Bonus Debentures: Features and Implications

[The following post is contributed
by Prachi Narayan of Vinod Kothari
& Company. She can be contacted at
prachi@vinodkothari.com.]
Introduction
The reward of being a
shareholder is singular: share in profits of the company. A few widely known
forms of corporate rewards include cash dividends, bonus shares, preference
shares, bonds, debentures, warrants and options, of which cash dividends and
bonus shares are most popular.
Just on the lines of
bonus shares are another fairly innovative instrument called as bonus debentures.
This post is an attempt
to understand the concept, rationale, features, benefits and implications of the
issue of bonus debenture.
Economic rationale
Bonus debentures are
issued out of distributable profits and reserves to the shareholders for free.
Like any other debenture, bonus debentures also carry a face value, an interest
and a maturity period. In essence, this instrument has some features similar to
bonus shares, some resembling debentures and some distinct ones of its own. But
before delving into the nuances of this instrument, it would be appropriate to
reflect upon the rationale behind issuing such instruments.
A company usually
employs two methods to share its divisible profits with its investors: cash
dividends and bonus shares. While cash dividends involve immediate payment of
cash by the company, bonus shares involve issuance of additional shares to the
equity investor. Cash dividends involve huge outflows from the company
immediately, which could have been retained by the company for business
purposes for a little longer.
Bonus shares being the
other alternative, do work well but then it leads to dilution in equity, as
there is an expansion in the equity base of the company that eventually reduces
the earnings per share as well as dividend pay-out.
A bonus debenture is
thus unique as it perfectly subsumes within itself the benefits of cash
distribution and capitalisation of profits (erstwhile bonus shares) thereby
limiting the outgo of huge cash from the company and making it a staggered
outflow (at least until redemption). This ensures availability of funds to meet
business and operational needs of the company.
How is the issue done?
A company may declare bonus
debentures out of its free reserves, i.e. profits available for distribution to
shareholders. Instead of paying dividends in cash, shareholders receive
debentures equivalent to the amount of dividend. In layman terms, the company
issues a paper acknowledging the dividend, having a face value, coupon rate and
a redemption period.
For example, take a shareholder
who owns 100 shares in company. The company declares a dividend of Rs. 5 per
share. Total dividend share receivable by the shareholder is Rs. 500. The company
issues 100 bonus debentures with face value of Rs. 5 each carrying a coupon
rate of 10%, redeemable at the end of 3 years.
Such bonus debentures
may be secured or unsecured. Secured bonus debentures shall be secured in
manner provided in rule 18 of the Companies (Shares and Debentures) Rules,
2014. Further, secured bonus debentures may be listed with stock exchanges to
provide better liquidity to the shareholders.
Benefits of Bonus
Debentures
This instrument caters to
the needs of the investor as well as the company. From a company’s perspective
the instrument helps the company improve its return on equity as there is an
increase in the debt capital of the company, which in turn brings the advantages
of leverage. These instruments are issued from the accumulated profits and thus
do not impact reported profits of a company. There is no immediate cash outflow
and the company is able to utilize its excess cash over a period of time, at
least until maturity of the instruments. Further, it is one of the most
efficient ways of offering “bonus” without expanding the equity capital base
and without diluting the earnings per share. Bonus debentures do not dilute the
share value unlike bonus shares. Further, the interest payments made to
investors are tax deductible. Hence, the company can save on the tax outgo to
the extent of interest payment made in a given period.
From a shareholder’s
perspective, bonus debentures are additional rewards that shareholders receive
from company. Issue of bonus debentures entitle them to yearly interest until
such debentures mature or are redeemed.  In
addition, it is a tax-free receipt of redemption amount. The amount of bonus
debentures is not taxable in the hands of debenture holders as the dividend
distribution tax is paid by the company. Listed bonus debentures further
provide a shareholder with better liquidity options, as shareholders can easily
sell them in the secondary market if they desire.
Provisions of law
Bonus debentures are not
expressly covered under provisions of Companies Act, 1956 or Companies Act,
2013. Further, section 123 (5) of the Companies Act, 2013 provides that a
dividend shall be paid to shareholders in cash or shall be utilized to issue
fully paid up bonus shares or shall be used for payments of  such amounts that are unpaid on the shares
held by the members. Except for these, any other form of dividend paid to the
shareholder is not explicitly allowed by the Act.  Further, provisions relating to bonus shares
under section 63 of Companies Act, 2013 are not attracted as they specifically
deal with the issue of shares only.
