We know that making investment in securities / shares is one of the common investment avenue available to an individual in addition to making fixed deposits, purchasing land or building etc.

In shares, bonus shares are often issued by the company. Bonus shares are used by the company as one of the method of capitalizing their profit and to improve the marketability and liquidity of the shares in the stock market (since number of shares increases and price per share falls after issue of bonus shares).

Any profit or loss arising on sale and purchase of shares / securities falls under the head “Capital Gain” (Except Business Income for those who are involved in to the business of sale and purchase of shares)

In this article we will discuss about tax advantage available to an individual in case of bonus shares.

Before that let’s understand the existing and proposed (by Finance Budget 2018) tax structure on Long Term Capital Gain (LTCG) and Short Term Capital Gain (STCG).

Existing Capital Gain tax structure for FY 2017-18 for Individual

Nature of Capital Asset Short Term Capital Asset Long Term Capital Asset STCG Tax Rate LTCG Tax Rate
Listed Securities (other than unit) in a recognised Stock Exchange in India Holding <= 12 months Holding > 12 months 15% NIL u/s 10(38)
Unlisted shares (Both equity and Preference) Holding <= 24 months Holding > 24 months Slab rate 20% with Indexation benefit
Unlisted securities other than shares (like debentures) Holding <= 36 months Holding > 36 months Slab rate 20% with Indexation benefit

Proposed Capital Gain tax structure for FY 2018-19 for Individual

Nature of Capital Asset Short Term Capital Asset Long Term Capital Asset STCG Tax Rate LTCG Tax Rate
Listed Securities (other than unit) in a recognised Stock Exchange in India Holding <= 12 months Holding > 12 months 15% NIL upto Rs 1 Lac.

Beyond Rs 1 lac:

-20% with Indexation benefit

-10% without indexation benefit

Unlisted shares (Both equity and Preference) Holding <= 24 months Holding > 24 months Slab rate 20% with Indexation benefit
Unlisted securities other than shares (like debentures) Holding <= 36 months Holding > 36 months Slab rate 20% with Indexation benefit

Hence for FY 2017-18, LTCG arising on listed securities will be fully exempt. However in FY 2018-19, LTCG upto Rs 1 lac will be exempt and LTCG beyond Rs 1 lac will be taxable at lower of 20% with indexation benefit or 10% without indexation benefit.

In the case of listed securities for determining which stock is sold out FIFO (First In First Out) method is applied i.e oldest stock is assumed to be sold first.

In case of Bonus shares, additional shares are given free of cost based on the ratio of bonus (i.e 1:1, 1:3 etc). Many a times these bonus shares are used by investors to reduce their income tax liability.

Let’s understand the same with the help of below example:

S.N Particulars Case 1  Case 2  Case 3  Case 4  Case 5
a Existing number of listed shares held        100.00        100.00        100.00        100.00       100.00
b Existing Cost per share  (Rs)        400.00        400.00        480.00        480.00       300.00
c Period of holding on 15.03.18 13 months  2 months  5 days  5 days  2 months
d Bonus ratio on 15.03.18 1:1  1:1  1:1  1:1  1:1
e Price just before bonus share (Rs)        500.00        500.00        500.00        500.00       500.00
f Price immediately after bonus share (Rs)        250.00        250.00        250.00        250.00       250.00
g No of shares sold after bonus issue        100.00        100.00        100.00        200.00       100.00
h Sale consideration (f*g)   25,000.00   25,000.00    25,000.00   50,000.00  25,000.00
i Cost of acquisition (b*g) (Max a*b)   40,000.00   40,000.00    48,000.00   48,000.00  30,000.00
j Long Term Capital Gain / (Loss) (h-i) (15,000.00)
k Short Term Capital Gain / (Loss) (h-i) (15,000.00)   (23,000.00)     2,000.00   (5,000.00)
l Remaining No of Bonus shares        100.00        100.00        100.00              –       100.00
m Cost of acquisition for Bonus shares NIL  NIL  NIL  NIL  NIL

Case 1) In case 1 Mr X was holding 100 number of listed shares of a company say ABC Ltd since last 13 months. The acquisition price per share was Rs 400. Hence total cost was Rs 40,000/-.

Now ABC Ltd issues bonus shares in the ratio of 1:1 (i.e 1 bonus share for every 1 share held). Hence Mr X will get additional 100 shares as bonus share.

Say price before bonus issue was Rs 500 per share and immediately after bonus issue price became Rs 250 (i.e half of Rs 500). Now if Mr X sold 100 shares then for the purpose of determining cost of acquisition FIFO method will be applied and the cost for first 100 shares will become Rs 40,000 and cost of remaining 100 bonus shares will be Nil.

Sale consideration for 100 shares will be Rs 25,000 (i.e sale price X number of shares) and there will be Long term Capital Loss of Rs 15,000 which can be set off against other Long term capital Gain. (However there is a school of thought that since the income would have been exempt u/s 10(38) so loss should also be exempt and this loss can not be adjusted against non exempt sources).

Case 2) In case 2 Mr X was holding 100 number of listed shares of a company say ABC Ltd since last 2 months. The acquisition price per share was Rs 400. Hence total cost was Rs 40,000/-.

Now ABC Ltd issues bonus shares in the ratio of 1:1 (i.e 1 bonus share for every 1 share held). Hence Mr X will get additional 100 shares as bonus share.

Say price before bonus issue was Rs 500 per share and immediately after bonus issue price became Rs 250 (i.e half of Rs 500). Now if Mr X sold 100 shares then for the purpose of determining cost of acquisition FIFO method will be applied and the cost for first 100 shares will become Rs 40,000 and cost of remaining 100 bonus shares will be Nil.

Sale consideration for 100 shares will be Rs 25,000 (i.e sale price X number of shares) and there will be Short term Capital Loss of Rs 15,000 which can be set off against other Long as well as short term capital Gain.

Case 3) In case 3 Mr X was holding 100 number of listed shares of a company say ABC Ltd since last 5 days. The acquisition price per share was Rs 480. Hence total cost was Rs 48,000/-.

Now ABC Ltd issues bonus shares in the ratio of 1:1 (i.e 1 bonus share for every 1 share held). Hence Mr X will get additional 100 shares as bonus share.

Say price before bonus issue was Rs 500 per share and immediately after bonus issue price became Rs 250 (i.e half of Rs 500). Now if Mr X sold 100 shares then for the purpose of determining cost of acquisition FIFO method will be applied and the cost for first 100 shares will become Rs 48,000 and cost of remaining 100 bonus shares will be Nil.

Sale consideration for 100 shares will be Rs 25,000 (i.e sale price X number of shares) and there will be Short term Capital Loss of Rs 23,000 which can be set off against other Long as well as short term capital Gain.

Hence we can see that by way of investing into shares which are about to issue bonus shares, one can reduce his overall tax liability.

That’s why it has been observed that prices after bonus issue falls higher than the ratio of bonus issue because everyone tries to liquidate their position which creates huge selling pressure in the market and as a result prices falls disproportionately during the initial phase after bonus issue.

Above strategy is called Bonus stripping.

If one can prove that acquisition and disposal of the shares was not done with the main objective of tax avoidance, then as per current rules, one can well set off the loss on bonus stripping. However if it can be proved that bonus stripping was done only with the motive of tax avoidance then assessing officer may apply cost on proportionate basis between original and bonus shares.

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