Making sense of stock splits, bonus issues & share buybacks

Housing Development Finance Corp Ltd (HDFC) has announced a stock split. Each share of a face value of Rs 10 would be split into five shares of face value of Rs 2 each. So what are the implications for investors? Does it indeed increase their wealth? Is a stock split similar to a bonus issue? What about the tax implications? Is their potential for tax planning? Today’s article seeks to address these and related issues.

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.

Let’s take the HDFC 5 for 1 stock split. This means following the stock split, the company’s shares will start trading at one-fifth the price of the previous day. Consequently, you will own five times the number of shares that you originally owned and the company in turn will have five times the number of shares outstanding.Consider the following example.

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? Generally, stock splits are announced to make a scrip more liquid, more affordable to the average investor — since post the split, the share price adjusts proportionately to the split ratio.
Here, it has to be reiterated that the shares only appear to be cheaper, it makes no difference whether in the above example you buy one share for Rs 3,000 or five for Rs 600 each. However, earlier the minimum ticket size was Rs 3,000, now it is a more affordable Rs 600.

As far as the tax implications for stock splits are concerned, well, 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 that what is applicable for 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 Rs 1,500 per share was Rs 1,50,000, after the split the cost of 500 shares would be reduced to Rs 300 per share, thereby keeping the total cost constant at Rs 1,50,000.

Bonus shares
Bonus shares are shares issued free of cost to the shareholders of a company. As this is essentially a book entry (reserves get capitalised), following a bonus issue, though the number of shares increase, 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 share holder. 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 calculating 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. This is known as bonus stripping. It may be noted here that through Section 94(8), the Income-Tax Act has introduced measures to curb bonus stripping, but strangely, the same are only applicable to mutual fund units and not to shares.

Share buybacks
Then there are share buybacks. Essar Oil, Reliance, Siemens and Infosys are some examples of companies that have bought back their shares.

Generally, companies buy back 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 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 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 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.