What Are Non-Redeemable Preference Shares?

Non-redeemable preference shares are a class of stock that an issuing company cannot forcibly buy back or “redeem.” This characteristic makes them a permanent fixture on the company’s books. For the issuing corporation, these shares are a source of long-term capital without a required repayment of the principal investment. For investors, they offer rights and returns that differ from common stock and are designed for those who prioritize income and capital preservation over voting rights and growth potential.

Core Features and Shareholder Rights

The most defining feature of preference shares is the dividend right. These shares come with a fixed dividend, meaning the payout is a set percentage of the share’s initial price, known as its par value. This structure provides a more predictable income stream compared to the variable dividends of common stock.

A distinction exists between cumulative and non-cumulative dividend rights. If the shares are cumulative, any missed dividend payments accumulate and must be paid in full before any dividends can be distributed to common stockholders. With non-cumulative shares, if the company does not declare a dividend in a given period, that dividend is lost forever for the shareholder.

Another right is the liquidation preference, which establishes a shareholder’s priority in a company’s capital structure. In a business sale or liquidation, holders of preference shares are entitled to receive their initial investment back before common stockholders receive any proceeds. This preference is set at a “1x” multiple, meaning they get back the original amount they invested, plus any accrued dividends if the shares are cumulative.

Participation rights determine whether a shareholder can earn more than their fixed dividend rate. Non-participating preference shares cap the investor’s return at the predetermined dividend amount. Participating preference shares allow the holder to receive their fixed dividend and also “participate” in additional profits alongside common stockholders, often after common shareholders have received an equivalent dividend.

Voting rights for preference shareholders are typically limited or non-existent. They do not usually have a say in the election of the board of directors or other corporate matters. However, the terms may grant them voting rights under specific circumstances, such as if the company fails to pay dividends for several consecutive quarters.

Conversion and Exit Scenarios

Since the issuing company cannot redeem these shares, investors rely on other mechanisms to realize their value. One common exit path is a conversion feature. If preference shares are designated as convertible, the holder has the right to exchange them for a predetermined number of the company’s common shares, governed by a conversion ratio set when the shares are issued.

An investor would choose to convert when the market value of the common stock they would receive is greater than the effective value of their preference share. For example, if a preference share is worth $100 and is convertible into two common shares, the holder would likely convert if the common stock price rises above $50 per share. This allows the investor to transition to an equity position with greater potential for capital appreciation.

For non-convertible shares, the primary exit strategy is selling them on a secondary market. The liquidity and price of these shares are influenced by factors such as the company’s financial health, prevailing interest rates, and the specific features of the shares, like their dividend rate and whether they are cumulative.

The final exit scenario is a corporate event like a merger, acquisition, or liquidation. In these cases, the liquidation preference feature is triggered, and preference shareholders are paid out according to their priority before any remaining assets are distributed to common stockholders.

Accounting and Tax Implications

The accounting treatment of non-redeemable preference shares under Generally Accepted Accounting Principles (GAAP) depends on the dividend payments. If the dividends are discretionary, meaning the company can choose to pay them, the shares are classified as equity on the balance sheet. If the dividends are mandatory and create a contractual obligation, the shares are treated as a liability, similar to debt.

This classification affects the tax treatment of the payments. When classified as equity, dividends paid on preference shares are not tax-deductible because they are a distribution of after-tax profits. This makes issuing preference shares a more expensive form of financing for the company compared to issuing debt, where interest payments are a business expense.

For the shareholder, dividends received from non-redeemable preference shares are treated as dividend income for tax purposes. The tax rate depends on whether the dividends are “qualified” or “non-qualified.” Qualified dividends, which meet certain holding period requirements, are taxed at lower long-term capital gains rates, while non-qualified dividends are taxed at the shareholder’s ordinary income tax rate.

When a shareholder sells their non-redeemable preference shares on a secondary market, any profit or loss is treated as a capital gain or loss. If the shares were held for more than one year, the gain is considered long-term and is taxed at preferential capital gains rates. If held for one year or less, the gain is short-term and is taxed at the individual’s ordinary income tax rate.