Sources Of Business Finance

Table of Contents

SOURCES

OF

BUSINESS FINANCE

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Sources of Short Term FINANCE SOURCES

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Medium Term FINANCE

SOURCES

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LONG Term FINANCE

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Dividend Procedures of Issuing DIVIDEND

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Bonus Shares

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Bonus Issue and SEBI Guidelines

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Webilography

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SOURCES

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BUSINESS FINANCE

There is no escaping the fact that businesses need finance (funds), both in the short term, and long term, to expand, operate or just plain survive. A business represents, in many respects, a continuous flow of money in and out of the company in the form of income and expenditure. Expenditure can be classified as either Capital Expenditure, which includes the purchase of fixed assets and spending on items which are to held by the business in the long-term, and will be accounted for in the Balance Sheet, and Revenue Expenditure, which essentially relates to the purchase of goods and service which will or have already been consumed, in the day to day operations of the business.

It’s important that a business is aware and willing to tap every possible source of finance available, particularly at critical stages of the firm’s development. We can initially segment sources of finance into those internally available to the business, and those that are available externally.

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Internal Sources of Funds

Profit The business can retain profit (after tax, interest and dividend payments have been deducted), to finance the businesses intended future expenditure. To find out more about profit and the calculation of retained profit, visit our article on the Trading and Profit & Loss Account.

Depreciation By deducting depreciation from profit, the business makes provision for the eventual replacement of worn-out machinery / plant. This can be seen as a further form of profit retention, and thus an internal source of finance.

Sale of Assets Companies may choose or be forced to sell-off assets of the business in order to raise finance.

It is normally the case that internal sources of finance are not sufficient to fund the total current and 3

future planned expenditure of a business, and therefore the business must look externally for potential sources of finance. We can further segment Sources of Finance into those that address Short-Term Finance needs arising out of working capital requirements, Medium-Term Finance normally involving borrowing over a period greater than one year and less than five years, and Long-Term Finance capital required for a period of borrowing exceeding five years. In the following section we will consider external sources of short, medium and long-term finance.

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Sources of Short Term Finance

Trade Credit Trade credit represents one of the main sources of short-term finance for a business, current assets such as raw materials may be purchased on credit with payment terms normally varying from between 30 to 90 days. As such, trade credit represents an interest free short-term loan, and constitutes approximately 60%, of current liabilities in the average non-financial business ( this percentage is often far higher for small businesses ). In a period of high inflation there are clear advantages to purchasing via trade credit, however these advantages must be weighed against the discount incentives suppliers offer for early payment.

Loans and Overdrafts Overdrafts are the most important source of short-term finance available to businesses. They can be arranged relatively quickly, and offer a level of flexibility with regard to the amount borrowed at any time, whilst interest is only paid when the account is overdrawn. In comparison loans normally involve higher rates of interest, and are inflexible in terms of the emphasis they place on regular installment payments being made. Barclays offer a range of products and services to businesses, their site is worth a visit as it contains some excellent information for those considering starting a business. Factoring Instead of waiting for customers to pay invoices within the payment period, a company may enlist the services of a Debt Factoring firm. The factoring company provides the business with a percentage of the face value of the invoice, commonly 80%, within days of a invoice being raised. The factoring company then assumes responsibility for collecting payment of the invoice, on receipt of payment the factor will pay the business the remaining 20%, whilst charging a fee for the service they provide. There are many firms offering this service, one example being Independent Commercial Finance Limited, whose site also includes an interest calculator.

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SOURCES

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MEDIUM TERM FINANCE

Leasing Leasing enables a business to acquire the use of assets such as plant and machinery without having to pay large sums of money for ownership of the equipment, initially. Instead a business simply leases the equipment from a leasing company who retain ownership. There are two main forms of lease in the UK, an Operating Lease, in which the company pays for use of the equipment for a set period of time after which it is returned to the leasing company, or a Finance Lease, where at the end of the lease period there is the option to purchase the equipment outright for a further nominal amount. Whilst leasing does not inject money directly into the business, and in the long term usually costs more than buying the equipment outright, in cash flow terms its an effective method of a business getting the equipment it needs when its cash flow is tight. There are many examples of companies that offer leasing services to businesses, one example is the leasing-network, whose site also includes a neat little lease calculator.

