What is a Bonus Issue?
Companies often employ various strategies to reward their shareholders and strengthen their market position. Bonus shares are a way in which companies reward their existing shareholders. In this article, we will discuss what a bonus issue is, how it works, and its benefits to the company. We will also examine how it differs from dividends and stock splits.
What is a Bonus Issue?
A bonus issue is a corporate action wherein a company gives additional shares to its existing shareholders at no extra cost. These shares are proportionally allocated to their shareholding as of the record date. [To be eligible for receiving bonus shares, investors must be shareholders of the company before the record date]. The primary object of issuing bonus shares is to capitalise on the company’s retained earnings and reserves while rewarding shareholders.
A bonus issue does not increase a company’s market capitalisation, but the number of shares increases. Thus, the price reduces in the same proportion. The face value (FV) of the stock remains the same after a bonus issue.
How do Bonus Shares Differ From Regular Dividends?
Although both bonus shares and regular dividends are ways to reward shareholders, they are entirely different corporate actions. Dividends involve distributing a portion of the company’s profit in cash directly to the shareholders’ bank accounts. On the other hand, bonus issues do not provide any immediate monetary benefits. Instead, they increase the number of shares owned by each shareholder. The additional shares improve the potential earning capacity of the shareholders.
Why Do Companies Issue Bonus Shares?
Capitalisation of Profits
Accumulated profits, also known as retained earnings, are the cash that remains after a company distributes dividends to its shareholders. Bonus issues allow companies to capitalise their accumulated profits or reserves and convert them into share capital. The company can then use the capital to fund expansion, investments, and other activities.
A bonus issue increases the number of outstanding shares in the company. An increase in the number of shares will dilute the share price and improve its liquidity, potentially attracting more investors.
Unlike cash dividends, bonus issues are a way to reward shareholders without affecting the company’s cash reserves. It helps maintain investor confidence.
Steps in Bonus Issue
The process of a bonus issue involves the following steps:
1. Board Approval
A company’s board of directors hold a meeting to discusses whether they are in a position to issue bonus shares. If yes, the board approves the bonus issue proposal and puts the decision up for shareholder vote.
2. Shareholder Approval
Once shareholders approve, the information is made public and communicated with the Securities and Exchange Board of India (SEBI) and other organisations, including stock exchanges (NSE and BSE).
3. Bonus Ratio
A bonus ratio specifies how many bonus shares will be issued for each existing share in the company. For example, a bonus ratio of 2:1 implies that shareholders will receive 2 additional shares for each share they hold, taking the total shares held to 3 (1+2).
How is the Bonus Ratio Determined? The bonus ratio is determined by considering various factors, including the company's financial performance, capital requirements, and market conditions. The amount of reserve or retained earnings to be capitalised also determines the bonus ratio.
4. Record Date
A record date is set to identify eligible shareholders who will receive bonus shares. Only shareholders on record on this date are entitled to the bonus. The company collects the names and details of shareholders as on the record date from depositories.
5. Issuance of Bonus Shares
After the record date, bonus shares are allotted to the shareholders in the bonus ratio.
How Do Bonus Issues Impact Shareholders?
A bonus issue affects the shareholders as on the record date as follows:
Increased number of shares
Existing shareholders receive additional shares, which increases the total shares they hold in the company. However, there won’t be any change in shareholding patterns and ownership.
No change in face value
A bonus issue does not reduce the face value of the shares.
Change in market price
The share price of the company adjusts downward after a bonus issue due to the increased supply of shares. However, this adjustment is usually temporary and will stabilise over time.
Example of a Bonus Issue
Berger Paints Ltd had recently declared the issuance of bonus shares in a 1:5 bonus ratio, which means that a shareholder as of the record date will receive one bonus share for every 5 shares held. The record date for the bonus was September 23, 2023.
If you had held 5 shares of Berger Paints Ltd on September 23, 2023, you would have received one bonus share from the company.
On the record date, the stock fell 8.65%. It fell 16.85% till October 4, 2023, when it started to stabilise. However, the fall in the stock price was purely due to the bonus adjustment that we discussed.
