The fine line between debt and equity in redeemable preference shares
- Redeemable preference shares are a valuable tool in a company’s capital-raising strategy, provided their structure reflects a clear understanding of the distinction between debt and equity.
There can be no doubt that redeemable preference shares have fast become a key instrument for businesses seeking to raise capital. How can businesses say no when the dual benefits of financing flexibility and potential tax advantages are put on the table.
Yet, these benefits depend largely on how the shares are structured. A recent tax ruling in Kenya drew attention to the importance of understanding the distinction between debt and equity, especially when the features of an instrument blur the lines between the two.
The issue arose when a company issued redeemable preference shares to its parent company abroad. While the shares were presented as equity, the tax authority viewed them as interest-free loans. This interpretation meant the company was liable for withholding tax (WHT) on deemed interest under the provisions of the Income Tax Act. The case turned on a detailed examination of the shares’ characteristics and whether they aligned more closely with equity or debt.
Traditionally, redeemable preference shares are classified as equity because they represent ownership in the issuing company, and their rights are often superior to ordinary shares. They may also include preferential treatment in dividend payments or capital distribution in the event of liquidation. However, these instruments can take on debt-like features when certain terms are included, such as mandatory repayment obligations or shareholder-controlled redemption rights.
In this case, the key features of the preference shares raised questions about their nature. The shares were redeemable at the shareholder’s discretion, which meant the issuing company could not control when the repayment obligation would arise. Furthermore, the shares carried no voting rights and provided for dividends only when distributable profits were available, and the company’s directors recommended them. Taken together, these features suggested a financial obligation that resembled debt rather than equity.
From a tax perspective, this distinction is critical. If the shares are treated as debt, they may trigger the deemed interest provisions of the Income Tax Act. These provisions are designed to apply when interest-free loans are advanced, effectively treating them as if they generate interest, which is then subject to WHT. In contrast, if the shares are classified as equity, payments to shareholders would generally take the form of dividends, which are also subject to WHT but under a different regime.
The question of control over redemption emerged as a decisive factor. When redemption rights are held by the shareholder, the instrument creates a financial obligation akin to a loan. By contrast, instruments redeemable only at the issuing company’s discretion are more likely to be treated as equity. This distinction aligns with international accounting standards, which define financial liabilities as obligations to deliver cash or other financial assets to another entity.
The case offers valuable insights for businesses structuring redeemable preference shares. To ensure these instruments are treated as equity for tax purposes, companies should carefully consider the terms of issuance.
Features that support an equity classification include:
· Redemption rights that rest solely with the company.
· The absence of a fixed coupon or interest rate.
· No mandatory obligation to pay dividends.
· Retaining full discretion over profit distributions.
On the other hand, terms that grant shareholders control over redemption or create repayment obligations risk reclassifying the shares as debt. This can lead to significant tax implications, including exposure to deemed interest provisions and additional WHT liabilities.
Businesses with non-resident shareholders should pay particular attention to these issues. Cross-border funding arrangements can be complex, and structuring redeemable preference shares effectively may offer a way to optimise tax efficiency while avoiding unintended consequences. For instance, ensuring that redemption rights are controlled by the company, and not the shareholder, can help maintain the equity classification of the shares.
Proper legal and tax advice is essential in navigating these complexities. A clear understanding of how the terms of redeemable preference shares interact with tax laws can help businesses align their financial instruments with their strategic objectives. This requires not only careful planning for new issuances but also a review of existing funding arrangements to address potential risks.
The challenge lies in balancing the operational and tax advantages of redeemable preference shares with compliance requirements. By designing instruments that clearly align with their intended purpose, businesses can mitigate tax exposure, maintain flexibility in their funding structures, and achieve their broader financial goals. This approach ensures that redeemable preference shares remain a valuable tool in a company’s capital-raising strategy, provided their structure reflects a clear understanding of the distinction between debt and equity.
