What Is a Bonus Share?

Bonus shares are additional shares the company gives to existing shareholders, free of cost. Shareholders can transact these shares in the secondary market to meet liquidity requirements.

There are certain situations when a company is unable to pay a 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, there is a ‘capitalisation’ of the profits, since the profits or reserves of the company are converted into share capital. 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 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. Companies issue bonus shares following the constant ratio formula that allows a fixed number of shares to each shareholder based on the number of outstanding shares. Let’s try to understand what bonus shares mean with the help of an example.

Let’s say you hold 200 shares of company XYZ. Now, the company issued bonus shares at the ratio of 4:1, which means four bonus shares for each share you have. Accordingly, you become entitled to 800 bonus shares for the 200 shares you have.

However, the total value of your investment in the company remains the same. For example, assume the earlier share price was ₹20 per share; thus, your investment was worth ₹4,000. Then, although you own 1,000 shares instead of 200, the share price has dropped to ₹4 per share and your investment’s total value is still ₹4,000.

Who Is Eligible for Bonus Shares?

Shareholders who own shares of the company before 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 fifteen days.

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 are 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. Before 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

Advantages And Disadvantages Of Bonus Shares

Advantages for companies:

1. Bonus shares can be a good alternative to paying dividends. Companies, therefore, issue bonus shares when they are cash-strapped.

2. Bonus shares increase the issued share capital of the company, making it look like an attractive option to investors.

3. Bonus shares increase participation among retail investors by increasing liquidity

For shareholders:

1. Bonus shares allow the shareholder to diversify more, especially if the price per stock is too high for a retail investor.

2. The increased liquidity in the market may help in the capital gain.

3. Bonus shares experience no tax, unlike the TDS on dividend income. However, you do experience taxes on any capital gains made by the share.

On the con side, neither the investors nor the corporations receive any income from the release of bonus shares. Additional shares reduce income per share, which might disappoint investors, making the stocks less attractive.

How Bonus Share Is Different from Stock Split?

A stock split is another way for companies to increase the number of shares trading in the market. Although both sound similar, stock split and bonus shares aren’t quite the same. A stock split allows companies to increase share liquidity but involves no cost. And hence, the company’s cash reserve remains intact. Bonus shares, however, are paid out from the capital reserve.

Conclusion

Bonus shares involve allotting additional free shares to existing shareholders to meet their liquidity requirements. Unlike issuing fresh shares, bonus shares don’t add to the company’s earnings.