Bonus Shares

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Issue of bonus equity shares be issued to the preference shareholders [2009] 90 CLA (Mag.) 3 Amit Jain In the article below, Shri Amit Jain, Deputy General Manager-Corporate in Bennet, Coleman & Co. Ltd., New Delhi, emphasises the feasibility of the preference shareholders of a company being allotted bonus equity shares. If there is no bar to a company issuing preference shares that are capable of conversion into equity shares, there can be no serious impediment to the allotment of bonus equity shares to preference shareholders. However, as the 9th edn. of the Law and Practice of Income-tax by Kanga Palkiwala and Vyas points out at p. 123, the Incometax Act, 1961, unlike the Income-tax Act, 1922, would bring the bonus shares issued to preference shareholders in the tax net as dividend by virtue of sub-clause (b) of clause (22) of section 2

Bonus equity shares – Preference Shares – SEBI Guidelines for issue of Bonus Shares – Income-tax Act, 1961

introduction 1. Issuance

of bonus equity shares to the preference shareholders is a never tried and unusual proposition. However in the era of globalisation

and participation of many international partners in the success of a corporate; such bonus issue may be remunerative for the issuer as well as the allottee. 1.1 The

company issuing preference shares will get good pricing at the startup stage or during diversification/capacity enhancement and, on

the other hand, the allottee can play an important part in the success of the company and get remunerated accordingly. Being an equity holder at a later stage, it can very well bring its expertise and a sense of responsibility in the affairs of the company. 1.2 Pursuant

to some agreement or terms of arrangement between the subscribers of preference shares and the company, the latter may be

required to issue bonus equity shares to them. The relevant provisions of the Companies Act, 1956 (‘the Act’), SEBI SEBI (Disclosure & Investor Protection) Guidelines, 2000 (‘SEBI Guidelines’) for issue of bonus shares and Income Tax Act, 1961 have been analysed in the succeeding paras.

meaning of ‘bonus share’ and implications i mplications of issuing bonus shares 2.

The term ‘bonus share’ has not been defined in the Act. However, provisions of section 78, section 205 and other relevant provisions

facilitate the understanding of the term ‘bonus shares’. In the common man’s language, it has been explained that when a company is prosperous and accumulates surplus, it converts its surplus into capital and divides the capital among the members in proportion to their rights. This is done by issuing fully paid shares representing the increased capital. 2.1

Wikipedia defines the word ‘bonus share’ as follows : “A bonus share is a free share or stock given to current shareholders in a company,

based upon the number of shares that the shareholder already owns. While the issue of bonus shares increases the total number of shares” issued and owned, it does not increase the capital of the company. Although the total number of issued shares increases, the ratio of number of shares held by each shareholder also remains constant. 2.2

An issue of bonus shares is referred to as a bonus issue. Depending upon the constitutional documents of the company, only certain

classes of shares may be entitled to bonus issues, or may be entitled to bonus issues in preference to other classes. 2.3 In

Inland Revenue Commissioner v. Blott [1921] 2 AC 171 and CIT v. Dalmia Investments Co. Ltd. [1964] Ltd. [1964] 52 ITR 567 (SC), (SC), it has been

held that if a company declares a bonus out of undivided capitalised profits and allots it to its shareholders in satisfaction of the Bonus unissued shares in the company as fully paid up, the shares so allotted are known as bonus shares and they are capital and not income in the hands of shareholders. Hence, the company can distribute the profits to its shareholders in two ways ways : (a) by cash in the form of dividend, and (b) by fully paid shares in the form of bonus shares. 2.4 Section

205 provides that the company shall distribute dividend out of its profits. Sub-section (3) of section 205 provides that no dividend

shall be payable except in cash. Further, proviso to this sub-section stipulates that nothing in this sub-section shall be deemed to prohibit the capitalisation of profits or reserves of a company for the purpose of issuing fully paid bonus shares or paying up any amount for the time being un-paid on any shares held by the members of the company. 2.5 Sub-section

(2) of section 78 stipulates that the accumulated securities premium can be utilised by the company for the following purposes

: (a) in paying up un-issued shares of the company to be issued to members of the company as fully paid bonus shares, (b) in writing off the preliminary expenses of the company, (c) in writing off the expenses of, or the commission paid or discount allowed on, any issue of securities or debentures of the company, or (d) in providing for the premium payable on the redemption of any redeemable preference shares or of any debentures of the company. Accordingly, issue of bonus shares is the conversion of money held either in the form of profit or security premium into the equity shares, which really means that the undistributed profit has been permanently ploughed back into the business and converted into share capital. 2.6 When

fully paid-up bonus shares are issued to the shareholders what actually happens is that the profits are capitalised and the existing

shareholders, instead of receiving any money in cash out of undistributed profits, receives pro-rata fresh shares. However, articles of

association of a company, intending to issue bonus shares should provide for the capitalisation of accumulated profit and securities, premium realised in cash. Similarly, the company will also have to ensure that the subscribed and paid-up capital after issue of bonus shares does not exceed the authorised capital. If, as a result of the issue of bonus share, the subscribed and paid-up capital is likely to exceed the authorised capital, it would be necessary for the company to increase the authorised capital by following the procedure laid down in the Act including passing a resolution at the general body meeting and paying the prescribed fees to the Registrar of Companies. 2.7