Hire Purchase A hire purchase agreement enables a business to purchase ownership of plant and machinery from a supplier, by paying by installments to a third party, a finance house. The buyer will normally place a down payment with the supplier who will then deliver the equipment; the finance house then pays the supplier the remaining amount owed for equipment, collecting installments from the buyer over a set period of time for this amount plus interest. Hire purchase agreements are curious creatures, in that ownership of the equipment first passes to the finance house, and will not pass to the buyer until the last installment is paid. If the business fails to pay installments the equipment will be repossessed by the finance house.

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SOURCES

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LONG TERM FINANCE

Share Capital The most important source of long-term finance for a limited company is usually that raised from shareholders, the owners of the business. Share Capital is raised through the sale of shares to individuals or institutions, who in return for their investment receive interest in the form of a dividend, which constitutes a share of the profits made by the business. In addition the shareholder may be able to make a Capital Gain on their investment by selling their share holding at a latter date. Dependent on the type of Share, the shareholder will also have certain voting rights. There are two main types of Share, the Ordinary Share and the Preference Share and these are each considered below:

Main Types of Shares

Ordinary Shares The majority of Share Capital will be raised through the issue of Ordinary Shares. Ordinary Shareholders, are the legal owners of the business, and are entitled to full shareholder voting rights at meetings - the Annual General Meeting (A.G.M.), or at ExtraOrdinary General Meetings (E.G.M.s). They are entitled to receive returns out of the companies profit, in the form of Dividends. Unfortunately dividends are not guaranteed on ordinary shares, and are dependent on the performance. Thus if the business has had a particularly poor year, the Directors of the company may decide that a dividend is not paid to the ordinary shareholder. There is considerable risk involved in being an Ordinary Shareholder / Owner of a business, particularly if the business is declared insolvent, however in good 8

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Dividend Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend. For a joint stock company, a dividend is allocated fast as a fixed amount per share. Therefore, a shareholder receives a dividend in proportion to their shareholding. For the joint stock company, paying dividends is not an expense; rather, it is the division of an asset among shareholders. Public companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a special dividend to distinguish it from a regular one. Cooperatives, on the other hand, allocate dividends according to members' activity, so their dividends are often considered to be a pre-tax expense. Dividends are usually settled on a cash basis, as a payment from the company to the shareholder. They can take other forms, such as store credits (common among retail consumers' cooperatives) and shares in the company (either newly-created shares or existing shares bought in the market.) Further, many public companies offer dividend reinvestment plans, which automatically use the cash dividend to purchase additional shares for the shareholder. Forms of payment Cash Cash dividends (most common) are those paid out in the form of a cheque. Such dividends are a form of investment income and are usually taxable to the recipient in the year they are paid. This is the most common method of sharing corporate profits with the shareholders of the company. For each share owned, a declared amount of money is distributed. Thus, if a person owns 100 shares and the cash dividend is $0.50 per share, they will receive $50.00 in total. Stock Stock or scrip dividends are those paid out in form of additional stock shares of the issuing corporation, or other corporation (such as its subsidiary corporation). They are usually issued in proportion to shares owned (for example, for every 100 shares of stock owned, 5% stock dividend will yield 5 extra shares). If this payment involves the issue of new shares, this is very similar to a stock split in that it increases the total number of shares while lowering the price of each share and does not change 10

