Bonus shares are generally issued by a company on a pro-rata basis to their shareholders when they wish to reallocate their reserves into their equity, or when they want to increase the liquidity of the shares in the market, or for any other such reasons.
Generally issue of shares can be taxed under the dividend distribution tax, and the head of ‘income from other sources’. While dividend distribution tax has been abolished since 2020, the issue of taxing bonus shares was still disputed as tax assessing officers have held that such allotments will attract income tax under the ‘income from other sources’ head. Taxpayers contend this, arguing that the issue of bonus shares does not affect the wealth of a company as it neither increases nor reduces the funds of the company or the overall shareholding of an investor. After several tribunal holdings, the Karnataka High Court has recently looked into this matter.
What are Bonus Shares?
Bonus shares are an issue of additional shares to the existing shareholders of a company, made at no cost to the company. They are issued on a pro rata basis i.e. in a proportional basis to the shares currently held by them. The shares are issued from the accumulated or retained earnings of the company which is the profits of the company that is set aside and not distributed as dividend.
Bonus shares are generally issued by a company to increase liquidity of their shareholding in the market and increase their equity base. An issue of bonus shares will increase the availability of the shares in the market and result in a lower share price which could incentivize investors to buy more shares. It is also an added advantage for shareholders who might be able to increase their shareholding at no extra cost.
ITAT Rulings on Taxing the Allotment of Bonus Shares:
In previous rulings before the tax tribunals, assessing officers have alleged that the income received by shareholders from the issue of bonus shares should be taxed on its fair market value under ‘income from other sources’ head. This is taxed under Section 56 of the Income Tax Act, 1961 (‘ITA’) wherein incomes from other sources that are not chargeable to other heads are taxed. This includes income from interest on securities, income from plant and machinery, etc. which are not taxable under the head of ‘income from profits and gains from business or profession’.
These shares have been taxed under Section 56 of the IT Act wherein the income from any property (other than immovable property) is taxed on the full amount if it is sold at higher than the fair market value, or the aggregate fair market value in cases where it sold lower than the value in the market. The fair market value of the shares is determined as per Rule 11UA of the Income Tax Rules.
In general, taxpayers have contended this move by arguing that an issue of bonus shares does not lead to an aggregate increase or decrease in the wealth of an individual and hence such income cannot be taxable. The matter has been heard before the tax tribunals of India in multiple cases.
In 2014, the income tax appellate tribunal (‘ITAT’) at Mumbai held that the issue of additional shares could not attract tax under Section 56(2) (vii) of the ITA in the case of Sudhir Menon HUF v ACIT. In this case, the taxpayer was offered additional shares at a face value of INR 100 each on a proportional basis. The taxpayer subscribed to half the shares offered and the rest were distributed to the other shareholders. The assessing officer adopted the year end market value of the shares, and due to the higher value, treated this difference as inadequate compensation under Section 56 of the ITA.
The tribunal on analyzing the mater held that the issue of bonus shares is a capitalization of the profit of the company which results in neither an increase or decrease in the wealth of a shareholder or in their shareholding percentage. A bonus issue just leads to greater liquidity of shares in the market and a proportionate allotment does not affect the shareholders. Hence, it cannot attract tax under Section 56 of ITA.
However, the tribunal also held that in the event of a disproportionate issue of bonus shares, where the value of the property being passed is greater than his existing property then there is a possibility of attracting tax under this Section.
This decision was relied on by the Delhi ITAT in the case of DCIT v. Smt. Mamta Bandhari wherein they held that the Section 56 of ITA was not for the allotment of bonus shares when there was no increase or decrease in the shareholding of the shareholder. In a proportional allotment of bonus shares, there is no receipt of property by the shareholder as what is received by them is the split shares out of their own holding. The shareholder is getting his own value of the existing shares at a reduced overall value due to the issue of bonus shares. Hence, Section 56 of ITA is not attracted.
Karnataka High Court in the case of PCIT v. Dr. Ranjan Pai
After the above decisions by the tax tribunals, a similar matter was appealed from the Bangalore ITAT to the Karnataka High Court. The ITAT had held that when a shareholder receives the bonus issue there is a depression in the overall value of shares held by him which is counterbalanced by the shares received through the bonus issue. Hence, such issue should not be taxed under the ‘income from other sources’ head. The matter was then appealed by the income tax department.
Facts:
- As part of search and seizure conducted by the income tax department, undisclosed income was found at the taxpayer’s residence. As part of assessing the undisclosed incomes, the income tax officers taxed 100,000 bonus shares received by him and assessed the fair market value of such shares at 12.4 crores.
- The taxpayer contended that the conversion of reserves into capital by way of bonus shares did not involve a release of profit and hence could not be taxed under Section 56 of the ITA.
- The revenue officers contended that since the taxpayer did not pay adequate compensation for the shares, they had to be taxed at fair market value.
Holding:
The High Court held that the allotment of bonus shares made on a pro rata basis could not attract tax liability under Section 56 of the ITA. The Court held that the issue of bonus shares by a company is only a reallocation of funds by the company from its reserves to its capital, and it does not lead to any inflow or outflow of funds for the company. Further, shareholders receiving such allotment on a pro rata basis are not gaining any advantage that can be taxed under Section 56.
Important takeaways from the case:
- The case sheds light on the intention behind Section 56 of ITA which is to tax the benefits received by shareholders on allotment of shares.
- In case of bonus shares, there is no extra benefit being allotted to shareholders as there is no increase in their wealth.
- When a shareholder receives a bonus share, the intrinsic value of the existing shares held by them will go down as the value of the shares is lowered in the market.
- The value after the bonus shares are added will be the same as the value held before by the shareholders. Hence, there is no benefit availed by the taxpayer that can be taxed under the ITA.
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