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Dividends are one of the most important sources of earning for long term investors who invest in stocks. Companies declare dividends in two forms i.e. cash dividend and stock dividend (Bonus shares). Cash dividends are tax free in the hands of investors as company declaring the dividend pays dividend distribution tax on it. There is less clarity regarding tax implication of bonus shares/stock dividends. In this article, we will discuss the tax treatment of bonus shares.

What are Bonus shares?
Bonus shares are new shares issued to existing shareholders of a company. These are issued to shareholders in proportion to their current holdings. For example, the company may announce one bonus share for every share held by an investor. As the investor now holds two shares, EPS gets halved. Hence bonus share do not affect total EPS of investor.
Bonus shares are considered free shares as their cost of acquisition is taken as zero, although they are not free in true sense.

Purpose of bonus shares
As mentioned above, bonus shares do not have any impact on total EPS. If total EPS doesn’t change, then the question arises – what’s the need of bonus shares? Bonus shares basically help in solving two purposes:

1.     Improving the liquidity of a share – Suppose company’s shares are quite illiquid. Reason for illiquidity can be many but we are not bothered about that right now. At this point of time, company announces 1:1 bonus share. Since number of shares gets doubled in the market, supply of shares increase, resulting in a downward pressure on the stock price. Now, as the stock is available at cheaper valuation, more buyers get interested in it and hence liquidity improves.
2.     Tax saving – In case of cash dividends, companies have to pay dividend distribution tax resulting in diminished return for investors. In case of bonus shares, no dividend distribution tax is levied. These are treated as normal shares and tax implication only arises in case of short term capital gains (holding period less than 12 months) in the hands of investor.

Tax Calculation
Cost of acquisition of bonus shares is taken as zero hence the capital gain on selling a bonus share is equal to its selling price.
Let’s take an example to understand the calculation of short term capital gain tax in case of bonus shares (Long term capital gain tax is zero).

No. of Shares held originally               - 100
Bonus Announcement                        - 1:1
Total Number of Shares post bonus   - 200
Purchase Price                                   - 50

 Total number of shares held post bonus is 200 and let’s say investor sells 100 shares @ 60 before one year. Taxable short term capital gain in this case will be 100*(60-50) = 1000. If the existing short term capital gain tax rate is 15%, tax liability will be 0.15*1000 = 150.
Now, investor sells the rest 100 shares after some time (in same year) @ 70. Taxable short term capital gain in this case will be 100*(70-0) = 7000. Note that the cost of acquisition of bonus share is taken as 0. Hence the tax liability for this case will be 0.15*7000 = 1050.

Recommendation
Because of higher tax implication in case of short term capital gains on bonus shares, it’s advisable to sell them post one year holding period. Tax liability becomes zero on long term capital gains in that case.

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