the market capitalization or the total value of the shares held (see also Stock dilution). Property Property dividends or dividends in specie (Latin for "in kind") are those paid out in the form of assets from the issuing corporation or another corporation, such as a subsidiary corporation. They are relatively rare and most frequently are securities of other companies owned by the issuer, however they can take other forms, such as products and services. Other Dividends can be used in structured finance. Financial assets with a known market value can be distributed as dividends; warrants are sometimes distributed in this way. For large companies with subsidiaries, dividends can take the form of shares in a subsidiary company. A common technique for "spinning off" a company from its parent is to distribute shares in the new company to the old company's shareholders. The new shares can then be traded independently. PROCEDURES Dividends must be "declared" (approved) by a company’s Board of Directors each time they are paid. For public companies, there are four important dates to remember regarding dividends. These are discussed in detail with examples at the Securities and Exchange Commission site. Declaration date The declaration date is the day the Board of Directors announces its intention to pay a dividend. On this day, a liability is created and the company records that liability on its books; it now owes the money to the stockholders. On the declaration date, the Board will also announce a date of record and a payment date. In-dividend date This is the last day, which is one trading day before the ex-dividend date, where the stock is said to be cum dividend ('with [including] dividend'). In other words, existing holders of the stock and anyone who buys it on this day will receive the dividend, whereas any holders selling the stock lose their right to the dividend. After this date the stock becomes ex dividend.

Ex-dividend date

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The ex-dividend date (typically 2 trading days before the record date for U.S. securities) is the day on which all shares bought and sold no longer come attached with the right to be paid the most recently declared dividend. This is an important date for any company that has many stockholders, including those that trade on exchanges, as it makes reconciliation of who is to be paid the dividend easier. Existing holders of the stock will receive the dividend even if they now sell the stock, whereas anyone who now buys the stock will not receive the dividend. It is relatively common for a stock's price to decrease on the ex-dividend date by an amount roughly equal to the dividend paid. This reflects the decrease in the company's assets resulting from the declaration of the dividend. The company does not take any explicit action to adjust its stock price; in an efficient market, buyers and sellers will automatically price this in. Record date Shareholders who properly registered their ownership on or before the date of record will receive the dividend. Shareholders who are not registered as of this date will not receive the dividend. Registration in most countries is essentially automatic for shares purchased before the ex-dividend date. Payment date The payment date is the day when the dividend cheques will actually be mailed to the shareholders of a company or credited to brokerage accounts. Dividend-reinvestment plans Some companies have dividend reinvestment plans, or DRIPs. These plans allow shareholders to use dividends to systematically buy small amounts of stock, usually with no commission and sometimes at a slight discount. In some cases the shareholder might not need to pay taxes on these re-invested dividends, but in most cases they do. Dividend reinvestment plans-in case of mutual funds: When the dividend is paid in cash it will attract the dividend distribution tax (DDT) and the same is not taxable in the hands of the person, but in case of dividend reinvestment plan where the dividend is not paid in cash but distributed as additional units will not attract the DDT and the same will be taxable in the hands of the person as capital gains when he realises the gain by selling the units. Criticism •

Management and the board may believe that the money is best re-invested into the company: research and development, capital investment, expansion, etc. Proponents suggest that a management eager to return profits to shareholders may have run out of good ideas for the future of the company. Some studies have demonstrated that companies that pay dividends have 12

higher earnings growth, however, suggesting that dividend payments may be evidence of confidence in earnings growth and sufficient profitability to fund future expansion. •

When dividends are paid, individual shareholders in many countries suffer from double taxation of those dividends: the company pays income tax to the government when it earns any income, and then when the dividend is paid, the individual shareholder pays income tax on the dividend payment; in many countries, the tax rate on dividend income is lower than for other forms of income to compensate for tax paid at the corporate level. Taxation of dividends is often used as justification for retaining earnings, or for performing a stock buyback, in which the company buys back stock, thereby increasing the value of the stock left outstanding. In contrast, corporate shareholders often do not pay tax on dividends because the tax regime is designed to tax corporate income (as opposed to individual income) only once. The shareholder will pay a tax on capital gains (which is often taxed at a lower rate than ordinary income) only when the shareholder chooses to sell the stock. If a holder of the stock chooses to not participate in the buyback, the price of the holder's shares should rise, but the tax on these gains is delayed until the actual sale of the shares. Certain types of specialized investment companies (such as a REIT in the U.S.) allow the shareholder to partially or fully avoid double taxation of dividends.

