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Bonus shares: A tax saving scheme?

Lots of Indian companies offer “bonus” shares: a 1:1 bonus means that for every share you own, you get one “free” share. Now given that the company’s fundamentals don’t change, the number of outstanding shares doubles but the net profit remains the same. Meaning, to retain the same P/E, the share price must come down by half.
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.
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 for mutual funds. In Section 94, subsection 8, the law states that if you get any bonus units for funds 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 units 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 units , which can’t be taken as a loss – but it can be taken as the cost of the remaining 100 units.
This doesn’t apply to shares. You can still save tax by bonus stripping on shares.

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