DEFINITIONS:
Announcement date: The date on which bonus issue is announced.
Ex-date: Any day between the announcement date and the record date.
Record date: The date on which the bonus takes effect, and shareholders on that date are entitled to the bonus.
Cum bonus Shares/units: Shares/units before the bonus is effected.
Ex-Bonus Shares/units: Shares/units after the bonus is effected.
When companies issue additional financial assets/units without any consideration, on the basis of holding shares/mutual fund units on a particular date, is called a bonus issue. The shareholders become eligible for these bonuses without any consideration, just by the virtue of holding shares/units on the record date. The issuance of bonus makes the share/unit an attractive investment option as it allows investors to gain a larger number of shares/units without having to pay for the additional shares/units. However, this also allows investors to utilise the opportunity of bonus issue in order to avail certain tax benefits. This is also called bonus stripping.
In bonus stripping, the investors acquire shares before the record date, however, once the bonus is issued, sell the original shares acquired before the record date. This generally creates a short-term capital loss which can be set off against any other capital gains. The bonus shares are then generally held for a period beyond one year and then disposed off at a concessional rate of tax applicable to long term capital gains. Considering how the sole purpose of this entire transaction maybe to gain tax benefit, without any commercial intent, raises the question of its taxable nature.
Before we divulge deeper into the aforementioned question, it is pertinent to note that bonus issues are of two kinds:
Mutual fund issue (unit issue) and
Share bonus issue (financial asset issue).
This understanding is important to note how they are individually assessed by the taxman.
1. Mutual fund issue (unit issue):
Section 94(8) of the Income Tax Act, 1961, states:
Where—
any person buys or acquires any units within a period of three months prior to the record date;
such person is allotted additional units without any payment on the basis of holding of such units on such date;
such person sells or transfers all or any of the units referred to in clause (a) within a period of nine months after such date, while continuing to hold all or any of the additional units referred to in clause (b), then, the loss, if any, arising to him on account of such purchase and sale of all or any of such units shall be ignored for the purposes of computing his income chargeable to tax and notwithstanding anything contained in any other provision of this Act, the amount of loss so ignored shall be deemed to be the cost of purchase or acquisition of such additional units referred to in clause (b) as are held by him on the date of such sale or transfer.
However, the section goes on to clarify the term “units” as:
Explanation. —For the purposes of this section, —(d) “unit” shall have the meaning assigned to it in clause (b) of the Explanation to section 115AB.
Section 115AB provides:
Explanation. —For the purposes of this section, —(b) "unit" means unit of a mutual fund specified under clause (23D) of section 10 or of the Unit Trust of India;
Therefore, when any units are purchased three months before the record date and are sold within nine months of the record date then the loss, if any, shall be apportioned to the cost of acquisition of the bonus share. This section, in effect, prevents the tax benefit to the investors regardless whether they possessed any commercial intent while purchasing the original units. However, the application of section 94(8) is exclusively and explicitly restricted to Units (mutual funds) as defined under section 115AB.
2. Share bonus issue (financial asset issue):
Section 55(aa) of the Act, states:
(aa) in a case where, by virtue of holding a capital asset, being a share or any other security, within the meaning of clause (h) of section 2 of the Securities Contracts (Regulation) Act, 1956 (42 of 1956) (hereafter in this clause referred to as the financial asset), the assessee—
(A) becomes entitled to subscribe to any additional financial asset; or
(B) is allotted any additional financial asset without any payment,
then, subject to the provisions of sub-clauses (i) and (ii) of clause (b), —
(i) in relation to the original financial asset, on the basis of which the assessee becomes entitled to any additional financial asset, means the amount actually paid for acquiring the original financial asset;
(ii) in relation to any right to renounce the said entitlement to subscribe to the financial asset, when such right is renounced by the assessee in favour of any person, shall be taken to be nil in the case of such assessee;
(iii) in relation to the financial asset, to which the assessee has subscribed on the basis of the said entitlement, means the amount actually paid by him for acquiring such asset;
(iiia) in relation to the financial asset allotted to the assessee without any payment and on the basis of holding of any other financial asset, shall be taken to be nil in the case of such assessee;
Therefore, essentially the above section states that if any bonus shares are issued without the exchange of any consideration then the cost of acquisition for such bonus shares shall be nil. Unlike Section 94(8), the loss, if any, arising due to the sale of shares acquired before the record date, can be set off with other capital gains. However, to reiterate Section 55(aa) restricts its applicability to securities as defined under Section 2 of Securities Contracts (Regulation) Act, 1956.
Hence, the tax application for bonus issued to equity share holder and bonus issued to mutual fund unit holder is different as the calculation of the cost of acquisition differs. In case of the bonus units, the cost of acquisition shall be the loss incurred during the sale of the original units which take place within nine months of the record date. In case of financial asset under Section 55, the cost of acquisition shall be nil. However, whenever the sale of these bonus shares take place there would have not been any cost of acquisition while calculating the capital gains, hence the entire sale consideration shall be taxed accordingly and appropriately.
Circular: No. 704, dated 28-4-1995: (This is negligible as amendments to section 55 and 94 cover the said question, however, it allows us to further our argument, hence the same is discussed)
iii) As regards the second issue, where securities are acquired in several lots at different points of time, the First-in-first-out (FIFO) method shall be adopted to reckon the period of the holding of the security, in cases where the dates of purchase and sale could not be correlated through specific numbers of the scrips. In other words, the assets acquired last will be taken to be remaining with the assessee while assets acquired first will be treated as sold. Indexation, wherever applicable, for long-term assets will be regulated on the basis of the holding period determined in this manner.
Therefore, another way to look at the said question of taxing bonus stripping is in the manner in which the Capital gains are calculated, through their holding period. The Circular: No. 704, dated 28-4-1995 puts light upon the issue, wherein the CBDT has stated that for the calculation of holding period, First-in-first-out (FIFO) method must be used. Hence, logically the calculation of holding period would also determine the cost of acquisition of the shares, making no alteration to the cost of acquisition of the cum-bonus shares and ex-bonus shares and making the cost of acquisition of the bonus share - nil.
It is pertinent to note that though section 55(aa) does provide certain tax benefits to investors, regardless whether the transaction lacks any commercial intent or not, with the introduction of GAAR, which is yet to take potency and efficacy in terms of its implementation, could bring such transactions to tax. However, this would depend on a number of factors and on a case to case basis.
*Disclaimer : The view expressed are not of the firm and only of the author.
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