Preference shares, more commonly referred to as preferred stock, are shares of a company’s stock with dividends that are paid out to shareholders before common stock dividends are issued. If the company enters bankruptcy, preferred stockholders are entitled to be paid from company assets before common stockholders.
What is Redemption of Preference Shares?
Redemption of preference shares is a process where a company buys back its issued preference shares from shareholders. This usually happens on a predetermined date and often at a pre-agreed price. This process effectively removes preference shares from circulation, and shareholders regain their investment value. Companies use redemption as a financial strategy to adjust their equity structure or to return surplus cash to shareholders, particularly for preference shares with a fixed redemption period.
Reasons for Preference Shares Redemption
Financial Restructuring: Companies may redeem preference shares to optimize their capital structure. This can include adjusting the debt-to-equity ratio or altering the balance between different types of equity to suit the company’s financial strategy better.
Improving Financial Ratios: Redeeming preference shares can improve certain financial ratios, such as earnings per share (EPS), which can make the company more attractive to investors.
Tax Efficiency: Sometimes, redemption is driven by tax considerations. Preference dividends may not be tax-deductible, whereas interest on debt is. Thus, converting preference shares to debt can be more tax-efficient.
Market Signaling: Redeeming preference shares can signal to the market that the company is confident about its cash flows and financial health, potentially boosting investor confidence and the company’s stock value.
Cost Reduction: If the dividend rate on preference shares is high, redeeming them can reduce the company’s cost of capital, especially if they can be replaced with cheaper sources of finance.
Contractual Obligations: Some preference shares have a fixed redemption date or condition as part of their issuing terms. Companies must redeem these shares to adhere to these contractual obligations.
Excess Cash Utilization: Companies with excess cash reserves might choose to redeem preference shares, using surplus funds effectively and providing value to shareholders.
Period of Redeemable Preference Shares
In terms of Section 55 (2) of the Act, a limited share company may issue preference shares which must be used for a period not exceeding 20 years from the date of issue. A company that participates in the establishment and management of infrastructure projects may issue preferential shares for more than 20 years but not more than 30 years, subject to at least 10% use of those shares annually from year 21 onwards or earlier, equally, at the discretion of preference shareholders.
The term “infrastructure projects” means the infrastructure projects referred to in Schedule VI of the Companies Act, 2013.
Procedure for Issuing Preferences
- Check whether the Articles of Association contain a preferential issuance clause. If not, amend AOA first.
- Call a Board Meeting for the following purposes: Increase the budget of the Authorized Preferences, if required; Authorizing the issuance of preferred shares; Calling a General Assembly for the approval of shareholders.
- Convene a General Assembly for the following purposes:
- To increase the preferred budget allocation, if required;
- To authorize the issuance of preferred shares in the form of a Special Resolution.
- File form MGT-14 with the Registrar of Companies within 30 days of shareholder accreditation and a copy of the Special Resolution and Explanatory Statement.
- Take the Application Fee for preferred shares through bank channels
- Assign preferred shares within 60 days from the date of receipt of the application fee. Assignments may be made by the board or any committee or any other authorized person.
- Form PAS-3- file within 15 days or 30 days as the case may be, from the date of distribution.
- A Share Certificate (Form SH-1) must be issued to potential shareholders within 2 months from the date of allocation.
Redemption out of Company Profits
When shares of preference are proposed to be used for corporate profits, it will be required, for that benefit, to transfer, an amount equal to the maximum number of shares to be used, the reserve, to be called a Capital Redemption Reserve Account, and the provisions of this Act in regards to share capital reduction apply as if Capital Redemption Reserve Account were paid-up. The capital redemption reserve account may be used by the company, in payment of non-issued company shares which will be provided to company members as fully paid shares.
FAQs
What are the tax implications for a company when redeeming preference shares?
When a company redeems preference shares, it does not face direct tax implications, but the transaction may affect the company’s distributable profits and overall tax liabilities. The dividends paid on preference shares are subject to tax, and the redemption amount could impact the company’s tax filings if it leads to adjustments in capital structure or dividend distributions.
How does the redemption of preference shares affect a company's capital structure?
The redemption of preference shares reduces a company’s preference capital and may impact its overall capital structure. It could lead to a decrease in debt-to-equity ratio if the redemption is funded through retained earnings or a new issue of shares. This process affects the company’s financial leverage and could influence investor perception.