Indian investors love bonus shares and have a marked aversion to companies that raise debt. So, what should they make of companies that mix and match the two and issue bonus debentures? Last week, Britannia Industries announced a bonus debenture issue to mark its centenary year.

What is it?

Similar to bonus shares and dividends, companies issue bonus debentures to reward their equity shareholders. The company allots these debentures, free of cost, to its shareholders at face value. Shareholders receive interest on them at a pre-determined rate at fixed intervals until maturity. When the debentures mature, they are redeemed and the principal amount (the face value of the debenture) is paid out to shareholders. Bonus debentures may also be listed on the stock exchange in which case holders can sell them at market prices. Britannia Industries for example, is issuing one debenture of ₹60 each for every equity share of face value ₹2 for a tenure of three years, at an interest rate not exceeding 8 per cent, to be paid annually.

Issuance of bonus debentures is not as common as bonus shares or dividends as they are not expressly provided for in the Companies Act. They are issued under a ‘scheme of arrangement’ which involves approval from shareholders, the Court and the RBI and in some cases, the Ministry of Corporate Affairs.

Only a handful of companies such as Hindustan Unilever, Britannia Industries, Blue Dart Express, Dr Reddy’s Labs and NTPC have issued bonus debentures in the past.

Why is it important?

From the perspective of the company, issue of bonus debentures does not entail immediate cash outgo like dividends. Hence the money retained until the maturity of the instrument can be used to fund new projects or acquisitions. There is no question of equity dilution too unlike in the issue of bonus shares. Also, interest paid on the debentures can be claimed as an expense by the company for tax purposes, thereby helping reduce its tax incidence. Since the issue of bonus debentures involves transfer of money from the reserves of the company to debt, this move will boost its return on equity. At the same time, this will lead to an increase in the debt to equity ratio. While companies with low debt may benefit from leverage, for high-debt companies, this may not be an ideal route to reward shareholders.

Why should I care?

Bonus debentures aren’t exactly tax-payer friendly. The sums companies distribute by way of bonus debentures are treated as dividends under Sec 2(22) (b) of the Income Tax Act and hence are subject to dividend distribution tax in the hands of the company. Shareholders are taxed for dividends above ₹10 lakh and bonus debentures are taken into consideration for this calculation too. The interest you earn on the debentures attracts tax at your slab rate. If you choose to sell the debentures in the market, you will have to pay short-term capital gains tax on your gains if you sell within three years or else, long-term capital gains tax. When you sell bonus shares on the other hand, long-term capital gains up to ₹1 lakh is exempt from tax and gains above that are taxed at 10 per cent. This apart, liquidity may be a concern for bonus debentures as traded volumes may be thin and hence, you may not be able to sell the desired quantity at the desired price.

Once a company declares it, the wait for bonus debentures may be long, given the many regulatory approvals. For instance, from approval by its Board in March 2010 to actual allotment in March 2011, the bonus debenture issue of Dr Reddy’s Labs took a year to fructify.

The bottomline

Bonus debentures may appear to be win-win for both shareholders and the company, but there is more to it than what meets the eye.

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