5.3 Preferred Shares: Features, Cumulative Dividends & Taxation

Preferred Share Fundamentals and the Corporate Capital Structure

Preferred shares represent a hybrid financial security that blends the characteristics of fixed-income debt instruments with the legal form of equity ownership. Like bonds, preferred shares typically offer a predetermined, regular dividend payment and lack active participation in corporate earnings growth. Like common shares, they represent an equity interest on the corporate balance sheet, have no stated maturity date (unless structured with a retraction feature), and dividends do not constitute a legal debt obligation until declared by the board of directors.

The Capital Structure Hierarchy

In the corporate capital hierarchy, preferred shares occupy a vital middle ground between debt obligations and common equity:

Corporate Capital Structure (Seniority Hierarchy)
 ├── 1. Secured Bonds (1st Mortgage Bonds, ETCs)
 ├── 2. Senior Unsecured Debt (Senior Debentures, Bank Facilities)
 ├── 3. Subordinated Debt (Subordinated Debentures)
 ├── 4. Preferred Shares (Cumulative & Non-Cumulative)
 └── 5. Common Shares (Residual Claimants)

Core Characteristics of Preferred Shares

1. Seniority in Dividend Distribution: A corporation cannot declare or distribute any dividends to common shareholders unless all preferred dividend entitlements for the current period (and all cumulative prior arrears) have been paid in full.
2. Liquidation Preference: If a company undergoes liquidation, dissolution, or bankruptcy restructuring, preferred shareholders hold a prior claim over common equity on corporate assets up to the stated par value of their shares (standardized at $25.00 per share in Canadian retail markets) plus any accrued unpaid dividends. However, preferred shareholders remain subordinate to all secured bondholders, unsecured debenture holders, and general trade creditors.
3. Discretionary Dividend Obligation: Unlike bond coupon payments—which represent contractual legal obligations whose omission triggers technical default and potential bankruptcy—preferred dividends are paid at the discretion of the board of directors. If a company suffers operating losses, the board may pass (skip) the preferred dividend without being forced into bankruptcy.
4. Absence of Stated Maturity: Most plain-vanilla preferred shares are perpetual securities that remain outstanding indefinitely unless the issuer exercises a redemption (call) option or the investor exercises a retraction right.
5. Standard Par Value: While common shares in Canada generally trade on a "no par value" basis under the CBCA, preferred shares are almost universally issued with a nominal stated par value, predominantly $25.00 per share in Canada (and $100.00 for institutional series).

Contingent Voting Privileges

Under normal business operations, preferred shareholders have no voting rights at annual shareholder meetings and cannot vote on the election of corporate directors. However, standard preferred share indentures in Canada include contingent voting rights:

• If the issuing corporation fails to pay preferred dividends for a specified duration—typically 6 to 8 consecutive quarters—the preferred shareholders automatically obtain voting rights.
• In most corporate charters, this contingent privilege grants preferred shareholders the collective right to elect a designated number or percentage of directors (commonly two board members or 25% of the board) to ensure their interests are directly represented until all dividend arrears are settled.

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Major Preferred Share Classes and Features

To accommodate diverse corporate financing requirements and investor risk tolerances, preferred shares are issued with a wide array of contractual features.

1. Cumulative vs. Non-Cumulative Preferred Shares

• Cumulative Preferred Shares: If corporate earnings decline and the board omits a scheduled dividend payment, the unpaid amount is not forfeited; instead, it accumulates as dividend arrears. The corporation is legally prohibited from paying any dividends to common shareholders until all accumulated arrears, plus the current dividend, are paid in full.
  • Accounting Note: Dividend arrears do not constitute a formal balance sheet liability because the dividend has not been declared; however, they must be fully disclosed in the notes to the financial statements.
• Non-Cumulative Preferred Shares: If the board of directors passes on a scheduled dividend, the shareholder's right to that payment is permanently extinguished. The corporation may resume paying common dividends in future quarters provided current preferred dividends are maintained.

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Preferred Share Taxation: The Canadian Dividend Tax Credit Advantage

For Canadian individual investors holding investments in taxable (non-registered) accounts, preferred shares offer an extraordinary structural tax advantage over bonds, debentures, and guaranteed investment certificates (GICs).

The Mechanism: Gross-up and Dividend Tax Credit (DTC)

Under the Canadian Income Tax Act, interest income is taxed at the taxpayer's full marginal income tax rate (100% inclusion). In contrast, eligible dividends paid by Canadian public corporations are eligible for the Dividend Tax Credit (DTC) system, designed to eliminate the double taxation of corporate earnings:

1. The actual cash dividend is grossed up by 38% to reflect the pre-tax corporate profit earned by the corporation.
2. Personal income tax is calculated on the grossed-up amount at the investor's federal and provincial marginal brackets.
3. The investor then deducts a federal Dividend Tax Credit (approx. 15.02% of the grossed-up dividend) and a corresponding provincial Dividend Tax Credit directly from total taxes payable.

Comparative Tax Illustration (Top Marginal Bracket)

Consider an Ontario investor in the highest marginal tax bracket (approx. 53.53% on interest vs. 39.34% on eligible Canadian dividends):

Key Insight: Even though the preferred share offered a lower pre-tax nominal yield (5.00% vs. 6.00%), it generated more after-tax spendable income than the fully taxable corporate bond. For this reason, high-net-worth Canadian retail investors heavily utilize preferred shares in taxable non-registered accounts.

Corporate Holding Company Advantage

Under Section 112 of the Income Tax Act, dividends received by a Canadian taxable corporation from another taxable Canadian corporation are generally deductible in computing taxable income. As a result, corporate investors often pay little or no regular tax on these dividends (private corporations may owe a refundable Part IV tax), which makes preferred shares popular for corporate cash management.

Registered Account Suitability Warning

• Non-Registered Accounts: Highly suitable. The investor captures the full benefit of the Dividend Tax Credit.
• Registered Accounts (RRSPs, RRIFs, TFSAs): Suboptimal for the DTC. Inside registered accounts, all investment income grows tax-sheltered, meaning the Dividend Tax Credit is completely wasted. When funds are eventually withdrawn from an RRSP or RRIF, all distributions are taxed as 100% regular income, forfeiting the dividend's preferential tax status.

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Capital Structure Comparison Matrix

The following matrix contrasts the essential investment features across corporate debt, preferred shares, and common shares in Canada: