As stock market investors, we are beneficiaries to various corporate actions like bonus, rights and stock splits. These corporate actions are accompanied by stock price movements in short and long run affecting capital gains whenever we sell shares. As there is an effect on capital gains, tax implication also changes if we sell shares prior to one year. Through this article, we will try to understand what effect stock splits have on taxes payable in case of capital gains.
What is Stock Split
Stock split is a corporate action to increase the number of outstanding shares by issuing more shares to existing shareholders. For example, in a 2 for 1 stock split, a new share is issued against every share held. This means if there were 10 lakh outstanding shares prior to the split, now there would be 20 lakh shares. There is no increase in the market capitalization of the company, hence post split, price of the stock decreases in reverse ratio of split. In the above case, stock price gets halved.
Motivation for Stock Split
Stock split is usually announced by management to reverse stock illiquidity because of higher stock price as compared to other companies in same sector. Stock price is high; hence there are fewer participants due of affordability issue leading to illiquidity.
Tax Implication in case of Stock splits
Stock splits bear similarity to bonus share but tax calculation is slightly different. In case of bonus shares, cost of acquisition is zero but in case of stock split, the cost of acquisition reduces in reverse ratio of split. For example, if one holds 100 shares at the rate of Rs 200, total investment is Rs 20000. If the company announces 2 for 1 split, stock holder will have 200 shares, but the acquisition price of share will be 100 (200/2 = 100) now.
Now if investors sells the shares in the market at Rs 200 per share before one year, short term capital gain will be equal to 200 * (200 – 100) = 20000. Keep in mind, purchase price for calculation of short term capital gain should be Rs. 100 and not Rs. 200 as shown above. Short term capital gain tax will be calculated on Rs 20000.
Effect on Stock Price
Stock split normally results in stock price appreciation post the split. As the stock appears cheap now, there is a demand push from small and retail investors leading to price rise. Another reason for price appreciation can be attributed to psychological feeling that stock is good now as its price was very high before split. Good performance is expected to continue post split too leading to price rise in short run.
Reverse Stock Split
There is another corporate action which is quite similar to stock split but is performed in reverse fashion. Here we combine existing outstanding shares so as to reduce total number of shares in market. This is the reason it’s named as reverse stock split. Motivation for reverse stock split is opposite to stock split as here promoters want to increase the price of shares. Stocks may be trading at a very low price leading to conclusion that it’s a penny stock. Promoters try to remove this notion by announcing reverse stock splits.
Capital gains are calculated in similar way as it is done for stock split, but in this case number of outstanding shares reduces and the acquisition price increases in the same proportion as the reverse stock split.
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