Bonus Issue of Shares: Definition and How It Works

What Is a Bonus Issue?

A bonus issue, also known as a scrip issue or a capitalization issue, is an offer of free, additional shares to existing shareholders.

For example, a company may give one bonus share for every five shares held. Companies issue bonus shares to attract more investment and reward shareholders.

Understanding Bonus Issues

Bonus issues increase a company’s outstanding shares but not its market capitalization. Companies usually fund a bonus issue through profits or existing share reserves. The issuance of bonus shares is not taxable; however, shareholders must pay a capital gains tax if they sell them for a net gain.

A company allocates bonus issues according to each shareholder’s stake. Bonus shares do not dilute shareholders’ equity because they are issued in a constant ratio that keeps the relative equity of each shareholder the same as before the issue.

For example, a three-for-one bonus issue entitles each shareholder to three shares for every one that they hold before the issue. A shareholder with 1,000 shares receives 3,000 bonus shares (1,000 × 3 ÷ 1 = 3,000).

Why Do Companies Issue Bonus Shares?

Companies typically issue bonus shares for several key reasons:

1. First, they encourage more retail investor participation in their stock by lowering the price per share and enhancing the liquidity of outstanding shares.

2. Second, bonus issues provide an alternative to issuing a dividend payment to reward shareholders.

3. Third, they reflect a financially sound company that can keep growing and generating shareholder value.

Below, we discuss these reasons in greater detail.

Advantages of Bonus Shares

They encourage retail participation: Increasing the number of outstanding shares adds to their liquidity and decreases a company’s stock price, making shares more affordable and easier to trade for retail investors.

Lower-priced shares allow investors to acquire more units, while increased liquidity reduces slippage costs.

They’re an alternative to paying dividends: Companies generating irregular profits may issue bonus shares rather than cash dividends to build shareholder confidence without touching earnings.

Bonus issues may be particularly appealing for smaller companies that want to attract more investors but can’t afford to pay regular dividends.

They convey a sense of financial health: A company that issues bonus shares demonstrates that it has sufficient share reserves and/or retained earnings to reward prospective investors and current shareholders.

Share issues also signal that a company is financially sound enough to keep growing and adding shareholder value.

They involve favorable tax treatment: Bonus shares aren’t taxed when issued, making them more appealing than a cash dividend from a tax perspective.

Nonqualified dividends are subject to a tax rate of 10% to 37%.2 Shareholders pay a lower capital gains tax on bonus shares sold for a net gain.

Disadvantages of Issuing Bonus Shares

There’s an opportunity cost: A company could use earnings set aside for a bonus issue for other purposes that may add more shareholder value.

For example, retained earnings could be used for a strategic acquisition in a new growth market or to fund updated equipment and machinery. Lost opportunities also have the potential to create bad press for a company, which may negatively impact investor sentiment.

They could have a negative impact on dividends: Issuing bonus shares does not generate cash for the company, which could result in a decline in future dividend payments, potentially upsetting shareholders.

Additionally, some investors who receive bonus shares may think that the company may prioritize that form of reward over a cash dividend in the future.

There’s no immediate financial benefit: Unlike a cash dividend payment, shareholders don’t immediately benefit financially because the company’s stock price drops proportionally to the additional bonus shares issued.

For example, say that an investor buys 100 shares of XZY Ltd. stock for $10 each, and the company has a one-for-one bonus issue. The investor now holds 200 shares (100 original shares + 100 bonus shares).

As a result of the growth in shares outstanding, each is now worth $5 ($10 ÷ 2). The existing investor’s account value has not changed and there’s been no immediate financial gain.

Stock Splits vs. Bonus Shares

When a company declares a stock split, existing shares are divided (split) up, which increases an investor’s holdings, but the investment value remains the same because the value of each share decreases in proportion to the split.

Bonus shares don’t affect existing shares by splitting them up. They add to them. In addition, their face value isn’t reduced as it is in a stock split. But the share price adjusts in proportion to the issuance ratio.

Companies typically declare a stock split to enhance share liquidity. It increases the number of shares trading and makes shares more affordable to retail investors.

When a stock is split, there is no increase or decrease in the company’s cash reserves. In contrast, when a company issues bonus shares, the shares are paid for out of cash reserves, which deplete.

The Bottom Line

A bonus issue of shares is the offer of additional shares to existing stockholders at no direct cost. It increases a company’s number of outstanding shares but not its market capitalization, as the stock price adjusts proportionally to reflect the additional shares issued.

Companies primarily issue bonus shares to attract retail investors, provide an alternative to a dividend, and/or convey a sound financial position. On the flip side, earnings set aside for bonus issues could mean lost opportunities to generate better shareholder value.

Although investors aren’t taxed when a company issues bonus shares, they are if they sell their shares for a net profit.