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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.

  • Anonymous says:

    >Hi Deepak,

    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

  • Deepak Shenoy says:

    >Anshul: Nope, unfortunately not. Gains in property can only be offset by investing the gain amount in another property, or buying 54EA investments like bonds from Rural Electrification Corporation.

  • Anonymous says:

    >Hi Deepak,
    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

  • Deepak Shenoy says:

    >Hi Saravanan: Yes, it works for demat shares as well, which, like materialised shares, are measured in FIFO for tax purposes.

    Read this article and the Income Tax Act, Section 45, Item 2A.

  • The Green Man says:

    >Hi Deepak,
    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 ?

  • Deepak Shenoy says:

    >GreenMan: Getting professional advice is always helpful, but nowadays good professionals are swamped with work during the times you need them the most. Plus, your work is perhaps too small for their time.

    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.

  • Newbie_Blogger says:

    >hi Deepak,

    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.

  • Deepak Shenoy says:

    >Karthick: Thanks…and no the company does not benefit. It just moves an entry from one head (reserves) to another (equity capital). There is no impact on profit or revenue or otherwise.

  • Anonymous says:

    >Hi Deepak,
    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.

  • Anonymous says:

    >Pls take a look at the below article which maintains the holding period to be 3 months before and after the record date.
    http://www.rediff.com/money/2004/mar/27shan.htm

  • Deepak Shenoy says:

    >anon: No, that’s only for dividend stripping (you need to either buy 3 months prior or hold till 9 months after the dividend) No such rule applies for bonus – bonus stripping is tax-legal.

    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).

  • Jignesh says:

    >hi deepak, thats a very useful information, thanks..

    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.

  • Deepak Shenoy says:

    >jignesh: no dilution to shareholders, since all of them get proportionate bonus shares to their current holding.

    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.

  • Anonymous says:

    >Hi Deepak,

    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?

  • Anonymous says:

    >how much time after company giving a bonus share. give me proper guidline of company bonus share. one time company give a bonus share and after company hope to give a next time bonus share. what a time limit of bonus share.

  • Nilesh says:

    >Deepak,

    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

  • Anonymous says:

    >Hi Deepak
    i want to know what are the benifits gain by company to issue bonus shares n split shares

  • Venu says:

    >Hai,

    Now GAIL has informed bous share 1:2, so if i buy shares now then am i eligible to get bonus shares

  • amit says:

    >This is not right. Section 94(8) is applicable only to Mutual Funds and not shares. So for shares you can still follow the same process.

  • zakir says:

    >Hi Deepak,
    I ll be greatful to you for clarifying my below said doubt..

    I was holding GMR Infra 150 shares @ 150 rs.

    Recently with split share( 1:1 ), i had 300 shares at 75 rs.

    i bought some shares and reduced my buying average to 70rs..

    Now i sold 250 shares @ 72 ( with profit of 1.25rs/share )

    But my scrip summary shows zero stock balance ( though i am holding 50 shares ) and that i have suffered loss.

    I am unable to understand whether i have had profit/loss.
    Please let me know and whom should i contact to update my scrip summary statistics.
    Thankin you
    Zakir,,,,,

  • Anonymous says:

    >That is against the tax law. misleading people!!! writer should study tax legislation before post any advice.

  • Saket Agarwal says:

    Hi,
    This article of yours is by far the most enlightening. So many concepts have become clearer after reading your article.
    I appreciate your selfless contribution here. Keep up the good work