Redeemable preference shares offer companies a flexible way to raise capital while providing investors with a fixed return and a set redemption date. While they are classified as equity, these shares function similarly to debt because the company is obligated to repay shareholders at a future date. This structure allows businesses to secure funding without diluting ownership since redeemable preference shares do not carry voting rights. The shares are recorded as liabilities on the balance sheet, and dividends are treated as finance charges rather than profit distributions. While they offer stable returns for investors, companies must carefully plan for their redemption obligations to avoid liquidity issues down the line.
Redeemable Preference Shares
Redeemable preference shares are a specialized financial instrument that allows companies to raise capital while maintaining control over their financial obligations. These shares provide investors with a fixed return and the right to repayment at a predetermined date or at the discretion of the company. Unlike ordinary shares, redeemable preference shares function more like debt, influencing a company’s balance sheet and financial strategy.
In this guide, we will explore how they work, their benefits, risks, tax implications, accounting treatment, and real-world applications.
1. What Are Redeemable Preference Shares?
Redeemable preference shares are a type of preference share capital that includes a clause allowing (or requiring) the company to buy back the shares at a future date. These shares often carry a fixed dividend rate and, unlike ordinary shares, typically do not provide voting rights.
Key Characteristics:
- Repayment Obligation: The issuing company must redeem the shares at an agreed date or when it decides.
- Fixed Dividends: Shareholders receive a predetermined return, similar to interest payments on debt.
- Limited Voting Rights: Unlike ordinary shareholders, holders of redeemable preference shares usually do not influence corporate decisions.
- Hybrid Nature: While they appear as equity, accounting standards classify them as liabilities in many cases.
2. Why Do Companies Issue Redeemable Preference Shares?
Companies issue them for various strategic reasons, including:
Advantages for Companies:
- Flexible Financing: Unlike traditional debt, these shares do not require monthly repayments, providing liquidity flexibility.
- Maintains Ownership Control: Since these shares typically lack voting rights, founders and key stakeholders retain decision-making power.
- Attractive to Investors: Investors benefit from fixed returns, making these shares appealing to risk-averse stakeholders.
- Tax Efficiency: Depending on jurisdiction, dividend payments on these shares may offer tax benefits over traditional debt interest.
Advantages for Investors:
- Lower Risk Than Ordinary Shares: Fixed dividends ensure predictable income.
- Higher Priority in Liquidation: In case of company insolvency, preference shareholders are paid before ordinary shareholders.
3. Risks and Limitations
While redeemable preference shares offer benefits, they also come with significant risks and considerations.
Risks for Companies:
- Debt-Like Obligation: Even though classified as equity in some cases, redeemable preference shares function as a liability, increasing financial obligations.
- Potential Liquidity Strain: The company must be prepared to repurchase shares at maturity, which can be financially demanding.
- Impact on Credit Rating: Rating agencies may treat these shares as debt, affecting borrowing capacity.
Risks for Investors:
- No Growth Potential: Unlike ordinary shares, which benefit from capital appreciation, redeemable preference shares provide a fixed return with no upside in company performance.
- Issuer Default Risk: If the issuing company struggles financially, it may delay or fail to redeem the shares.
4. Accounting and Tax Treatment
Accounting Classification (IFRS & GAAP)
Under IFRS 9 and IAS 32, redeemable preference shares are often classified as a financial liability rather than equity. This is because the company has a contractual obligation to repurchase the shares, making them similar to debt instruments.
- Balance Sheet Treatment:
- Listed under liabilities rather than equity in most cases.
- Income Statement Impact:
- Dividend payments are treated as a finance cost rather than a distribution of profits.
- Cash Flow Statement:
- Redemption payments fall under financing activities, affecting cash flow.
Tax Implications
- For Companies: In many jurisdictions, dividends on redeemable preference shares are not tax-deductible, unlike interest payments on traditional debt.
- For Investors: Dividend income may be taxed differently from capital gains, often at a lower tax rate in some regions.
5. How Companies Use Redeemable Preference Shares
Example: ABC Manufacturing Ltd.
ABC Manufacturing Ltd. needed to raise $50 million to expand its production facility. Instead of taking on a high-interest bank loan, it issued redeemable preference shares with the following terms:
- Fixed 6% annual dividend
- Mandatory redemption in 5 years
- No voting rights
Outcome:
- ABC Manufacturing secured funding without diluting ownership.
- Investors benefited from a low-risk fixed return.
- In Year 5, the company will repurchase the shares, avoiding long-term financial obligations.
6. Comparison With Other Financing Options
| Feature | Redeemable Preference Shares | Ordinary Shares | Corporate Bonds |
|---|---|---|---|
| Dividend/Interest | Fixed dividend | Variable dividend | Fixed interest |
| Voting Rights | No | Yes | No |
| Balance Sheet Classification | Liability | Equity | Liability |
| Redemption | Yes | No | No |
| Investor Risk | Moderate | High | Low |
Key Takeaways
- Redeemable preference shares are hybrid instruments, functioning as equity but often classified as liabilities.
- They provide fixed returns to investors, making them attractive to risk-averse stakeholders.
- These shares help companies raise capital without giving up control, but they come with redemption obligations.
- Accounting standards (IFRS, GAAP) often treat them as debt, impacting financial statements.
- Tax treatment varies by jurisdiction, requiring careful consideration before issuance.
- Companies should assess liquidity risks before committing to a redemption timeline.
Further Reading: