Bonus shares and tax planning

Its the last fortnite of a great financial year for the stock market and for us the investors. I am sure all of us have made a decent amount of money (profit). But just after the end of March 2010 some part of the profit has to be given to the government in the form of income tax on the short term capital gains that we have made.

Before I go any further let me briefly touch upon the difference between short term and long term capital gains in case of shares. Am sure a lot of you must be knowing about this already.

In case of shares bought through normal transactions on the stock exchange the following happens
a) If sold within one year from the date of purchase then the difference between the sale price (share sale price + brokerage) and cost of purchase (i.e. share purchase price + brokerage) would be termed as short term capital gain or loss as the case may be and 15% of the gain is payable as short term capital gains tax.
b) On the other hand if the shares are sold after one year from the date of purchase then the gain or loss on that becomes long term capital gain on which no tax is payable.

Within the broad contours of this there exists some scope for tax planning if you have bought some shares which have given bonus. However, please note that such scheme is applicable only for long term investment. This scheme in common parlance is called bonus stripping.

Today's ET carried an article on the same. (Link)

Lets first understand what is a bonus share.
Bonus shares are nothing but shares issued free of cost to the shareholders of a company. As this is essentially a book entry (reserves get capitalised), the number of total shares increase following a bonus issue, though the proportional ownership of shareholders does not change.

Though the article in ET is quite good, but for better understanding I have tried to explain the same through an example.

Imagine a Company A in which You invest Rs 15000 (100 shares @ Rs 150 per share). It declares a 1:1 bonus.
After the record date you get 100 shares as bonus and thus you will have 200 shares. Since no money was paid for the bonus shares thus the total cost of investment remains Rs 15000. However the average cost of per share now becomes Rs 15000/ 200 shares = Rs 75 / share. (For the sake of simplicity brokerage has not been considered in the example). Also assuming the ruling market price of each share is Rs 80.

Herein the cost of the shares would be as follows
a) Shares bought by you - first 100 shares - Rs 150 / share
b) Shares received as bonus - Cost is nil.

So the following 2 scenarios could arise.
Scenario 1 - All shares sold at Rs 80 within one year from date of purchase.
This will not lead to any savings in tax. The calculation will be as follows.
a) On shares bought - Short term Capital loss (Rs 80 - Rs 150) X 100 shares = Rs (7000)
b) On bonus shares - Short term Capital gain (Rs 80 - Rs Nil) X 100 shares = Rs 8000
Net capital gain = Rs 1000
Tax payable = Rs 150

Scenario 1 - First 100 shares sold at Rs 80 within one year from date of purchase and rest 100 shares sold after 1 year from the date of allotment of bonus shares (please note that in case of bonus shares 1 year is calculated from the date of allotment and not purchase of original shares)
This arrangement will lead to savings in tax. The calculation will be as follows.
a) On shares bought - Short term Capital loss (Rs 80 - Rs 150) X 100 shares = Rs (7000)

Since the bonus shares will be sold after 1 year, hence no tax would need to be paid on the same.

This loss of Rs 7000 can be set off against the other short term capital gains during the year. It thus leads to a saving of 15% of Rs 7000 = Rs 1050 on the tax outgo front.
Please note that this scheme works only if the bonus shares are held for a period of more than one year from the date of allotment.

Thus if this scheme is used before the end of March 2010 you could end up saving a lot on tax.

Stock splits

Stock splits on the other hand is different from a bonus issue and does not offer tax planing opportunites like bonus shares.
In the example mentioned above if the stock was split in the ratio 2:1 you would still have 200 shares but when the shares are sold, the capital gains tax implications are different than those applicable to bonus issues. In this case, the original cost of the shares also has to be reduced. Thus after the split the cost of 200 shares would be reduced to Rs75 per share, thereby keeping the total cost constant at Rs 15,000.

I hope I have been able to explain the concept.

However, please consult a tax practitioner for further guidance.