Capitalization of Profits’ denotes the process of conversion of accumulated profits or reserves of a company into capital by means of a share issue. This share issue is called as bonus issue, capitalization or free issue. It involves the issue of new shares to existing shareholders by converting the accumulated profits or reserves into share capital of the company.
Section 63. Issue of bonus shares
(1) A company may issue fully paid-up bonus shares to its members, in any manner whatsoever, out of—
(i) its free reserves;
(ii) the securities premium account; or
(iii) the capital redemption reserve account:
Provided that no issue of bonus shares shall be made by capitalising reserves created by the revaluation of assets.
(2) No company shall capitalise its profits or reserves for the purpose of issuing fully paid-up bonus shares under sub-section (1), unless—
(a) it is authorised by its articles;
(b) it has, on the recommendation of the Board, been authorised in the general meeting of the company;
(c) it has not defaulted in payment of interest or principal in respect of fixed deposits or debt securities issued by it;
(d) it has not defaulted in respect of the payment of statutory dues of the employees, such as, contribution to provident fund, gratuity and bonus;
(e) the partly paid-up shares, if any outstanding on the date of allotment, are made fully paid-up;
(f) it complies with such conditions as may be prescribed.
(3) The bonus shares shall not be issued in lieu of dividend.
123. Declaration of dividend
(5) No dividend shall be paid by a company in respect of any share therein except to the registered shareholder of such share or to his order or to his banker and shall not be payable except in cash:
Provided that nothing in this sub-section shall be deemed to prohibit the capitalisation of profits or reserves of a company for the purpose of issuing fully paid-up bonus shares or paying up any amount for the time being unpaid on any shares held by the members of the company:
In the cases of Inland Revenue Commissioner v. Blott and CIT v. Dalmia Investments Co. Ltd., the Supreme Court held that if a company declares a bonus out of undivided capitalized profits and allots to its shareholders unissued shares in the company as fully paid-up, in satisfaction of the bonus, the shares so allotted are known as bonus shares. These shares are considered to be capital and not income in the hands of shareholders.
Listed companies have to comply with the Securities and Exchange Board of India’s Issue of Capital and Disclosure Requirement Regulations, 2009 with respect to bonus issues.
Since the SEBI Regulations, 2009 do not apply to private companies (including deemed public companies), these companies are not required to follow and comply with any of the requirements of the regulations with regard to their bonus issues.
The private companies will have to comply with the provisions of their respective Articles of Association(“AoA”) in this regard. There are no separate guidelines, rules or regulations on this subject.
Bonus shares may be either ordinary or preference shares on the one hand or redeemable preference shares on the other. The company may also instead of issuing bonus shares issue bonus debentures by capitalising its accumulated profits.
The AAR dealt with the issue of deduction of tax at source while issuing bonus shares to non-resident equity shareholders. The case dealt with the tax deduction, but the AAR recognised issuance of 80,000 redeemable 12% preference shares of Rs. 100 each as fully paid bonus preference shares to the existing equity shareholders. [Briggs of Burton (India) (P.) Ltd., In re]
Therefore, going by the above provisions and judicial precedents it can be concluded that bonus preference shares (and/or equity shares) can be issued to equity shareholders.
Section 2(22) “dividend” includes—
(a) any distribution by a company of accumulated profits, whether capitalised or not, if such distribution entails the release by the company to its shareholders of all or any part of the assets of the company ;
(b) any distribution to its shareholders by a company of debentures, debenture-stock, or deposit certificates in any form, whether with or without interest, and any distribution to its preference shareholders of shares by way of bonus, to the extent to which the company possesses accumulated profits, whether capitalised or not ;
Issue of bonus shares-Does not entail release of assets of the company
Shashibala Navnitlal vs. CIT (1964) 54 ITR 478 (Guj)
Assessee purchased certain number of redeemable preference share of a company which had capitalized its accumulated profits by issuing such preference shares of to holders of ordinary shares. Said company redeemed those preference shares from general funds. ITO sought to assess amount received by assessee on such redemation as dividend within meaning of section 2(6A)(a) of 1922 Act.
