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Date: 21 June 2008		Compiled by Mr. M. Sathya Kumar
	Issue of Bonus Shares : A Lucrative Preposition A bonus share is a free share of stock given to current shareholders in a company, based upon the number of shares that the shareholder already owns. While the issue of bonus shares increases the total number of shares issued and owned, it does not increase the value of the company. Although the total number of issued shares increases, the ratio of number of shares held by each shareholder remains constant. An issue of bonus shares is referred to as a bonus issue. Depending upon the constitutional documents of the company, only certain classes of shares may be entitled to bonus issues, or may be entitled to bonus issues in preference to other classes. A bonus issue (or scrip issue) is a stock split in which a company issues new shares without charge in order to bring its issued capital in line with its employed capital (the increased capital available to the company after profits). This usually happens after a company has made profits, thus increasing its employed capital. Therefore, a bonus issue can be seen as an alternative to dividends. No new funds are raised with a bonus issue. Unlike a rights issue , a bonus issue does not risk diluting your investment. Although the earnings per share of the stock will drop in proportion to the new issue, this is compensated by the fact that you will own more shares. Therefore the value of your investment should remain the same although the price will adjust accordingly. The whole idea behind the issue of Bonus shares is to bring the Nominal Share Capital into line with the true excess of assets over liabilities. Whether Bonus shares are miraculous? Few things match the sheer joy of getting a fat bonus at work. That is what shareholders of a good company feel when their company decides to throw a few shares (free of cost) in their direction. Here’s explaining what bonus shares are all about and why investors like investing in such companies. Free shares are given to you and are called bonus shares. Make money with shares. They are additional shares issues given without any cost to existing shareholders. These shares are issued in a certain proportion to the existing holding. So, a 2 for 1 bonus would mean you get two additional shares -- free of cost -- for the one share you hold in the company. If you hold 100 shares of a company and a 2:1 bonus offer is declared, you get 200 shares free. That means your total holding of shares in that company will now be 300 instead of 100 at no cost to you. Bonus shares are issued by cashing in on the free reserves of the company. The assets of a company also consist of cash reserves. A company builds up its reserves by retaining part of its profit over the years (the part that is not paid out as dividend). After a while, these free reserves increase, and the company wanting to issue bonus shares converts part of the reserves into capital. What is the biggest benefit in issuing bonus shares is that its adds to the total number of shares in the market. Say a company had 10 million shares. Now, with a bonus issue of 2:1, there will be 20 million shares issues. So now, there will be 30 million shares. This is referred to as a dilution in equity. Now the earnings of the company will have to be divided by that many more shares. Since the profits remain the same but the number of shares has increased, the EPS (Earnings per Share = Net Profit/ Number of Shares) will decline. Theoretically, the stock price should also decrease proportionately to the number of new shares. But, in reality, it may not happen. A bonus issue is a signal that the company is in a position to service its larger equity. What it means is that the management would not have given these shares if it was not confident of being able to increase its profits and distribute dividends on all these shares in the future. A bonus issue is taken as a sign of the good health of the company. When a bonus issue is announced, the company also announces a record date for the issue. The record date is the date on which the bonus takes effect, and shareholders on that date are entitled to the bonus. After the announcement of the bonus but before the record date, the shares are referred to as cum-bonus. After the record date, when the bonus has been given effect, the shares become ex-bonus. Issue of bonus shares Bonus shares are issued by converting the reserves of the company into share capital. It is nothing but capitalization of the reserves of the company. There are some conditions which need to be satisfied before issuing Bonus shares: 1) Bonus shares can be issued by a company only if the Articles of Association of the company authorizes a bonus issue. Where there is no provision in this regard in the articles, they must be amended by passing special resolution act at the general meeting of the company. 2) It must be sanctioned by shareholders in general meeting on recommendations of BOD of company. 