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Shareholders in companies which pay little or no cash dividends can reap the benefit of the company's profits when they sell their shareholding, or when a company is wound down and all assets liquidated and distributed amongst shareholders. This, in effect, delegates the dividend policy from the board to the individual shareholder.

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Payment of a dividend can increase the borrowing requirement, or leverage, of a company.

Dividend Policy Once a company makes a profit, they must decide on what to do with those profits. They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends. Once the company decides on whether to pay dividends, they may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the company in the financial markets. What they decide depends on the situation of the company now and in the future. It also depends on the preferences of investors and potential investors.

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BONUS SHARES A bonus share is a free share of 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 value of the company. Although the total number of issued shares increases, the ratio of number of shares held by each shareholder remains constant. 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. A bonus issue (or scrip issue) is a stock split in which a company issues new shares without charge in order to bring its issued capital in line with its employed capital (the increased capital available to the company after profits). This usually happens after a company has made profits, thus increasing its employed capital. Therefore, a bonus issue can be seen as an alternative to dividends. No new funds are raised with a bonus issue. Unlike a rights issue, a bonus issue does not risk diluting your investment. Although the earnings per share of the stock will drop in proportion to the new issue, this is compensated by the fact that you will own more shares. Therefore the value of your investment should remain the same although the price will adjust accordingly. The whole idea behind the issue of Bonus shares is to bring the Nominal Share Capital into line with the true excess of assets over liabilities. Whether Bonus shares are miraculous? Few things match the sheer joy of getting a fat bonus at work. That is what shareholders of a good company feel when their company decides to throw a few shares (free of cost) in their direction. Here’s explaining what bonus shares are all about and why investors like investing in such companies. Free shares are given to you and are called bonus shares. Make money with shares. They are additional shares issues given without any cost to existing shareholders. These shares are issued in a certain proportion to the existing holding. So, a 2 for 1 bonus would mean you get two additional shares -- free of cost -- for the one share you hold in the company. If you hold 100 shares of a company and a 2:1 bonus offer is declared, you get 200 shares free. That means your total holding of shares in that company will now be 300 instead of 100 at no cost to you. Bonus shares are issued by cashing in on the free reserves of the company. The assets of a company also consist of cash reserves. A company builds up its reserves by retaining part of its profit over the years (the part that is not paid out as dividend). After a while, these free reserves increase, and the company wanting to issue bonus shares converts part of the reserves into capital.

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What is the biggest benefit in issuing bonus shares is that its adds to the total number of shares in the market. Say a company had 10 million shares. Now, with a bonus issue of 2:1, there will be 20 million shares issues. So now, there will be 30 million shares. This is referred to as a dilution in equity. Now the earnings of the company will have to be divided by that many more shares. Since the profits remain the same but the number of shares has increased, the EPS (Earnings per Share = Net Profit/ Number of Shares) will decline. Theoretically, the stock price should also decrease proportionately to the number of new shares. But, in reality, it may not happen. A bonus issue is a signal that the company is in a position to service its larger equity. What it means is that the management would not have given these shares if it was not confident of being able to increase its profits and distribute dividends on all these shares in the future. A bonus issue is taken as a sign of the good health of the company. When a bonus issue is announced, the company also announces a record date for the issue. The record date is the date on which the bonus takes effect, and shareholders on that date are entitled to the bonus. After the announcement of the bonus but before the record date, the shares are referred to as cum-bonus. After the record date, when the bonus has been given effect, the shares become ex-bonus. Issue of bonus shares Bonus shares are issued by converting the reserves of the company into share capital. It is nothing but capitalization of the reserves of the company. There are some conditions which need to be satisfied before issuing Bonus shares: 1. Bonus shares can be issued by a company only if the Articles of Association of the company authorizes a bonus issue. Where there is no provision in this regard in the articles, they must be amended by passing special resolution act at the general meeting of the company. 2. It must be sanctioned by shareholders in general meeting on recommendations of BOD of company. 3. Guidelines issue by SEBI must be complied with. Care must be taken that issue of bonus shares does not lead to total share capital in excess of the authorized share capital. Otherwise, the authorized capital must be increased by amending the capital clause of the Memorandum of association. If the company has availed of any loan from the financial institutions, prior permission is to be obtained from the institutions for issue of bonus shares. If the company is listed on the stock exchange, the stock exchange must be informed of the decision of the board to issue bonus shares immediately after the board meeting. Where the bonus shares are to be issued to the nonresident members, prior consent of the Reserve Bank should be obtained.

