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HMRC internal manual

International Manual

Thin capitalisation: practical guidance: 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). This is because these shares may sometimes be regarded as equity and sometimes regarded as a financial liability (debt). How these financial instruments are accounted for may therefore affect thin cap financial ratios.

Requirements of IAS 32/FRS 25 and FRS 102

Under IFRS, Current UK GAAP and New UK GAAP, the question of whether preference shares are categorised as either a financial liability or as an equity instrument will be determined according to their substance and the terms of the contract.

Preference shares having the substance of debt will be shown as a liability in the balance sheet and dividend payments to holders of the instrument will be accounted for as an interest expense in the profit and loss account. Preference shares with the substance of equity will be disclosed as an equity instrument and payments to holders of the instrument will be accounted for as an equity dividend and therefore as an adjustment to shareholders’ funds

For thin capitalisation purposes, it is therefore important to examine two things:

  • the terms of the 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 important information as to the underlying substance of those shares (that is, whether they are in substance debt or equity). However, the treatment of those preference shares for thin capitalisation purposes will depend crucially on how relevant shares will be viewed by a third party lender.

Consider the following examples:

Example 1

An entity has a 5 year loan that is being reviewed by HMRC for thin capitalisation purposes. It also has redeemable preference shares with a dividend of 5% that must be, paid annually, irrespective of the entity’s profits. The terms of the preference share contract do not permit the preference shares to be redeemed during the life of a loan.

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 an interest expense.

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 take account of the 5% preference share dividend when assessing the borrower’s ability to service debt.

Example 2

Redeemable preference shares have a dividend of 5% per year, but the dividend is not paid until the shares are redeemed, which is outside the term of a loan.

As above, the preference shares would be classified as a liability in the accounts, and the dividends as interest.

Since the cash flows that relate to the preference shares will not be paid during the loan term, a third party lender is likely to ignore these shares when assessing the borrower’s ability to pay its debts. In particular, 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 may concern a third party lender.

In this situation, it may be appropriate to adjust the accounts figures in order to arrive at the relevant amounts for thin capitalisation purposes.