Example:
A company issues redeemable preference shares on 15 August 2010 with a face value of $2 each. These shares will be redeemed for their face value after eight years, or earlier if a takeover offer is made and accepted by the board of the company. Dividends will be paid annually at 7.25% of the issue price at the same time as dividends on ordinary shares are paid. The company is not permitted to pay a dividend on its ordinary shares unless and until all arrears of dividends on the redeemable preference shares have been paid.
End of exampleThe following steps determine if it is an equity interest
Equity test step 1: is the interest an equity interest?
As the interest is in the form of a share, it is an equity interest unless it is a debt interest.
Debt test step 1: is there a scheme?
There is a scheme in the form of an arrangement between the issuing company and the holder.
Debt test step 2: is the scheme a financing arrangement?
The contract in respect of redeemable preference shares is a scheme that is an arrangement entered into to raise finance for the entity.
Debt test step 3: does the issuing entity receive a financial benefit under the arrangement?
The issuing company receives a financial benefit under the arrangement. The value of the benefit is the price the holder paid for the preference shares – namely, $2.
Debt test step 4: does the issuing entity have an effectively non-contingent obligation to provide a financial benefit?
The issuing company does not have an effectively non-contingent obligation to pay an annual dividend because the payment of the dividends is contingent upon the availability of profits of the issuer. However, the issuing company has an effectively non-contingent obligation to repay the issue price on redemption.
Debt test step 5: is it substantially more likely than not that the financial benefit to be provided will be at least equal to or exceed the financial benefit received?
The valuation of the benefits is to be in nominal terms because the performance period is within 10 years. The value of the benefit received by the company at issue date is the price of the security – namely, $2. The value of the financial benefit to be provided under the scheme is the return of the principal amount of $2.
The $2 future financial benefit provided by the company is equal to the $2 it received, so the interest meets the debt test.
Tiebreaker rule
The interest meets both the equity and the debt tests. Therefore, it is characterised as debt.