What is a Cumulative Preference Share?
Cumulative preference shares offer an additional layer of security. Investors in this category enjoy the carry-forward of unpaid dividends and are settled before equity shareholders receive payouts.
In simpler terms, an unpaid dividend does not just disappear if a corporation is unable to pay it within a particular fiscal year. Rather, it builds up as arrears, which must be paid in full by the company before any profits are distributed to regular shareholders.
Cumulative preference shares sit higher in the capital structure than equity shares, as such preference shareholders have a greater claim to the company’s distributable earnings. Although cumulative preference shares receive preference over equity shares, they remain below creditors in the event of liquidation.
The dividend rate on cumulative preference shares is usually predetermined and represented as a percentage of the share’s face value. No matter how profitable the business is in a given year, this set rate stays the same.
How Cumulative Preference Shares Work
Understanding how the stock market works and how businesses allocate their revenues is helpful in understanding how cumulative preference shares operate. When a company makes revenue, it can choose to either reinvest it or pay out dividends. The dividend amount for equity stockholders is variable and determined by the board, at its discretion. However, preference shareholders have a predetermined dividend rate that has been agreed upon and is expected to be upheld by the firm.
In the case of cumulative preference shares, an extra layer of protection is added. When a company is unable to pay its predetermined dividend in a given year, whether owing to poor financial performance or a deliberate choice to save funds, the obligation does not disappear. Instead, it accumulates. The shortfall is put to the arrears account, which must be settled before equity stockholders may receive dividends in subsequent years.
For example, suppose an investor holds cumulative preference shares with a fixed dividend of ₹10 per share per year. If the company skips this dividend for two consecutive years, the investor is owed ₹20 per share in arrears. In the third year, when the company returns to profitability and decides to pay dividends, it must first clear the ₹20 in arrears to cumulative preference shareholders, and only then may it pay dividends to equity shareholders.
Key Features of Cumulative Preference Shares
Understanding the defining characteristics of cumulative preference shares helps investors place them correctly within the wider landscape of types of shares. The following are their defining features.
- Fixed dividend rate: The dividend rate on cumulative preference shares is established at the time of issuance and is independent of the company’s performance.
- Accumulation of unpaid dividends: Any dividend that is not paid in a given year is carried over as arrears. These arrears must be settled before equity owners get any payout since they build up over time.
- Priority over equity shareholders: Dividends, including all accrued arrears, must be paid to cumulative preference shareholders before equity shareholders.
- No voting rights: In most cases, cumulative preference shareholders do not have the right to vote at general meetings, unless their dividends have been in arrears for a specified period as defined in the company’s articles of association.
- Redeemable or irredeemable: Depending on the conditions of issue, cumulative preference shares may be structured as irredeemable (perpetual in nature) or redeemable (repaid after a certain period).
- No guaranteed payment: The corporation is not legally obligated to pay dividends annually, even with the accumulating function. The obligation is deferred; it must be satisfied before equity dividends are paid, but the corporation is not subject to a strict deadline.
Dividend Arrears Explained (Most Important Concept)
What really sets cumulative preference shares apart from their non-cumulative counterparts is the idea of dividend arrears, which is essential to comprehending this share category. Familiarity with dividend income from stocks and how businesses handle their profit distribution requirements is crucial to completely comprehend this idea.
The accumulated unpaid dividends owing to cumulative preference stockholders that have not been paid in prior years are referred to as dividend arrears. Each year that the company fails to pay or only partially pays the set dividend, the gap is added to the arrears. The arrears do not earn interest; they simply accumulate as a fixed liability on the company’s obligation to preference shareholders.
To give an example, let’s say a corporation has issued cumulative preference shares with an 8% dividend rate and a face value of ₹100. This implies that stockholders are entitled to ₹8 per share per year. The table below illustrates the amount of dividends actually paid.
| Year | Dividend Paid | Arrear |
| 1 | 0 | ₹8 |
| 2 | ₹4 | ₹4 |
| 3 | 0 | ₹8 |
| Total | ₹20 | |
In Year 4, the corporation must pay ₹20 per share in arrears to cumulative preference owners before paying dividends to equity shareholders.
Since dividends are only a liability after the board declares them, dividend arrears are usually included in the company’s financial statements as a note rather than as a liability on the balance sheet. When reviewing corporate reports, investors should be aware of this crucial accounting distinction.
Cumulative vs Non-Cumulative Preference Shares
The table below compares cumulative and non-cumulative preference shares.
| Particulars | Cumulative Shares | Non-Cumulative Shares |
| Unpaid dividends | Accumulated as arrears and paid later | Lapses permanently and are not repaid |
| Dividend security | Higher as dividends must be cleared first, before equity shares are paid | Lower as unpaid dividends are lost |
| Risk to investors | Lower | Higher |
| Dividend cost to the company | Higher over time if dividends are deferred | Limited to the current year only |
| Use case | Companies with variable but recoverable earnings | Companies with stable earnings |
In essence, if dividends on non-cumulative shares are unpaid, they do not accrue; rather, they lapse and are no longer payable in the next year. However, unpaid dividends on cumulative shares accrue and have to be repaid before equity share dividends are paid.
