Preference Shares - The Preferred Option

Preference share issuers have been companies with zero or near zero tax liability. Last year, even with MAT at 12.9 per cent ( at a tax rate of 43 per cent ), it made sense for corporates to issue preference shares at around 15 per cent. This meant a pre-tax cost of a little over 17 per cent, which was reasonable, given the high interest regime last year. Investors in preference shares were mainly high tax and high dividend-paying corporates. These corporates invested to the extent of exemptions available under Section 80M of the IT Act.

A tax-free yield of 15 per cent for the 43 per cent tax bracket worked out to a notional taxable yield of over 26 per cent on pre-tax basis which was attractive. However, the market for preference shares was restricted to corporates with large dividend payouts and their appetite was limited to the extent of exemption available under Section 80M. Preference shares never went up in popularity charts with individuals since they did not enjoy any tax breaks except the deduction under section 80 L of the IT act, which was meagre.

 

With complete tax exemption of dividend income in the current Budget, investment in preference shares would no longer be restricted by the exemption u\s 80 M. Any high tax - paying corporate would now be interested in this investment. Individuals would also find them attractive since dividend would be completely tax-free. The credit policy has removed investment in preference shares by banks from the 5 per cent investment limit. Tax-paying banks would now find preference shares as an attractive investment avenue offering higher than normal pre-tax yields. All this would substantially increase the demand side and deepen the market for such instruments and make them popular. Given their quasi-equity nature and low cost, preference shares are expected to be a preferred source of funding by companies with high export income, greenfield projects and infrastructure projects. Financial institutions and banks paying low or no tax could also look at raising cheap funds through the preference share route as it meetsthe

criteria of Tier II capital.

The important question that arises is : could issuers reduce cost of funds through preference shares? Unlike interest, dividend on preference shares is a distribution of profits and not a charge to it. Hence, preference shares are likely to be preferred by zero or near zero tax issuers who are largely indifferent to pre-tax or post- tax cost. The 10 per cent tax on distributed profits by the issuer is a hindrance which increases the cost of funds. MAT, though now in the form of deferred tax, increases the cost because of uncertainty associated with tax deferral.

However, even with dividend tax and MAT at 10.5 per cent ( assuming 35 per cent tax for a corporate), the cost of funds through preference shares is expected to be lower than institutional funds. This is because of different tax incidence of the issuer and the investor. For example, a company is able to raise funds at 17 per cent from institutions. At this pre-tax cost, it would not mind raising preference shares upto 14 per cent. Assuming dividend tax and MAT, a tax free yield of 14 per cent translates to a notional yield of 21.5 per cent ( at 35 per cent tax) for companies and 20 per cent( at 30 per cent tax) for individuals. These yields are very attractive, given the scenario of falling interest rates and depressed equity market. On the flip side, if an investor expects a lower taxable yield of 19 per cent from the issuer, he would not mind investing in preference shares at 12 to 13 per cent. Given the tax liabilities of the investors - whether individual or corporate - the actual saving in cost of funds

raised through preference shares would depend upon the risk profile of the issuer.

Now, the risks. A company need not declare dividend on these shares if there are no profits. However, as generally cumulative preference shares are issued , the issuer has to accumulate dividends. But there is no remedy for delayed dividends except that under the Companies Act voting powers are vested in the preference share holders for delay in paying dividends for over two years. Delayed dividend would also lower the yields . Unlike NCDs, preference shares are unsecured. Since they are quasi- equity, preference shares carry higher risk than debentures and investors need to be careful in investing in mediocre companies. Investors are also justified in expecting a higher yield than debentures which should be at least 2 per cent.

Preference shares are an attractive investment opportunity mainly because of the tax-free nature of the yield whose notional taxable yield is expected to be higher than other taxable instruments. It affords issuers the scope of raising long-term funds at cheaper rates. Being quasi-equity , investors need to be careful in their investment in preference shares. Rating of preference shares would help investors in assessing the risk of such instruments .

Sidharath Kapur is senior vice president, investment banking division, Apple Finance. The views expressed here are his own.

Preference shares are likely to be preferred by zero or near zero tax issuers who are largely indifferent to pre-tax or post- tax cost..