An Obvious Preference

The 1997-98 Finance Bill restructured tax on dividend income. Dividend paid out to individuals has become tax-free whereas companies need to pay a tax of 10 per cent on distributed dividends. This measure, alongwith the credit policy relaxation that removed preference shares and debentures from the 5 per cent investment ceiling on incremental deposits for banks, has set the stage for investment in preference shares. A number of low tax-paying corporates are looking keenly at this instrument and experts feel that it is just a matter of time before the first retail issue of preference shares is floated.

The taxation angle

 

Funding for a corporate can be done through equity and/or preference shares on which dividend is paid and through debt on which interest is paid. Interest is treated as an expense, whereas dividend is treated as distributed profit after accounting for all expenses and taxes. Interest therefore is allowed to be set off as a business expenditure against business income, whereas dividend is not.

Due to this, if a company pays tax and is funding through debt, then it will be able to set off interest payments on it against business income. It will have to pay lower tax as the taxable income would have come down when interest was set off.

However, if the company had used the equity or preference share route then it would have to pay dividend, which it cannot set off against its business income. This would result in higher taxable income. For a company that pays higher income tax, say at the highest rate of 35 per cent, dividend pay-outs would be expensive. Conversely, for a tax-paying company that has a small tax outgo, there is little distinction between dividend and interest. Hence, the preference share route makes sense only for low tax-paying companies. In fact, in the current scenario, preference shares could be preferred by many issuers over equity, since they do not add to the equity of the company. Thus, there is no unfavourable impact on the earning per share.

Low tax-paying corporates are now finding it increasingly beneficial to go ahead with preference shares as the cost of funds for them is lower. Says Diptesh Shah, general manager, Global

Trust Bank:"Preference share dividend works out to be more economical for a company having a lower tax incidence rather than a company having a higher tax incidence."

Corporate interest

A large number of low tax-paying corporates, especially export houses, are therefore likely to go ahead with preference shares.

Recently, ATCO Industries has come up with a private placement preference share offer of Rs 14 crore. The company is using the proceeds of the issue for its ongoing capital expenditure programme and long term working capital needs. The group is planning a further issue of Rs 60-65 crore for diversification into plastics and mineral water projects.

D S Lodha, executive director, ATCO, says: "A large number of high net worth individuals, some cash rich corporates and banks have participated in the ATCO issue. Most of the banks participating in the issue are private sector banks. ''

Apart from ATCO, some of the companies which are actively considering going ahead with preference shares include Mastek, Tata Finance, EID Parry, Rallis and Ramco. Market sources say that the Rallis issue is likely to be as large as Rs 25 crore whereas the Ramco issue is a smaller one aggregating Rs 8-10 crore.

Why banks are bullish

The other reason for this buoyancy in the preference share market is that until recently, banks were allowed to invest only 5 per cent of their incremental deposits during the previous year in shares and debentures. The latest credit policy confines this restriction only to equity shares.

A number of private sector banks and some public sector banks are also bullish on the preference share issue as the dividend on preference shares is tax free. Says P H Ravikumar, vice-president, ICICI Bank: "Essentially profit making banks would like to look at the preference share route as dividend on these shares is tax free."

Says S Prabhu, assistant vice president, treasury, Timesbank: "For a 35 per cent tax category bank, the return on a preference share could be as high as 19-21 per cent. There is no other comparable instrument which gives this kind of a return."

For most of the banks, credit offtake has not been too good. This has kept most banks cash surplus. Most such banks are seeing preference shares as a means of deploying their funds. The other reason for the popularity of this instrument in the banking sector is that as compared to all other advances where banks have a 40 per cent priority sector commitment, investment in preference shares does not have any priority sector commitment attatched to it.

The rating factor

However, one risk that the bank has to undertake is that the preference share is unsecured debt as compared to a secured non-convertible debenture. Rating for preference shares has not been made compulsory as compared to other instruments like commercial paper and non convertible debentures (NCDs) above 18 months. Bankers are of the opinion that in case rating were to be made mandatory for preference shares, too, it would bring in a higher comfort level to the banks.

At present, banks have to evaluate the creditworthiness of the corporate, according to their own risk assessment methods.

The retail investor

Although all the current preference share issues are private placements, it is expected that there may be some amount of retail interest in preference shares before long. Currently, the retail investor's awareness of the preference share market is low.

What sort of returns could a retail investor expect from preference shares? For an investor who falls within the high or medium tax-paying bracket, the returns on a preference share would be more than those in a fixed deposit (FD) scheme of a bank or a company. While on a bank FD, the individual investor would get a return of 10-11 per cent, a company fixed deposit would give a return of 14.5-15 per cent. Post tax however, the returns would be lower. As compared to this, the yield on a 3-5 year preference share issue could be as much as 13-16 per cent.

Soon one may see preference shares being listed.