In absence of any
explicit provision of law governing issue of bonus shares, it is obvious that
one would wonder as to what would be the procedure of issuing such instruments.
Bonus debentures are issued pursuant to a scheme of arrangement under sections
391-394 of Companies Act, 1956, that involves approval of shareholders and the High
Court and Reserve Bank of India (in case issued to non-resident shareholders).
It is pertinent to note here that since a scheme is approved by the members,
the requirement for an express provision in the articles of association of the
company is also not required.
Further, a company may
additionally choose to list its bonus debentures to provide better liquidity to
its shareholders. In such a scenario, compliance with provisions of debt
listing agreement, 100% asset cover for the listed bonus debentures- in line
with rule of 18 of
Companies (Share Capital and
Debentures) Rules, 2014 and provisions of debt listing agreement, appointment
of debenture trustees and creation of debenture redemption reserve in line with
71(4) of Companies Act, 2013, rule 18(7)(c) of Companies (Share Capital and
Debentures) Rules, 2014 and rule 7 of Companies (Share Capital and Debentures)
Rules, 2014 would be required. Further,
provisions of private
placement under section 42 of the Companies Act, 2013 will mutatis mutandis apply to bonus debentures.
Scheme of arrangement
Bonus debentures are
issued as a scheme of arrangement under sections 391-394 of Companies Act, 1956,
as express provisions on such instruments are absent.  Any scheme under section 391-394 is essentially
an arrangement either between the company and its shareholders or the company and
its creditors, as the case may be. Further, a scheme of arrangement between the
company and its members may be for any arrangement that the company and its members
may enter into, not necessarily pertaining to reconstruction only. In this case,
the scheme is drawn for distribution of dividends other than cash. The scheme
would thus have to be in full compliance with provisions of sections 391-394 of
the Companies Act, 1956 as corresponding provisions under Companies Act, 2013
are yet not enforced.
The provisions as they
stand today require the scheme to be approved by the High Court and by majority
of shareholders of the company. In case of bonus debentures, it is worthy to
note here that a separate meeting of creditors may not be required at all unlike
a scheme of reconstruction or merger/demerger. In a scheme of reconstruction or
merger approval of creditors is required as the interests of creditors are
likely to get affected by such a scheme. A scheme purely between the company
and its members for distribution of dividend in no way affects the interests of
the creditors as the creditors anyways have no right/share in the divisible
profits of the company.
Further, Reserve Bank of
India vide Notification No.FEMA.291/2013-RB
dated October 4, 2013
has amended its guidelines so as to grant a
general permission to Indian companies to issue debentures to non-resident
shareholders, including the depositories that act as trustees for the ADR/GDR
holders, by way of distribution as bonus from its general reserves under a
scheme of arrangement approved by a court in India and subject to no-objection
from the income tax authorities.
Taxation of Bonus
Debentures
Section 2(22)(b) of the
Income Tax Act, 1961 provides that dividend includes a distribution by a
company to its shareholders of debentures by way of bonus to the extent of
accumulated profits of the company. Thus, it is evidently clear that the
allotment of bonus debentures is treated as dividend and company shall pay
dividend distribution tax (DDT) on the amount of bonus debentures issued. Since
such dividend is exempt in the hands of the shareholder, there would be no tax
payable by the shareholder. In subsequent years, when the debentures are either
sold or redeemed, only the difference between the sale price or redemption
amount would be subjected to capital gains tax.
Further, the yearly
interests paid by the company to its shareholders until redemption qualify as
admissible deduction under the provisions of Income Tax Act, 1961.
Precedents in India
The concept of bonus
debentures is still nascent and is yet to gain ground among Indian companies.
In India, the bonus debentures were first issued by Hindustan Unilever Ltd in
2001. Post that Britannia Industries Limited came with its issue of bonus
debentures in 2009, followed by Dr. Reddy’s Laboratories Ltd in 2010.
Coromandel International Ltd. made its first attempt of bonus debentures in the
year of its golden jubilee in 2011. In recent times, Blue Dart Express Ltd and
National Thermal Power Corporation (NTPC) have rewarded their shareholders with
fully paid up bonus debentures.
Even though
bonus debentures may seem to be truly rewarding for both the shareholders as
well as the company, the presence of the instruments in the market is less.
This may primarily be due to the fact that legal procedures involved for
approval of the scheme from various authorities is lengthy and time consuming.  Some simplification of the lengthy procedures may
provide the necessary impetus to companies to come out with bonus debentures,
as successful implementation of the scheme has been very positive for the
companies opting for it.
Prachi Narayan

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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