Difference between cumulative and non-cumulative preference shares?

Cumulative preference shares accumulate unpaid dividends, prioritising their payment over equity shareholders. Non-cumulative preference shares do not accumulate dividends; missed dividends are lost.

How are cumulative preference shares taxed?

Dividends from cumulative preference shares are generally taxed as "Income from Other Sources". In India, they are taxed at your applicable income tax slab rate, and the company may deduct TDS (Tax Deducted at Source) before payout.

Can companies skip dividend payments on cumulative preference shares?

Yes, companies can skip dividend payments during unprofitable periods or financial distress. However, these unpaid dividends accumulate on the balance sheet and must be settled in full before any dividends can be paid to equity shareholders.

Are there guaranteed returns with cumulative preference shares?

No, returns are not strictly guaranteed because dividends can only be paid out of profits. If a company stays unprofitable indefinitely, dividends may never be paid. However, they are safer than equity because the right to the income persists until profits are available.

What is the difference between cumulative and non-cumulative preference shares?

Cumulative preference shares accumulate unpaid dividends as "arrears," prioritising their payment over equity shareholders in future profitable years. Non-cumulative preference shares do not accumulate dividends; if a dividend is missed in a given year, the entitlement to that specific payout is lost forever.

Cumulative Preference Shares: Meaning with Examples |Angel One

Businesses raise capital through the issuance of various types of shares. Among these are preference shares, which have different rules. Cumulative preference shares are a type of preference share, where holders are given predetermined dividends and preference over ordinary shareholders.

Additionally, any unpaid dividends for cumulative preference shares are accumulated and paid at a later date. This aspect attracts investors who want a stable income. However, understanding the operation of cumulative preference shares is crucial, as it helps investors make informed decisions.

Key Takeaways

Cumulative preference shares provide fixed dividends and priority over equity shareholders in dividend payments and liquidation.

If a company skips dividends, the unpaid amounts accumulate as arrears and must be cleared before equity dividends.

These shares offer stable income potential but usually carry limited voting rights and fixed returns.

Investors gain dividend security, though payments still depend on the company generating sufficient profits.

What Are Cumulative Preference Shares?

Cumulative preference shares contain all the features and benefits of ordinary preference shares, such as entitlement to higher dividend payouts, preference in payment of dividends, and preference in payment over equity shares during the liquidation of the company.

In short, cumulative preference shares are regular preference shares with one additional benefit. The extra advantage here is that the holders of these shares have the right to receive dividends even if the issuing company has missed out on paying them in the past.

Sometimes, companies might not be able to generate profits due to a number of reasons. This lack of profits may force them to defer dividends for a certain period of time. Even under such a situation, cumulative preference shareholders retain the right to receive these "dividends in arrears," unlike equity shareholders.

Under the Companies Act, 2013, if dividends remain unpaid for two years or more, cumulative preference shareholders also gain the right to vote on all resolutions placed before the company. If you still haven’t gotten a clear understanding of the concept, here’s a cumulative preference shares example to better drive the point home.

Cumulative Preference Shares - An Example

To understand cumulative preference shares, consider a simple example. A company issues preference shares with a face value of ₹100 and promises a 10% yearly dividend. Investors, therefore, expect ₹10 per share each year. Suppose the company faces weak business conditions for two years and cannot distribute dividends.

During this period, the dividend remains unpaid. Because these are cumulative preference shares, the unpaid dividend does not disappear. Instead, it accumulates as dividend arrears. When the company returns to profit in the third year, it must first clear the unpaid dividends for the previous two years. Only after paying these arrears can the company distribute dividends for the current year. Equity shareholders receive dividends only after these obligations are fully settled.

Advantages of Cumulative Preference Shares

Now that you’ve seen the cumulative preference shares example, let’s move on to the various advantages that these shares offer to both the investors and the issuing company. Here’s a brief glimpse at some of the benefits that come with these shares.

Investors get to enjoy a fixed rate of dividend that is usually higher when compared with regular equity shareholders.

Cumulative preference shares get preference over equity shares with respect to dividend payouts as well as claims during liquidation.

Cumulative preference shares don’t lose out on the dividends if the company fails to pay them. The unpaid dividends keep accumulating as "dividends in arrears" till the company is legally required to clear them before paying any equity dividends.

For the issuing company, these shares allow for raising capital without diluting voting control, as these shareholders typically cannot vote on board matters.

Disadvantages of Cumulative Preference Shares

While cumulative preference shares offer several benefits, they also come with certain drawbacks:

Fixed Dividend Rate: The dividend rate is fixed and does not increase with the company’s profitability, potentially resulting in lower returns compared to equity shares during high-profit periods. Additionally, under the New Tax Regime, these dividends are fully taxable at the investor's applicable slab rate.

Conditional Voting Rights: While shareholders generally do not have voting rights, under Section 47 of the Companies Act 2013, they gain the right to vote on all resolutions if dividends remain unpaid for a period of two years or more.

Dividend Payment Obligation: The accumulation of unpaid dividends creates a mounting financial liability that can strain the company's balance sheet, especially if the company faces prolonged financial difficulties.

Potential Dilution: For convertible cumulative preference shares, converting these into equity can dilute the ownership and Earnings Per Share (EPS) of existing equity shareholders.

Limited Capital Appreciation: Preference shares generally do not appreciate as much as equity shares and often face lower liquidity in the secondary market, limiting potential capital gains for investors.

Missed Payments with Cumulative Preference Shares

One of the characteristics of the cumulative preference shares is the treatment of missed dividends. In case of non-payment by a company, the dividends will accumulate in the form of arrears every year until the company makes a profit again. Once profits resume, the firm has to settle the cumulative preference shareholders initially with the arrears they are owed.

Equity holders are only paid dividends after settling these obligations. This structure offers an additional defence of preference shareholders. Although they are allowed to pay their dividends later, they still have the right to dividends. Nevertheless, investors cannot forget that payment will be provided if the company makes a sufficient profit.

The biggest difference is in the treatment of dividends. The unpaid dividends accumulate in cumulative preference shares and should be paid before ordinary shareholders are paid dividends. In non-cumulative preference shares, missed dividends do not add up; a dividend that has been omitted cannot be repaid at some time in the future.

Both cases are normally fixed dividend paying instruments that are superior to ordinary shareholders, although cumulative preference shares have greater protection in instances where a companies earnings are volatile.

Conclusion

Cumulative preference shares are a great way for companies to secure funding for their operations. Not only does issuing these shares give companies some flexibility, but it also doesn’t dilute the ownership or control. That said, here’s something that you should note. The dividend rate for cumulative preference shares is usually slightly lower than that of regular preference shares due to the unpaid dividends getting accumulated instead of lapsing. Learn a free stock market course online at Smart Money with Angel One.

Cumulative Preference Shares