Updated: Jul 25, 2020
Understanding Preferred Stock
Preferred shares are equity like securities issued by corporations that pay dividends that qualify for dividend tax credits (in Canada). The shares are "preferred" because the dividends must be paid preferentially before any dividends are paid on the corporation's common shares.
Preferred shareholders have priority over common stockholders re: to dividends and generally have higher yields than the common stock. The dividends may be paid monthly or quarterly and may at a fixed rate, or determined by a benchmark interest rate like the LIBOR. There are also adjustable-rate preferred shares where the dividend rate or yield depends on certain other factors.
‘Participating’ preferred shares may also be issued and are structured to pay additional dividends related to the company’s common stock dividends or, the company's profits. The decision to pay a preferred share dividend is made by a company's board of directors prior to each payment date.
Preferred shares are equity, but in many ways, they are mixed assets with features similar to both a stock and a bond. Preferred shareholders have a prior claim on a company's assets if it is liquidated, though their claim is subordinate to bondholders.
Failing to pay a preferred dividend is not considered a default. Preferred shares usually have a lower credit rating than an issuers bonds because they have less rights. Preferred shares usually have higher yields than an issuer’s bonds. Preferred stockholders have limited rights which usually does not include voting.
Preferred stock has debt and equity like features but generally provide a consistent predictable cash flow.
If a company has multiple series of preferred stocks, they may in turn be ranked in terms of priority.
Cumulative Preferred Shares
If a company is in trouble and suspends the preferred dividend, the shareholders may have the right to receive payment in arrears before dividends to common shareholders are paid Shares that have this arrangement are known as cumulative preferred shares.
Callable preferred stock
A ‘callable’ preferred stock is another type of preferred stock. The issuer has the right to re-call or redeem the stock at a pre-set price at a certain date.
Callable preferred stock terms include the re-call price, the date after which it can be called, and a ‘call premium’ (in some cases). The terms are outlined in the preferred shares prospectus. The terms of a callable preferred share term cannot be changed after the issue date.
What happens to preferred shares if a company is taken over?
Preferred shares are generally not voting shares, so a purchaser does not have to redeem or buy the preferred shares when taking over a company. The buyer has the same options as the original owner/issuer regarding the preferred shares.
Sometimes the offer to buy a company is a 'stock-for-stock’ deal i.e. the buyer offers shares as part of the purchase price in a combined company to replace the existing shareholdings. The buyer could also offer a combination of cash and stock in making the offer for the company.
Taxation of Dividends
Eligible dividends from Canadian companies are taxed at a much lower rate than interest and foreign dividends. If you make less than $40,000 the tax rate on dividends is actually negative. Canadian dividend-paying stocks are generally considered to be tax-efficient investments.
Eligible dividend income from Canadian preferred shares is taxed more favourably than interest income because of a dividend tax credit. Dividends are not deductible in determining their taxable income by the issuing company but are taxed in the hands of the individual receiving them. The tax applicable to dividends may vary from province to province.
For dividends to officially be recognized as eligible dividends and qualify for the dividend tax credit they have to be designated as eligible by the company paying the dividend.
Eligible dividends from Canadian corporations received by an individual are "grossed up" by 38%, as of 2018The gross-up rate for non-eligible dividends, as of 2019, is 15%.
The federal dividend tax credit is 15.0198% for eligible dividends and 9.0301% for non-eligible dividends.
There is no gross-up or dividend tax credit for dividends received by a corporation and dividends received from Canadian corporations may be deductible under s. 112 of the Income Tax Act (ITA), but Part IV tax (ITA s.
Canadian-controlled private corporations (“CCPCs”)
Dividends can be paid by CCPCs, if income (other than investment income) is subject to tax at the general corporate income tax rate. CCPC eligible dividends are grossed up by 15% and the corresponding dividend tax credit is 10.4% (9/13ths of the gross-up) for 2019 and later years.
CCPCs can also pay a ‘capital dividend' This is a tax-free dividend paid but requires the CCPC o file a special election. The capital dividend results from 50% of the capital gains realized by a CCPC. The dividend tax-free because the CCPC has to pay tax on the capital gain.
Most but at all preferred stock dividends are treated as qualified dividends and taxed at the lower long-term capital gains rate. However, investors at the highest tax bracket pay 20% on qualified dividends, while others pay only 15%.However, people in ordinary income tax brackets at 15% and below pay no tax on qualified dividends.
The treatment of dividends may vary from state to state.
G.Wahl, Managing Director, The PensionAdvisor