On bonus issues, stock splits & buybacks

The tax treatment is different in each case

As most readers would know Reliance Power has announced a 3:5 bonus. What are the implications of a bonus issue for investors? Does it indeed increase their wealth? Is a bonus similar to a stock split? How about the tax implications? Is there potential for tax planning? Today’s article seeks to address these and related issues.

Bonus shares
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.

Also, post the bonus, the share price should fall in proportion to the bonus issue, thereby making no difference to the personal wealth of the shareholder. However, more often than not, a bonus is perceived to be a strong signal given out by the company and the consequent demand push for the shares causes the price to move up.

As far as tax is concerned, 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. An incidental tax planning benefit is that since the market price of the original shares falls 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. It is important that investors understand the reasons that companies may split their shares and how a stock split 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 (a stock split and a bonus) the net worth of the company remains unaffected.

A typical example is a 2-for-1 stock split. Say a company announces a 2-for-1 stock split. This means following the stock split, the company’s shares will start trading at half the price from the previous day. Consequently, you will own twice the number of shares you originally owned and the company, in turn, will have twice the number of shares outstanding. Consider the case of Stock X below:

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 them more affordable. It needs to be reiterated here that the shares only appear to be cheaper, though it makes no difference whether you buy one share for Rs3,000 or two for Rs1,500 each.

As far as the tax implications for stock splits are concerned, well, there isn’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 than those applicable to bonus issues. Here, the original cost of the shares also has to be reduced. For instance, in the above example, if the cost of the 100 shares at Rs150 per share was Rs 1,50,000, after the split the cost of 200 shares would be reduced to Rs75 per share, thereby keeping the total cost constant at Rs1,50,000.

Share buybacks
A share buyback is quite different from a bonus issue or a stock split. Essar Oil, Reliance, Siemens and Infosys are some examples of companies that have bought back their shares.

A buyback is essentially a financial tool in the hands of the corporate 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 buyback their shares when they perceive their own shares to be undervalued or when they have surplus cash for which there is no ready capital investment need.

Share buybacks also prevent dilution of earnings. In other words, a buyback programme enhances the earnings per share, or conversely, it can prevent an EPS dilution that may be caused by exercises of stock option grants, etc.

Last, but not the least, a buyback also serves as a substitute for dividend payments. This brings us to the crucial issue of tax implications of a buyback. A very important consideration is whether the amount paid on buyback is dividend or consideration for transfer of shares. If it is indeed considered to be 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?

In the case of Anarkali Sarabhai vs CIT (1997) 90Taxman509 (SC) had laid down the principle that redemption of shares by the company which issued the shares (in this case preference shares) will tantamount to sale of shares by the shareholders to the company.

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