Bonus Shares - Taxability

Introduction:

Prime motive of long term investors is to earn healthy dividends on their investment regularly. Investee Companies declare dividends in two form i.e. Cash Dividend and Stock Dividend (Bonus shares). Cash dividends are tax free in the hands of investors as Company declaring the dividend pays Dividend Distribution Tax on it. There is less clarity regarding tax implication of stock dividend/bonus shares. In this article, we will discuss the tax treatment of bonus shares:

Meaning of Bonus Shares:

Bonus shares are new shares issued to existing shareholders of a company. These are issued to shareholders in proportion to their current holdings. Hence bonus share do not affect total EPS of investor.

Bonus shares are considered free shares as their cost of acquisition is taken as zero, although they are not free in true sense.

Why Bonus Shares:

As mentioned above, bonus shares do not have any impact on total EPS. If total EPS doesn’t change, then the question arises – what’s the need of bonus shares? Bonus shares basically help in solving two purposes:

• Improving the liquidity of a share – Suppose company’s shares are quite illiquid. Reason for illiquidity can be many but we are not bothered about that right now. At this point of time, company announces 1:1 bonus share. Since number of shares gets doubled in the market, supply of shares increase, resulting in a downward pressure on the stock price. Now, as the stock is available at cheaper valuation, more buyers get interested in it and hence liquidity improves.

• Tax saving – In case of cash dividends, companies have to pay dividend distribution tax resulting in diminished return for investors. In case of bonus shares, no dividend distribution tax is levied. These are treated as normal shares and tax implication only arises in case of short term capital gains (holding period less than 12 months) in the hands of investor.

Cost of Acquisition of Bonus Shares:

Cost of acquisition of bonus shares is taken as zero hence the capital gain on selling a bonus share is equal to its selling price.

Long Term Holding of Bonus Shares:

Because of higher tax implication in case of short term capital gains on bonus shares, it’s advisable to sell them post one year holding period. Tax liability becomes zero on long term capital gains provided it is sold through a stock exchange and Securities Transactions Tax is paid on this sale transaction.