Redemption of Preference Shares in a Joint Stock Company

In this article we will discuss about the Redemption of Preference Shares in a Joint Stock Company.

Section 80 of the Companies Act allows a company, if authorised by its Articles of Association, to issue preference shares which can be redeemed by the company according to the terms of the issue; but the following legal restrictions apply to such redemption:

1. No shares can be redeemed unless they are fully paid, i.e. partly paid shares must become fully paid before they can be redeemed.

2. Shares can be redeemed only out of profits of the company which would otherwise be available for dividend or out of the proceeds of a fresh issue of shares made for the purpose of the redemption.

Both sources can be used simultaneously, i.e. a part of the amount needed for redemption may be collected by issue of new shares and the balance by using the profits that would otherwise be available for distribution of dividends.

3. To the extent that the shares are redeemed out of profits, Capital Redemption Reserve Account must be credited, debiting the Profit & Loss Account, General Reserve or other accounts showing profits otherwise available for distribution of dividends.

Capital Redemption Reserve Account can be utilised for the issue of folly paid bonus shares to the members of the company; otherwise it must be maintained intact unless sanctioned by the Court, the provisions of the Companies Act relating to the reduction of share capital of a company apply to Capital Redemption Reserve Account as if it were paid up share capital of the company

4. Before the shares are redeemed, the premium, if any, payable on redemption must be provided for out of the profits of the company or out of Securities Premium Account.

Purpose of Legal Restrictions on Redemption of Preference Shares:

The purpose of all the legal restrictions on redemption of preference shares is not to allow redemption of preference shares affect adversely the security available to the creditors of the company.

Consider the following balance sheet of a joint stock company:-

The amounts in General Reserve and Profit & Loss Account cannot be depended upon because they can disappear at any time by distribution of dividends.

On the other hand, uncalled amount on preference share has been included in the amount of security available to creditors because in case of winding up, if the amount otherwise available is insufficient to make full payment to the creditors, the liquidator will call upon the preference shareholders to pay the uncalled amount and he will use this amount also to meet the creditors’ claim.

The purpose of imposing the restriction that the preference shares must be fully paid before they can be redeemed is to ensure that the uncalled amount on preference shares is not lost to creditors by way of security due to redemption.

The fact that the security available to creditors remains intact when preference shares are redeemed out of proceeds of a fresh issue of shares made for the purpose is obvious. But it should be understood that even when the company redeems preference shares out of profits otherwise available for dividends, the effect is indirectly the same.

In this case, the amount of preference shares to be redeemed is transferred from accounts showing divisible profits to Capital Redemption Reserve Account which can be used only for one purpose, namely issue of folly paid bonus shares.

Section 80(d) of the Companies Act makes it clear that the provisions of the Act relating to the reduction of the share capital of a company shall apply to the Capital Redemption Reserve Account as if it were paid up share capital of the company.

If in the example given earlier, the company makes a final call of Rs 20 each on preference shares bringing up the paid up preference share capital to Rs 1,50,000 and then redeems all the preference shares at par, transferring Rs 1,50,000 from General Reserve to Capital Redemption Reserve Account, the balance sheet of the company will be as follows:—

Interpretation of ‘Proceeds of a Fresh Issue’:

In the light of the purpose of law in imposing restrictions on redemption of preference shares explained earlier, the correct interpretation of the phrase ‘proceeds of a fresh issue of shares’ used in section 80 of the Companies Act can be made. The word ‘proceeds does not include the amount of the premium if shares are issued at a premium but stands for the actual amount received if shares are issued at par or at a discount.

When the shares are issued at a premium, the amount of securities premium received cannot be depended upon as security to creditors because the amount can be used by the company in writing off certain expenses specified in section 78 of the Companies Act which does not mention redemption of preference shares as one of the purposes’ for which securities premium can be used.

Of course, securities premium can be used for buy-back of shares but for that, certain conditions have to be fulfilled and hence, that is a special case.

Capital Redemption Reserve Account:

As only those profits which are otherwise available for dividends can be used for redemption of preference shares, transfer to Capital Redemption Reserve Account should be made only from such accounts as represent divisible profits.

Amounts in Securities Premium Account, Forfeited Shares Account, Profit Prior to Incorporation Account and Capital Reserve Account must not be transferred to Capital Redemption Reserve Account.

The credit balances in Profit & Loss Account, General Reserve, Dividend Equalization Reserve are the examples of the balances available for distribution of dividend and hence for transfer to Capital Redemption Reserve Account.

Illustration 1: 

A company has 40,000 12% redeemable preference shares of Rs 100 each, fully paid. The company decides to redeem the shares on December 31, 2011 at a premium of 5 per cent.

The company makes the following issues:

(a) 1,00,000 equity shares of Rs 10 each at a premium of 10 per cent.

(b) 10,000 14% debentures of Rs 100 each.

The issue was fully subscribed and all the amounts were received. The redemption was duly carried out. The company has sufficient profits. Give journal entries.

Illustration 2:

The following notes to Ronnie Limited’s Balance Sheet are given to you: