This article is written by Abu Ali, a student of WBNUJS, Kolkata.
With the aim of maximizing its profits, a body corporate takes up various initiatives in order to deal with its stock and bring about a change in the same as a consequence of which the price of the stock is also impacted. Broadly, there are five major corporate actions in this regard viz.
- Bonus shares
- Stock split,
- Rights issue, and
- Buyback of shares.
A bonus share, also known as scrip issue/plough share/capitalization issue is an additional share issued, without consideration, by the company out of (i) its free reserves, (ii) the securities premium account; or (iii) the capital redemption reserve account [S. 63 (1) Companies Act, 2013] to its existing shareholders only on a pro-rata basis (such as 1:1, 2:1, 3:1 etc.). A company issues bonus shares for various reasons such as:
- To increase the stock liquidity so that trading of shares in the stock market increases thereby resulting in an increase of participation.
- To reward its shareholders for their faith and confidence in the company and thereby boost their morale, and
- To bring its stock price to a reasonable price bracket (see here).
Difference between bonus shares and dividend and stock split
The difference between a bonus share and a dividend has perplexed both the investor and the company alike. Basically, both these corporate acts are a reward for an investor and seem to be quite similar since both are given out without consideration. However, they come with inherent differences that makes one prevail over the other. Let us see how.
(i) Difference under the tax laws: When a bonus share is issued, it brings down the EPS (earnings per share) of the company since there are more shares now (the additional shares having no consideration) with the same paid-up capital. Generally, a company is exempted from paying taxes on bonus shares (see here). But if a shareholder intends to trade bonus shares (either buying or selling), then it is taxed under the Income Tax Act, 2011 (see here). On the other hand, where a company intends to declare dividends to its shareholders, it has to first pay dividend distribution tax (DDT) which is levied on the company’s earnings. From the investor’s perspective, he/she does not have to pay tax up to a certain limit. Thus, we see that a company is better off issuing bonus shares rather than declaring dividends.
(ii) State of the company while issuing bonus shares or declaring dividends: Dividend is only paid out of the profits made by the company in a given year. However, the declaration of dividends is contingent upon the decision of the Board of Directors. So basically, dividend is paid out of profits. On the other hand, a company may issue bonus shares even when it is not making profits or is running at a loss. Bonus shares can be issued both ways either out of the current year profits or from the reserves of past years (see here).
Bonus shares and stock splits look deceptively similar insofar as both of them result in an increase in the number of shares, no cash flow is involved and the shares are made more affordable by bringing the market value of each share within an affordable range. To explain a bit more, in stock split, if a shareholder owns a 100 shares worth ₹ 20 and then the company splits its stock in the ratio of 2:1, this would result in each share becoming two smaller shares meaning that the shareholder would finally hold 200 shares and that the price of each share would be reduced to ₹10. However, the main difference between them could be seen in terms of face value and their availability. Bonus shares are only available to the existing shareholders while in case of stock split, the new shares are available to both the existing shareholder as well to any potential investor. Regarding face value of a share, when a bonus share is issued, the face value of the share remains the same while in case of a stock-split, the face value of the share is changed.
Impact of bonus shares
Every corporate action does leave an impact in some way or the other. Among other things, its effect i.e. issuing bonus shares can be seen on:
- The value of the shares or the market price of the shares;
- Size of the company;
- Balance sheet;
Impact on value of shares
Since every corporate action yields a certain end-result, a shareholder being awarded bonus shares is naturally expected to ponder over the action and its impact on the value of shares because the market price of a share is a very important consideration for an investor. Let us see how and in what way the value of shares is affected.
As discussed earlier, bonus shares increase the outstanding shares of the company (see here). One may ask as to why a company would be at a loss by giving out free shares. This misconception is cleared by the fact that the company does not incur any loss but it only capitalizes its reserves thereby keeping the ratio of shares and capital in due proportion and which also results in an increase in the paid-up capital of the company. It is to be borne in mind that this capitalization must be “made with the consent of the controller of capital issues and approval of RBI.” along with other requirements [1. Such issuance of bonus shares must be authorized by the AoA of the company; 2. Sanctioned by shareholders and BOD; 3. Compliance with SEBI guidelines].
Let us consider the example of Mahindra & Mahindra Limited. In the year 2017, it announced bonus shares at the ratio of 1:1 i.e. for every one share that a shareholder held, he/she would get another share without consideration. As on 26th December, 2017 Mahindra & Mahindra was trading at ₹ 1,555.90. The very next day, the value of share went down to ₹ 777.95. This explains that when a company issues bonus shares, the value of the share in the market reduces as per the ratio. In the instant case, where the ratio was 1:1, it meant that the value of the share is halved due to the addition of an extra share. An investor should be clear that though the value of the shares has reduced, it is compensated by the extra shares issued to him.