Issues of bonus shares are not liable to be taxed in the hands of the allottees at the time of allotment. However, when the allottee sells or

disposes of such bonus shares, the profit or gain so realised upon sale are taxed in the hands of the holder pursuant to the extant provisions in the Income-tax Act.

whether Reserves created by revaluation of Fixed Assets can be used for issue of Bonus Shares ? 3.

Ministry of Corporate Affairs, vide its Circular dated 6th September, 1994, has advised the private/closely held and unlisted companies not

to issue bonus shares out of reserves created by revaluation of fixed assets. The latest SEBI Guidelines on bonus shares stipulate that the bonus shares have to be made out of the free reserves built out of the genuine profits or share premium collected in cash only and reserves created by revaluation of fixed assets cannot be capitalised for this purpose.

SEBI Guidelines on Issue of Bonus shares 4.

Chapter XV of SEBI Guidelines prescribes that a listed company proposing to issue bonus shares shall comply with the following :

“15.1.(a) No company shall, pending conversion of FCDs/PCDs, issue any shares by way of bonus unless similar benefit is extended to the holders of such FCDs/PCDs, through reservation of shares in proportion to such convertible part of FCDs or PCDs. (b) The shares so reserved may be issued at the time of conversion(s) of such debentures on the same terms on which the bonus issues were made. “15.1.1 The bonus issue shall be made out of free reserves built out of the genuine profits or share premium collected in cash only. 15.1.2 Reserves created by revaluation of fixed assets are not capitalised. 15.1.3 The declaration of bonus issue, in lieu of dividend, is not made. 15.1.4 The bonus issue is not made unless the partly-paid shares, if any existing, are made fully paid-up. 15.1.5 The company –  (a) has not defaulted in payment of interest or principal in respect of fixed deposits and interest on existing debentures or principal or redemption thereof ; and (b) has sufficient reason to believe that it has not defaulted in respect of the payment of statutory dues of the employees such as contribution to provident fund, gratuity, bonus, etc. 15.1.6 A company which announces its bonus issue after the approval of the Board of directors must implement the proposal within a period of six months from the date of such approval and shall not have the option of changing the decision. 15.1.7 (i) The articles of association of the company shall contain a provision for capitalization of reserves, etc. (ii) If there is no such provision in the articles, the company shall pass a resolution at its general body meeting making provisions in the articles of association for capitalisation. 15.1.8 Consequent to the issue of bonus shares if the subscribed and paid-up capitals exceed the authorised share capital, a resolution shall be passed by the company at its general body meeting for increasing the authorised capital....”

Meaning of ‘Preference Shares’ capital and implications of issuing Preference Shares 5. Section

80 of the Act authorizes a company limited by shares and if so authorised by its articles to issue preference shares, which shall be

redeemable or convertible not later than twenty years from the date of its issue. Sub-secion (1) of section 85 of the Act defines preference share capital as follows : “(1) Preference share capital means, with reference to any company limited by shares, whether formed before or after the commencement of the Act, that part of the share capital of the company, which fulfils both the following requirements, namely :(a) that as respects dividends, it carries or will carry a preferential right to be paid as fixed amount or an amount calculated at a fixed rate, which may be either free of or subject to income-tax, and (b) that as respects capital, it carries or will carry, on a winding up or repayment of capital, a preferential right to be repaid the amount of the capital paid up or deemed to have been paid up, whether or not there is a preferential right to the payment of either or both of the following amounts, namely –  (i) any money remaining unpaid, in respect of the amounts specified in clause (a) up to the date of the winding up or repayment of capital, and (ii) any fixed premium or premium on any fixed scale, specified in the memorandum or articles of the company.” 5.1 ‘Preference

shares’, as defined in the Oxford Dictionary means a share or stock whose entitlement for payment of dividend takes priority

over that of ordinary shares. As per Wikipedia, preferred stock, also called preferred shares or preference shares, is typically a higher ranking stock than voting shares, and its terms of issue are negotiated between the corporation and the investor. 5.2

Preferred stocks usually carry no voting rights but may carry superior voting rights or special advantages to common stock. Preferred stock

may carry a dividend that is paid out prior to any dividends to common stock holders. Preferred stock may have a convertibility feature into

common stock. Preferred stockholders will be paid out in assets before common stockholders and after debt holders in bankruptcy. Terms of the preferred stock are stated in a “Certificate of Designation”. 5.3