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Only fully paid up bonus share can be issued. Partly paid up bonus shares cannot be issued since the shareholders become liable to pay the uncalled amount on those shares. It is important to note here that Issue of bonus shares does not entail release of company’s assets. When bonus shares are issued/credited as fully paid up out of capitalized accumulated profits, there is distribution of capitalized accumulated profits but such distribution does not entail release of assets of the company. Issue of Bonus Shares by Public Sector Undertakings It has come to the notice of the Government that a number of Central Government Public Sector Undertakings are carrying substantial reserves in their balance sheets against a relatively small paid up capital base. The question of the need for these enterprises to capitalize a portion of their reserves by issuing Bonus Shares to the existing shareholders has been under consideration of the Government. The issue of Bonus Shares helps in bringing about at proper balance between paid up capital and accumulated reserves, elicit good public response to equity issues of the public enterprises and helps in improving the market image of the company. Therefore, the Government has decided that the public enterprises, which are carrying substantial reserves in comparison to their paid up capital sold issue Bonus Shares to capitalize the reserves for which the certain norms/conditions and criteria may be followed and fulfilled. There are some SEBI guidelines for Bonus issue which are contained in Chapter XV of SEBI( Disclosure & Investor Protection) Guidelines, 2000 which should be followed in deciding the correct proportion of reserves to be capitalized by issuing Bonus Shares. Private sector banks, whether listed or unlisted, can also issue bonus and rights shares without prior approval from the Reserve Bank of India. Liberalising the norms for issue and pricing of shares by private sector banks, the RBI said that the bonus issue would be delinked from the rights issue. However, central bank approval will be required for Initial Public Offerings (IPOs) and preferential shares. These measures are seen as part of the RBI's attempt to confine itself to banking sector regulation and leave the capital market entirely to the SEBI. Under the guidelines, private sector banks have also been given the freedom to price their subsequent issues once their shares are listed on the stock exchanges. The issue price should be based on merchant bankers' recommendation, the RBI has said. It means though RBI approval is not required but pricing should be as per SEBI guidelines. The RBI, however, clarified that banks will have to meet SEBI's requirements on issue of bonus shares. As per current regulations, private sector banks whose shares are not listed on the stock exchange are required to obtain prior approval of the RBI for issue of all types of shares such as public, preferential, rights or special allotment to employees and bonus. Banks whose shares are listed on the stock exchanges need not seek prior approval of the RBI for issue of shares except bonus shares, which was to be linked with rights or public issues by all private sector banks. Bonus Issue & SEBI Guidelines

