The grandfathering clause and set-off provisions can be used to reduce the tax payable on sale of bonus shares, says Arvind A Rao.
Illustration: Uttam Ghosh/Rediff.com
Investors will remember Budget 2018 for a long time for the proposal to reintroduce long-term capital gains (LTCG) on the sale of shares and equity mutual funds.
What is notable is that a 10 per cent tax will be levied on LTCG without the benefit of indexation, as is available in other asset classes.
The only relief offered was that LTCG up to Rs 100,000 in a financial year will not be taxed.
Another concession made to equity investors was that they will be spared from paying taxes on LTCG realised after April 1, 2018, but earned until January 31, 2018.
The finance minister referred to this provision as the grandfathering of gains in his Budget speech.
A specific methodology for arriving at the cost of purchase of shares and mutual fund units has been provided in Section 112A of the Income Tax Act.
Investors can use these provisions to reduce their tax liability on the sale of bonus shares.
Read CBDT's FAQ closely
The Central Board of Direct Taxes (CBDT) in its FAQs (frequently asked questions) dated February 4, 2018, has provided answers to various questions that arose regarding the proposed LTCG tax.
Here, we shall specifically refer to question number 21 in the FAQ, where it has clarified how the cost of acquisition is to be calculated in the case of bonus shares acquired before February 1, 2018.
The CBDT has said that the cost of acquisition of bonus shares too will be determined according to the methodology provided in Section 112A of the IT Act.
The answer to question number 21 should provide some tax relief to equity investors.
For the uninitiated, bonus shares are allotted to existing investors without any consideration.
Hence the cost of acquiring bonus shares is practically nil for investors.
At the same time, the share price of companies issuing bonus shares drops, to the extent of the bonus ratio, immediately after the record date for bonus shares (the date on which they are issued).
Modus operandi for reducing tax
1. Many companies have issued bonus shares over the past year.
2. You can sell your original holdings in these companies.
3. Since share prices have fallen after the Budget, it is quite likely you will incur short-term capital losses on these shares.
4. You can carry forward these losses for eight years and set them off against both short-term and long-term capital gains.
5. After a year of acquisition, sell the bonus shares.
6. Set off carried forward short-term capital losses incurred on sale of original shares against long-term capital gains incurred on sale of bonus shares and thereby reduce tax liability.
How to calculate acquisition cost
An example will help to illustrate how bonus shares will be taxed under the new regime.
MOIL issued bonus shares in the ratio of 1:1 with the share price going ex-bonus on September 27, 2017.
It implies that every shareholder who held shares of MOIL on September 27, 2017, was eligible to get one bonus equity share for every share held in the company.
If you bought 200 MOIL shares on September 18, 2017, at the high price of the day, your cost of buying each share would have been Rs 425.
On September 27, you would have 400 shares of MOIL. The ex-bonus price of the shares dropped to Rs 181.50.
Now, in case you decide to hold on to the MOIL bonus shares for a period of at least 12 months so that it qualifies as a long-term capital asset, your cost of acquisition of the bonus shares will be calculated according to the methodology proposed in the Budget.
This number will be taken to be the higher of the two prices, which is zero (the actual cost of bonus shares to you) and the highest price at which MOIL quoted on January 31, 2018, which is Rs 246.
The cost of these bonus shares thus works out to Rs 246 per share.
Carry forward short-term capital loss
Now, if you sold the original 200 MOIL shares on, say, February 15, 2018, at a price of Rs 236 per share, you will incur short-term capital loss of Rs 189 per share (Rs 425 less Rs 236).
At this rate per share, the total short-term capital loss on sale of these shares would be Rs 37,800.
If you do not have any other short-term capital gains for the financial year ending March 31, 2018, then the current income tax provisions allow you to carry forward this short-term capital loss of Rs 37,800 to subsequent years.
The 200 bonus MOIL shares turn a year old on September 28, 2018. Hypothetically, on October 1, 2018, you decide to sell these shares for a price of, say, Rs 275 per share.
As the shares have been held for more than 12 months, the bonus shares are long-term capital assets and the resulting gains would be long-term in nature.
As worked out in the above paragraphs, the cost of acquisition of these bonus shares is Rs 246 per share under the new regime.
The resulting LTCG on sale of these bonus shares will thus amount to Rs 29 (Rs 275 less Rs 246) per share and Rs 5,800 for 200 shares.
At the prescribed rate of 10 per cent, your tax liability on these gains will be Rs 580.
But spare a moment to recollect that you have brought forward short-term capital losses from financial year 2017-2018.
Under the existing income-tax provisions regarding set-off and carry-forward of capital losses, short-term capital losses carried forward are allowed to be set off against short-term capital gains or even long-term capital gains for the subsequent years (up to eight years).
This implies that the short-term capital losses of Rs 37,800 incurred on sale of the original 200 MOIL shares during 2017-18 can be set off against the LTCG of Rs 5,800 earned on sale of 200 bonus shares in 2018-2019.
The resulting taxable LTCG will be zero.
Secondly, it can also be inferred that you are not liable to pay any LTCG tax on the sale of bonus shares as long as MOIL's share price doesn't exceed Rs 435 per share.
The price of Rs 435 per share has been worked out by adding the short-term capital loss of Rs 189 per share to the cost price of bonus shares at Rs 246 per share.
A large number of companies have rewarded their investors with bonus issues in 2017.
All those investors who bought shares in 2017 just to participate in the bonus issue can reap the benefits of the grandfathering clause proposed in Budget 2018.
Those investors who are holding on to shares that have issued bonus shares prior to 2017 too stand to benefit as the long-term capital losses incurred on sale of the original shares will also be allowed to be set off against LTCG earned on sale of their bonus shares.
Arvind A Rao is a certified financial planner and Sebi-registered investor advisor.