If a company is in need of is in need of fresh capital to finance its growth and wishes to raise it from the existing shareholders of the company, it issues ‘rights shares’. Rights shares are shares allotted to the company’s existing shareholders at a discount to the existing market price. Suppose you hold 100 shares of Company ABC and the current market price of each share is Rs 50. The company announces a rights issue of 1:5 at Rs 40. This means that for every 5 shares that you hold you are entitled to receive one share and you will have to pay the discounted price of Rs 40 per share. Since you hold 100 shares, if you opt for the rights you will receive 20 shares (1 x 100/5) at a total cost of Rs 800 (Rs 40 x 20 shares).
Rights issue – In proportion to your existing holding
A rights issue is offered in proportion to your existing holding. Hence, you cannot buy how many ever shares you desire. Taking the above example forward, if the company announces a rights issue of 1:5, and you presently hold 100 shares, you will be eligible to receive an additional only 20 shares.
The record date
When a rights issue is announced, the company also announces a record date for the issue. The record date is the date on which the rights issue will take effect, and, the shareholders on that date are entitled to the rights.
After the announcement of the rights but before the record date, the shares are referred to as cum- rights.
After the record date, when the rights has been given effect, the shares become ex- rights.
Tax liability on rights issue
Rights are allotted at a discount to existing investors. The difference between sale proceeds and total cost of shares bought (original+ rights issue) is taken as your capital gains. Long term capital gains (for shares held for more than 1 year) are exempted from tax and short term capital gains are taxed at a rate of 15%. Suppose you buy 100 shares of ABC Limited at a total cost of Rs. 20000 on April 01, 2007. On December 31, 2007, the company declares a right issue in the ratio of 1:2 at a price of Rs. 150. Thus if you subscribe fully to rights issue, you are allotted additional 50 shares at a cost of Rs. 7500 (50*150). If you sell all your 150 shares on say January 31, 2007 at a price of Rs. 210 per share, your total sale proceeds will be Rs. 31500 (210*150). Your short term capital gains is Rs. 14000 (31500-27500) and you will have to pay tax of Rs. 2100 (14000*15/100).