Very often, some preferred stocks are traded with very attractive yields in the stock markets and, depending on the depressed yields in the market markets, one may be tempted to buy these. Although dividends are now taxable, when maturity is caught, one would think that the post-tax yield would be much better than the yield available on debt instruments of such maturity. If you are an investor with taxable income in high brackets, you will need to do a little more homework and check your potential tax liability.
If the preferred shares are issued at the issue price by the company subscription, there should be no difficulty and you can proceed with your purchase decision based on the post-tax internal rate (IRR). Simple simple calculation. However, if the company issues these preferred shares to its equity shareholders through a bonus, you will have to pause and do the math again.
The bonus preference is equal to the redemption dividend of the shares, which is now taxed in your hands, along with the dividend on the preferred shares. Therefore, your calculation will be hay due to tax.
The definition of dividend refers to the distribution of profits collected by a company, if such distribution releases a portion of all or any of the company’s assets to the company’s shareholders.
In 1964, the Gujarat High Court analyzed the bonus preference shares redemption case and stated that when bonus preference shares were issued, it was not equal to the dividend as the company’s assets were not released. However, the Gujarat High Court held that at the time of redemption, the company had released the assets and as a result was taxed as dividend. The decision of the Gujarat High Court under the Income Tax Act of 1922 was upheld by the Authority of Advance Ruling in its judgment of 2005, confirming that the position is the same under the present Income Tax Act.
Consider a simple example. You bought the preferred share with face value ₹100, has a 6% dividend, and matures one year later. If share is available at ₹90, you expect your post-tax return to maturity to be approximately 14.5%, with a 10% appreciation on long-term capital gains tax ₹10, and 33% tax on dividends ₹6.
However, if the total redemption income is taxed as a dividend, approximately 33% of the total after tax factor ₹106, you are the only one left ₹71, gives you -21% negative yield. You are not really pocketed.
Usually the investor’s first reaction is to buy the shares after they have been issued as bonus shares. How can this be considered a dividend in my hands?
In the case of the Gujarat High Court, the bonus preference shares were purchased by the taxpayer. The High Court further held that there was no difference as to whether the shares were subsequently purchased by the investor, and whether the company received them as part of the issue.
The next question is whether the investor can claim the cost of purchasing the shares as an exemption from the tax-free redemption amount as dividend. The Gujarat High Court clearly considered the issue and rejected the argument. Also, the amended law is now clear — against dividend income, you can only claim interest as an expense and that too only up to 20% of dividend income. Therefore, gross redemption income is taxed as dividends, without reducing the cost of purchase.
Can you claim the capital cost of the shares as capital loss? This seems possible because redemption is equivalent to a transfer of security, and the redemption amount is, however, taxed under a different head of income.
Conversely, if you are the original distributor of the bonus preference shares and you sell them before redemption, the proceeds from the total sale will be taxed as capital gain and not as dividend. Acquisition cost is taken as nil, similar to bonus equity shares.
As an investor, if you own such bonus preference shares, you must sell these shares before maturity to avoid such tax on redemption.
Alternatively, you can give them as a gift before maturity, whose income does not have to be with you, and whose income is not taxable even after making such a maturity income factor.
Otherwise, don’t be surprised if the company also deducts tax at source on income earned through redemption. As the saying goes, it feels so good to be true.
Gautam Nayak is a partner in CNK & Associates LLC.