Investors seeking stable and regular income often turn to preference shares, a financial instrument that lies somewhere between equity shares and debt. One of the key features of preference shares is the priority they receive when it comes to dividend payments. There is often confusion surrounding whether dividends are compulsorily payable to preference shareholders. The answer depends on the type of preference shares and the financial position of the issuing company. Understanding the rules and obligations tied to preference dividend payments is essential for investors, company directors, and anyone involved in corporate finance.
Understanding Preference Shares
What Are Preference Shares?
Preference shares, also known as preferred stock in some countries, are a class of ownership in a company that has a higher claim on its assets and earnings than common shares. Preference shareholders usually receive dividends before common shareholders and have a fixed dividend rate specified at the time of issuance. However, they generally do not have voting rights in the company’s meetings.
Types of Preference Shares
There are several types of preference shares, each with different terms and dividend conditions:
- Cumulative Preference Shares: These accumulate unpaid dividends. If the company cannot pay a dividend in one year, it is carried forward to the next year.
- Non-Cumulative Preference Shares: These do not accumulate unpaid dividends. If a dividend is not declared in a given year, shareholders lose the right to receive it later.
- Participating Preference Shares: These receive a fixed dividend and may also share in additional profits with equity shareholders.
- Convertible Preference Shares: These can be converted into equity shares at a predetermined time and rate.
- Redeemable Preference Shares: These are repaid by the company after a certain period or under specific conditions.
Dividend Obligations to Preference Shareholders
Is the Dividend Compulsory?
The payment of dividends to preference shareholders is not always compulsory. The key factor is whether the company has sufficient profits available for distribution. Dividends are paid out of profits, and no company is allowed to declare a dividend if it has not made enough distributable profits in a financial year. However, when profits are available, the nature of the preference shares determines the company’s obligation.
Dividend in Cumulative Preference Shares
In the case of cumulative preference shares, the company is obligated to pay the fixed dividend even if it could not do so in previous years. Unpaid dividends are treated as arrears, and they must be cleared before any dividend can be paid to equity shareholders. Therefore, while dividends are not payable if there are no profits, cumulative preference shareholders will eventually receive their due when profits become available.
Dividend in Non-Cumulative Preference Shares
For non-cumulative preference shares, the situation is different. If a company does not declare a dividend in a given year due to insufficient profits, the preference shareholders lose their right to the dividend for that year. It is not carried forward to the next period, making such dividends non-compulsory and dependent on annual performance.
Legal and Accounting Implications
Company Law Considerations
In most jurisdictions, corporate laws regulate dividend distribution. Companies must comply with legal provisions, ensuring dividends are declared from actual profits or reserves. Failure to follow proper procedures can result in penalties for directors. For cumulative preference shares, arrears are recorded in the books and disclosed in the balance sheet until paid. This creates a legal liability on the company.
Impact on Financial Statements
Preference dividends, especially arrears, affect the financial health of a company. They are shown as a liability, reducing the retained earnings available for other uses. This may impact the company’s ability to declare dividends to common shareholders, attract new investment, or fund expansion plans. Companies must consider these factors when issuing preference shares or delaying dividend payments.
Priority Over Equity Shareholders
Order of Dividend Distribution
Preference shareholders are always paid dividends before equity shareholders. This priority is one of the most important features that attract investors to preference shares. If a company decides to declare a dividend, it must first clear any obligation to preference shareholders. Only after this can dividends be considered for equity shareholders.
Restrictions on Equity Dividends
If a company has cumulative preference shares with outstanding dividend arrears, it cannot declare dividends to equity shareholders until all such arrears are paid. This creates a situation where preference shareholders are protected even in periods of weak financial performance, ensuring a degree of reliability in returns.
Dividend Policy and Investor Confidence
Role in Investor Decision Making
Clear and consistent dividend policies boost investor confidence. For preference shareholders, understanding whether dividends are compulsorily payable is a key factor in assessing risk. Cumulative preference shares offer more security, especially for risk-averse investors seeking steady income.
Company’s Perspective
From the company’s point of view, issuing preference shares with fixed dividend obligations requires careful planning. While it provides an alternative to debt without diluting control, it also creates a financial commitment that must be honored before profits are distributed elsewhere. Companies need to ensure they have reliable revenue streams to support such commitments.
Taxation of Preference Dividends
Tax treatment of preference dividends varies by country but generally follows specific rules:
- Preference dividends are usually not tax-deductible expenses for the company, unlike interest on debt.
- Shareholders may be taxed on the dividend income they receive, depending on personal tax brackets and local laws.
Tax efficiency is often a consideration in choosing between preference shares and other forms of financing.
Practical Examples
Scenario 1: Company With Profits and Cumulative Preference Shares
A company has cumulative preference shares with a fixed 8% dividend rate. It did not pay dividends for the past two years due to losses. This year, it makes a profit. Before paying any dividend to equity shareholders, it must first pay the 8% dividend for the current year and clear arrears for the previous two years. This shows the compulsory nature of dividend payments once profits are available.
Scenario 2: Company With Losses and Non-Cumulative Preference Shares
A company issues non-cumulative preference shares. In a year where it makes a loss, it chooses not to declare any dividend. The preference shareholders have no legal claim to dividends for that year, and no arrears are recorded. If the company earns profits next year, it only pays the current year’s dividend, not for the missed year.
The statement dividend is compulsorily payable to preference shareholders is true only under certain conditions. It applies most clearly to cumulative preference shares when the company has sufficient profits. For non-cumulative shares, dividends are not a legal obligation if not declared. Understanding the terms attached to different types of preference shares is essential for both investors and issuing companies. Preference shares offer a structured and prioritized return, but they do not eliminate all risks. The nature of the preference share cumulative or non-cumulative along with the company’s profitability, determines whether dividends are truly compulsory or conditional.
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