What are Bonus Shares: They are new shares issued to existing shareholders without any additional cost. It is usually distributed based on the proportion of the current holdings of an investor. Bonus shares are the accumulated earnings of a company which is not given out as dividends but converted into shares. This practice is also called a Bonus Issue of shares.
Example: A company might announce bonus shares in the proportion of 1:1. This means that for every 1 share held by an investor, the company issued another 1 bonus share. Since the investor now holds two shares, EPS gets halved. Hence the bonus shares do not affect the EPS of the investor.
Note: Bonus shares are considered free shares as their cost of acquisition is taken as zero, although they are not free in the true sense.
Advantages of Bonus Shares
As mentioned above, bonus shares do not have any impact on total EPS. If total EPS doesn’t change, then the question arises – what’s the need for bonus shares? Bonus shares help in solving two purposes:
- Increase the Liquidity Base: When the price per share of a company is relatively high, it becomes difficult for the investors to buy new shares. Hence, bonus shares are issued to investors. An increase in the number of shares results in downward pressure on the stock price and reduces the price per share. This increases the marketability and liquidity of the shares and in turn, the retail participation.
- Tax Saving through Bonus Shares: In the case of cash dividends, companies have to pay dividend distribution tax resulting in diminished returns for investors. In the case of bonus shares, no dividend distribution tax is levied.
Tax Calculation in Case of Capital Gains
Any profit or loss arising on the sale and purchase of shares/securities falls under the head “Capital Gain” (Except Business Income for those who are involved in the business of sale and purchase of shares). Before we talk about Bonus Shares, let’s take a look at Tax Implications on LTCG (Long Term Capital Gains) and STCG (Short Term Capital Gains).
| Type of Capital Gain | Tax Rate |
| Long Term Capital Gain (when Securities Transaction Tax is not applicable) | 20% + Surcharge and Education Cess |
| Long Term Capital Gain (when Securities Transaction Tax is applicable) | Exempt |
| Short Term Capital Gain (when Securities Transaction Tax is not applicable) | Normal slab rate applicable to Individuals |
| Short Term Capital Gain (when Securities Transaction Tax is applicable) | 15% + Surcharge and Education Cess |
The taxability of gains from the sale of Equity and Debt mutual funds are different. Funds with more than 65% of the portfolio consisting of equities are called Equity Funds.
Tax Calculation in Case of Bonus Shares
The cost of acquisition of bonus shares is taken as zero hence the capital gain on selling a bonus share issue is equal to its selling price.
Let us take an example to understand the calculation of capital gain tax in case of transfer of bonus shares.
| No. of Shares held originally | 100 |
| Bonus Announcement | 1:1 |
| Total Number of Shares post bonus | 200 |
| Purchase Price | 50 |
The total number of shares held after the bonus issue will be 200. Now, the investor sells 100 shares @INR 50 before 1 year. Taxable Short Term Capital Gain would be as under-
| Selling price (100*60) | 5000 |
| Cost of acquisition (100*40) | (4000) |
| Capital gain on sale of original shares | 1000 |
Short Term Capital Gain tax of INR 150 (i.e. 15% of INR 1000) is payable.
Now, the investor sells the remaining 100 shares after some time (in the same year) @INR 50. Taxable short term capital gain on transfer of bonus share would be as under-
| Selling price (100*50) | 5000 |
| Cost of acquisition (100*0) | 0 |
| Capital gain on sale of bonus shares | 5000 |
Short term capital gain tax of INR 750 (i.e. 15% of INR 5000) is payable.
Note: Long term capital gain tax on the transfer of shares is payable @10% from F.Y. 2018-2019.
What is Bonus Stripping?
Now investors mainly indulge in Bonus Stripping to evade income taxes. The transaction related to the buy/purchase of Bonus Shares is done in a manner where the net result would be a Short Term Capital Loss. This loss can later be adjusted against any Capital Gains.
Example
- Investors buy units three months before the record date of the new bonus shares
- Once the company issues the bonus shares, the investors sell the original shares they bought above
- This leads to Short Term Capital Loss
- After 1 year, the investor sells the bonus shares
- Yash identified that Parle is going to issue bonus units in the ratio of 1:1. Before the record date, he acquires 400 units of Parle. The price of the units on the said date was INR 500. Total purchase price= INR 2,00,000.
- On the day of the bonus issue, he receives 1 bonus unit for every unit held i.e. 400 bonus units.
- Now, post the bonus issue, the market value of the units will decline. Each share is now worth INR 200. Yash sells the 400 units he purchased for INR 200. He makes a loss of INR 1,20,000.
- Later, after a year, he sells the bonus units. Since the cost of acquisition of bonus units is Nil, the entire proceeds received from the sale of bonus units would be his long term capital gains.
In this case, Yash can first set off the short term losses made from original units held, against the long term capital gains made from the sale of bonus units. Subsequently, if the capital gains remaining after set-off is greater than Rs 1 lakh, he would be taxed on it at the rate of 10% only.
Income tax implications on Bonus Stripping
Section 94(8) of the Income Tax Act, 1961 keeps a check on the Bonus Stripping. It stated 3 conditions when a shareholder cannot carry forward or book loss on sale transactions. Also, These losses would be considered as the Purchase Price of the bonus units acquired if a person:
- acquires units within 3 months before the record date
- on which bonus units are subsequently announced,
- and the original units are sold within 9 months from the record date
Keep in mind, the practice of bonus stripping is considered narrow-minded and anyone can get caught u/s 94(8) of the Income Tax Act, 1961
To conclude, bonus shares have a lot of advantages. It is a great way for companies to increase their liquidity base and enhance the faith of investors. It also yields a higher dividend to investors as he holds a larger number of shares in the company due to bonus shares.