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8.3.3 Why Investors Buy Preferred Shares

This section explores the reasons why investors, including both individual and institutional investors, buy preferred shares, highlighting benefits such as dividend tax credits and preferential tax treatment.

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]

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## What is a primary reason conservative individual investors purchase preferred shares? - [ ] To benefit from capital appreciation - [ ] To engage in high-risk investments - [x] To take advantage of the dividend tax credit - [ ] To leverage their portfolios > **Explanation:** Conservative individual investors seek income and prefer the dividend tax credit provided by preferred shares. ## Why are institutional investors attracted to preferred shares? - [ ] Preferred shares have high growth potential - [ ] They are less liquid than common shares - [x] They receive preferential tax treatment - [ ] They are always traded at premium > **Explanation:** Institutional investors are drawn to preferred shares because of their preferential tax treatment. ## How are dividends treated when paid from one taxable Canadian company to another similar company? - [ ] They are taxed at a high rate - [ ] They are treated as capital gains - [x] They are not taxable in the hands of the receiving company - [ ] They incur withholding tax > **Explanation:** Dividends paid from one taxable Canadian company to another are not taxable to the receiving company. ## Which investors are primarily targeted by preferred shares? - [ ] Speculative investors - [ ] Younger investors seeking growth - [x] Income-oriented investors - [ ] Foreign investors > **Explanation:** Preferred shares primarily target income-oriented investors looking for stable dividend payments. ## How does purchasing preferred shares benefit a taxable Canadian company? - [ ] Provides high growth potential - [x] Dividends received are not taxable - [ ] Guarantees capital preservation - [ ] Ensures liquidity > **Explanation:** Taxable Canadian companies benefit by receiving dividends on preferred shares tax-free from similar companies. ## How is dividend income treated differently from debt interest for resident taxable Canadian companies? - [ ] Debt interest is tax-deductible - [x] Dividend income is not taxable, but debt interest is - [ ] Both are treated as capital gains - [ ] Both are subject to withholding tax > **Explanation:** Dividend income is not taxable for resident taxable Canadian companies, whereas debt interest is taxable. ## What is one significant reason preferred shares are not as attractive to growth-focused investors? - [x] They primarily offer fixed dividend income rather than capital gains - [ ] They can be easily liquidated - [ ] They have high volatility - [ ] They are not subject to any taxes > **Explanation:** Growth-focused investors may find preferred shares less attractive because they focus on fixed dividend income instead of capital gains. ## Which of the following does not explain why institutional investors might prefer preferred shares? - [ ] Preferential tax treatment - [ ] Income generation - [x] High levels of liquidity - [ ] Mitigated tax concerns > **Explanation:** While preferred shares offer tax benefits and income, they do not necessarily guarantee high liquidity. ## How does the dividend tax credit benefit individual investors? - [ ] It converts dividends into capital gains - [x] It reduces the amount of tax payable on dividend income - [ ] It defers tax payments - [ ] It exempts dividends from taxes > **Explanation:** The dividend tax credit reduces the amount of tax that individual investors must pay on their dividend income. ## Why might preferred shares not be an ideal investment for foreign investors? - [ ] They provide high returns - [ ] They are very volatile - [ ] They can be quickly sold off - [x] They do not benefit from the dividend tax credit > **Explanation:** Foreign investors may find preferred shares less attractive as they do not benefit from the Canadian dividend tax credit.

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Tuesday, July 23, 2024