Cumulative Preference Shares vs Equity Shares
Understanding how cumulative preference shares differ from equity shares is just as crucial as comparing them to non-cumulative shares. The table below shows the difference between equity and preference shares of this category.
| Parameter | Cumulative Preference Share | Equity Share |
| Dividend type | Fixed, and arrears are accumulated | Variable, and declared at the discretion of the board |
| Dividend priority | Paid before equity shareholders | Paid after all preference shareholders |
| Voting rights | Generally absent | Present |
| Capital appreciation | Limited | High potential |
| Risk level | Lower | Higher |
| Claim in liquidation | Before equity, after creditors | Last in line, after creditors and preference shareholders |
Advantages of Cumulative Preference Shares
The advantages of cumulative preference shares are listed below.
- The cumulative preference share investors do not lose out on unpaid dividends.
- Cumulative preference shares are among the more dependable income-generating securities in the equity market segment because of their set dividend rate and accumulation characteristic.
- Cumulative preference shareholders are ranked higher than equity shareholders in the event of a corporate liquidation, providing a level of capital protection that equity shares do not.
- For investors who want equity market exposure without the full volatility of equity shares, cumulative preference shares can serve as a middle ground.
- The market’s perception of the firm may be positively impacted by the issuing of cumulative preference shares with a defined dividend rate, which can indicate investor-friendly governance.
Disadvantages of Cumulative Preference Shares
Like any investment medium, cumulative preference shares have some disadvantages, as discussed below.
- While arrears accrue, the corporation is under no legal responsibility to pay them by a specified date.
- Cumulative preference shareholders usually do not carry voting rights.
- Since these shares earn fixed dividends, even if the company earns higher profits, the dividend does not rise.
- Because cumulative preference shares pay a set dividend, increasing interest rates might reduce their relative appeal compared to other fixed-income choices on the market.
- Cumulative preference shares are often less liquid than equity shares on secondary markets.
Why Companies Issue Cumulative Preference Shares
From a business standpoint, cumulative preference shares fulfil certain strategic and financial objectives. Understanding how companies raise capital is critical to understanding why cumulative preference shares are issued.
- One main reason is that issuing preference shares does not dilute existing equity owners’ voting rights, unlike equity shares.
- Companies in the sectoral industries can issue preference shares as they offer flexibility in dividend payments, whilst providing fixed income and capital gains opportunities to investors.
- Companies may also issue cumulative preference shares as part of structured financing agreements or to satisfy regulatory capital requirements in specific areas, such as financial services.
Taxation of Preference Shares in India
The table below shows the capital gains and dividend tax on shares.
| Particulars | Taxability |
| Dividend earned by a resident | Applicable slab tax rate |
| Short-term capital gains | 20% if transferred on or after 23-07-2024 |
| Long-term capital gain | 12.5% without indexation if transferred on or after 23-07-2024 |
FAQ‘s
A cumulative preference share is a share that guarantees the investor that any unpaid dividends will not be forfeited. If the company misses a dividend payment in a given year, the unpaid amount is carried forward as arrears and must be paid out, along with any subsequent arrears, before the company can distribute dividends to ordinary equity shareholders.
Cumulative preference shares can be a good fit for investors who prioritise income stability over capital growth. The accumulation feature ensures that missed dividends are not permanently lost, which makes these shares more predictable than equity shares. However, they come with limitations such as no voting rights, limited upside potential, and no strict timeline for clearing arrears. Investors with a conservative risk profile and a preference for fixed income may find these shares suitable, provided they understand the trade-offs involved.
If a company is unable to pay the fixed dividend on cumulative preference shares in a given year, the unpaid amount is recorded as dividend arrears. These arrears carry forward and accumulate over successive years. The company is obligated to clear all outstanding arrears in full before it can pay any dividends to equity shareholders. The arrears do not earn interest; they simply continue to accumulate until the company has the distributable profits to clear them.
The key difference between cumulative and non-cumulative shares lies in how unpaid dividends are treated. With cumulative preference shares, any dividend that is not paid in a given year accumulates as arrears and must be cleared before equity shareholders receive any dividend. In the case of non-cumulative preference shares, unpaid dividends for a year are permanently forfeited, and the investor has no future claim on them. This makes cumulative preference shares more protective for investors, particularly in companies with fluctuating earnings.
Cumulative preference shares are relatively safer than equity shares within the same company, primarily because of their fixed dividend entitlement and priority over equity shareholders. However, they are not risk-free. The company is not legally bound to pay arrears by any specific date, and in the event of insolvency, preference shareholders are paid only after all creditors and debtholders have been settled. The degree of safety ultimately depends on the financial health and creditworthiness of the issuing company.
No, cumulative preference shares do not guarantee dividends in the strict sense. The company is not legally compelled to pay the dividend every year. What the cumulative feature guarantees is that any unpaid dividends will be preserved as arrears and must be settled before equity shareholders can receive dividends. The payment depends on the company having sufficient distributable profits and making the decision to declare dividends. In practice, this provides greater dividend security than equity shares, but it is not a guarantee.
Companies issue cumulative preference shares primarily to raise capital without diluting the voting rights of existing equity shareholders. This is particularly relevant for companies in cyclical industries where earnings fluctuate, as the deferral mechanism provides financial flexibility during lean periods. The fixed dividend and accumulation feature make these shares attractive to income-focused investors, broadening the pool of potential investors. Companies may also use them to meet specific financing or regulatory requirements.
Dividends earned by preference shareholders are taxed at the applicable slab rate in the hands of investors. In case of short-term capital gains, 20% tax rate is levied. While in the case of long-term capital gains, 12.5% tax rate is applied.
