Preference Shares

SEBI has recently allowed listing of non-convertible redeemable preference shares, that is, those that are not convertible into equity shares and are redeemed at maturity. Listing will give investors the option of exiting rather than waiting for the instrument to mature. As the shares are listed on the exchanges and an STT is levied on the transaction. Thus any sell beyond one year will be treated as long term, and there is no long term capital gain Tax on Shares.

Preference shares are not very popular due to lack of knowledge among the investors and the small size of the issuances. SEBI has mandated a rating of AA- and above and a minimum of three-year tenure for listing.

Preference shares do not carry voting rights. Companies, too, may pay dividend only when they earn a profit. In the cumulative option, if the company does not pay dividend in one year, the holder has the right to the payment in the next year, before any dividend is distributed to Equity Shares.

Preference shares are quasi-debt instruments. Preference shares combine features of equity and debt. They carry equity risk as the principal is not secured. Also, they entitle holders to a dividend similar to fixed deposit interest and have a set tenure.Preference shares are offered as part of share capital. The company pays fixed dividend to their holders. In this, they are unlike ordinary shares, where dividend is not fixed. Dividend income up to Rs.10 lakhs is tax-free in the hands of an investor. Dividend income more than Rs.10 lakhs will be taxed at 10%.

An investor usually compare Preference Shares with non-convertible debentures, or NCDs, which also pay a fixed rate, besides protecting the principal (unlike preference shares), as well as tax-free bonds, which are long-term but protect both principal and interest. In the worst case scenario of liquidation, holders of preference shares are put below NCD holders in terms of claim on assets.

Hence, dividend on preference shares is higher than what one earns from NCDs and tax-free bonds. But a lot will depend on the rating of preference shares. So, while investing in preference shares, one should look for tax arbitrage along with the risk. Interest income from NCDs is taxed while dividend income from preference shares is tax fee up to a Dividend income of Rs. 10 Lakhs. On the other side, interest from tax-free bonds is not taxed.

Tax-free bonds' tenure usually exceeds 10 years. On the other hand, while listing will make preference shares more liquid, they also have the advantage of being redeemed by the issuing company. Also, holders of preference shares are in some cases given preferential allotment during issue of shares.

In the above chart we are presuming that the Dividend income of an investor will be less then Rs.10 lakhs per annum.

Before investing in preference shares one should look at the company's past profitability and dividend payouts and how it plans to use the funds from the issue. The credibility and reputation of the management is also equally important. Credit rating of the company will help an investor to understand what kind of company he is investing in and whether it will grow in size and popularity.