Running a business often requires raising capital, whether to expand operations, reduce debt, or invest in growth opportunities. While there are many ways companies can raise funds, one of them is through a rights issue.
What is a rights issue?
A rights issue allows companies to raise funds by offering their existing shareholders the opportunity to purchase additional shares at a discounted price. This approach helps companies meet their financial needs while giving shareholders a chance to increase their stake in the company.
Now, whenever a company announces a rights issue, there are a few terms you’d come across. Rights entitlements (REs), a record date and a rights entitlement ratio.
First, Rights Entitlements.
REs are temporary demat securities issued to shareholders who own shares on the record date of the rights issue. You can think of them as tokens that basically allow you to buy the discounted shares. Once you get the REs, you can either
- Apply for the rights issue and buy additional shares at a discounted price, or
- Trade the REs on the stock market.
Second, a record date is set to determine which shareholders will qualify for the offer. You should have the company’s shares in your demat account on the record date to be eligible to receive the REs. So, if you are not an existing shareholder, you’ll have to purchase the shares at least one day prior to the record date.
Lastly, rights entitlement ratio. This ratio decides the number of REs you’ll get with respect to the number of shares you hold on the record date. For instance, if you are holding 100 shares of ABC Ltd and the company announces a rights issue in the ratio 1:5 then you’ll receive 20 REs.
Now, if you are eligible for a rights issue, you have 3 choices. You can either,
- Exercise the rights: Buy shares at the discounted price,
- Renounce the rights: Sell REs on secondary market, or
- Take no further action: Your rights will lapse after a certain time period.
Let us understand the tax implication in all 3 cases:
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Exercising the right: This means that you’ll be purchasing the shares at the discounted price. Now, when you purchase these shares, there will be no tax liability. However, when you sell them, capital gains tax will be applicable.
In this case, your cost of acquisition will be the discounted issue price and the date of acquisition will be the date on which you receive the right shares.
The applicable tax rates for sale of right shares or renouncement are given below:
Here’s an example to understand better.
You bought 100 shares of ABC Ltd. at ₹80/share in 2021. Currently, the shares trade at ₹200. ABC announces a rights issue in 2024, allowing shareholders to buy additional shares at ₹150 each in a 1:5 ratio. You are entitled to 20 right shares. Here’s how the tax is calculated if you exercise the rights and sell all shares for ₹240/per share after 2 months.
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Renouncement of rights: If you don’t want to exercise the REs, you can even sell them on the secondary markets. Someone else can buy those and buy the right shares even if they are not a shareholder of the company.
In this case you will receive an immediate cash consideration which will result in capital gains. REs can only be traded between a definite time window and hence, the gains can only be short-term. The cost of acquisition in this case will be zero as you were a shareholder and the REs were issued to you.
So in our previous example, assuming the REs are traded at ₹42 and you decide to sell all the 20 REs, the sale value will be ₹840 (20 x ₹42) and the entire value becomes your capital gain. The tax rate for STCG is 20% and hence, the tax liability will be ₹168.
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Take no further action: Rights entitlement which are neither exercised nor renounced will lapse after the closing date of the issue. There could be two cases here:
- If you were an existing shareholder who received the REs and do not take any action, then in this case there will be no tax liability.
- If you had bought the REs from the secondary market and did not take any action then you can claim short term capital loss equal to the cost of acquisition as the REs extinguish and the sale value becomes NIL.
This was about rights issue, we’ve also covered taxation of other corporate actions like stock splits and dividends.