Where preference share capital is constituted by application of capitalised accumulated profits in paying up in full preference shares issued to shareholders as bonus shares credited as fully paid up, return of preference share capital involved in redemption of preference shares must amount to distribution of capitalised accumulated profits representing preference share capital. Amounts which are returned to shareholders on redemption are amounts paid up on preference shares and since amounts paid up on preference shares are capitalised accumulated profits, it must follow as necessary consequence that capitalised accumulated profits reach hands of shareholders when redemption takes place and consequently there is distribution of capitalised accumulated profits on redemption. Distribution of capitalized accumulated profits entailing release of assets of company took place when preference shares were redeemed by company and, therefore, amount received by assessee clearly fell within definition of “dividend” contained in section 2(6A)(a) of 1922 Act. Thus, amount paid by assessee for purchase of those shares was in nature of capital expenditure and could not, therefore, be claimed as allowable expenditure under section 12 of 1922 Act.
SUPREME COURT OF INDIA in case of P.K. Badiani v CIT  105 ITR 642 (SC)
The assessee was a major shareholder in a company in which the public were not substantially interested within the meaning of section 23A of the 1922 Act. He was also the managing director of the said private limited company. He had a mutual open and current account in the books of the company. He in the accounting year 1957-58 had withdrawn considerable amounts of money from the company’s account. The Income-tax Officer treated the withdrawals made by the assessee as advances or loans given by the company to him and taxed the amount as dividend under section2(6A)(e) ofthe1922Act. On appeal, it was found that the aggregate amount of development rebate allowed to the company under section 10(2)(vib) of 1922 Act was Rs. 2,36,470. The said amount had been debited in the profit and loss account of the company for the accounting year 1956, leaving a balance of Rs. 6,641 only in the profit and loss account. The Appellate Assistant Commissioner treated the entire sum of Rs. 2,43,111 as accumulated profits possessed by the company. Finding the highest advance to the assessee at a particular point of time to be aggregating to Rs. 1,83,493 he directed the addition of the said amount in the assessee’s income under section 2(6A)(e) of the 1922 Act. The High Court directed some modification in the calculation of the said amount. On instant appeal, the main question came up for determination was whether the aggregate of the development rebate allowed to the company under section 10(2)(vib) of the 1922 Act could be treated as accumulated profits in the hands of the company under section 2(6A)(e) of 1922 Act.
The expression “accumulated profits” occurring in clause (e ) of section 2(6A) of 1922 Act or in any of the other clauses, means profits in the commercial sense and not profits liable to tax as income under the 1922 Act, that is to say, the profits made in the real and true sense of the term.
The purpose of section 2(6A) of the 1922 Act, corresponding to section 2(22) of the 1961 Act is to include within the term “dividend” for the purpose of taxation certain distributions or payments of certain items of money or the like as deemed dividend for the purpose of taxation. Under clause (e ) an advance or loan of money to a shareholder by a private company has been directed to be treated as dividend to the extent to which the company possessed accumulated profits. The advance or the loan, by a legal fiction, is to resemble the actual dividend. For the purpose of distribution of the dividend the amount of development rebate could form part of the profits of the company; a fortiori, it would be so for the purposes of clause (e) also.
Further, if money is paid to a shareholder of a private company by way of advance or loan after the accumulated profits have been capitalised in accordance with the law and the articles of association, then such payment, although it may represent a part of the assets of the company or otherwise, cannot be co-related to the capitalised profits of the company. To the extent the profits have been capitalised the company cannot be said to possess any accumulated profits. But, in the instant case, the accumulated profits of the company in the year in question were never capitalised. Mere transferring the sum of Rs. 2,36,470 by debiting it to the profit and loss account to the development reserve account did not amount to the capitalisation of profits. The nature of the assets in the hands of the company did not change. It remained profits in the hands of the company.
In view of the above, the development reserve created by the company by duly charging the amount of profit and loss account, although liable as a deduction under the 1922 Act, constituted accumulated profits of the company within the meaning of section 2(6A)(e) of 1922 Act.
Accordingly, the decision of the High Court was to be affirmed.
Note: The decision was in favour of revenue.
