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Stock split and Bonus and capital gains tax implications on sale

Generally, investments in equities are made for the potential capital gain. Despite this investment in equities is being considered risker than fixed income instruments. However, apart from capital gains, equity instruments can confer other benefits to investors such as bonuses, stock splits and share buybacks. Let us examine the significance of these for investors and the tax consequences of each such corporate action.

BONUS SHARES

Bonus shares are nothing but shares issued free of cost to the shareholders of a company, by capitalising a part of its reserves. Following a bonus issue, though the number of total shares increase, the proportional ownership of shareholders does not change.

Also, the share price should fall in proportion to the bonus issue, thereby making no difference to the personal wealth of the holder. However, more often than not, handing out of bonus is perceived to be a positive sign. It means the company is able to service its larger equity. Considering the strong signal given out by the company, a consequent demand push for the shares causes the price to move up.

Since no money is paid to acquire bonus shares, these have to be valued at nil cost while making calculations for capital gains. The originally acquired shares will continue to be valued at the price paid at the time of acquisition. Since the market price of the original shares fall on account of the bonus, there may arise an opportunity to book a notional loss on the original shares.

STOCK SPLITS

Stock splits are a relatively new phenomenon in the Indian context. Recently, companies such as ONGC, Infosys, and HDFC, among others, have announced a stock split. It is important that investors understand why companies may split their shares and how this is different from a bonus issue. In a stock split, the capital of the company remains the same, whereas in a bonus issue the capital increases and the reserves decrease. However, in both actions, the net worth of the company remains unaffected.

A typical example is a two-for-one stock split. Say, a company announces a two-for-one stock split in a month. That means a month from that date, the company's shares will start trading at half the price from the previous day. Consequently, you will own twice the number of shares that you originally owned and the company, in turn, will have twice the number of shares outstanding. Consider the adjoining table where the price of 100 shares costs 3000. After the stock split, while the number of shares increases to 200, the price also comes down to `1500 .

The question that arises is if there is no difference to the wealth of the investor, then why does a company announce a stock split? Well, the primary reason is to infuse additional liquidity into the shares, by making these more affordable. The shares only appear to be cheaper; it makes no difference whether you buy one share for 3,000 or two for `1,500 each. As far as the tax implications for stock splits are concerned, there aren't any. A stock split, like a bonus issue, is tax-neutral. However, when the shares are sold, the capital gains tax implications are different that what is applicable for bonus issues. Here, the original cost of the shares also has to be reduced. For instance, in the above example, if the cost of 100 shares at `150 per share was 1,50,000, the cost of 200 shares after the split would be reduced to `75 per share, thereby keeping the total cost constant at `1,50,000.

SHARE BUYBACKS

These are a comparatively new phenomenon. Reliance, Siemens and Infosys are some examples of companies which have done so. A buyback is essentially a financial tool in the hands of the company, that affords flexibility in the capital structure. A buyback allows the company to sustain a higher debt-equity ratio. It is also a tool to defend against possible takeovers. Generally, companies do this when they perceive their own shares to be undervalued or when they have surplus cash for which there is no ready capital investment need.

Stock buybacks also prevent dilution of earnings. In other words, a buyback program enhances the earnings per share. Conversely, it can prevent an earnings per share (EPS) dilution that may be caused by exercises of stock option grants and so on.

A buyback also serves as a substitute for dividend payments. This brings us to the issue of tax implications of a buyback. An important consideration is whether the amount paid on buyback is dividend or consideration for transfer of shares. If considered a dividend, the same will not be taxable in the hands of the investors. Also, to what extent, if at all, can the amount paid on buyback be taken as dividend? Is the entire amount paid dividend or is it only the premium paid over the face value? According to a Supreme Court judgement, (Anarkali Sarabhai v CIT, 1997, 90Taxman509 ), the principle that redemption of shares by the company which issued the shares (in this case, preference shares) is tantamount to sale of shares by the shareholders to the company.

The Finance Act, 1999, reiterated this stand. Now, if a company purchases its own shares, the difference between the money received by the shareholder and the cost of acquisition will be deemed as capital gains. Further, this will not be treated as dividend, since the definition of dividend does not include payments made by the company on purchase of its own shares.
 

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