Sunday, October 29, 2006
Bonus shares: A tax saving scheme?
Only profitable companies can give a bonus, out of their profits. Technically, a bonus is nothing but moving a liability (profit or reserve) over to capital. So it doesn't affect the balance sheet at all on the assets side, only minor moves on the liabilities side.
But we notice that stock prices of companies that have offered bonus shares suddenly ZOOM ahead in the market. Why? There's no reason to do so, is there?
There is. And it's a legal way to avoid paying tax.
(Post Note: It Used to be legal, now it has been plugged. The following article is only useful for historical notes, and is no longer applicable - Deepak, 2007)
Avoiding tax through bonuses
Let's say you're a stock trader with Rs. 15 lakh in short term capital gains. This, in general, would need you to pay 10.2% short term capital gains tax, which is an outflow of about Rs. 1.5 lakhs, which you can only offset if you have a short term capital loss. How do you have such a loss without really losing money?
The answer: Bonus shares.
Let's say a company's stock is at Rs. 300, and offers a 1:1 bonus. You buy 10,000 shares for Rs. 30 lakhs (okay, you're a rich trader) before the bonus record date (usually a date much after the bonus announcement).
Now after the record date the price comes down to Rs. 150 and you now have 20,000 shares. Sell 10,000 shares. The tax department expects you to price shares based on "First In First Out", and for pricing purposes the cost of bonus shares is ZERO; so you have:
10,000 shares at Rs. 300
10,000 shares at Rs. 0
If you sell 10,000 shares at Rs. 150, the first lot is sold - so you incur a Short term LOSS of Rs. 150 per share, a total loss of Rs. 15 lakhs. This completely offsets your gain you had made earlier so you now have to pay no tax.
What about the remaining shares, you say? Well, hold them for a year, and since long term capital gains tax has been removed, you can safely take home the money. Other capital gains saving avenues need you to hold for at least 3 years, and this is a one year holding only!
That's why the share price of companies goes up when they make bonus announcements. So many traders buy to make their short term capital gains lesser!
Note: Bonuses are different from "split" shares in this regard. For tax purposes of Split shares, "The cost of such shares gets proportionately divided and the period of holding also continues to be the same as that of the original lot." So the aforementioned bonus based tax avoidance scheme is not available.
Note also that the method mentioned above is legal. The I.T. department may remove this loophole soon, of course, just as they did with dividends.
Post note, 2007: It seems that the MoF has cut the bonus stripping ability too. In Section 94, subsection 8, the law states that if you get any bonus units for shares purchased within three months prior to the record date, and then sell the original shares within nine months AFTER the record date, you can't claim the loss. (But the loss can be considered as acquisition cost of the remaining shares).
Meaning, if the record date is Feb, and you buy 100 shares in Jan for Rs. 200 each, and get another 100 as a bonus. Now if you sell the first 100 in March for Rs. 120 each, the loss will be Rs. 80 per share, which can't be taken as a loss - but it can be taken as the cost of the remaining 100 shares.
20 Comments:
Thanks for a great post and informing us about this legal loophole.
Would like to know just one thing that whether capital gains in property can be offset by short term losses in stocks or not?
Thanks,
Anshul Gupta
Does this hold good for shares held in demat format as well? Because I was of the opinion that shares in demat format follow "Last in first out" logic. i.e. if we sell half of our holding after bonus issue, the bonus shares will be considered as the ones that were sold.
Thanks,
Saravanan
Read this article and the Income Tax Act, Section 45, Item 2A.
Since these tax rules are so complicated, would you advise hiring a professional to make the tax calculations and providing such possible advices to save tax for individuals ?
Remember that you should always be aware of the law. A professional may give you advice, but the responsibility of your taxes is yours alone.
So hire a professional if you must, but keep yourself informed as well.
I am a first-time visitor to your blog. The article on bonus shares was very useful. Thank you.
I have a related question. Does a company benefit in any way by declaring a bonus issue?
thanks,
Karthick.
For the Bonus shares to work for making short term capital loss, Is there any rule which says, the Stock needs to be purchased 30 days in advance ( or some X period) before the record date.
I had come across something of this kind. Pls clarify.
http://www.rediff.com/money/2004/mar/27shan.htm
Even the rediff article mentions the period only for dividend stripping.
There is an element of caution there - a law can later be passed with potential retrospective effect later (like it was done with dividend stripping).
i was wondering about effect to issuing company. doesnt bonus issue dilutes companies share holding. it also dilutes it eps so ultimate effects comes on the share price and pe of the company. this is one more way to increase control in the company. can u pls through some light.
There is an effect to EPS, which is why share price changes (for 1:1 bonus, share price becomes half) PE is technically not affected.
There is no way to increase promoters holding in the company through bonus shares. It can be done only through preferential or rights issues.
Thanks for your very informative blog.
I have 2 questions I am hoping you might be able to answer.
1. I understand that (at least until recently) it has been very common for Indian companies to issue bonus shares. Companies in India seem more inclined to issue bonus shares than companies in other countries. I understand that this is because, historically, Indian shareholders have obtained very favourable tax treatment in respect of bonus shares issued by Indian companies. However, I see that you have posted a note saying that "It Used to be legal, now it has been plugged. The following article is only useful for historical notes, and is no longer applicable - Deepak, 2007." My question is: Now that the tax benefit has been "plugged", will Indian companies be less inclined to issue bonus shares than they have been in the past? Or, is it the case that there other good reasons for issuing bonus shares which mean that Indian companies are likely to continue issuing bonus shares as often as they have in the past?
2. When Indian companies issue bonus shares, do they usually issue bonus shares "at par value", or instead, do they usually issue bonus shares "at a premium"? Also, does the recent "tax plug" referred to above, affect what is likely to happen in this regard in the future?
What if the condition of 'holding stock for more than 3 months prior to the record date'. Can, then, such original units be used to square off ST capital gains ?
nilesh
i want to know what are the benifits gain by company to issue bonus shares n split shares
Now GAIL has informed bous share 1:2, so if i buy shares now then am i eligible to get bonus shares
Disclaimer: The author of this page is not a registered financial advisor, and you should not construe anything written here to be investment advise. You should consult a qualified broker or other financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. No representation is being made that any investment made on the basis of data or information on this blog will result in profits. Te author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments. In short: Apply your own thoughts before investing; I could be wrong. I do not accept responsibility for any losses incurred by interpretation of content in this blog. Further all content on this blog is free to view; no reader is expected to pay any amount as fee or any other consideration to me (the author) for reading my views.