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The SEBI has issued guidelines for Bonus issue which are contained in Chapter XV of SEBI (Disclosure & Investor Protection) Guidelines, 2000. A company issuing Bonus Shares should ensure that the issue is in conformity with the guidelines for bonus issue laid down by SEBI (Disclosure & Investor Protection) Guidelines, 2000. It is a detailed guideline which talks about that the bonus issue has to be made out of free reserves; the reserves by revaluation should not be capitalized. Bonus issue should not be made in lieu of dividend. There should be no default in respect to fixed deposits. Bonus issue should be made within 6 month from date of approval. This is not exhaustive but a lot of things are more in the guidelines regarding this. Bonus issue vis-à-vis Share split There is much hair-splitting on the relative benefits of a bonus issue vis-à-vis a share split. An investor with a short-term outlook may benefit by a split, while one willing to wait may prefer a bonus issue. - Laxmikant Gupta A few years ago, corporate action relating to existing shares was relegated to mainly dividends, rights issues and bonus issues. Now a days splitting of shares has become a common phenomenon. What a stock split does is divide each of the existing shares into a number of shares of a lower value. Unlike in the case of a bonus issue, the existing shares are converted into new shares of a lower value. In a bonus issue, additional new shares are allotted to the shareholder; the existing shares continue as they are, and there is no change in their face value. The news about bonus issues or share splits is normally received positively by shareholders. Bonus or split in units is normally done when the Net Asset Value of the fund is at respectable levels. Similarly, normally, corporates announce bonus or split when the share price goes to a respectable level and the management sees bright prospects for profitability and net worth. With splitting of paid-up capital allowed, corporate started doing it without touching the reserves. This way they could limit the paid-up capital value even while increasing the liquidity of shares in the market, which is always desirable. The Balance-Sheet perspective Rewarding by bonus shares means actual capitalization of reserves. Rewarding by split does not mean anything from the balance-sheet perspective. It only increases the liquidity of stock by reducing the paid-up capital. If the corporate comes up with further new share issues, by way of private placement, the lower base of the paid-up capital and the higher percentage stake of new investors can be attractive features if the capital has only been split. If expanded by bonus shares, then, the existing shareholders would already have a higher stake vis-à-vis further new issue size. Of course, the equity dilution will be lower in that case. As per Section 55 of The Income-Tax Act, 1961 bonus shares entail zero costs while all the purchase cost can be loaded on to the original shares. For bonus shares, the one-year holding requirement for Long-Term Capital Asset (LTCA) eligibility starts from the allotment date of bonus shares. In the case of split, the one-year eligibility is along with the original form of capital, which is split. In other words, the one-year does not start on the split date but on the date of purchase of original shares. 17

When does the shareholders benefit - by bonus or by split? For a long-term investor, neither option makes a difference. Relative benefit on either option may get neutralised over time. In case of further shares issue by way of private placement, the equity dilution may be less had shareholders been rewarded with bonus issues. However, much depends on the pricing and the premium parts of the issue. An investor with a short-term outlook may benefit by a split rather than a bonus issue. Shares after split are recognised as LTCA if originally these have been held for one year. However, in the case of bonus issues, the new shares need to be held for one year to become LTCA. Periodic bonus announcements show up the real strengths of a company in building up reserves, in its profit model and, of course, in the intention to reward. Further, splitting is more beneficial to short-term stakeholders, while bonus shares are more for long-term stakeholders. Bonus Issue & Taxation For some years now, the issue of bonus equity shares has been a common phenomenon on the Indian bourses. However, one reads about other types of bonuses being issued by companies to shareholders. While some issue bonus dividends, while others proposes to issue bonus preference shares. The big question: what will be the tax treatment of the different types of bonuses, and which is more beneficial? To get a grip on the tax treatment, one needs to understand two provisions in the tax laws: the definition of dividend, and the manner of computing capital gains in respect of bonus issue of securities. Definition of dividends: Under the tax laws, if a company distributes its accumulated profits through the release of any of its assets to shareholders, the distribution will be regarded as a dividend. The definition also includes the distribution of debentures or deposits by a company, irrespective of whether the debentures or deposits are interest-bearing or not. Further, any issue of bonus shares to preference shareholders (equity shares are not included) is also deemed to be a dividend. Computation of capital gains: In the case of bonus shares and securities, if a person, by virtue of his holding a share or any other security, is allotted additional shares and securities without having to make any payment, then for the purpose of computing capital gains, the cost of the new shares and securities is to be taken as nil. The cost of the original share or security remains unchanged. For example, if a company issues bonus equity shares, there is no tax implication in the hands of the shareholders in the year of issue of the bonus shares. But when the bonus shares are finally sold, the entire sale proceeds are taxable as capital gains. This is because the cost of the acquisition of such shares is regarded as nil. Bonus dividends: This is a one-time dividend given on a particular occasion through the issue of dividend warrants (cheques). The company pays this out of its post-tax profits, and, therefore, does not get any deduction from its taxable income. Bonus debentures: Since bonus debentures are covered by the definition of dividends due to their specific inclusion, shareholders will have to pay tax on the 18

