One of the most important aspects of that helps investors determine the returns and risk in the share, is capitalisation.
Quick Overview of Capitalisation shares
✔️What are capitalisation shares?
✔️Capitalisation shares according to the Companies Act
✔️Capitalisation shares as a replacement for cash dividends
It is a matter of choice
Capitalisation shares as bonus shares
Some reasons for issuing capitalisation shares
Some advantages of issuing capitalisation shares
Some disadvantages of capitalisation shares
Practical example of issuing capitalisation shares
Capitalisation also helps investors to choose those stocks that meet their diversification and risk criteria.
What are capitalisation shares?
Strictly speaking, capitalisation shares can be defined in two ways.
Substitution for a cash dividend
Capitalisation shares are shares issued by a company to its shareholders in lieu of a cash dividend.
Put differently, the issue of capitalisation shares is based on a resolution of the board of directors to capitalise the company’s profits instead of distributing it to shareholders.
Capitalisation or bonus issue
Capitalisation shares are shares issued by a company as new and free shares to existing shareholders in proportion to their existing shareholdings.
In this regard, capitalisation shares are referred to as ‘bonus shares.’
Capitalisation shares according to the Companies Act
Section 47
Section 47 of the Companies Act (Act 71 of 2008) regulates as follows with regard to capitalisation shares:
- The board of a company may pass a resolution, approving ‘the issuing of any authorised shares of the company, as capitalisation shares, on a pro-rata basis to shareholders of one or more classes of shares.’
- The board is allowed to issue shares of one class as a capitalisation share in respect of shares of another class.
- The board may, when deciding to issue a capitalisation share, concurrently allow any shareholder, entitled to a capitalisation share, to choose instead a cash payment, ‘at a value determined by the board.’
- However, the board of a company is not allowed to offer a shareholder a cash dividend in the place of a capitalisation share unless the board has ‘considered’ the solvency and liquidity test.
The solvency and liquidity test
In terms of section 4 of the Companies Act, the directors of a company are required to apply the solvency and liquidity test when they authorise the capitalisation of shares.
Section 4 implies that a company satisfies the solvency and liquidity test at a particular time (in this instance, the authorisation of capitalisation shares) if the board of the company considers ‘all reasonably foreseeable financial circumstances of the company.’
The financial circumstances to be evaluated include, inter alia, the following:
- Whether the fairly valued assets of a company (aggregate assets when the company is a member of a group of companies) equal or exceed the fairly valued liabilities of a company (aggregate liabilities when the company is a member of a group of companies) at the particular time.
- The ability of the company to pay its debts as they become due in the ordinary course of business for a period of 12 months after the date that the test is executed.
The accounting records (that meet the requirements of section 28 of the Companies Act) and the financial statements (that satisfy the requirements of section 29 of the Companies Act) of the company must form the basis of the test.
A company is required to use a fair valuation of the company’s current and assets and liabilities, including any ‘reasonably foreseeable contingent assets and liabilities.’ However, the fair valuation to be used is not clearly described in section 4, only mentioning that it must be ‘reasonable in the circumstances.’
Capitalisation shares as a replacement for cash dividends
It is a matter of choice
As mentioned, companies issue capitalisation shares to shareholders in the place of cash dividends. A strategy applied from time to time by some companies for a variety of reasons.
However, the issue of capitalisation shares may not be acceptable for some shareholders of a company as a substitution for a cash dividend. It is therefore not unintentionally that section 47 of the Companies Act determines that the board of a company may allow a shareholder to choose between a capitalisation share and a cash payment.
And one of the rules of life is that choices have consequences. Zig Ziglar, an American motivational speaker, once said: ‘Every choice you make has an end result.’ This is also true with regard to the choice between capitalisation shares and cash dividends.
Choice of capitalisation shares
Typically, the strategy to offer capitalised shares in lieu of a cash dividend is particularly attractive to companies that prefer to conserve cash resources.
Choosing the option of capitalisation shares will enable a shareholder to share in the future growth of a company.
In addition, the shareholder will not be taxed on the value of the shares that have increased his or her share portfolio, because capitalisation shares are specifically excluded from the definition of ‘dividend’ in section 1(1) of the Income Tax Act (Act 58 of 1962). Therefore, it will not be subjected to dividend tax.
With regard to capital gains tax (CGT), section 78 (1) of the Eighth Schedule to the Income Tax Act regulates as follows when the issue of capitalisation shares ‘constitutes a dividend:’ ‘… those capitalisation shares … must be treated as having been acquired for expenditure and paid equal to the amount of that dividend.’ (Accentuation by article writer.)
Based on the description of section 78 (1) above, the base cost of capitalisation shares received in lieu of cash dividends equals the value of the dividend that was replaced by the capitalisation shares. For example, if the total amount of the dividend was R5 000, the base cost would be R5 000.
The South African Revenue Services (SARS) defines base cost as: ‘Base cost includes those costs actually incurred in acquiring, enhancing, or disposing of an asset that is not allowable as a deduction from income.’
No income is generated from capitalisation shares in this regard and no expenses incurred. Hence, the base cost will be the value of the dividend that was exchanged for the capitalisation shares.