After the exercise of issuing bonus shares, the number of shares, obviously increase in the market. Consequently, the EPS reduces. So while the profit of the company remains same, its shares increase. So now when there are more shares in the market, it becomes liquid thereby making it easy to buy and sell. An investor who did not buy a company’s share citing its high value would now be enticed to consider investing in those shares. A company thus issues bonus shares also with the intent of encouraging more participation in dealing with shares. In short, the change in value of shares follows a simple rule of demand and supply. Where due to issuance of bonus the supply of shares in the market goes up, the demand of the same accordingly adjusts. The hidden benefit that is accrued to the company is that no sooner does it announce bonus shares than a bulk of investors tries to purchase them.
Impact on size of the company
Issuance of bonus shares does not change the size of the company. It is just the number of shares that has increased and that too after increasing the issued capital proportionately. Thus, the value of the total stock remains the same wherein only the quantity of shares is increased.
Impact on balance sheet of the company
The balance sheet is not particularly affected because of bonus shares. Bonus shares involve capitalizing the reserves and relocating the figures from ‘Reserves/Surplus’ column to the ‘Share Capital’ column. No effect is thus observed on the total net worth of a company since there’s no cash outflow.
Impact on ownership of the company
This process does not have any impact on ownership and that the company’s ownership remains unaltered because “the price of the entire shareholding does not change.” (see here) For example if a company has total shares of 10,00,000 and an investor X holds 15,000 shares then his ownership in the company would be 1.5%. Now if the company were to issue bonus shares in the ratio of 1:2, it would still yield the same result i.e. the shareholder X’s ownership remains constant.
Vesting of shares
Vesting of bonus shares follows a different procedure under the Company Law. But even before that, one must know as to what exactly the term “vesting” means. With that we must also be aware of certain related definitions and concepts. They may be discussed under the followed heads:
- Announcement date: it is the date at which the company announces the issuance of bonus shares. This announcement date is usually accompanied by a record date
- Record date: it is the date on which the company determines the number of investors holding the company’s shares as on that date. Only those shareholders whose names are there on the lift of record date are eligible for bonus shares. Thus, being a shareholder before the record date is the eligibility for being awarded bonus shares. In more simple terms, it is the cut-off date until when a shareholder has to be in the records of the company to be eligible for bonus shares.
- Ex-record date: this is another key concept. This is fixed as one business day before the record date. This is the date by which an investor, in order to be eligible for bonus shares ought to have completed his stock purchase by then. So for example, if 15th May is the record date declared by the company, then 14th May would be the ex-dividend date and an investor must have finished his stock trading by then.
- Payment date: it is the date on which the company pays out the bonus shares
There are certain conditions which need to be fulfilled before a company can issue bonus shares. Firstly, the AoA (Articles of Association) of the company must have a provision for issuing bonus shares, the relevant whereof is S. 36(2)(a) of the Companies Act, 2013. Secondly, such issue of bonus shares must be authorized by the members of the company upon the recommendation of the Board of Directors. Thirdly, the company must not have defaulted in any respect (either in payment of principal or interest or any debt securities it may have issued).
Let us now understand what vesting actually is. Vesting is a legal term meaning to give or to earn a right to some benefit (either present or future) either in the form of certain rights, cash and for our purposes, bonus shares. Vesting of bonus shares is a corporate strategy to retain its shareholders. For the purposes of bonus shares, vesting of bonus shares would mean the time period during which an investor must be a recipient in the company’s list of shareholders.
The following is the procedure for issue of bonus shares:
- Call for meeting of Board of Directors: S. 173(3) mandates that a notice of not less than seven days be given to every director of the company calling for the meeting of the Board of Directors.
- Holding of the meeting: The meeting is held as per the requirements, the Board is presented with a resolution of bonus shares and the ratio of shares and dates are fixed thereafter.
- Approval of bonus shares: An extra-ordinary general meeting (EOGM) is held wherein issue of bonus shares is approved by a special resolution.
- Filing of Resolutions with the ROC: the company would file MGT-14 with the ROC within a time period of thirty days from the approval of the bonus shares resolution
- Allotment of shares: the Board is again called for allotment of shares the notice of which must be given seven days prior to such notice. The meeting is then held whereby shares are allotted.
- Filing Form PAS-3: This form contains the list of allottees along and if it’s a case of bonus shares, then a copy of the meeting which approves the allotment of bonus shares must also be attached. This form needs to be filed with the ROC within thirty days from the date of allotment of shares.
- Final issuance of shares: within two months of allotment, the company issues an allotment letter and share certificates.
It may thus be safely concluded that issuing bonus shares is beneficial to both the investor and the company. It benefits the investor inasmuch as he gets free shares and induces potential investors to now invest in that company and the company benefits by creating an impression in the market that it’s doing very well in its business (even if it does not, because those shares are paid from the company’s reserves), making its shares more transferable and affordable.
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- Income Tax Act, 2011 (https://dor.gov.in/sites/default/files/IT%20Act%20%28English%29_0.pdf)
- In Re. Commissioner of Income Tax, Madras vs AAV Ramachandra Chettiar (1964) 1 Mad LJ 281
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