On the completion of 25 years of its operations recently, Dr Reddy’s Laboratories Ltd announced a bonus issue of debentures to its equity shareholders. Every shareholder would get six bonus debentures of Rs5 each on each equity share of Rs5 each held by them on the record date. The debentures would carry interest and would be redeemed at the end of 36 months. A shareholder would, therefore, get Rs30 per share at the end of three years, plus interest thereon during the period of three years.
From a commercial perspective, the company avoids an upfront cash outflow that a dividend would have entailed. Shareholders, however, have the option of selling the debentures in the market if they desire liquidity. What is the tax treatment of such bonus issue of debentures?
There are two provisions that could possibly apply. One is the provision relating to bonus issue of securities. This provides that where by virtue of holding a security (in this case, a share), a taxpayer is allotted an additional security (in this case, the six debentures) without any payment, the cost of the original security (share) remains unchanged, while the cost of the bonus securities (the debentures) is to be taken at nil. Normally, this provision applies to bonus issue of shares. If this provision were to apply, there would be no tax application at the time of allotment of bonus debentures. Effectively, tax would be paid on the value of the debentures only at the time of sale or redemption of the bonus debentures as capital gains.
The second provision that could apply is the definition of dividend. The definition includes a distribution by a company to its shareholders of debentures by way of bonus to the extent of the undistributed profits of the company. This provision, therefore, specifically covers an issue of bonus debentures.
If the amount of bonus debentures is treated as dividend, the company issuing the bonus debentures would have to pay a dividend distribution tax at 16.61% of the value of the debentures issued. The dividend would be exempt from tax in the hands of the shareholder since dividend distribution tax (DDT) would have been paid on such a dividend.
Can both provisions be applied simultaneously? It is obvious that if the bonus debentures are regarded as dividend at the time of issue, tax is already being paid thereon. Subsequently, when the bonus debentures are sold or redeemed, the cost of such bonus debentures cannot be taken as nil as that would mean that the amount of the debentures would again be taxed as capital gains after having already been taxed as dividends.
This would amount to double taxation of the same income, firstly by treating it as dividend and secondly by treating it as capital gains. This is not permissible.
Which provision would then apply? The general principle of interpretation under the income-tax law is that when two provisions apply to a transaction, it is the more specific provision that applies. The provision relating to bonus securities applies to all bonus securities, while the provisions of dividend apply specifically to issue of bonus debentures. The dividend provision is, thus, more specific. So, for tax purposes, the allotment of bonus debentures would be treated as dividend.
Since such dividend is exempt in the hands of the shareholder, there would be no tax payable on such dividend by the shareholder, but the shareholder would have to declare the value of the debentures along with other dividend income as exempt income in the return of income in the year of allotment of the debentures.
At the time of sale or redemption of the debentures, it is only the difference between the sale price or redemption amount and the amount of the debentures allotted, which would be subjected to capital gains tax.
Though a bonus debenture issue seems to be more tax efficient than an issue of bonus equity shares as it attracts a DDT of only 16.61% against a long-term capital gains tax of 20.6%, that is not quite correct. In case of listed bonus equity shares, you always have the option of selling the shares after one year and realizing capital gains which is exempt from tax. Of course, commercially, an issue of bonus debentures and an issue of bonus equity shares are two different things altogether.
An issue of bonus debentures does not dilute the equity capital and, therefore, does not result in substantial diminution in the market value of the equity shares, while an issue of bonus equity shares would invariably end up lowering the market value of the existing equity shares.
Gautam Nayak is a chartered accountant. Your comments, reactions and questions to this column are welcome at firstname.lastname@example.org