Preferred Share Financing and Potential Application of Section 43A of the Eighth Schedule to the Income Tax Act

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In a preferred stock financing transaction, the funder subscribes for preferred shares in the share capital of a company. Unlike a loan where interest on a credit facility is taxable in the hands of the lender, dividends received by the preferred stock holder are generally exempt from income tax. This tax benefit is, in turn, beneficial to the business, as the lender can charge the business a lower financing rate than would otherwise have been charged if the financing had been advanced in the form of a ready.

However, there are certain instances in which dividends received in respect of preferred shares become taxable. The following is a brief summary of such a circumstance, of which the parties should be aware when entering into a preferred stock financing agreement.

Financing Preferred Shares and the Equity Kicker

In a preferred stock financing transaction, the funder subscribes for preferred shares in the share capital of a company. Unlike a loan where interest on a credit facility is taxable in the hands of the lender, dividends received by the preferred stock holder are generally exempt from income tax. This tax benefit is, in turn, beneficial to the business, as the lender can charge the business a lower financing rate than would otherwise have been charged if the financing had been advanced in the form of a ready.

Although an unlimited number of rights can potentially apply to a share, preferred shares are generally understood in the finance industry to fall into two broad categories:

  • Financing of preferred shares. These shares entitle their holders (i) to a capital reimbursement equal to its subscription price and (ii) to dividends calculated on this subscription price by reference to a determined interest rate or the time value of the ‘silver.
  • Equity kicker preference shares (hereinafter referred to as “equity kickers”). These shares are issued at a nominal issue price. Unlike preferred stock financing, dividends on equity kickers are calculated by reference to the value of the issuer or some or all of the issuer’s assets.

Acquisition of voting rights

Preferred stock holders generally have no voting rights. However, it is not uncommon for the financing terms of the preferred shares to contain a provision allowing the holder (or, collectively, the holders) of these shares to be entitled to a majority of the voting rights in the event of default (i.e. i.e. triggering event) in respect of the preferred shares occurs.

This mechanism whereby a preferred stockholder acquires voting rights is potentially problematic for tax purposes, particularly when the financing structure includes redeemable stock kickers.

Paragraph 43A of the Eighth Schedule to the Income Tax Act

Paragraph 43A of the Eighth Schedule to the Income Tax Act applies if:

  • a company (the shareholder) sells a share it holds in another company (the issuer);
  • at any time during the eighteen-month period preceding the date of this transfer, the shareholder held a “qualifying interest” in the issuer;
  • in connection with the transfer of the share or in the eighteen months preceding such transfer, the issuer pays the shareholder an “exempt dividend” in respect of the relevant share (and an “exempt dividend” is an dividend exempt from both normal tax and dividend tax); and
  • a portion of these exempt dividends constitute “extraordinary exempt dividends”.

A shareholder holds a “qualifying holding” in a company if he holds, inter alia, 50% of the voting rights in this company or 20% of the voting rights in this company if no other person holds the majority of the voting rights in this society. business.

If paragraph 43A applies, “extraordinary exempt dividends” are deemed to be part of the proceeds of disposal of the share (i.e. subject to capital gains tax) . An exempt dividend is an “extraordinary exempt dividend” if the applicable share (i) is a preferred share (as defined in Section 8EA of the Income Tax Act), to the extent that the dividends payable in respect of that share exceed the dividend calculated at a rate of 15% per annum, or (ii) is not a preferred share, the dividend exceeds 15% of the greater of the market value of the share at the beginning of the eighteen-month period and the market value of the share on the date of its disposal.

If, in terms of a preferred share financing agreement (i) the terms of the financing preferred shares provide that the holder of such preferred shares becomes entitled to voting rights equal to or greater than the defined “eligible interest” thresholds in paragraph 43A, if a triggering event occurs; and (ii) the holder, on the date of such occurrence, also holds an equity kicker which is redeemable at the holder’s option following the occurrence of the triggering event, then:

  • the holder will hold a “qualifying stake” in the issuer by virtue of the voting rights attached to his preferred financing shares;
  • dividends accruing to the holder in respect of the equity kicker held by him will constitute “extraordinary exempt dividends” to the extent that they exceed 15% of the greater of the market value of the equity kicker on the date on which the equity kicker is redeemed and the date eighteen months prior to such redemption date; and
  • in the event that the market value of the kicker share on the redemption date is greater than its market value on the date eighteen months preceding the redemption date (i) the market value of the share on its redemption date will be wholly attributable to the dividend payable in respect of such share, and (ii) 85% of such dividends will therefore constitute “extraordinary exempt dividends” and will be subject to capital gains tax between hands of the holder.

In conclusion, when entering into a preferred equity financing agreement where the funder must also hold a redeemable equity kicker, we recommend ensuring that the terms of the preferred equity financing do not contain a provision allowing the funder to acquire voting rights in the manner contemplated above. . Thus, the funder will never be able to hold a qualifying holding in the issuer and, therefore, paragraph 43A will not apply.

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