Proper investment portfolio management plays a significant role in modern day wealth creation. Investors are often confronted with decisions regarding the most appropriate investment opportunity suited to their investment needs, taking into account both risk and reward. According to SA Shares, an online trading platform in respect of Johannesburg Stock Exchange shares, it is recommended that any investment portfolio should consist of at least 10% (ten percent) to 15% (fifteen percent) of preferred stock, otherwise known as preference shares (“Preference Shares”).

When an investor invests in Preference Shares, it is of utmost importance to consider the meaning and inner workings of the Preference Shares investment, including the benefits and risks surrounding such Preference Shares investment. Terms such as “participating”, “cumulative”, “non-convertible” and “redeemable” have meanings attached to them in relation to Preference Shares and may significantly influence the rewards of the Preference Shares investment.

This article explores the nature and inner workings of Preference Shares including a consideration of the possible benefits which Preference Shares present for investors. Please note that this article only deals with the general nature of Preference Shares and anything contained herein is subject to the memorandum of incorporation (“MOI”) of the company concerned.

Nature of Preference Shares:

In general, shares usually refer to a unit of ownership in a company which allows such owner to exercise particular rights in respect of the company. Different classes of shares exist as founded in terms of each company’s MOI.

Shares can be allocated into either ordinary shares or Preference Shares. Usually, shareholders of Preference Shares do not have a right to participate in surplus profits of the company, unless such right is specifically conferred upon the shareholder of the Preference Shares. Should that be the case, the Preference Shares are known as participating Preference Shares. The participation of the shareholder of the Preference Shares is limited to the fixed percentage dividend to which the shareholder of the Preference Shares is entitled, unless there is a provision to the contrary in the Preference Shares terms.

A cumulative Preference Shares gives the shareholder of the Preference Shares a prior right to both arrear and current preference dividends. This means that if a preference dividend is not paid in one year due to insufficient profits, the non-paid dividends are carried over to successive years and must be distributed before anything is paid as dividends to holders of other shares ranking after such Preference Shares. The holder of a non-cumulative Preference Shares will not be entitled to an accrual and will lose the right to receive a dividend if the company does not declare a dividend on the dividend payment date.

Convertible Preference Shares entitles the company or the holder to request that the Preference Shares be converted into ordinary shares on pre-determined terms. Upon conversion, the shareholder of the Preference Shares will lose its preferential rights. Non-convertible shares do not entitle the company or the holder to request the conversion of the Preference Shares into ordinary shares.

Redeemable Preference Shares entitles the company or the shareholder of the Preference Shares, dependant on the Preference Shares terms, to repurchase the Preference Shares at any time. However, usually the Preference Shares will be redeemable only after 3 (three) years after date of issue to obtain the tax benefit discussed herein below.

Investor benefits associated with Preference Shares:

In addition to any benefits that may be attached to the nature of the Preference Shares as described above, a further benefit of Preference Shares investments for some investors may be the exclusions contained in the Income Tax Act No. 56 of 1962 which stipulates that dividends derived from Preference Shares shall not to be taxed as income of the receiver – subject to certain requirements being met. The dividends will inter alia not be taxable as income tax provided that the share does not constitute a hybrid equity instrument (usually if the share is redeemable within 3 (three) years of date of issue) and the share is not a third-party backed share.

The requirements associated with Preference Shares are comprehensive and specific to each transaction, it is therefore important to structure any Preference Shares agreement in line with the relevant tax requirements applicable to Preference Shares in order to obtain the tax benefits associated with the Preference Shares investment.

The main disadvantage of Preference Shares is that they usually lack general voting rights and subsequently, the shareholder of the Preference Shares lacks control over the company as the shareholder of the Preference Shares will not be able to influence the company’s policy and decisions. This disadvantage may only exist in the eye of certain holders – insofar as investors do not want to be burdened by meetings and updates regarding the company’s business, which is usually within the domain of the ordinary shareholders, but still desire to reap the rewards of the guaranteed dividends, then Preference Shares may be the appropriate investment instrument for them.

Concluding remarks:

Preference Shares can be favourable investment instruments and are usually worthwhile investments for investors who require a stable income without much involvement in the affairs of the company concerned. In order to ensure that the Preference Share agreements cater for the investor’s specific needs and for the investor to obtain any possible tax benefits associated therewith, it is imperative to crystallise the terms of the investments accordingly in the Preference Shares agreement.

VDMA’s team of experts are available to assist you and your business with any legal requirements pertaining to Preference Shares and Preference Share agreements.

Published 24 November 2021