Last Updated on May 25, 2022 by Neera Bhardwaj
Often the best things in life come for free, and one such freebie for investors are bonus shares! The only condition a shareholder has to meet to be eligible for bonus share offerings is to own shares in the company offering bonus shares. In this article, we dive deep into what are bonus shares and why they are issued.
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What are bonus shares?
When companies, despite being profitable, are unable to pay out their accumulated profits as dividends, they offer bonus shares to their existing shareholders. The bonus shares are offered to shareholders in proportion to their current holding levels. Companies that have dried up liquidity and are facing a shortage of cash in their balance sheet resort to bonus shares as a means to reward their shareholders.
Bonus shares are a medium through which companies convert their accumulated earnings into share capital. So, in a way issuing bonus shares saves the company from the liability to pay out dividends and helps shore up cash reserves. It’s important to understand that bonus shares don’t involve any cash flows in and out of the company. The net asset base of the company remains intact, and only the share capital is altered.
Why do companies issue bonus shares?
The last thing a company would want is the shareholders losing faith in the company. Non-payment of dividends out of accumulated profits on account of dried up cash balances is likely to result in something similar. To edge past this problem, shareholders are allotted bonus shares as a reward for investing in the company.
Issuing bonus shares also helps companies capitalize their reserves. Restructuring on the liability side occurs when the reserves are depleted and the equity capital rises equally. Since bonus shares are offered against the profits made by the company, the profit and loss account (forming part of the reserves) is reduced, and equity capital is increased. Bonus shares mark the steady income provided by the company to the shareholders, and in a way, it is a return delivered to the shareholders.
Features of bonus shares
- Issue of bonus shares promotes the goodwill of the company among the shareholders and possible investors
- There is no change in the shareholding pattern post a bonus issue, as the allotment of bonus shares is done pro-rata
- Since the company’s share price falls considerably post a bonus issue, it provides an opportunity for the retail investors to buy the company’s shares
- After a bonus issue, the share’s liquidity gets a considerable push by the increased number of outstanding shares
- Bonus shares can only be issued once a period of 12 mth has elapsed since the last issue for consideration. Also, only two bonus issues are allowed in five years. Otherwise, companies might misuse this opportunity to escape the liability of paying dividends
Types of bonus shares
Fully paid bonus shares
When the shareholders are offered bonus shares in proportion to their current holdings, they are called fully paid bonus shares. To issue fully paid bonus shares, a company can utilize its balances in security premium accounts, capital reserves, profit and loss accounts, capital redemption reserves, and so on.
Partly paid bonus shares
You don’t need to pay a single penny in case of partly paid bonus shares as well. Partly paid bonus shares are offered when the company wants to convert its existing partly paid shares into fully paid shares. Partly paid shares are those on which the company would demand the remaining money from the customers in calls.
Benefits of bonus shares for investors
- Bonus shares don’t attract any tax implications when sold after holding them for longer than 12 mth. Also when the bonus shares are credited to the demat accounts of the shareholders, they don’t need to pay any taxes on the bonus shares received
- Bonus shares are beneficial to investors who believe the company will flourish in the long run and bring manifold returns to their investment
Disadvantages of bonus shares for investors
When you see the bigger picture, you find that bonus shares do not award any real value to the shareholders. The value of the shares drop down in proportion to the bonus shares offered, and the net effect is nothing from the shareholders’ viewpoint. Also, from the company’s point of view, we find that the market capitalization doesn’t change; it remains intact.
Let’s understand this with an example. Suppose AB Pvt Ltd came up with a bonus issue of 1:2, that is for every two shares held in AB Pvt Ltd, the shareholders will receive one bonus share.
The price of the share before the bonus issue was Rs 200.
Mr X held 50 shares in AB Pvt Ltd, and his investment value totalled 50×200 = 10,000.
According to the terms of the bonus issue, Mr X received 25 more shares. Although as a result of the bonus issue, the share fell to Rs 133.34.
When we calculate the investment value of Mr X after the bonus issue, we find that it’s still the same as it was before the bonus issue.
75 shares @ Rs 133.34 each = 10,000.
We observe that there is no real change in the portfolio value of the investor, which remains the same before and after the bonus issue.
Tax implications on bonus shares
The fact that the bonus shares come at zero consideration make them a perfect case for capital gains. The whole of the proceeds from the sale of bonus shares is considered as capital gains because the consideration price is nil.
If the bonus shares are sold after holding them for 12 mth, a long-term capital gain arises, which is taxable at 10%. However, when shares are sold within 12 mth from the date of credit to respective demat accounts, short term capital gain is realized. STCG is taxable in the hands of the receiver at 15%.
Bonus shares have some visible shortcomings for the shareholders in the short run, due to the stock price dips and tax implications. But in the long run, bonus shares will bring you multifold returns. Long term or portfolio investors should mainly keep an eye on companies issuing bonus shares. They are a cash cow for both the issuing company and the shareholders.
While the shareholders get the benefits coupled with an extra number of shares, the issuing company gets relief from paying out cash dividends, its equity capital gets solidified, the goodwill receives a significant boost, and most importantly, the accumulated profits are capitalized.