Bonus shares are free additional shares that a company may decide to issue to its existing shareholders in a certain proportion to the current holding.
MUMBAI: Like good back benchers, Rakesh Khanna was lost in his thoughts. He usually paid attention in class, but today was different. Before the class started, the heartthrob of the class, Suma Ganeshan, had come up to him, and asked him a question. She wanted to understand the tax implications of bonus shares. This was something he himself was trying to figure out, and if he wanted to make some impression on her, he had to figure it out soon. Both Rakesh and Suma were students of Sentinel Centre for Human Resources Management (SCHMRD).
After class, Rakesh logged onto the best professor of them all, www.google.com. In sometime he became expert enough to talk some sense, when Suma came calling.
Bonus shares are free additional shares that a company may decide to issue to its existing shareholders in a certain proportion to the current holding. So if a company comes out with a 1:1 bonus issue, an investor gets 1 free share for every share that he holds.
When an investor receives bonus shares he does not need to pay any tax. A company has a certain amount of reserves, which it has built over the years, by retaining a proportion of the profit and not giving it out as a dividend. When bonus shares are issued the company converts a part of these reserves into shares. There is no outflow from the company to the shareholder. Given this, the shareholder does not earn any income and hence there is no tax.
Suma was impressed. This guy had some brains. But she still had some doubts. “What happens if I sell the bonus shares?” When an investor sells any shares he makes a capital gain. The capital gain is the difference between the cost of acquisition of the share and the price at which it is sold. But what is the cost of acquisition (COA) of a bonus share? As per the Income Tax Act, the COA of a bonus share is nil.
Take the case of Wipro. It announced a 1:1 bonus on April 22, 2005. On August 22, 2005, the stock, went ex-bonus i.e, the bonus shares became available in the market. If an investor sold these bonus shares on January 17, 2005 at the closing price of Rs 448.35, he would need to pay a 10% short-term capital gain tax. This would amount to a tax of Rs 44.835 on each share. Short-term capital gain tax has to be paid if the shares are sold within one year of getting them. On the other hand if the investor decides to hold on to the shares and sell them only after a year (sometime after August 22, 2006) the capital gain becomes a long-term gain. As per present regulations, long-term capital gain, in case of shares, does not attract any tax.
But how do you identify bonus shares from the shares that are originally held? Let’s say an investor had 100 shares of Wipro. After the 1:1 bonus,, he has 200 shares. If on January 17, 2006 he decides to sell 100 shares, has he sold the original shares or the bonus shares? As per the Income Tax Act, the first in first out system works in such cases. So the shares that the investor sells would be the shares that he bought originally and not the bonus shares. But the next time he decides to sell Wipro shares, bonus shares would have been deemed to be sold. And depending on the period of holding,capital gain tax would have to be paid.
Suma was impressed. “I should be spending more time with this guy,” she thought. They say, “A way to a man’s heart is through his stomach”. And a way to a woman’s heart? Well that they are still trying to figure out.
The example is hypothetical
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