It is not uncommon for companies to raise capital by preference share funding (i.e. issuing preference shares to investors) as an alternative to debt funding for new business ventures and / or fulfilment of contractual obligations.
In the normal course, the company which requires funding will issue preference shares to the investors in return for the capital investment.
The company and its shareholders may then agree on the terms of redemption of the preference shares by the company. The redemption envisages repayment to the preference shareholders of their initial capital, interest and any other benefit vested in the preference shares.
The issuing of the preference shares is not a taxable event, however this position will be different on redemption by the company of the preference shares.
A company can redeem preference shares either by:
- utilisation of its reserves / retained earnings, which result in the proceeds being dividend in nature and subject to dividend withholding tax; alternatively
- repayment of the Contributed Tax Capital (“CTC”) initially invested (“return of capital”) by the preference shareholders and subject to capital gains tax in certain circumstances.
In considering the definitions of a “dividend” and “return of capital” as described in section 1 of the Income Tax Act (the “Act”), it is trite that the definitional components of the latter terms permit a company to transfer an amount as consideration for the acquisition of any shares in the company, subject to certain exceptions, including but not limited to Section 8E of the Act.
If the consideration payable for redemption of the preference shares, results in a reduction of the CTC of the company, the amount so paid cannot be classified as a dividend under section 1 of the Act.
The preference shareholders’ tax treatment on redemption of the preference shares are determined by the method of redemption which is applied by the company, i.e. through retained earnings or CTC.
Redemption through a dividend distribution:
- The dividend is paid from a company’s retained earnings and represents an after-tax amount.
- If the preference shareholder is a resident company, the dividend will be exempt from both income and dividend tax.
- However, if the preference shareholder is a natural person or a trust, the company is obliged to withhold dividend tax at a rate of 20% (twenty percent), and the preference shareholder will only receive 80% (eighty percent) of the redemption amount.
Redemption through a return of capital
- If the company redeems its preference shares through its CTC, payments received by the preference shareholders are capital in nature, and not considered to be income.
- However, should the return of the capital to the preference shareholders exceed the expenditure required to acquire the preference shares, the excess amount will be treated as a capital gain and capital gains tax will be levied on such excess amount.
A word of caution:
- If the company is obligated (in terms of its MOI or otherwise) to redeem the preference shares within a period of 3 (three) years from the date of the issuance thereof, the preference shares may be considered a hybrid-equity instrument. However, if redemption of the preference shares occurs within the aforesaid period, at the instance of the company, same shall not be considered to be a hybrid-equity instrument.
- On the triggering of the hybrid-equity provisions of the Act, the dividends declared by the company will then be regarded as income that accrued to the preference shareholder and be included in the taxable income of such shareholder.
There is a plethora of different tax consequences which enters the fray on the redemption of preference shares. It is advisable that each factual matrix of the shareholders and company be meticulously investigated prior to any redemption event to avoid any adverse consequences.