Choice of cash dividend
Conversely, the choice of a cash dividend has immediate tax consequences because Dividends Tax is triggered.
According to SARS, Dividends Tax ‘is a tax on shareholders when dividends are paid to them, and under normal circumstances, is withheld from their dividend payment by a withholding agent (either the company paying the dividend or, where a regulated intermediary is involved, by the latter). (Accentuations by article writer.)
Dividends Tax, sometimes also referred to as Dividend Withholding Tax (DWT), replaced the Secondary Tax on Companies (STC) on April 1, 2012. STC was a tax levied on companies on the declaration of dividends. The introduction of Dividends Tax shifted the tax liability from the company to the shareholder.
The current Dividends Tax rate is 20%, applicable to any dividend paid on or after February 22, 2017.
Example of Dividends Tax:
Let us say, a shareholder has 1 000 shares in company TSG and is entitled to a dividend of 75 cents per share, which equates to a total dividend of R750. The Dividends Tax will amount to R150 (R750 x 20%). Hence, the shareholder will receive R600 (R750 – R150) and SARS R150.
Choosing the cash dividend, a shareholder has cash available, using it as he or she sees fit.
Capitalisation shares as bonus shares
A company may decide to issue extra shares, free of charge, to existing shareholders in the same proportion as their existing shareholdings. This issue of shares as bonus shares is also referred to as a scrip dividend, stock dividend, or capitalisation issue, indicating that part of a company’s retained earnings is capitalised and utilised to fund the issue of the shares.
A company does not and cannot receive cash from the shareholders for the purpose of issuing bonus shares. Hence, an amount equal to the total value of capitalised shares issued is to be adjusted against retained earnings and transferred to share capital, also referred to as owners equity.
Capitalisation shares can be offered to all the shareholders of a company or can be restricted to a certain class of shares.
Example of a capitalisation issue (bonus issue):
- Company AIK may decide to issue 3 preference shares for every one ordinary share held by shareholders.
Tax implications
Capitalisation shares, as bonus shares, are tax neutral, regulated by section 78 (1) of the Eighth Schedule that they ‘must be treated as having been acquired for expenditure incurred and paid of nil.’ Simply put, their base cost is zero and capital gains tax (CGT) will only be triggered and payable whenever the shares are sold in the future.
Some reasons for issuing capitalisation shares
- Capitalisation shares may be issued by a company when the company has performed well but its cash flow does not allow the payment of dividends. This will satisfy investors who want their investment portfolios to grow.
- Typically, the issuing of capitalisation shares increase the liquidity of the shares, making trading in the market easier. Sometimes, the share price of a company is at such a level that it becomes difficult for investors to sell or buy them on a stock exchange.
When bonus shares are issued, the total worth of the shares remains the same but the price per share reduces, enabling easier trading on a stock exchange. Put differently, when capitalisation shares are issued, the share price is adjusted on a proportionate basis, keeping the net worth of the shares at the same level.
- A company may issue capitalisation shares when it plans to restructure its reserves.
- If excess profits need to be retained for future use, contrary to distributing them as cash dividends, a capitalisation issue can ensure that the position of the company’s balance sheet is correctly reflected.
Some advantages of issuing capitalisation shares
- The company is enabled to let its shareholders share in the profits of the company, without distributing cash, protecting its cash flow.
- With more cash available, the company can expand its current projects or start new ones.
- Since issuing capitalisation shares increases the issued share capital of the company, the company is perceived bigger than it really is, making it more attractive to investors, encouraging active trading.
- From a shareholder’s viewpoint, shareholders, if they so wish, can convert the shares received into cash by selling them.
Some disadvantages of capitalisation shares
- Investors who depend on a dividend from the company for a flow of income may have to sell their shares to ensure liquidity. Consequently, this may reduce their ownership in the company in comparison to the shareholders who keep their shares. This may be viewed as unfavourably.
- Capitalisation shares require the transfer of retained earnings to share capital. This may agitate some shareholders as these earnings could have been paid as dividends in the future.
- Capitalisation shares encourage speculation which is not desirable.
Practical example of issuing capitalisation shares
Naspers – Unbundling of Prosus NV in 2019
With the unbundling and listing of Prosus NV on the Euronext Amsterdam Exchange, with a secondary listing on the Johannesburg Stock Exchange (JSE), Naspers shareholders were given two options from which they had to select one.
- Option 1
This was the default option.
For every one Naspers N ordinary share held, a shareholder received one Naspers M ordinary share. Upon the listing of Prosus, each Naspers M share was automatically exchanged for one Prosus share.
Concerning CGT, the initial cost (base cost) was deemed zero while the proceeds were the price at which the Naspers M ordinary shares were listed.
The option triggered capital gains tax (CGT). The CGT realised on the day that the M-shares were converted to Prosus shares.
- Option 2
For every one Naspers share held, a shareholder received an additional 0.36986 Naspers share. Fractions were rounded down to the closest whole number and the remaining fractional allocations were paid in cash to the shareholders.
Regarding CGT consequences, the additional shares were received at a nil base cost. Capital gains tax (CGT) will only come into play whenever the shares are sold in the future.
Note: This article does not intend to provide investment or trading advice. Its aim is solely informative.
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