Chapter 13: Tax Provisions for Special Cases

Bonus Shares: Cost of Acquisition and Holding Period

A bonus issue represents capitalization of free reserves or securities premium by issuing additional shares to existing equity shareholders in proportion to their shareholding without monetary consideration.

• Cost of Acquisition under Section 55(2)(aa):
  • For bonus shares allotted on or after April 1, 2001: The cost of acquisition is statutorily deemed to be NIL (zero).
  • For bonus shares allotted prior to April 1, 2001: The assessee has the legal option to adopt the Fair Market Value (FMV) of the bonus shares as on April 1, 2001 as their cost of acquisition.
• Period of Holding: The period of holding for bonus shares commences strictly from the date of allotment of the bonus shares by the company, NOT from the date of acquisition of the original shares.
• Impact on Original Shares: The cost of acquisition of the original shares remains completely unchanged; their period of holding continues to date from their initial purchase.

Share Split and Consolidation of Shares

A stock split sub-divides existing shares into a higher number of shares with a proportionally lower face value (e.g., a 1:5 split converts a Rs. 10 face value share into five Rs. 2 face value shares). Consolidation is the inverse operation.

• Tax Neutrality at Split: The sub-division or consolidation of shares does not constitute a "transfer" under Section 47; no capital gains tax is triggered at the time of the corporate action.
• Cost of Acquisition Proportioning: $$\text{New Cost per Share} = \frac{\text{Original Cost of Acquisition}}{\text{Sub-division Ratio}}$$
• Period of Holding: Under Section 2(42A)(f), the holding period of the sub-divided shares includes the period for which the original un-split shares were held by the assessee.

Comparative Summary: Bonus vs Stock Split

Historical Evolution of Share Buyback Taxation

The taxation of share buybacks by domestic companies in India has undergone significant legislative overhauls:

1. Pre-July 2019 Regime: Domestic companies paid buyback distribution tax on unlisted shares, while listed buybacks via tender offer enjoyed exemption under Section 10(38) / 10(34A).
2. July 2019 to September 2024 Regime (Section 115QA): All domestic companies (listed and unlisted) were mandated to pay Buyback Tax at an effective rate of 23.296% (20% tax + 12% surcharge + 4% cess) on distributed income (consideration paid minus amount received on issue of shares). The proceeds were completely tax-free in shareholder hands under Section 10(34A).
3. Revised Regime Effective October 1, 2024 (Finance Act 2024): Section 115QA was abolished for buybacks initiated on or after October 1, 2024. The tax burden is completely shifted from the company to the shareholder.

Mechanism of the Revised Share Buyback Regime (Post-October 1, 2024)

Under the revised framework, buyback proceeds are categorized into two separate tax computations:

• Deemed Dividend under Section 2(22)(f): The entire consideration received by the shareholder on buyback of shares is treated as deemed dividend under Section 2(22)(f) and taxed under "Income from Other Sources" at the shareholder's applicable slab rates. No deduction for cost of shares is permitted against this dividend income.
• Capital Loss on Surrender of Shares: The original cost of acquisition of the shares surrendered in the buyback is treated as a capital loss in the hands of the shareholder under Section 46A: $$\text{Capital Gain/Loss} = \text{Deemed Consideration (NIL)} - \text{Cost of Acquisition of Shares Buyback} = -\text{Cost of Shares}$$ This capital loss (short-term or long-term, depending on whether the surrendered shares were held for $\le$ or > 12 months) can be set off against other capital gains realized during the year or carried forward for 8 assessment years.
• TDS Obligation: Domestic companies are mandated to deduct TDS under Section 194 at 10% on buyback payments to resident shareholders exceeding Rs. 5,000.

Concept of Rights Issues

Under Section 62 of the Companies Act, 2013, a rights issue offers existing shareholders the statutory pre-emptive right to subscribe to additional shares at a discounted subscription price in proportion to their existing shareholding. A shareholder faced with a rights entitlement has three choices:

1. Exercise the rights entitlement and subscribe to the shares.
2. Renounce the rights entitlement in favor of another person for a consideration.
3. Allow the rights entitlement to lapse unexercised.

Tax Treatment of Exercising Rights

Where the shareholder subscribes to the rights shares:

• Cost of Acquisition: The cost of acquisition of the rights shares is strictly the actual subscription amount paid to the company under Section 55(2)(aa)(iii).
• Holding Period: The period of holding for rights shares begins from the date of allotment of the rights shares, not the acquisition date of the original qualifying shares.
• Cost of Original Shares: The cost and holding period of original shares remain intact.

Tax Treatment of Renunciation of Rights Entitlement

Rights Entitlements (REs) are credited directly to demat accounts as temporary tradable securities:

• Cost of Acquisition of Rights Entitlement: Since the existing shareholder received the rights entitlement for free by virtue of their pre-existing shareholding, its cost of acquisition is deemed to be NIL under Section 55(2)(aa)(ii).
• Character of Gain: The entire consideration received on renouncing the rights entitlement is taxable as Short-Term Capital Gain (STCG) because the holding period of an RE (from offer date to renunciation date) is always well under 12 months.
• Taxation in Hands of the Renouncee (Buyer of RE): The person who purchases the rights entitlement and subscribes to the shares pays two amounts: the purchase price of the RE to the original shareholder, and the subscription price to the company. $$\text{Cost of Acquisition to Renouncee} = \text{Purchase Price Paid for RE} + \text{Subscription Price Paid to Company}$$ The holding period for the renouncee begins from the date of allotment of the rights shares.

