Invest in preferreds, get tax break

The easiest way to grasp the concept of preferred shares is to think of them as bonds that pay dividends instead of interest. Of course, it’s not quite that simple, but it gives you the idea.

The advantage of collecting your payments in dividends is that you get a tax break. Interest is taxed as regular income.

Dividends, by contrast, get the benefit of the dividend tax credit, which reduces the amount you pay considerably.

The rationale for this is that corporations pay dividends to shareholders out of after-tax earnings. In other words, this is from money that has already been taxed once.

The dividend tax credit is supposed to eliminate double taxation. It doesn’t, of course. In fact, the credit has been watered down considerably over the years. But even in its present emasculated state, it still provides a better deal than straight interest income when the money is received oside a registered plan.

Big tax advantage
To give you an idea of the magnitude of this tax advantage, a top-bracket Ontario taxpayer paid a rate of 46.41 per cent on interest income received in 2001.

If the money had come as dividends instead, the rate would have been only 31.33 per cent.

The credit actually works most effectively for lower-income taxpayers. If you had taxable income of between about $12,000 and $30,000 in Ontario in 2001, your effective rate on dividend income would have been only 4.67 per cent. (

The rate will vary depending on where you live but the principle is the same across Canada.

Next page: Explaining common, preferred shares

Explaining common, preferred shares
Dividends are paid by common stock and preferred shares, or preference shares as they are more correctly known.

Preferreds (the commonly-used term) are actually something of a cross between a stock and a bond. As with bond interest, the dividend is usually (but not always) fixed. Payments are normally made quarterly.

Preferreds rank ahead of common stocks in the financial pecking order. This means that a company must pay all its preferred dividends first, including any which are overdue, before owners of common stock get a cent.

In the event a firm is wound up, preferred shareholders rank ahead of common stock owners, but behind bond holders in terms of asset distribution.

Normally, preferred shareholders have no voting rights in a company, whereas common stockholders do.

Preferreds like bonds
Although the price of preferreds will normally not vary as greatly as that of the common stock of the same company, these shares do carry the potential for a capital gain if interest rates decline. They also tend to fall in value when rates rise, in the same manner as bonds.

Like bonds, preferreds are rated as to safety by the national bond rating agencies.

The rating P-1 is the highest rating and safest.

The rating P-5 is the lowest and most risky.

Lower rated preferreds will usually offer a higher yield, perhaps much higher than normal. But you have to be very careful if you decide to invest in them. The low rating is a red flag; it means the company is likely in financial difficulty.

If you pick up the business section of the paper and come across a preferred share with an extraordinarily high yield, you can be sure there’s a good reason for it. No one gives away something for nothing.

From the book 6 Steps to $1 Million by Gordon Pape, published by Prentice Hall Canada.