Benefits of Bonus Issue
- Bonus shares are exempt from taxes.
- It multiplies returns in the long term.
- Bonus shares are free of cost to the investors.
- From the company’s point of view, it helps to enhance the company’s value and image in the market. Additionally, the company will have more free-floating shares in the market with the issue of bonus shares.
How is a Bonus Issue Different From a Stock Split?
Although both bonus issues and stock splits result in an increase in the number of shares, they are completely different corporate actions with different purposes. A stock split is a corporate action in which a company divides its existing shares into multiple shares of a smaller price. On the other hand, a bonus issue is a corporate action wherein a company gives additional shares to its existing shareholders at no extra cost.
A bonus issue is a method to reward shareholders whereas a stock split is done to increase share liquidity, reduce share price and make it more affordable for more investors.
In a bonus issue, the face value of the shares does not change. However, its face value reduces in the same ratio in a stock split.
Regulatory & Compliance Requirements of Bonus Issues
In India, all corporate actions are governed by the Companies Act of 2013. According to the act, a company can only issue bonus shares to its members out of its:
1. Free reserves
2. Securities premium account
3. Captial redemption reserve account
Given below are some of the mandatory requirements that a company should comply with to issue bonus shares:
- The company shall capitalise its profits or reserves for the purposes of issuing fully paid-up bonus shares subject to the following [Section 63(2) and Regulation 293]:
- Authorisation by the Articles of Association
- Approval of its Shareholders/Members by passing a special resolution in a duly convened general meeting, basis recommendations of the Board
- No default in payment of interest or principal in respect of fixed deposits or debt securities so issued
- No default in payment of statutory dues of the employees, such as, contribution to provident fund, gratuity and bonus
- Make all the outstanding partly-paid-up shares on the date of allotment as fully paid-up
- None of its promoters or directors is a fugitive economic offender.
- The company shall abstain from withdrawing from the decision of its board recommending a bonus issue if it has been announced. (Rule 14)
- The Issuer Company shall implement the bonus issue:
- Within fifteen days from the date of the board meeting where shareholders’ approval is not required for capitalization of profits or reserves for making the bonus issue
- Within two months from the date of the board meeting where shareholders’ approval is required for capitalization of profits or reserves for making the bonus issue. (Regulation 295)
You can read more about the regulatory and compliance requirements related to bonus issues here.
Tax Implications of Bonus Issues
In bonus issues, the shareholders receive additional shares at zero cost. However, bonus shares are subject to capital gains tax when sold. The cost of acquisition or purchase price of the bonus shares will be ₹0 as it is free. Bonus shares are subject to capital gains tax.
For example, assume you are holding 100 shares of a company that you had bought at ₹100 per share. After a 1:1 bonus issue, you will receive 100 additional shares, taking the total number of shares held to 200.
|No. of shares originally held||100|
|Total number of shares post-bonus||200|
|Purchase price of original shares||₹100|
Let us assume that you sell 100 shares at ₹150 before 1 year (short-term capital gain). The taxable short-term capital gain would be;
|Selling Price (100 x 150)||₹15,000|
|Cost of Acquisition (100 x 100)||(₹10,000)|
|Capital gain on sale of original shares||₹5,000|
A short-term capital gain tax of ₹750 (i.e. 15% of ₹5,000) is payable.
Now you sell the remaining 100 shares (bonus shares) within the same year at ₹150. The taxable short-term capital gain would be:
|Selling price (100 x 150)||₹15,000|
|Cost of Acquisition (100 x 0)||(₹0)|
|Capital gain on sale of bonus shares||₹15,000|
A short-term capital gain tax of ₹2,250 (i.e. 15% of ₹15,000) is payable.
In conclusion, bonus issues are a popular corporate action used by companies to reward shareholders, enhance share liquidity, and capitalise profits. It doesn't change the total value of your investment, but it can affect the share price temporarily. It is also crucial to be aware of the tax implications of bonus issues.