Tax Neutrality of Amalgamations under Section 47(vii)

An amalgamation involves the merger of one or more companies (amalgamating companies) to form a unified entity (amalgamated company).

• Conditions for Tax Neutrality: Under Section 2(1B), all properties, liabilities, and at least three-fourths in value of shareholders of the amalgamating company must become shareholders of the amalgamated company.
• Exemption for Shareholders: Under Section 47(vii), the allotment of shares in the amalgamated company in exchange for shares held in the amalgamating company is not regarded as a transfer; hence, no capital gains tax is triggered.
• Cost of Acquisition: Under Section 49(2), the cost of acquisition of the shares in the amalgamated company is deemed to be the cost at which the shareholder acquired the shares in the amalgamating company.
• Period of Holding: Under Section 2(42A)(c), the period of holding of the new shares includes the period for which the old shares were held in the amalgamating company.

Demergers under Section 47(vid)

A demerger involves the hiving off and transfer of an undertaking by a demerged company to a resulting company on a going-concern basis:

• Tax Neutrality: Under Section 47(vid), the issue of shares by the resulting company to the shareholders of the demerged company is tax-exempt.
• Apportionment of Cost of Acquisition: The cost of original shares held in the demerged company is split between the demerged company and the resulting company based on the net book value ratio: $$\text{Cost of Resulting Company Shares} = \text{Original Cost} \times \frac{\text{Net Book Value of Assets Transferred}}{\text{Net Worth of Demerged Company Immediately Before Demerger}}$$ The remaining cost balance represents the revised cost of acquisition of shares in the demerged company.
• Holding Period: The holding period of shares in the resulting company includes the holding period of shares in the demerged company.

Stock Lending and Borrowing Mechanism (SLBM)

The Stock Lending and Borrowing Mechanism is a SEBI-regulated framework facilitating short selling and arbitrage by enabling participants to lend or borrow shares via clearing corporations:

• Tax Neutrality under Section 47(xv): Lending securities through an approved intermediary under an agreement complying with SEBI guidelines is not regarded as a transfer for capital gains tax.
• Lending Fee Characterization: The lending fee received by the lender is considered consideration for lending the asset and is taxable under the head "Income from Other Sources" at applicable slab rates.
• Corporate Actions during Lending: Any dividends declared during the lending period are collected by the borrower and passed on to the lender through the clearing corporation as "manufactured dividend", taxable in the lender's hands under IFOS.
• Return of Securities: When the borrower returns identical securities to the lender upon tenure expiry, no capital gains tax arises. The lender's original cost of acquisition and holding period remain uninterrupted.

Conversion of Preference Shares into Equity Shares

• Statutory Exemption under Section 47(xb): Any transfer by way of conversion of preference shares of a company into equity shares of that company is explicitly excluded from the definition of transfer.
• Cost of Acquisition under Section 49(2AE): The cost of acquisition of the equity shares received on conversion is deemed to be that part of the cost of acquisition of the preference shares in relation to which such equity shares were allotted.
• Holding Period under Section 2(42A)(hf): The period of holding of the converted equity shares includes the period for which the preference shares were held prior to conversion.

Concept of Segregated Portfolios in Mutual Funds

SEBI permits mutual fund schemes to create a "segregated portfolio" (commonly referred to as a side pocket) in the event of a credit event (downgrade to below investment grade or default) in a debt instrument.

• Mechanism: The distressed debt security is isolated into a separate segregated portfolio, while the remaining liquid securities continue in the "main portfolio". Existing unitholders are allotted an equal number of units in the segregated portfolio matching their units in the main portfolio.

Tax Treatment of Segregation under Section 49(2AG) and 49(2AH)

• Apportionment of Cost of Acquisition: The original cost of acquisition of units in the unsegregated scheme is apportioned between the main portfolio and the segregated portfolio in the ratio of their respective Net Asset Values (NAVs) immediately before and after the segregation: $$\text{Cost of Segregated Portfolio Units} = \text{Original Cost} \times \frac{\text{NAV of Segregated Assets}}{\text{Total NAV Immediately Prior to Segregation}}$$ $$\text{Cost of Main Portfolio Units} = \text{Original Cost} - \text{Cost of Segregated Portfolio Units}$$
• Period of Holding under Section 2(42A)(hh): The period of holding of units in the segregated portfolio includes the period for which the original units in the unsegregated scheme were held by the investor prior to segregation.
• Taxation upon Recovery/Redemption: When the AMC subsequently recovers funds from the defaulted issuer and liquidates units in the segregated portfolio, the redemption proceeds are subjected to capital gains tax based on the apportioned cost and total holding period.