Legality of Tax Planning vs. Tax Avoidance – Issue of Bonus Shares by Listed / Unlisted Companies
Bonus issue of shares are permitted by the Companies Laws globally. The Board of the Company are not liable to give answer to shareholders for reasoning or timing or sourcing of the issue of Bonus shares. Generally, the Companies issue the Bonus shares to reward its shareholders, if the Company is doing good in business and having earnings. However, there are other considerations, which help the management / promoters to plan issue of Bonus shares to its shareholders e.g.
- Increase the no. of shares in the market thereby increasing liquidity in the market
- Increase the number of shares in the market thereby avoiding the sale of shares by institutional investors in the market
- Reward the shareholders by utilizing the available surplus earned by Company
- to help investors / promoters of closely held Companies, to defer tax outgo on other capital gains.
Since the cost of acquisition for bonus shares remains “NIL”, it offers an excellent tax planning tool to defer tax liability on other capital gain income of the Investors. If we analyse the past data, the Bonus shares helped a lot of tax payment deferment and also saved a huge amount of tax out go for Institutional Investors, promoters of large corporates, HNIs, Long term retail investors etc.
In case of listed Companies and mutual funds, bonus stripping became a general practice, by which investors tries to defer the present tax liability to future or adjust the losses against the other capital gain income. Under this practice, an assessee buys the securities shortly before the record date and sale it at bonus adjusted price after the record date. This results into acquisition of bonus securities at “ZERO” value and the sale of original securities at a loss.
Bonus stripping like dividend stripping was a tax planning activities widely used in case of mutual fund schemes also. To curb the practice, the Government of India introduced section 94 (8) in Income Tax Act,1961. As an anti -avoidance measure to deal with Bonus stripping, the Government amended the section 94(8) to cover the transactions of securities and units both. Present law says that the losses arising from such transactions will be ignored for the purpose of calculation of income for capital gain tax if :
- Investor who buys the units / securities within a period of 3 months prior to record date (date on which bonus allotted) and
- If such Investor sells or transfers all or any of the units / securities within 9 months after the record date.
Note: However, the section 94(8) is has not been able to address the tax evading of closely held companies by issue of bonus shares.
Taxation of Listed and Unlisted Entities:
Long Term Gain / Loss | Short Term Gain / Loss | |
Holding period | Listed Securities =>1 Year
Unlisted > 36 Months |
Listed Securities <1 Year
Unlisted < 36 Months |
Applicable tax rates * | 10% | 15%.
However, investor can set off the loss against the other short term gains, which attracts @30% |
Indexation Benefits | Yes | No |
* Subject to applicable surcharges / exemptions etc.
Applicable tax rates on sale of listed shares are @10% in case of long-term gains (sold after holding for more than one year) after a threshold of Rs1 lakh per financial year and @15% in case of short-term gains, i.e., gains on selling shares in one year or less. The long term capital gain tax on sale of an unlisted share also enjoy indexation benefit under the Income tax laws of India.
Although the section 94(8) is applicable in all the circumstances but the unlisted or closely held companies plans the bonus stripping in a different way with a longer duration to avoid the legal provisions. Also, in case of new startups, Unicorns, initial acquisitions of equities of the Companies at higher prices etc. and subsequent issue of Bonus shares e.g. Recently, a listed Company called – “FSN – Ecommerce Ventures Ltd” (Known by name “Nykka”) , the Company issued 5 bonus shares for each 1 shares of equity held. This resulted into an option to shareholders to book almost 80% of the cost of initial IPO price as a loss and claim set off against any other capital gain income.
Taxation of Gifted Unlisted Shares
The gift made by a relative as defined under Income tax laws does not attract any tax; however, the gains made from sale of such gifted shares will be taxed like any other asset of the assessee who received gifts. The taxation here remains the same for a person who sells shares out of his own holding or gift received. A point to note here is that, the cost price and the period of holding of the assets for computing capital gains will be the cost paid by the original owner. Here, people prefer to give a simple declaration of giving huge value of gifts by avoiding stamp duty amount.
Example:
A hypothetical example of bonus issues misused by unlisted Company’s (“ A Pvt Ltd”) promoters is as under:
1. Financial year 2016-17 : A pvt limited Company’s 5,90,000 shares representing almost 100% of its issued capital was acquired @ Rs.700 per share (face value of the shares were Rs.10 each)
2. Financial year 2016-17 : The newly introduced promoters subscribed for 8,40,000 Nos shares @ Rs.665 (10 Face Value + 655 Premium)
3. Financial year 2017-18 : The newly introduced promoters subscribed for 5,93,000 Nos shares @ Rs.675 (10 Face Value + 665 Premium)
Total issued shares stood at 20,23,000 Nos. as on March 31,2018 with an average cost of acquisition for new promoters @ Rs. 678.14 Per share.
4. Financial year 2018-19 : Even though there was no significant or material business activities were carried out by the Company since inception, a bonus issue was planned. The Company issued 20 Bonus shares for each 1 shares held, and the capitalization of equal amount (equivalent to face value of Bonus shares) was done from securities premium account.
5. Financial Year 2019-20 onwards : Investee Companies where the funds of the “A Pvt Ltd” were deployed made business losses and the valuation of “A Pvt Ltd” determined by qualified chartered accountants / merchant bankers was in the range of Rs.30-35 per share. The new promoters / shareholders were free to offload their shareholdings not more than 5% with twin taxation benefits –
i. The promoter’s may plan gift of the shares to their close relatives (as defined in the Income tax act), wherever, taxable long term capital gain taxes are there.
ii. There will be indexation benefits as the A Ltd’s shares were held for more than 3 years and the total cost of acquisition post indexation may be Rs.150 Crs approx..
- Since cost of acquisition for shareholders for almost 95% of the issued share capital of “A ltd” is Nil, because they were bonus shares, the shareholders may divest the shares to few of the far relatives, by which they may book losses almost equal to 100% of the capital by selling less than 5% of their total holdings of the A ltd as under:
Type of Shares | Shares | % of the Issued Capital | Cost of Acquisition | Looking at the Erosion, the sale valuation may be |
Acquired / Right Issues | 20,23,000 | 4.76% | Book Cost – Rs. 136.34 Crs
(Post indexation cost for capital gain purposes – Rs 145 Crs) |
Rs.6.57 Crs. Approx. |
Bonus | 4,04,60,000 | 95.24% | Nil | N.A. |
Total | 100.00% | Rs.136.34 Crs |
Note: Above table shows, that the investors while retaining almost 95.24% stake in the unlisted Company may able to book a capital loss (post indexation) of Rs.139 – 140 Crs which was almost equal to their entire investments made in the Company. This will help them to get benefits of long term tax liability reduction of Rs. 15 Crs approx. and diluting equity 4.76% of the total equity of the “A Pvt Ltd”.
Question arises :
- Should the tax authorities not think about the formula of average cost of acquisition instead of “Nil” Cost for Bonus shares by Private Limited Companies?
- Should the revenue authorities should not insist on properly executed with valid stamp duties payments as proof of actual gifts.
- Although this is a legal practice for tax avoidance—An action taken to lessen tax liability and maximize after-tax income. Is it a legal ? However, with the GAAR coming into existence, this is covered under “ General Anti-Avoidance Rule (GAAR) which is an anti-tax avoidance law in India ?