Meaning of Bonus Shares
Under Company Law
Companies Law has not defined the term “dividend” but under Section 179(1) it has provided that the amount available for distribution as dividend can be distributed as bonus shares.
While dividend can be distributed only from the profit available for distribution as dividend – bonus shares can be issued at times from the restrictive reserves as well – following the capital maintenance concept – which we will discuss further below.
As per the definition of the Bank and Financial Institutions Act, 2073 under Section 2(KaGna) “dividend” means the cash dividend, interim dividend and bonus share given pursuant to this Act and other prevailing laws.
Section 2(tha) of the Company Act provides that: “Bonus share” means a share issued as an additional share to shareholders,
- By capitalizing the saving earned from the profits or the reserve fund of a company, or
- Increase of the paid-up value of a share by capitalizing the saving or reserve fund
Under Tax Law
But the definition of dividend provided by Income Tax Law is quite technical. Under Section 2(Ka.Gha) of the Income Tax Act, “dividend” means dividend of an entity as mentioned in section 53.
Following that definition, under Section 53(1) of the Income Tax Act – the term distribution includes both payments made to beneficiaries (e.g. dividend in cash or kind) and the capitalization of profits (e.g. bonus shares).
Section 53(4) also provides that any capitalization of profit is also a “distribution of profit”. This provision is a direct classification of “distribution of profit” rather than “characterized / anti-abuse” definition as discussed above for dividend. This straightforward classification might have been assumed under the Tax Law because of the following reasons: (i) Generally Accounting Standards and Company Law do not allow capitalization of profit unless there are distributable profits, (ii) The capitalization of profits does not reduce the value of the net assets of the company and thus there less chance for the manipulation of the wealth and tax liabilities within the company, and (iii) The capitalization of earnings into shares in most entities represent that these earnings in the form of shares can be easily traded and cashed in.
Distribution of Bonus Shares
Out of General Reserve
A company is required to adopt a special resolution in the general meeting before issuing the bonus shares and issue them only out of the amount available for distribution as dividend under Section 179 of the Companies Act, 2063. It also provides that when a company issues bonus shares, the information of the same shall be given to the Office of Company Registrar’s before issuing such shares.
Revaluation Reserve is not a distributable profit so neither dividend nor bonus share can be distributed from such reserves. This is a generally accepted accounting canon and also it is restricted under Section 56(10) of the Companies Act.
Out of Restricted Reserves
Bonus share is a means of converting the free reserves of the company into share capital so there is no intrinsic loss in the net worth of the company by the reason of the distribution of bonus shares. For this reason in some circumstance the distribution of the bonus share is also allowed from the restricted reserves as well. Under Section 29(3) of the Companies Act, 2063 a company can distribute fully paid bonus shares out of the amount available that is collected from selling the shares at a price greater than its face value (i.e. share premium).
Similarly fully paid bonus shares can also be issued out of the capital redemption reserves created as per the requirement of the Companies Act, 2063. Capital Redemption Reserves are required to be created under Section 65(7) out of the distributable profits while redeeming the preference shares of the company except when they are redeemed by the reason of the fresh issue of the shares. Similarly, Section 61(6) of the Act also requires the Capital Redemption Reserves to be created when the shares are bought back. These reserves are required to be maintained by the Company as if they were the paid up capital of the company. So these reserves are not allowed to be used in any other manner other than to issue fully paid bonus shares out of them.
Taxation of Bonus Shares
Bonus Shares are also termed as the “distribution of profit / dividend” under the Income Tax Act, 2063. So the tax treatment of the issuance of the Bonus Shares is the same as distributing dividend under the Act. More discussion on that topic here: Link Here
The withholding tax rate applicable in the payment of dividend has seen certain changes since the introduction of the Income Tax Act, 2058. For the period 2058.12.19 to 2060.03.32 the withholding tax rate on dividend was 10%. For the period 2060.04.01 to 2064.03.32 the withholding tax rate on dividend was reduced to 5%. For the period 2064.04.01 to 2066.03.31 the withholding tax rate on dividends distributed to resident persons remained the same at 5% but the dividend distributed to non-resident was increased back to 10%. Finally, from 2066.04.01 the rate got revised to 5% for both residents and non-resident recipients of the dividend.
The withholding rate is applied on the amount being distributed. Since the withholding requirement falls on the entity distributing the dividend – the amount of dividend is grossed with the applicable dividend rate and the entire amount is approved as “proposed dividend” by the BoD and General Meeting of the entity as required. This is quite straightforward.
However, in the case of Capitalization of Dividend – there is no actual cash payment to the shareholders – in fact there is no intrinsic increment in the wealth of the shareholder by the reason of capitalization of dividend. There may be some prospective increment in wealth by the reason of reinvestment but not any realized gains at the present. Capitalization of dividend in fact is only a restriction in the form of distributable profits. It sure seems there is no reason to withhold taxes on the capitalization of the dividend as it is only but only a change in the form of wealth without any realization. But the laws generally do not treat the capitalization of dividend separately from the distribution for taxation because the instruments representing the investment (i.e. share units) are generally tradable. This leads to the notion that when the dividends are capitalized they become realizable by the reason of being tradable. So there is no difference in the tax treatment for “payment of dividend” and “capitalization of dividend”.