3) Guidelines issue by SEBI must be complied with. Care must be taken that issue of bonus shares does not lead to total share capital in excess of the authorized share capital. Otherwise, the authorized capital must be increased by amending the capital clause of the Memorandum of association. If the company has availed of any loan from the financial institutions, prior permission is to be obtained from the institutions for issue of bonus shares. If the company is listed on the stock exchange, the stock exchange must be informed of the decision of the board to issue bonus shares immediately after the board meeting. Where the bonus shares are to be issued to the non-resident members, prior consent of the Reserve Bank should be obtained. Only fully paid up bonus share can be issued. Partly paid up bonus shares cannot be issued since the shareholders become liable to pay the uncalled amount on those shares. It is important to note here that Issue of bonus shares does not entail release of company’s assets. When bonus shares are issued/credited as fully paid up out of capitalized accumulated profits, there is distribution of capitalized accumulated profits but such distribution does not entail release of assets of the company. Issue of Bonus Shares by Public Sector Undertakings It has come to the notice of the Government that a number of Central Government Public Sector Undertakings are carrying substantial reserves in their balance sheets against a relatively small paid up capital base. The question of the need for these enterprises to capitalize a portion of their reserves by issuing Bonus Shares to the existing shareholders has been under consideration of the Government. The issue of Bonus Shares helps in bringing about at proper balance between paid up capital and accumulated reserves, elicit good public response to equity issues of the public enterprises and helps in improving the market image of the company. Therefore, the Government has decided that the public enterprises, which are carrying substantial reserves in comparison to their paid up capital sold issue Bonus Shares to capitalize the reserves for which the certain norms/conditions and criteria may be followed and fulfilled. There are some SEBI guidelines for Bonus issue which are contained in Chapter XV of SEBI( Disclosure & Investor Protection) Guidelines, 2000 which should be followed in deciding the correct proportion of reserves to be capitalized by issuing Bonus Shares. Private sector banks, whether listed or unlisted, can also issue bonus and rights shares without prior approval from the Reserve Bank of India. Liberalising the norms for issue and pricing of shares by private sector banks, the RBI said that the bonus issue would be delinked from the rights issue. However, central bank approval will be required for Initial Public Offerings (IPOs) and preferential shares. These measures are seen as part of the RBI's attempt to confine itself to banking sector regulation and leave the capital market entirely to the SEBI. Under the guidelines, private sector banks have also been given the freedom to price their subsequent issues once their shares are listed on the stock exchanges. The issue price should be based on merchant bankers' recommendation, the RBI has said. It means though RBI approval is not required but pricing should be as per SEBI guidelines. The RBI, however, clarified that banks will have to meet SEBI's requirements on issue of bonus shares. As per current regulations, private sector banks whose shares are not listed on the stock exchange are required to obtain prior approval of the RBI for issue of all types of shares such as public, preferential, rights or special allotment to employees and bonus. Banks whose shares are listed on the stock exchanges need not seek prior approval of the RBI for issue of shares except bonus shares, which was to be linked with rights or public issues by all private sector banks. Bonus Issue & SEBI Guidelines The SEBI has issued guidelines for Bonus issue which are contained in Chapter XV of SEBI( Disclosure & Investor Protection) Guidelines, 2000. A company issuing Bonus Shares should ensure that the issue is in conformity with the guidelines for bonus issue laid down by SEBI (Disclosure & Investor Protection) Guidelines, 2000. It is a detailed guideline which talks about that the bonus issue has to be made out of free reserves, the reserves by revaluation should not be capitalized. Bonus issue should not be made in lieu of dividend. There should be no default in respect to fixed deposits. Bonus issue should be made within 6 month from date of approval. This is not exhaustive but a lot of things are more in the guidelines regarding this. Bonus issue vis-à-vis Share split There is much hair-splitting on the relative benefits of a bonus issue vis-à-vis a share split. An investor with a short-term outlook may benefit by a split, while one willing to wait may prefer a bonus issue. - Laxmikant Gupta A few years ago, corporate action relating to existing shares was relegated to mainly dividends, rights issues and bonus issues. Now a days splitting of shares has become a common phenomenon. What a stock split does is divide each of the existing shares into a number of shares of a lower value. Unlike in the case of a bonus issue, the existing shares are converted into new shares of a lower value. In a bonus issue, additional new shares are allotted to the shareholder; the existing shares continue as they are, and there is no change in their face value. The news about