Jigar M. Patel
International Tax Attorney
Issuing bonus shares is a popular mode by which companies reward their shareholders. Bonus shares are allotted to shareholders out of the free reserves of the company without any cost being recovered from them. The issue of bonus shares is decided by the board of the company, based on a proportion to the actual number of shares held by each shareholder.
Receipt of Bonus Shares Taxable?
There is no tax liability in the hands of the shareholder on actual receipt of bonus shares, as it is not in the nature of any income distribution. However, under Section 55 of the Income-tax Act, the cost of acquisition of the bonus shares is treated as ‘Nil,’ thus giving rise to liability for capital gains tax at the time of their sale. Post bonus issue, the cost of the pre-bonus holding is treated at the same value and not averaged down on a proportionate cost basis.
How Bonus Stripping evolved as a tax saving strategy?
Keeping in view the above provision for determining cost of original holding of equity shares, bonus stripping came to be evolved as a strategy by investors for avoidance of their capital gains tax liability. As part of bonus stripping, an investor purchases equity shares or units of a mutual fund, just before the issuance of their bonus. Post bonus, there is a proportionate drop in the listed price of the shares or net asset value (NAV) of the units. On sale of the original shares or units held by the investor, it results in a book loss, which he attempts to set-off against his other taxable capital gains and thus plan to avoid his tax liability.
Bonus Stripping captured in the Tax Trap
Section 94(8) came to be introduced to plug tax avoidance via bonus stripping. Under the provisions of this section, if a taxpayer acquires any shares or units within three months prior to the record date on which issue of bonus is announced and if any such shares or units are transferred within 9 months from such record date, the capital loss arising from such transfer shall be ignored.
Smart Tax Saving via Strategic Bonus Stripping
The case-study below highlights how an investor can reap some smart tax saving if he plans bonus stripping in a strategic manner.
Case-Study: Sharma purchases 1,000 shares of a company on 1st May, 2024 at Rs. 500 each. The company declares a bonus issue in the ratio of 1:1 on 10th June, 2024, when Sharma receives 1,000 additional shares as bonus. Post bonus, the share price proportionately drops to Rs. 250 per share. If Sharma sells any of his original shares within nine months of the record date, that is anytime until 10th March, 2025, he would not be entitled to claim consequential loss in view of the provisions of section 94(8).
However, if he is patient enough to sell the originally held 1,000 shares in the last week of March 2025, when the share price is listed at Rs. 300, he would comfortably escape the tax trap of bonus stripping since the sale would be outside the nine-months window period. In this case, he can claim short-term capital loss (STCL) of Rs. 2,00,000 (1,000 shares purchased at Rs. 500 and sold at Rs. 300). This STCL can be set-off not only against STCG from equity, but also from any other capital asset.
Undoubtedly, he will need to bear in mind that whenever the bonus shares are sold, the entire sale consideration would be taxable. If held for more than 12 months, they would attract tax on LTCG at 12.5%.