Example of Tax Treatment in Distribution of Profit:
- Distribution of Dividend: A company is proposing to distribute a cash dividend of Rs. 800,000. Grossing up with dividend tax the amount comes to Rs. 842,105 (Rs. 800,000 / 95%) which is approved by relevant authority as per the Company Law. The dividend tax comes to Rs. 842,105 × 5% = Rs. 42,105 and cash dividend of Rs. 800,000 will be distributed to the shareholders. Such distribution is termed as
- Capitalization of Dividend: A company is proposing to capitalize a dividend of Rs. 800,000. Grossing up with dividend tax the amount comes to Rs. 842,105 (Rs. 800,000 / 95%) which is approved by relevant authority as per the Company Law. The dividend tax comes to Rs. 842,105 × 5% = Rs. 42,105 and the amount of Rs. 800,000 will be capitalized to each shareholder’s shareholding proportionally.
Company issuing the bonus share is required to withhold taxes on the amount of the bonus shares issued – in the same manner that is required in the case of the distribution of the profit.
- When the company issues both Cash Dividend and Stock Dividend: The company will typically withhold the taxes applicable on both cash and stock dividend from the cash dividend. Example: A company has announced Rs. 800,000 cash dividend and Rs. 500,000 stock dividend. The Company will capitalize Rs. 500,000 as share capital and distribute Rs. 800,000 as cash dividend and deposit taxes of Rs. 65,000 (Rs. 800,000 / 95% × 5% + Rs. 500,000 / 95% × 5%). The gross cost of the cash dividend comes to Rs. 865,000 and gross cost of the stock dividend comes to Rs. 800,000.
- When the company issues only Stock Dividend: The company has two alternatives –
- Announce additional cash dividend to cover the withholding requirement. Example: A company has announced Rs. 500,000 stock dividend. The Company will also announce a cash dividend of Rs. 26,316 (Rs. 500,000 / 95% × 5%) to the extent of withholding dividend (i.e. Rs. 526,316 × 5%) and capitalize Rs. 500,000 as bonus share.
- Ask the shareholders to deposit the withholding taxes on the bonus shares in the specified account maintained by the Company. This seems quite absurd but this method is famously being followed in Nepal. Example Here.
Bonus Elements
Bonus Shares
If we dissect and view the arrangement of stock dividend we notice that Bonus Shares is actually a combination of “receiving Cash Dividend” and “making a Reinvestment Decision” by the shareholders of the company – as bonus shares is provided only through the special resolution passed by the general meeting of the company.
For example: A company announced a Bonus Shares of Rs. 500,000. The gross cost of the announcement comes to Rs. 526,316 (Rs. 500,000 / 95% × 5%). So the Bonus Shares of Rs. 526,316 is announced in gross and Rs. 500,000 gets capitalized as share capital. Alternatively, this whole arrangement can be understood in two steps: (i) First the company releases the cash dividend of Rs. 500,000 (after taxes) to shareholders, and (ii) Secondly, the shareholders of the company decide to reinvest the amount of Rs. 500,000 into the company. This analogy proves that Bonus Shares = Cash Dividend + Reinvestment Decision and also supports why the capitalization of bonus shares is taxed just like cash dividends.
Accounting Perspective:
An accounting entry for the above example in the books of the company would be:
General Reserve Dr. Rs. 526,316
Withholding Taxes Cr. Rs. 26,316
Share Capital Cr. Rs. 500,000
Right Shares
Right share is the share issued to the existing shareholders to subscribe the share in proportion to their respective holding. Under Section 56(8) of the Company Act, the existing shareholders shall have the first right to subscribe the shares issued in proportion to their respective shareholding. Right shares provide the right to the existing shareholders of the company to subscribe the shares of the company because the shareholders need protection for anti-dilution in their shareholder against the new issues made by the company. When a company is in need of the funds it can issue additional shares but a share issue to new parties will lead to the dilution in the shareholding of the company – so the existing shareholders often get the first right to subscribe to the new issues of the company except in some few circumstances.
Fully Paid Right Shares
If we dissect and view the arrangement of fully paid right shares we notice that fully paid right shares are actually a combination of “receiving bonus shares”, “making an additional investment decision” by the shareholders of the company.
For example: A company called for the subscription of fully paid right shares at a current market price of Rs. 150 at a price of Rs. 75 to its existing shareholders based on their shareholding. This whole arrangement can be understood in two steps: (i) First the company provides some bonus shares to its shareholders, and (ii) Secondly, the shareholders of the company decide to invest an additional amount. This analogy proves that Fully Paid Right Shares = Bonus Shares + Investment Decision and also supports why the bonus share element may arise in fully paid right issues at the price lower than its face value.
Accounting Perspective:
An accounting entry for the above example in the books of the company with 1000 share units would be:
General Reserve Dr. (b/f) Rs. 26,316
Bank Dr. Rs. 75,000
Withholding Taxes Cr. Rs. 1,316 (25,000 / 95% × 5%)
Share Capital Cr. Rs. 100,000
Let’s take another example where the price of the right is higher than the face value of the shares: A company called for the subscription of fully paid right shares at a current market price of Rs. 150 at a price of Rs. 125 to its existing shareholders based on their shareholding. This whole arrangement can be understood in one single step: the shareholders of the company decide to invest an additional amount into the company.
Accounting Perspective:
An accounting entry for the above example in the books of the company with 1000 share units would be:
Bank Dr. Rs. 125,000
Share Capital Cr. Rs. 100,000
Share Premium Cr. Rs. 25,000
Partly Paid Right Shares
Right shares can be partly paid as well. The company necessarily does not need to pay up the right shares out of the general reserves for the bonus elements.
For example: A company called for the subscription of partly paid right shares at a current market price of Rs. 150 at a price of Rs. 75 to its existing shareholders based on their shareholding.
Accounting Perspective:
An accounting entry for the above example in the books of the company with 1000 share units would be:
Bank Dr. Rs. 75,000
Share Capital Cr. (75% paid up) Rs. 75,000