bonus issues or share splits is normally received positively by shareholders. Bonus or split in units is normally done when the Net Asset Value of the fund is at respectable levels. Similarly, normally, corporates announce bonus or split when the share price goes to a respectable level and the management sees bright prospects for profitability and net worth. With splitting of paid-up capital allowed, corporate started doing it without touching the reserves. This way they could limit the paid-up capital value even while increasing the liquidity of shares in the market, which is always desirable. The Balance-Sheet perspective Rewarding by bonus shares means actual capitalization of reserves. Rewarding by split does not mean anything from the balance-sheet perspective. It only increases the liquidity of stock by reducing the paid-up capital. If the corporate comes up with further new share issues, by way of private placement, the lower base of the paid-up capital and the higher percentage stake of new investors can be attractive features if the capital has only been split. If expanded by bonus shares, then, the existing shareholders would already have a higher stake vis-à-vis further new issue size. Of course, the equity dilution will be lower in that case. As per Section 55 of The Income-Tax Act, 1961 bonus shares entail zero costs while all the purchase cost can be loaded on to the original shares. For bonus shares, the one-year holding requirement for Long-Term Capital Asset (LTCA) eligibility starts from the allotment date of bonus shares. In the case of split, the one-year eligibility is along with the original form of capital, which is split. In other words, the one-year does not start on the split date but on the date of purchase of original shares. When does the shareholders benefit - by bonus or by split? For a long-term investor, neither options makes a difference. Relative benefit on either option may get neutralised over time. In case of further shares issue by way of private placement, the equity dilution may be less had shareholders been rewarded with bonus issues. However, much depends on the pricing and the premium parts of the issue. An investor with a short-term outlook may benefit by a split rather than a bonus issue. Shares after split are recognised as LTCA if originally these have been held for one year. However, in the case of bonus issues, the new shares need to be held for one year to become LTCA. Periodic bonus announcements show up the real strengths of a company in building up reserves, in its profit model and, of course, in the intention to reward. Further, splitting is more beneficial to short-term stakeholders, while bonus shares are more for long-term stakeholders. Bonus Issue & Taxation For some years now, the issue of bonus equity shares has been a common phenomenon on the Indian bourses. However, one reads about other types of bonuses being issued by companies to shareholders. While some issue bonus dividends, while others proposes to issue bonus preference shares. The big question: what will be the tax treatment of the different types of bonuses, and which is more beneficial? To get a grip on the tax treatment, one needs to understand two provisions in the tax laws: the definition of dividend, and the manner of computing capital gains in respect of bonus issue of securities. Definition of dividends: Under the tax laws, if a company distributes its accumulated profits through the release of any of its assets to shareholders, the distribution will be regarded as a dividend. The definition also includes the distribution of debentures or deposits by a company, irrespective of whether the debentures or deposits are interest-bearing or not. Further, any issue of bonus shares to preference shareholders (equity shares are not included) is also deemed to be a dividend. Computation of capital gains: In the case of bonus shares and securities, if a person, by virtue of his holding a share or any other security, is allotted additional shares and securities without having to make any payment, then for the purpose of computing capital gains, the cost of the new shares and securities is to be taken as nil. The cost of the original share or security remains unchanged. For example, if a company issues bonus equity shares, there is no tax implication in the hands of the shareholders in the year of issue of the bonus shares. But when the bonus shares are finally sold, the entire sale proceeds are taxable as capital gains. This is because the cost of the acquisition of such shares is regarded as nil. Bonus dividends: This is a one-time dividend given on a particular occasion through the issue of dividend warrants (cheques). The company pays this out of its post-tax profits, and, therefore, does not get any deduction from its taxable income. Bonus debentures: Since bonus debentures are covered by the definition of dividends due to their specific inclusion, shareholders will have to pay tax on the capital value of the debentures they get. Further, since bonus debentures are issued out of the post-tax profit accumulated by the company, the company does not get any deduction for the value of the debentures that have been issued. In subsequent years, when the debentures are either sold or redeemed, the sale price or