The Fine Line: How Do You Know Your Preference Share Dividends are Tax Exempt?
Preference shares are a versatile financial tool to raise capital, favoured by companies, particularly banks and financial institutions. Unlike interest received on loans, dividends on preference shares are often exempt from income tax making it an attractive option for companies needing funds.
Generally, dividends received by shareholders are exempt from income tax. However, this may not be the case for preference share dividends when the conditions set out in sections 8E and 8EA of the Income Tax Act are met. Investors and entities should ensure that they understand the implications of these sections as these will determine whether dividends will be deemed taxable income, considering the nature of the preference shares and the purpose for which the funds raised are used.
The Equity or Liability Test
Section 8E classifies preference shares as "hybrid equity instruments” when they have characteristics of a debt rather than an equity. Dividends of hybrid equity instruments are taxable unless the following criteria are met:
The preference shares should not be redeemable within three years of issuance. This section will kick in if, for example, the company raises capital by issuing shares that it will buy back from the shareholders in 2 years.
Dividends must not be linked to any debt or financial instrument, such as interest rates making the dividends more an interest payout than equity distribution. When a company pays out a steady 7% dividend, similar to interest rates, the shares are considered debt rather than equity. Consequently, the dividends from these shares are taxable income.
Section 8EA focuses on how the entity used the proceeds when issuing preference shares and other related conditions. For dividends to remain tax-exempt:
The proceeds from the issuance must be used for a "qualifying purpose" including the acquisition of shares in an operating company that is not part of the same group, or for substantial business expansions or operational investments.
The preference shares should not be "third-party backed shares." This means the shares should not be secured by guarantees from unrelated third parties where the return or the capital is dependent on the performance of these third parties.
Checks to maximise tax benefits
To maximise the tax benefits of preference share dividends, companies should adhere to the following best practices:
Review the Memorandum of Incorporation (MOI) to ensure that it allows for creating the necessary class of preference shares. This might involve amending the MOI and increasing the authorised share capital. This step is crucial to avoid any legal obstacles later in the process.
Comply with regulatory requirements, i.e. obtain the necessary approvals from directors and shareholders as required by the Companies Act. Timely registration with the Companies and Intellectual Property Commission (CIPC) is essential, as this process can take several weeks.
Select the correct type of preference shares (e.g., cumulative, non-cumulative, convertible, redeemable) based on the company's financial strategy and the tax implications. Different shares offer different rights and obligations, so selecting the right one is key to achieving the desired economic outcome.
Ensure that the proceeds from issuing preference shares are used for qualifying purposes as defined in section 8EA of the Income Tax Act. These include acquiring equity shares in an operating company or redeeming existing preference shares issued for a qualifying purpose. This ensures compliance with tax regulations and maximises tax benefits.
Example
Company ABC Ltd issues redeemable preference shares to raise capital. The dividends on these shares are set at a fixed rate and are cumulative. ABC Ltd. ensures that the funds raised are used for a qualifying purpose under section 8EA to acquire shares in an operating company.
By structuring the preference shares this way, ABC Ltd ensures that the dividends paid to shareholders are not deemed taxable income under section 8E. Additionally, the company's MOI is amended to create the necessary class of shares, and all regulatory approvals are obtained, ensuring compliance with the Companies Act. This careful planning allows ABC Ltd. to enjoy the tax benefits associated with preference share dividends.
Considerations
When considering the issuance of preference shares, companies should keep the following in mind:
Evaluate Tax Implications: Understand the specific provisions of the Income Tax Act that apply to preference shares to avoid unintended tax liabilities. Missteps in this area can result in significant tax burdens, negating the benefits of preference share funding.
Seek Professional Advice: Given the complexities involved, it is advisable to obtain tax and structuring advice from experts to ensure compliance and optimise tax benefits. Professional guidance can help navigate the intricate tax laws and tailor the funding structure to the company's needs. Here a CIBA Business Accountant in Practice holding a Tax Practitioner licence can offer valuable advice to an organisation.
Plan for Redemption: Set the redemption dates for preference shares for after 3 years to avoid classification as a "hybrid equity instrument," which would result in adverse tax consequences. Properly timing the redemption ensures that the preference shares maintain their favourable tax status.
In conclusion, preference shares can offer significant tax advantages if structured and managed correctly. By adhering to best practices and considering the specific provisions of the Income Tax Act, companies can ensure that dividends paid to shareholders are tax-efficient and compliant with regulatory requirements. Careful planning and professional advice are key to leveraging the benefits of preference share funding.
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