Bonus Preference Shares: A New Route for Unlocking Surplus Reserves

 Introduction

Several prominent listed companies, including Siyaram Silk Mills, TVS Motor Company, and Sundaram-Clayton, have recently adopted an innovative mechanism for rewarding shareholders and optimising capital structure through the issuance of bonus redeemable preference shares under schemes sanctioned by the National Company Law Tribunal (NCLT). 

Unlike a conventional dividend, where cash leaves the company immediately, or a buyback, which is subject to statutory limitations, bonus preference shares allow companies to capitalize accumulated reserves and distribute value to shareholders while deferring cash outflows to a future date.   

How the Structure Works

Under this arrangement, a company capitalizes a portion of its accumulated reserves and transfers the amount to preference share capital. In return, shareholders receive fully paid-up redeemable preference shares free of cost and in proportion to their existing equity holdings.   

Key characteristics of the structure include:

Ø  No cash payment is made at the time of allotment.

Ø  Existing equity shares remain intact and are not cancelled.

Ø  Shareholding percentages remain unchanged.

Ø  Preference shareholders become entitled to a fixed cumulative return.

Ø  The preference shares carry a predetermined redemption value and maturity date.   

 

Effectively, shareholders receive a future economic benefit while the company retains liquidity in the short term.

Illustrative Transactions

Siyaram Silk Mills

 

The company issued:

• Four Series-I preference shares and three Series-II preference shares of ₹10 each for every equity share held.
• Preference shares carried a cumulative dividend of 9% per annum.
• Series-I was redeemable after three years and Series-II after five years.
• The aggregate issue size was approximately ₹318 crore.   

 

TVS Motor Company

 

The company issued:

• Four redeemable preference shares of ₹10 each for every equity share.
• Cumulative dividend at 6% per annum payable on redemption.
• Redemption scheduled after twelve months.
• Total issue size was approximately ₹1,900 crore.   

 

Why Companies Prefer Bonus Preference Shares

1. No Dilution of Ownership

Unlike fresh equity issuance, bonus preference shares do not alter the existing equity capital structure or voting rights. The shareholding pattern remains unchanged.   

2. Deferred Cash Outflow

Instead of paying cash immediately, the company postpones payment until redemption. This helps conserve working capital and maintain liquidity for business operations.   

3. Avoidance of Buyback Restrictions

Section 68 of the Companies Act imposes limitations on buybacks, including quantitative thresholds and cooling-off periods. Bonus preference shares are not subject to these restrictions, providing companies with greater flexibility in distributing accumulated reserves.   

4. Unlocking Surplus Reserves

The structure enables companies to convert idle reserves into a shareholder entitlement without requiring an immediate cash distribution.   

Why NCLT Approval Becomes Necessary

The legal complexity arises because Section 63 of the Companies Act permits capitalization of reserves for issuing bonus shares but specifically states that bonus shares should not be issued in lieu of dividends.   

Since redeemable preference shares provide:

• a fixed cumulative return, and
• return of capital upon redemption,

they resemble a deferred distribution mechanism. Accordingly, companies have sought approval through NCLT-sanctioned schemes of arrangement under Section 230 of the Companies Act, thereby obtaining legal certainty and binding approval for all stakeholders.   

The NCLT scheme typically approves:

• allotment of preference shares,
• increase in authorised capital,
• amendment of memorandum provisions, and
• applicability to all shareholders, including dissenting shareholders.   

 

FEMA Implications for Non-Resident Shareholders

A significant driver behind the NCLT route is compliance with foreign exchange regulations.

Under the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019:

• Fully and compulsorily convertible preference shares are treated as equity instruments.
• Redeemable non-convertible preference shares are treated as debt instruments.   

Ordinarily, foreign direct investment regulations do not permit issuance of such instruments through the regular route. However, Regulation 6 of the FEMA (Debt Instruments) Regulations, 2019 specifically permits issuance of redeemable preference shares to non-resident shareholders pursuant to an NCLT-approved scheme of arrangement.   

The following conditions must be satisfied:

1. The original foreign investment must be FEMA-compliant.
2. The issue must comply with the Companies Act and the NCLT scheme.
3. The company must operate in a sector where foreign investment is permitted.   

Consequently, the presence of even a single non-resident shareholder can necessitate the NCLT route for the entire issuance.   

 

 

 

Tax Treatment

At the Time of Issue

The allotment of bonus preference shares generally does not trigger dividend taxation.

The article notes that the relevant dividend deeming provisions do not apply because:

• there is no release of assets at the time of issue, and
• the instrument does not fall within specific categories covered by the deemed dividend provisions.   

Therefore, shareholders generally do not recognize taxable income merely upon receipt of the preference shares.   

Tax Consequences at Exit

Tax implications arise when the instrument is redeemed or sold.

Dividend Route

Where amounts are characterized as dividends, they are taxable in the shareholder's hands at applicable slab rates.   

Buyback Route

If preference shares are retired through a buyback mechanism, capital gains taxation applies. However, promoters may face additional tax burdens under the applicable provisions.   

Redemption or Sale

Where shares are redeemed under Section 55 or sold on the stock exchange:

• gains are generally treated as capital gains,
• long-term capital gains may be taxed at 12.5%, subject to satisfaction of holding-period requirements.   

The holding period is particularly important. A tenure of at least twelve months may qualify the gain as long-term, whereas redemption before completing the stipulated period may result in short-term taxation at normal rates.   

 

 

Key Benefits and Risks

Benefits

For Promoters

• Opportunity to receive value at potentially lower capital gains tax rates compared to dividend taxation.   

For Public Shareholders

• Receipt of a listed, transferable instrument that can be traded prior to redemption.   

For Non-Residents

• Availability of a FEMA-compliant route for participation in reserve distribution schemes.   

For Companies

• Ability to reward shareholders while avoiding immediate cash outflows and preserving liquidity.   

Risks

• Dividend payable on the preference shares may not qualify as interest expenditure.
• Redemption creates a future funding obligation for the company.
• The structure may attract scrutiny under the General Anti-Avoidance Rules (GAAR) if perceived primarily as a tax-driven arrangement.   

Conclusion

Bonus redeemable preference shares are emerging as a sophisticated corporate restructuring tool that enables companies to monetize surplus reserves without disturbing ownership structures or causing immediate cash outflows. Supported by NCLT-approved schemes and a specific FEMA carve-out for non-resident shareholders, the structure offers significant commercial and tax advantages. However, careful consideration must be given to legal compliance, funding of future redemption obligations and potential GAAR implications before implementation.