the redemption amount received by the debenture holder will not be taxable to the extent of the capital value of the debentures already taxed as dividend in the year of the issue of the bonus debentures. A view is however possible that, the issue of bonus debentures is also covered by the provisions relating to taxation of capital gains on the sale of bonus issues, since it involves the allotment of a security (debenture) without any payment. Since it is covered under two different provisions of law, the provision that is more specific to the case will be applicable. Again, since the definition of dividends has a specific reference to the distribution of debentures to shareholders, the more acceptable view is that the issue of bonus debentures should be regarded as dividends, rather than be covered by the provisions relating to capital gains from bonus issues.In subsequent years, when the company pays interest on the debentures, the company is allowed a deduction for this while computing its taxable income; the interest is taxable as the income of the debenture holders who receive it. Therefore, where bonus issues of debentures are concerned, they are not tax-efficient at the time of issue, but are subsequently tax-efficient over the life of the debentures. Bonus issues of preference shares: The issue of such a bonus to equity shareholders does not involve any distribution of assets by the company to shareholders, nor is it otherwise specifically included in the definition of dividends. Such bonus issues will, therefore, be governed by the provisions relating to capital gains from bonus issues, and will not be taxed as dividends. Therefore, at the time of the issue of bonus preference shares, neither is the shareholder taxed, nor does the company get a deduction from its taxable income for the value of the bonus preference shares. When the bonus preference shares are finally sold by the shareholder or redeemed, the cost of the preference shares is to be taken as nil, and the entire sale/redemption proceeds taxable as capital gains in the shareholder’s hands. In subsequent years, however, preference dividends declared by the company are taxable as dividend income in the shareholder’s hands; on the company’s part, the dividend has to be distributed out of its post-tax profits, for which it does not get any deduction from its taxable income. Therefore, this is tantamount to double taxation of the company’s profits in subsequent years, since the company pays tax on its profits, while the shareholder pays tax on the distributed profits received as preference dividends. Bonus issues of preference shares are, therefore, tax-efficient in the year of allotment, but not so over the subsequent life of the preference shares. Therefore, in the current scenario, bonus preference shares are more beneficial from a shareholder’s tax perspective when compared with bonus debentures. However, when we compare the situation over the subsequent life of the preference shares or debentures, debentures prove to be more tax-friendly. Capital v/s Revenue Expenditure: Fusion & Confusion It is said that India has the most complex Income-tax legislation. The tax system bristles with complexities and uncertainties. Consequent upon this there are problems of evasions and avoidance. As such, let us probe two fiercely debated concepts of taxation laws i.e. Capital & Revenue Expenditure which is very much relevant mentioning here. These two propositions are rays with different wave-lengths but from the same source. While the former is susceptible to tax being more extensive, the latter is advantageous to assessee. This is being done with regard to the issuance of bonus shares but simultaneously dealing with other tests mechanism. The controversy was whether the expenditure incurred by the assessee Company on account of issue of bonus shares was Revenue Expenditure or a Capital Expenditure. This was remotely connected with Section 37 of The Income Tax Act, 1961 and Section 75 (1)(c)(I) of the Companies Act, 1956. On this issue, there was a conflict of opinion between the High Courts of Bombay & Calcutta on the one hand and Gujarat & Andhra Pradesh on the other. The Bombay and Calcutta High Courts were of the view that the expenses incurred in connection with bonus shares is a revenue expenditure whereas Gujarat and Andhra Pradesh High courts have taken a contrary view and have ruled that the expenses incurred in connection with the bonus shares is in the nature of capital expenditure because it expanded the capital base of the Company. This matter went to the Apex Court in the case of CIT, Mumbai v. General Insurance Corporation. In the instant case before their Lordships the assessee Company had during the concerned accounting year - incurred expenditure separately for the increase of its authorised share capital and the issue of bonus shares. The assessee being unsuccessful at various forums finally went to the Supreme Court on the second category i.e. the nature of expenditure incurred in the issuance of bonus shares. In Empire Jute Company Ltd v. CIT Supreme Court laid down the test for determining whether a particular expenditure is revenue or capital expenditure. It was observed that there was no all-embracing formula, which could provide ready solution