There are certain situations when a company is unable to pay dividend in cash, because of a possible shortage of liquid funds, despite having a profitable turnover. In such cases, the company issues bonus shares to the current shareholders instead of paying the dividend in cash. Bonus shares are issued as new or additional shares, free of cost and in proportion to the shares and dividends held by the shareholder.
Companies often issue bonus shares, even if they do not face a shortage of liquid funds. This is a strategy employed by certain companies to avoid the highly levied Dividend Distribution tax, which has to be paid when declaring dividends.
When the company issues bonus shares, since the profits or reserves of the company are converted into share capital, there is a ‘capitalisation’ of the profits. The company cannot charge the shareholders for the issue of the bonus shares. A sum that is equal to the value of the bonus issue, is adjusted against the profits or the reserve, and then transferred to the Equity Share Capital Account.
What is a bonus issue?
The term bonus issue or a bonus share issue is used to define an issue of bonus shares. The number of shares held by a shareholder is what a bonus issue is based on. Zero cash payments ensure that the position of liquidity remains unchanged.
It is important to note that the dividend per share drops since there is an increase in the total number of shares as a result of a bonus issue. This does not directly affect the value or capital of the company overall. Unlike in the case of Rights Issues, this does not dilute the shareholder’s investment. The value of the investment remains unaltered because, even though there is a decrease in the income per share, the shareholder owns a larger number of shares. The primary purpose of the issue of bonus shares is to equate the excess of assets over liabilities with the Nominal Share Capital.
A bonus issue is an assurance that the company will be able to service its larger equity. This means that the company would not have issued bonus shares if it could not guarantee an increase in profits from the shares and a distribution of dividends in the future. Therefore, a bonus issue also promotes company goodwill.
Who is eligible for bonus shares?
Shareholders who own shares of the company prior to the record date and the ex-date set by the company are eligible for bonus shares. India follows the T+2 rolling system for the delivery of shares, wherein the ex-date is two days ahead of the record date. Shares must be bought before the ex-date because, if an investor purchases the shares on the ex-date, they will not be credited with the ownership of given shares by the set record date and therefore, will not be eligible for the bonus shares.
Once a new ISIN (International Securities Identification Number) is allotted for the bonus shares, the bonus shares are credited to the shareholders’ accounts within a fifteen-day period.
What is the ‘Record Date’?
A cut-off date set by a company is known as the record date. Investors must be owners of shares in the company by this date for them to be eligible to receive a distribution. The record date is established so that a company can identify the eligible shareholders and send them their due distributions.
Guidelines to be followed by a company before issuing bonus shares
1. The Articles of Association must sanction a bonus issue before bonus shares can be issued. If the Articles of Association is unable to do so, the company must pass a special resolution act at their general meeting
2. In case of a general meeting, the bonus issue has to be sanctioned by the shareholders as well
3. SEBI-issued guidelines must be followed
4. The company must ensure the total share capital does not exceed the authorised share capital as a result of a bonus issue. In case of such a situation, the capital clause in the Memorandum of Association must be amended by increasing the authorised capital
5. If the company has taken loans, the financial institution(s) involved must be previously informed
6. Prior to a bonus issue, a company must notify the Reserve Bank and avail its consent
7. Bonus shares that are to be issued must be fully paid. If shares are partially paid, it will make the shareholders liable to pay the uncalled amount