Bonus Shares Definition
Bonus shares are a popular corporate action besides dividends and stock splits. Companies which are profitable and have retained good amount of profits back in the business as reserves, issue additional shares to its shareholders as bonus shares. It is also termed as capitalisation of reserves.
Bonus shares enjoy all the rights and privileges of the existing equity shares. The only difference between the existing equity shares and bonus shares is that equity shares are issued against the receipt of consideration (value) in cash and bonus shares are issued free of cost and hence the term bonus. Issue of Bonus Shares do not alter the shareholding pattern since the bonus shares are issued on pro-rata basis.
Legal Requirements for Bonus issues
Bonus Shares can be issued only after a period of 12 months from the issue of shares for consideration. It can be issued only out of free reserves i.e. the reserves created out of profits realised in cash. It has to be issued as Fully Paid and only 2 bonus issues can be made in a period of 5 years. The balance of reserves after bonus issue should work out to be 40% of the post issue capital.
Example – A company may issue a bonus in the ratio of 1:1 which means for every 1 share with face value of Rs.10, a shareholder will be allotted one more share of Face value Rs. 10. So the shareholder will end up having 2 shares of Face Value Rs. 10
Change in Price after Bonus issue
The impact of bonus shares on the market capitalisation is zero sum i.e. the market cap remains unchanged.
Post Bonus Ex – Bonus Price = Original Price prior to bonus * Number of Shares post bonus / Number of shares pre bonus
In case of bonus issue, the Company decides the book closure and record date to ascertain the eligible shareholders. The stock price prior to record date is termed as “Cum Bonus” and the price after the record date is termed as “Ex Bonus”. After the bonus issue, theoretically stock price gets adjusted in the ratio of bonus shares to existing equity shares.
Perceived Advantages of Bonus Issues
- Improved Liquidity in the stock since the number of shares outstanding and tradable in absolute quantity increases
- Reducing Entry barrier since ex bonus price is lower than earlier and therefore shareholders unable to buy stock earlier will now be able to leading to the widening of the shareholder base of the company
Risk of Auction of bonus shares sold without actual receipt of shares in Demat Account
Unlike stock splits where the shares with new face value are credited immediately, in case of a bonus issue of shares, the bonus shares are credited in your trading account/demat account after a few days (usually 15 days) and not immediately after the ex-bonus date. Investors cannot also sell theses shares else would carry a risk of auction due to default of pay in obligation of shares.
Caution – Ensure charts have been adjusted in case of Bonus Shares while conducting Technical Analysis of Chart patterns
Above, we have 2 charts of the same stock ITC in the same 1 year period ending September 2016. The stock of ITC Limited went Ex Split on 01-07-2016 with a bonus issue of 1 bonus share allotted for every 2 shares held. Accordingly the price was adjusted and quoted from 360 odd levels (pre bonus) to 240 levels (post bonus). As you can see in the first chart, the prices have not been adjusted for the bonus in the charts and therefore we can see a huge gap in the charts whereas in the second chart, the price has been adjusted for the bonus issue in the charts and therefore we see no anomaly in prices and see a normal price pattern. If any trader was to apply any technical analysis methods such as moving averages, RSI,bollinger bands, etc in the first chart, the results would be absurd and would lead to incorrect conclusions.
Hence, it is very important that traders ensure that the charts have been adjusted for bonus before applying any technical analysis studies. The adjustment in charts needs to be done in both price and volume before analysis.
Tax Implication of Bonus Shares
Under the Indian Income Tax Act, the cost of the bonus shares is considered as zero. This means that when bonus shares are sold, the entire selling price is considered as capital gains. Whether it is considered as short term capital gains or long term capital gains shall depend on the tenure for which the Bonus shares have been held.
If bonus shares are held for more than 12 months from the date of being credited in the demat account, in that case, they shall be considered as held for long term and the capital gains would be Long term capital gains and hence exempt from taxation. If bonus shares are held for less than 12 months from the date of being credited in the demat account, in that case, they shall be considered as held for short term and the capital gains would be Short term capital gains and hence 15% STCG tax would be applicable.
There is no such tax implication in case of stock splits.
Our take on Bonus shares
Bonus shares do not add any value from a shareholders perspective. If at all, it deteriorates the quality of shareholders due to increased activity and entry of weaker hands in the stock. The rationale is the same as Mr. Warren Buffett’s logic on Stock Split. Investors must be careful of tax implications in case of bonus shares. In the above example of ITC, if you had sold bonus shares immediately ex bonus, a tax liability of 15% would arise on the sale proceeds from bonus shares sold and this tax liability could be much higher than the actual gain in the shares. Also, to avoid the risk of auction, shares must be sold only after they are actually credited in your account. With SAMCO, this risk is avoided, since you can sell shares for delivery in CNC product only after the actual availability of shares in your demat account/trading account.