In Sher Singh v. Union of India [1984] 1 SCC 107, the Apex court considered the term ‘preference’ as an act of favouring one person or

thing over another. The expression ‘preference’ ‘amongst others’ means prior right, advantage precedence, etc. It signifies that other thing being equal, one will have preference over the others. 5.4

A company may issue redeemable preference shares if its articles so authorise. By virtue of sub-section (5A) of section 80, the period of

preference shares of redemption cannot exceed twenty years from the date of issue of such shares. The redemption can be effected only on the following conditions : • Redemption of such shares must be effected on such terms and in such manner as laid down in the articles of association of the company. • Such shares can be redeemed out of the profits or out of proceeds of a fresh issue of shares made for this purpose. • Such shares must be fully paid-up. • Premium, if any payable on redemption of such shares should be provided from out of the profits or out of the company’s security premium account. • An amount equal to redemption amount must be transferred to capital redemption reserve account, where the redemption is effected out of profits, otherwise available for distribution as dividend. 5.5

The redemption of preference share does not tantamount to reduction of the authorised share capital of the company.

Is Issue of Bonus Equity Shares to Preferential Share Holders valid in Law? 6. From

the above discussions, it is apparent that the preference share is a higher ranking stock than ordinary equity shares and its terms of

issue are generally negotiated between the company and the investors. The contract of arrangement between the company and the preference share subscriber may provide that the company shall issue equity shares to the holders of preference shares in a certain proportion at a later date of issue of preference share in the form of bonus shares. 6.1 Now

the issue is, will such a clause in the shareholders agreement with preference shareholders and issue of bonus equity shares to them

be valid in law when ordinarily, the bonus equity shares are issued to the equity shareholders only? If yes, what are the provisions of the relevant law which governs such an allotment and if no, then what are the provisions which bar such an issue. 6.2 From

the meaning of the expression ‘bonus share’ and the relevant provisions of the sections 78 and 205, it is apparent that the bonus

shares is a share allotted by capitalisation of profits or security premium. For this purpose, the company needs to have a provision in its articles and bonus issue should have been authorised by its shareholders. Accordingly the profits and money available in the security premium account belongs to the equity share holders and they may resolve to distribute or capitalise in any manner in accordance with the provision of the law.

bonus shares issued to preference shareholders – Liability to IncomeTax 7. Sub-clause

(b) of clause (22) of section 2 of the Income-tax Act provides that dividend includes any distribution to its shareholders by a

company of debentures, debenture-stock, or deposit certificates in any form, whether with or without interest, and any distribution to its preference shareholders of shares by way of bonus, to the extent to which the company possesses accumulated profits, whether capitalized or not. 7.1 Shareholders

may be given bonus shares of the same class which they hold or of a different class – White v. Bristol Aeroplane Co. Ltd.,

[1953] Ch. 65 (CA)]. Further, when the terms of arrangement of issue of preference shares include that the company shall allot bonus equity shares to the preference share allottees at a later date and the same has been authorised by the Board of directors and issue of preference shares has been approved by shareholders of the company and there is no restrictive provision in the Act, the issue of bonus equity share to the preference shareholders in accordance with the provisions of law is not an impracticable proposition. Further, where at the time of issue of bonus equity share, the issue is authorised under the company’s articles of association and approved by the equity shareholders of the company, it can be concluded that an issue of bonus equity shares to the preference shareholders is valid under law. 7.2 Having

established that such an issue is tenable in law, the mechanics of the issue can be easily outlined. The issue has to be first

approved by the Board of directors who must recommend it to the equity shareholders for their approval. The equity shareholders will then have to approve the issue as bonus to the preference shareholders by way of capitalisation of the profits of the company or the securities premium amount. The private/closely held and unlisted companies must ensure that bonus shares are not issued out of reserves created by revaluation of fixed assets. A listed company shall carry out the intimations to and obtain approvals from the stock exchanges as contained in the Listing Agreement. A return of allotment of bonus shares shall be filed with the Registrar of Companies in e-Form 2 within 30 days of the date of allotment. 7.3

Once the bonus issue is made, care should be taken to ensure that the total issued capital does not exceed the authorized capital.

7.4

These bonus shares shall carry the same rights as the existing equity shares or may vary depending upon the resolution passed at the

shareholders meeting authorising the issue of bonus shares to preference shareholders. The bonus shares so allotted shall carry the same rights as the other equity shares to the extent of the voting power. However, in case the bonus shares are issued with differential rights as to voting, then the rights of the preference shareholders shall stand restricted to that extent.  © All rights reserved with Jus Scriptum.