The tax angle to equity investments

Generally investors invest in equity for the potential capital gain. The increase in the value of their investments is the main motivator behind the additional risk they undertake by choosing to invest in equity rather than the less risky fixed income options.

However, apart from capital gains, equity instruments can confer certain other benefits to investors such as bonuses, stock splits and share buybacks. In this piece we examine the significance of these to investors and the tax consequences of each such corporate action.

Bonus shares

Bonus shares are free additional shares that a company may decide to issue to its existing shareholders in a certain proportion to the current holding. So, if a company comes out with a 1:1 bonus issue, an investor gets 1 additional share for every share he holds in the company.

A company has a certain amount of reserves which it has built up over the years by retaining a proportion of the profit and not giving it out as a dividend. While issuing bonus shares, the company converts a part of these reserves into shares.

Following a bonus issue, though the number of shares increases, the proportional ownership of shareholders does not change. Also, after the bonus issue, the cum-bonus share price should fall in proportion to the bonus issue, thereby making no difference to the personal wealth of the share holder.

However, more often that not a bonus is perceived as a strong signal by the company that the present good run is likely to continue. The management of the company would not have distributed these shares if it was not confident of distributing dividends on all the shares in the days to come.

As far as the tax implications are concerned, since no money is paid to acquire the bonus shares, these have to be valued at nil cost while calculating capital gains. The originally acquired shares will continue to be valued at the price paid at the time of acquisition. An incidental 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 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 fall. 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 in one month. That means that one 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 will have twice the number of shares outstanding. Consider the following example.

If an investor held 100 shares of company X valued at Rs 3,000 each (a total value of Rs 3,00,000). After a 2-for-1 stock split, he will hold 200 shares of Rs 1,500 each. The total value, however, remains the same.

The question that arises is: If there is no difference to the wealth of the investor, 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. Here it has to be reiterated that the shares only appear to be cheaper, it makes no difference whether you buy one share for Rs 3,000 or two for Rs 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. In case of a stock split, 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 Rs 150 per share was Rs 1,50,000, after the split the cost of 200 shares would be reduced to Rs 75 per share, thereby keeping the total cost constant at Rs 1,50,000.

Share buybacks

Share buybacks are also a comparatively new phenomenon. Reliance, Siemens and Infosys are examples of companies that have bought back their shares.

A buyback is a financial tool in the hands of a corporate that affords flexibility in the capital structure. It allows the company to sustain a higher debt-equity ratio. It is also a tool to defend against possible takeovers. Companies buyback 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 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. And, a buyback also serves as a substitute for dividend payments.

This brings us to the crucial 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 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?

The case of Anarkali Sarabhai v 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) is 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, then, 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.

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