INTM585180 - Thin capitalisation: accountancy issues: The change in the treatment of preference shares under IFRS
The tax treatment of preference shares, and in particular redeemable preference shares, can be complex. See, for example, the provisions described in INTM509080 (application of the unallowable purpose legislation) and INTM509140 (application of anti-arbitrage legislation to hybrid instruments). In addition, it has already been noted that such shares are sometimes treated as debt by third-party lenders (see INTM578020), and that for some practical purposes they may be regarded as being on the borderline between debt and equity (see INTM504020). This will in some cases lead to questions of form and substance.
Introduction of FRS 25 (implementing IAS 32)
Under IFRS (and new UK GAAP - FRS 25: Financial Instruments: Disclosure and Presentation), preference shares are categorised in accordance with their contractual substance, for accounting periods beginning on or after 1st January 2006. Preference shares having the substance of debt will be shown as a liability in the balance sheet and the preference dividends will be shown as interest payable in the accounts. Preference shares with the substance of equity will be shown as equity, and the preference dividends will be shown as dividends - as was the case prior to IFRS/FRS 25.
For thin capitalisation purposes, it is important for each case to examine two things:
- the terms of the individual preference share instrument to discover if it should be classified as debt or equity
- the likely way in which a third-party lender would treat the payments associated with the instrument when considering making a loan.
It is likely that the accountancy treatment of the preference shares will provide useful information as to the underlying substance of those shares (i.e. whether they are in substance debt or equity). However, the actual treatment of those preference shares for thin capitalisation purposes is very much dependent on the facts and circumstances of the individual case, and on actual cash flows, as evidenced by the examples below.
Consider the following examples:
The preference shares, being redeemable and with a fixed annual dividend, are classified in the accounts as a liability. The preference dividend is disclosed as interest payable.
Because the shares are not redeemable during the life of the loan, their redemption should not impact on the ability to service the entity’s 10 year loan. However, dividends are paid annually, irrespective of the level of profits, so they are therefore likely to be treated for thin capitalisation purposes as debt. Whatever the case, a third-party lender would be interested in the way in which the 5% payments affected the ability of the borrower to service debt.
As above, the preference shares would be classified as a liability in the accounts, and the dividends as interest.
Since the cash flows in relation to the redemption are outside of the loan term, equity treatment is again appropriate for thin capitalisation purposes. In this case, however, there are no payments during the term of the loan that are likely to affect the ability to service debt. A third-party lender is unlikely to be concerned about the accumulated dividends unless there is some indication that it will affect the ability to repay the loan, for example, a need to accumulate cash towards the eventual repayment, which will have an impact on the availability of cash during the term of the loan and at its end. There may also be an event or set of circumstances which would trigger earlier redemption, prompting early dividend payment, which might be of concern to a lender.
Again, the figures stated in the accounts will need to be adjusted in order to arrive at the relevant amounts for thin capitalisation purposes.