which can be sold at a later date to earn profit. We will give more on this in our later article. Income tax officials introduce different ways to tackle this. This doesn’t mean you should not do it. You must take advantage of the system. Income tax department has introduced few rules which have to be followed and you can use bonus share to save taxes and make profit.

Stock splits

Stock splits are almost like bonus share but the tax implication is little different. In this case, the cost of acquisition will also be reduced in the same proportion. For example, if an investor holds 100 shares bought at a rate of Rs 300, his or her total investment will be Rs. 30,000. If the company splits the shares in the ratio of 1:1, the investor will have 200 shares after the split. What is different in this case is that the purchasing price of share will also go down by 50%.

Hence when investors sell the shares in the market at Rs 200 per share, the capital gain will be number of shares * (200 – 150). The purchase price to be taken for calculation of capital gain will be Rs. 150 and not Rs. 300.

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