capital value of the debentures they get. Further, since bonus debentures are issued out of the post-tax profit accumulated by the company, the company does not get any deduction for the value of the debentures that have been issued. In subsequent years, when the debentures are either sold or redeemed, the sale price or the redemption amount received by the debenture holder will not be taxable to the extent of the capital value of the debentures already taxed as dividend in the year of the issue of the bonus debentures. A view is however possible that, the issue of bonus debentures is also covered by the provisions relating to taxation of capital gains on the sale of bonus issues, since it involves the allotment of a security (debenture) without any payment. Since it is covered under two different provisions of law, the provision that is more specific to the case will be applicable. Again, since the definition of dividends has a specific reference to the distribution of debentures to shareholders, the more acceptable view is that the issue of bonus debentures should be regarded as dividends, rather than be covered by the provisions relating to capital gains from bonus issues.In subsequent years, when the company pays interest on the debentures, the company is allowed a deduction for this while computing its taxable income; the interest is taxable as the income of the debenture holders who receive it. Therefore, where bonus issues of debentures are concerned, they are not tax-efficient at the time of issue, but are subsequently tax-efficient over the life of the debentures. Bonus issues of preference shares: The issue of such a bonus to equity shareholders does not involve any distribution of assets by the company to shareholders, nor is it otherwise specifically included in the definition of dividends. Such bonus issues will, therefore, be governed by the provisions relating to capital gains from bonus issues, and will not be taxed as dividends. Therefore, at the time of the issue of bonus preference shares, neither is the shareholder taxed, nor does the company get a deduction from its taxable income for the value of the bonus preference shares. When the bonus preference shares are finally sold by the shareholder or redeemed, the cost of the preference shares is to be taken as nil, and the entire sale/redemption proceeds taxable as capital gains in the shareholder’s hands. In subsequent years, however, preference dividends declared by the company are taxable as dividend income in the shareholder’s hands; on the company’s part, the dividend has to be distributed out of its post-tax profits, for which it does not get any deduction from its taxable income. Therefore, this is tantamount to double taxation of the company’s profits in subsequent years, since the company pays tax on its profits, while the shareholder pays tax on the distributed profits received as preference dividends. Bonus issues of preference shares are, therefore, tax-efficient in the year of allotment, but not so over the subsequent life of the preference shares. Therefore, in the current scenario, bonus preference shares are more beneficial from a shareholder’s tax perspective when compared with bonus debentures. However, when we compare the situation over the subsequent life of the preference shares or debentures, debentures prove to be more tax-friendly.

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Conclusion The economy is booming, the markets are buoyant, and Indian companies are increasing their profitability. Consequential of all this, many companies have announced issues of bonus shares to their shareholders by capitalizing their free reserves this year. In this bullish market, shareholders have benefited tremendously, even after accounting the inevitable reduction in share prices post-bonus, since the floating stock of shares increases. The whole purpose is to capitalize profits. We can say that Bonus shares go by the modern name of “Capitalisation Share”. Fully paid bonus shares are not a gift distributed of capital under profit. No new funds are raised. Earlier there was also a lot of confusion & chaos between the two fiercely debated concepts of taxation laws i.e. Capital & Revenue Expenditure which was finally settled after the case which come up in SC in 2006, named Commissioner of Income Tax v. General Insurance Corporation. Now it is also settled law that a bonus issue in the form of fully paid share of the company is not income for the Income Tax purpose. The undistributed profit of the company is applied and appropriated for the issue of bonus shares.

Webilography: http://www.businesscentral.co.za/businesstips/sourcesfinance.htm http://www.nexxusscotland.com/links/finance http://www.stockmarketguide.org/forumsmg/topic.asp?TOPIC_ID=18 http://www.economywatch.com/finance/sources-of-finance.html http://group.tnt.com/investors/shareinformation/dividendguidelines/index.aspx http://www.quickmba.com/site/search/results.php?q=dividend+policies http://en.wikipedia.org/wiki/Special:Search?search=dividend+policies&go=Go http://www.indianexpress.com/news/sebi-asks-companies-to-declare-dividendsin-clear-terms/418382/

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