The strain on cash due to COVID-19-related business interruptions has already caused companies to pay significantly lower dividends. Dividend yields are unlikely to rebound soon. The pressure on liquidity is anticipated to also impact the ability of companies to redeem preference shares or to pay scheduled preference share dividends.
Often the occurrence of a default event, such as missing a scheduled dividend payment (Trigger Event), gives the preference shareholder the right to demand redemption or places an obligation on the company to redeem.
This right or obligation to redeem impacts the tax profile of the preference shares. Whereas preference dividends are ordinarily exempt from income tax, a right to demand redemption of the preference shares (or an obligation to do so) is one of the debt-like features that may trigger taxation of the dividends. Not only future dividends could become subject to income tax, but all dividends declared during the year of assessment of the holder of the preference share in which the right or obligation to redeem arises.
There is a difference of views on the tax impact of the occurrence of a Trigger Event which provides the holder of the preference shares the option to demand redemption.
The first view is that because there is an existing right or obligation to redeem on the occurrence of a Trigger Event (in accordance with the preference share terms), provided the Trigger Event occurs three years and one day after the original date of issue, preference share dividends will not become taxable.
In terms of the second view, the right or obligation to redeem the preference shares is interpreted as a new right or obligation which arises on the occurrence of the Trigger Event, which results in the taxation of dividends because it qualifies as a new ‘date of issue’.
What has mostly been a theoretical point of debate for many years, may well become a stark reality for many preference shareholders, and to avoid uncertainty it is best not to hang one’s hat on interpretation.
Some preference share terms provide a certain extent of control in that the right or obligation to redeem does not arise immediately on the occurrence of a Trigger Event. The company is given a period of time in which to remedy the Trigger Event, and it is only if remedial action is insufficient, that the right to redemption arises which may trigger the tax on dividends.
In the absence of such control measures, it is crucial that companies with cash constraints renegotiate their preference share terms in advance of a scheduled dividend payment.
When the repayment profile of preference shares is renegotiated, such as an extension of the final redemption date, care should be taken to avoid creating redemption rights for the preference shareholder or redemption obligations on the issuer.
The same applies on early redemption of preference shares. If agreement is reached to redeem a portion of the preference shares early, which includes the payment of accrued dividends, the new obligation to redeem could result in the taxation of the dividends. The fact that the issuer may have had the right to voluntarily redeem early, would not be relevant if the parties reached a new agreement to redeem a portion early since it would not qualify as a voluntary redemption.
As is apparent from the above, tax needs to be front of mind when renegotiating preference share terms to address liquidity constraints.
