8.3.3 Why Investors Buy Preferred Shares

Why Investors Buy Preferred Shares

Preferred shares are attractive primarily to income-oriented investors due to their unique benefits.**

Reasons to Invest in Preferred Shares

Dividend Tax Credit

One significant advantage is the accessibility of the dividend tax credit. For Canadian individual investors, the dividends received from preferred shares may be eligible for this tax credit. This credit can substantially reduce the individual’s tax liability on dividend income, making preferred shares a more appealing option than other investment forms, such as bonds or regular interest-bearing accounts.

Income for Conservative Investors

Conservative individual investors often look for stable and predictable income streams. Preferred shares generally offer a fixed dividend which provides a reliable source of income. Compared to common shares, preferred shares usually deliver higher dividend yields and maintain precedence in payment distribution, presenting a safer alternative for conservative investors.

Institutional Investors

Institutional investors, such as pension funds and mutual funds, are also drawn to preferred shares due to their preferential tax treatment. For these institutions, the ability to minimize tax liabilities while earning stable income is critical. Moreover, factors like credit rating and yield are closely analyzed to match fund strategies and risk profiles.

Corporate Investment Strategy

Furthermore, Canadian corporations also invest in preferred shares, reaping benefits from the favorable tax laws. When one Canadian taxable corporation pays dividends to another, these dividends are generally tax-exempt in the hands of the receiving company. This aspect allows corporations to consider preferred shares a tax-efficient investment for surplus cash, avoiding the tax implications associated with debt interest.

Comparing Debt Interest to Dividends

One core difference between debt instruments and preferred shares lies in the tax treatment of returns. Debt interest is typically taxed fully as ordinary income for both individuals and corporations. Conversely, dividends, especially from preferred shares, benefit from tax relief measures, making them more tax-efficient.

Upcoming Topics

To gain a deeper understanding of the nuances of taxation for dividends and preferred shares, a more thorough discussion will be provided in Volume II of this course, covering broader aspects of investment tax strategies.

Key Takeaways

• Preferred shares are primarily purchased by income-focused investors.
• Individual investors benefit from the dividend tax credit, decreasing overall tax liabilities on dividend income.
• Institutional investors gain from the preferential tax treatment, enabling a reduction in taxable income from dividends.
• Canadian corporations favor preferred shares due to the tax-exempt status on intra-corporate dividends.
• The taxation of debt interest vs. dividends underlines the benefits of preferring dividend income over interest income from debt instruments.
• Detailed taxation topics are reserved for further discussion in Volume II.

Frequently Asked Questions (FAQs)

Q: What is the dividend tax credit?

A: The dividend tax credit is a federal provision that reduces the taxable income on dividends received by Canadian residents, making dividend income more tax-efficient compared to interest income.

Q: Why are preferred shares considered safe investments?

A: Preferred shares are safer due to their fixed dividend payments and higher claim priority over common shares in the event of liquidation.

Q: How do institutional investors benefit from investing in preferred shares?

A: Institutional investors benefit from the preferential tax treatment of dividends, which can result in lower taxable income compared to other investment forms.

Q: Why do Canadian corporations invest in preferred shares?

A: Canadian corporations invest in preferred shares to utilize the tax-exempt status of dividend income when exchanged between taxable Canadian companies, making it a strategic and tax-efficient investment.

Q: How are debt interest and dividends from preferred shares taxed differently?

A: Debt interest is taxed as ordinary income, generally at a higher rate. In contrast, dividends, particularly from preferred shares, enjoy more favorable tax treatment, reducing overall taxable income.

Glossary

• Dividend Tax Credit: A non-refundable credit that allows Canadian residents to reduce taxes on dividend income from Canadian companies.
• Institutional Investor: A non-individual entity such as a pension fund or mutual fund that makes substantial investments in securities.
• Debt Interest: The earnings paid by a borrower to a lender for the use of borrowed money, considered taxable income.
• Taxable Canadian Corporation: Any Canadian corporation subject to corporate tax laws and regulations.

Diagrams

    graph TD
	  A[Investors] --> B[Preferred Shares]
	  B --> C[Individual Investors]
	  B --> D[Institutional Investors]
	  B --> E[Canadian Corporations]
	  C --> F[Dividend Tax Credit]
	  D --> G[Preferential Tax Treatment]
	  E --> H[Tax-Exempt Dividends]