Redeeming Preference Shares: Dividend Rights and Tax Considerations

Redeeming Preference Shares

Preference shares are a type of share issued by companies that offer fixed income payments to its holders. When redeeming these shares, there are several aspects to consider regarding the payment of dividend rights. Here's what you need to know:

Dividend Rights Upon Redemption

When preference shares are redeemed, they lose their status as preference stocks. However, if the company has paid dividends with respect to those stocks during the period of redemption, it must continue paying these dividends until the end of their normal term. This is known as 'dividend arrears'. If the stockholder chooses to sell his shares before he would have received dividends, he cannot demand them later simply because he sold the shares.

Tax Law Considerations

In terms of tax law, when preference shares are redeemed, any accrued but unpaid dividends will generally become ordinary income to the holder. In some cases, the difference between the par value of the common stock and the price at which the shares were purchased may also be considered a capital gain. For example, if a taxpayer receives $3,000 in cash upon the redemption of a preferred stock with a par value of $50 per share, this amount represents both a return of principal ($50 x 60 = $3,000) and a return of earnings ($3,000 - $50 x 60 = $0).

Special Provisions

There are specific provisions regulating the treatment of dividends from real estate investment trusts (REITs), cooperatives, mutual savings banks, etc., and while they often follow similar principles, the mechanics can vary widely. Additionally, under certain circumstances—like the one mentioned above involving REITs—even though a corporation redeems all of its outstanding stock and ceases to exist, it still has an obligation to pay out accumulated earnings.

General Treatment of Dividends Upon Redemption

Generally speaking, when preference shares are exchanged or surrendered in lieu of the issuance of common stock, or when such shares are repurchased when held directly by the issuer, the entire consideration received is treated as a capital gain. But this rule does not apply to situations where the consideration consists solely of stock other than common stock of the issuing corporation.

Furthermore, a corporation can treat the distribution of money or securities upon conversion or exchange of convertible or exchangeable bonds as a redemption. Such a transaction could result in the accelerated recognition of remaining deferred taxes. But in practice, most corporations prefer to avoid the potential negative consequences that might arise when the acquisition costs of subsidiaries are written off after having been amortized over many years.

Lastly, when a distributor engages in a liquidating event resulting in the cancellation and redemption of membership interests in a partnership, distributions made prior to that time are deemed to be returns of capital rather than taxable income.

Regarding the private equity industry, LBO funds typically make disproportionate amounts of debt investments relative to pension funds and insurance companies, which tend to focus more heavily on mezzanine financing vehicles and senior secured loans made through separate accounts. These differences in funding structures have implications for the pricing power of different types of investors within a transaction.