When bonus shares are issued there is distribution of accumulated profits which are capitalised in the sense in which the expression is used in section 2(6A) of the 1922 Act and section 2(22A) of the 1961 Act. Despite there being distribution at that stage, there is no deemed dividend because the distribution in question does not entail release of company’s assets.
S.C. Cambatta vs. CIT (1952) 21 ITR 121 (Bom), a company may distribute its profits by bonus share in which case a shareholder is entitled to a share in the increased capital of the company. Such a distribution does not entail a release of any of the company’s assets because the assets which were represented by the accumulated profits continue to remain as part of the company’s assets, the only difference being that instead of the assets being profits they are capitalised and become part of the capital of the company. But when company distributes its profits by declaring dividends to the shareholders which dividends are paid by the company, there is release of part of company’s assets.
Provision to the contrary is now found in cl. (b) of section 2(22) under which issue of bonus shares to preference shareholders out of accumulated profits is treated as dividend. Such provisions were not there in cl. (b) of section 2(6A) of the 1922 Act.
Issue of redeemable preference shares as bonus out of accumulated profits does not entail release of the assets of the company
Issue of redeemable bonus preference shares or bonus debenture out of the accumulated profits, after their capitalisation, amount to distribution of accumulated profits but such distribution does not entail release of the assets of the company. This is because mechanism of issue of redeemable bonus preference shares and bonus debenture is the same as in issue of bonus shares described above. The transaction of their issue, takes nothing out of the coffers of the company and puts nothing in the pockets of the shareholders. Hence, such issue does not attract section 2(6A)(a) of the 1922 Act [Shashibala Navnitlal vs. CIT (1964) 54 ITR 478 (Guj) : TC41R.126].
As far as issue of preference shares as bonus out of accumulated profits is concerned, although issue of such shares would amount to distribution of accumulated profits, sub-cl. (a) of section 2(22) of the 1961 would not be operative because such distribution did not entail release of assets by the company to its shareholders.
It is important to note that bonus shares issued out of accumulated profits to equity shareholders is not dividend as this clause does not cover such a situation. Further, under the sub-clause (a) or first sub-clause, the payment shall be regarded as ‘dividend’ only in situation where such payment entails the release of assets by company to its shareholders. In the case of bonus issue out of accumulated profits to the equity shareholders, there is no release of any assets by the company and merely reserves are transferred to capital and hence there is no ‘dividend’ within the meaning of section 2(22)(a).
Taxability on Redemption of bonus preference shares:
Section 2(22) “dividend” includes—
(a) any distribution by a company of accumulated profits, whether capitalised or not, if such distribution entails the release by the company to its shareholders of all or any part of the assets of the company.
Issuing bonus equity shares to equity shareholders does not result in release of assets to the shareholders and hence it is not taxable as dividend. While issuing bonus shares, the accumulated profits simply get converted into share capital of the company. Issue of bonus shares in no way alters the asset position of the company.
AAR in case of Briggs of Burton (India) (P.) Ltd., In re  145 TAXMAN 400 (AAR – NEW DELHI)
The jurisdictional Commissioner in his comments has stated that from the reading of section 2(22), it will be clear that not only there has to be a distribution by the company of accumulated profits, but such distribution must entail the release of assets by the company to the shareholders. The question is, therefore, whether issue of bonus preference shares results in distribution of accumulated profits as well as entailing a release of assets of the Company to the shareholders. The Supreme Court in the case of CIT v. Dalmia Investment Company Ltd.  52 ITR 567 has held that after the accumulated profits are converted into capital and bonus shares are issued and credited as fully paid up, the company employs that money not as a reserve of profits, but as its proper capital issued to and contributed by the shareholders.
It has, therefore, been submitted that mere issue of redeemable bonus preference shares would not tantamount to payment of dividends unless these shares are redeemed by the Company. Only at that stage there will be release of assets of the company to the shareholders and due taxes would have to be deducted on the amounts paid out on such redemption.
If accumulated profits are capitalised and redeemable preference shares are issued as bonus to equity shareholders, then on redemption of such bonus preference shares there would certainly be release of assets in favour of the shareholders; such pay off of bonus share would be taxable as dividend u/s. 2(22)(a) of the Income Tax Act.