to the problem, and that no touchstone had been devised. It laid down that every case had to be decided on its own canvass keeping in mind the broad picture of the whole operation in respect of which the expenditure has been incurred. The Apex Court endorsed the text laid down by Lord Cave, LC, in Altherton v. British Insulated and Helsby Cables Ltd. In this case it was observed that when an expenditure was made, not only once and for all but with a view to bringing into existence an asset of advantage for the enduring benefit of a trade then there was a very good reason for treating such an expenditure as properly attributable not to Revenue but to Capital. This brings us to the crux of the problem. One of the arguments that could be advanced is that the expenses incurred towards issue of bonus shares conferred an enduring benefit to the Company, which resulted in an impact on the capital structure of the Company, and in that perception it should be regarded as capital expenditure. Conversely, the issuance of bonus shares by capitalisation of reserves was merely reallocation of a company’s fund and there was no inflow of fresh funds or increase in the capital employed which remained the same therefore did not result in conferring an enduring benefit to the Company and therefore the same should be regarded as revenue expenditure. The “enduring benefit” is of paramount importance while examining the rival contentions with which these two concepts are interwoven. There is also no unanimity in verdicts of various High Courts. In the back ground, the Supreme Court laid down the test whether a particular expenditure was Revenue or Capital in Empire Jute Company Ltd. v. CIT whereas the cases of Karnataka and Gujarat High Court dealt with the issuance of fresh shares and therefore the ratio decidendi of these courts did not apply to the issuance of bonus shares. However, the view as taken appears to be as laying down correct law. The Supreme Court did not agree with the observation of learned author A. Ramaiya which was of the view that while issuing bonus shares a Company converts the accumulated large surplus into Capital and divides the Capital among the members in proportion to their rights. The learned author felt that the bonus shares went by the modern name “Capitalisation of Shares”. The Apex Court has, therefore, marshalled the entire arithmetic and chemistry of the two very important propositions of the taxation law i.e. Capital expenditure and Revenue expenditure and made over a conceptual clarity by reiterating the evolved principle of “enduring benefit” vis-à-vis reallocation of a Company’s fund. The court has also laid down acid test for determining these two contingencies although the occasion was the event of issuance of bonus shares. The Capital expenditure is expenditure for long-term betterments or additions. This expenditure is in the nature of an investment for future chargeable to capital asset account whereas revenue expenditure is incurred in the purchase of goods for resale, in selling those goods and administering and carrying of the business of the Company. The free wheeling dissections by the Apex Court in Commissioner of Income Tax v. General Insurance Corporation of the various limbs of these twin concepts has cleared much of the haze. The Court held that the expenditure incurred in connection with the issuance of bonus shares is in the nature of revenue expenditure. The Bench said “the issue of bonus shares by capitalization of reserves is merely a reallocation of company’s funds. There is no inflow of fresh funds or increase in the capital employed, which remains the same. If that be so, then it cannot be held that the Company has acquired a benefit or advantage of enduring nature. The total funds available with the company will remain the same and the issue of bonus shares will not result in any change in the capital structure of the company. Issue of bonus shares does not result in the expansion of capital base of the company.” Conclusion The economy is booming, the markets are buoyant, and Indian companies are increasing their profitability. Consequential of all this, many companies have announced issues of bonus shares to their shareholders by capitalizing their free reserves this year. In this bullish market, shareholders have benefited tremendously, even after accounting the inevitable reduction in share prices post-bonus, since the floating stock of shares increases. The whole purpose is to capitalize profits. We can say that Bonus shares go by the modern name of “Capitalisation Share”. Fully paid bonus shares are not a gift distributed of capital under profit. No new funds are raised. Earlier there was also a lot of confusion & chaos between the two fiercely debated concepts of taxation laws i.e. Capital & Revenue Expenditure which was finally settled after the case which come up in SC in 2006, named Commissioner of Income Tax v. General Insurance Corporation. Now it is also settled law that a bonus issue in the form of fully paid share of the company is not income for the Income Tax purpose. The undistributed profit of the company is applied and appropriated for the issue of bonus shares. Article by Shagun Mehta of National law university
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