Bonus Shares: Meaning, Types, Advantages & Limitations
Similar to their name, bonus shares are given as a bonus to investors whose value depends on their holdings. These shares increase the number of shares held by an investor; however, the price at which the investor originally purchased the company’s shares goes down. Keep reading to learn about eligibility, types, advantages and disadvantages of bonus shares.
What Are Bonus Shares?
Bonus shares are the additional shares that a company offers to its existing shareholders as a ‘bonus’ without any additional costs. These are the company’s accumulated earnings that are not converted to dividend payouts but into free shares. Companies issue this type of share to encourage the participation of retail and small investors.
These shares are given on the basis of the number of shares the investor already holds. They are always announced in the form of a specific ratio. Bonus shares increase the company’s total number of shares in the market.
For instance, if a company declares a 1:2 bonus issue, every shareholder will receive one free share for every two shares they own. Therefore, if a shareholder has 20 shares of a company, he/she will receive 10 additional shares, bringing their total to 30. The proportion in which a company offers bonus shares is the same proportion in which the stock prices come down.
If you own one share of ₹500 and the company announces bonus shares in a ratio of 1:1, this means you will now have two shares of the company, which will be ₹250 each. This is because you have 2 shares in the same investment of ₹500. Although the share prices reduced, the company’s net assets remained the same.
Who is Eligible to Receive Bonus Shares?
Shareholders who own shares of the company before the record date and the ex-date are eligible for bonus shares. After announcing a bonus share, the company announces the record date. It is the date at which records are checked to determine the eligible shareholders. The ex-date is a day before the record date.
In India, the settlement cycle of shares is set to T+2 days, which means that you will need to purchase the stock at least a day before the record date so that they get transferred to your Demat account on the record date.
In the same way, an investor needs to buy the share at least a day before the ex-date to be eligible for bonus shares. Otherwise, they won’t be eligible to receive bonus shares.
Types of Bonus Shares
The two types of bonus shares are discussed below:
- Fully Paid Bonus Shares
Distribution of this type of bonus share takes place without any extra cost and as per the proportion of the investors’ holdings. Issuance of this type of bonus shares takes place from sources that include:
- Free reserves
- Capital redemption reserves
- Security premium account
- Partly paid Bonus Shares
Partly paid shares are only partially paid when compared to their full issue price. Hence, investors can get partly paid shares without paying the total issue price.
The remaining amount can be repaid in instalments when the company makes a call. When the bonus is applied on partly paid shares, and they get converted into fully paid shares, they become known as partly-paid up bonus shares. These bonus shares, however, cannot be issued through a capital redemption reserve account or security premium account.
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Guidelines to be Followed by Company Before Issuing Bonus Shares
Here are the guidelines that a company must follow before issuing bonus shares:
- The company’s Article of Association (AoA) should sanction bonus issues before issuing them.
- Management must pass a resolution for the issuance of bonus shares in the company’s annual general meeting. It should get the recommendation of the board of directors. The shareholders should sanction these recommendations.
- Companies should follow the exhaustive regulations of the Securities Exchange Board of India (SEBI) before issuing bonus shares.
- If the company is listed, the stock exchanges must be informed about the issue as soon as it is finalised in the board meeting.
- The company has to ensure that the total share capital does not exceed the authorised share capital. The bonus shares must be issued from the company’s free reserves.
- The company should notify the Reserve Bank of India (RBI) and get its consent before issuing bonus shares.
- Issuance of bonus shares is only possible when the shareholders pay for it fully. If not, they have to pay the uncalled amount.
What Are the Advantages of Bonus Shares?
Here are some benefits of the issuance of bonus shares:
- Investors do not need to pay any tax on receiving bonus shares.
- Bonus shares are particularly advantageous for investors who have a long-term investment horizon as they allow returns to get amplified.
- These shares are offered free of cost by the company. This increases the number of outstanding shares and enhances the liquidity of the stock.
- These shares instil a greater sense of faith in the company’s business and operation as it offers capital to the investors.
- The company pays higher dividends to investors who own bonus shares. This is because they own a greater number of shares in the company.
- Bonus shares help companies in a financial situation in which they are unable to pay cash dividends to their shareholders due to cash flow problems.
- These shares help the company enhance their liquidity in the market and attract small investors.
- When companies issue bonus shares, the number of free-floating shares also increases.
What Are the Disadvantages of Bonus Shares?
Here are some demerits of bonus shares:
- The company does not receive anything in return when issuing bonus shares.
- When a company frequently offers bonus shares, it results in the accumulation of shares. This reduces the earnings per share and acts as a disadvantage for the shareholders.
- Issuing bonus shares is costlier if we compare it to declaring dividends, and the cost of issuing bonus shares keeps on adding over the years.
How is Bonus Share Different from Stock Split?
A stock split is another corporate action by which a company increases the number of outstanding shares trading in the market. Although they might seem similar, they have their differences. With a stock split, a company can increase its stock’s liquidity with no additional costs involved. The company uses its capital reserves to pay for bonus shares, but capital reserves remain intact in case of a stock split.
Tax Implications of Bonus Issue
According to the Income Tax Act of 1961, there are no tax implications on a bonus share you receive during a particular financial year. In simpler words, a shareholder does not have to pay taxes to receive bonus shares.
However, the gains you earn by trading bonus shares fall under the category of capital gains and are taxable accordingly. Taxability of income earned by selling bonus shares depends on the holding period:
- Short-Term Capital Gains (STCG): If you sell a bonus share within 12 months of its issue, a 15% income tax will be applicable to STCG.
- Long-Term Capital Gains (LTCG): If you sell the shares after holding them for 12 months or more, the gains are referred to as long-term capital gains. LTCG of up to ₹1 lakh is tax-exempt. For gains more than ₹1 lakh, a 10% income tax is applicable.
A company can issue bonus shares to distribute its accumulated earnings to its shareholders. This not only helps in strengthening the company’s equity base but also retail participation in shares. Although the issuance of bonus shares means lower EPS, bonus issue is a tax-efficient way of distributing profits..
Frequently Asked Questions
When do bonus shares get credited?
It generally takes 15 days from the record date for the bonus shares to be credited to your demat account. You will receive a notification from CDSL when these shares are credited. First, you will receive the bonus shares under a temporary ISIN. After 4-5 days, you will receive a permanent ISIN and will get approval for trading.
Why do companies issue bonus shares?
Companies primarily issue bonus shares when they cannot pay cash dividends to shareholders due to a shortage of funds, even when they earn profits. Hence, investors are offered bonus shares free of cost instead of receiving cash dividends.
Why does my portfolio show a loss due to bonus issues?
When there is the issuance of bonus shares, share prices get reduced on the basis of the ratio of issue. The investment value of the stocks does not change; the shareholder just receives the remaining value in the form of bonus shares. Until the company credits your bonus shares to your demat account, your holding will show a temporary drop in your profit and loss statement.
Does the issuance of bonus shares make investors richer?
Issuing bonus shares does not indicate an increase in the overall profitability of a company; the profits remain the same, only the number of shares increases. This means that the earnings per share (EPS) that investors will receive decreases. Your total investment value will also remain the same as you will hold more shares but at a lower price.