Preferred split shares: Are they for you?

The kicker with preferred split shares is that you can get double the dividend you would normally get holding the same shares directly, or even more.

Among our recommended preferred shares, we include a section on preferred split shares. Here’s a primer on these securities: where they come from, how they work and where they belong in your portfolio, if at all. Our hope is that you’ll then be able to determine if preferred split shares deserve a place among your other investments.

To begin with, preferred split shares should not be considered as true preferred shares in the traditional sense. Traditional preferred shares give up the right to vote in exchange for a steady, fixed dividend and a prior claim on assets above common shares upon the dissolution of the underlying business.

Preferred split shares, on the other hand, are securities whose underlying interest is another security, not a business. Specifically, preferred split shares represent an investment in a split share corporation, which in turn invests in common shares. Preferred split shares, then, represent one of two interests in a bunch of common shares; the other interest in those common shares comes from the holders of what are called ‘capital shares’.

A typical split share setup

Let’s step back a bit, and look at how a split share corporation is set up. A split share corporation exists for a defined period of time. After being set up, it buys a big block of common shares, and then places those shares into a trust. The common shares may be all of one company, such as a block of Brookfield Asset Management Inc. shares (Partners Value Split), or they may be multiple companies, such as a portfolio of financial and utility stocks (Dividend 15 Split Corp.). The shares in the trust are referred to as portfolio shares, and the trust qualifies as a mutual fund trust for tax purposes.

Now, before we continue on, consider that the shares in the trust can generate two kinds of return. One, the shares could pay dividends. Two, the shares could increase in price. Simply put, the preferred split shareholders get all the dividends paid on the shares, and the capital split shares get all the capital gains. So really, a preferred split share is an interest in the future dividends paid on a bunch of common shares. So they are quite different from traditional preferred shares.

And so what the split share corporation does is sell interests in the trust to various investors, who either buy preferred split shares or capital shares. The corporation will also often list the two shares types on the Toronto Stock Exchange, so that getting in and out of them is made easier.

Where preferred split shares belong in a portfolio should be obvious by now. They have the income of a preferred share and the risk of a common share. You’d buy the preferred shares if you need to supplement your income, and your tax situation makes dividend income attractive relative to interest income. You’d hold them outside a registered plan to reap the tax benefits.

Pros and cons of splits

What’s the attraction? The kicker with preferred split shares is that you can get double the dividend you would normally get holding the same shares directly, or even more. How is that possible? It’s quite simple, really.

Two parties, the preferred split shareholders and the capital shareholders, finance the acquisition of the common shares in the trust. Let’s say they put up 50 per cent each. The preferred split shareholder only puts up 50 per cent of the money, but gets 100 per cent of the dividends. That doubles your yield. The capital shareholders, on the other hand, get 100 per cent of the capital gains.

Taxes are straight forward as well. The trust pays no tax, as it pays out all of its income in distributions each year. Investors get the dividend tax credit on the full dividends received.

Are there any downsides? Yes. First there is a limited life to these trusts. The preferred split shares will ultimately be redeemed, at the lower of par or the prevailing market price. Thus you can suffer a capital loss when the portfolio shares are sold. Secondly, there are management expenses collected by the corporation for managing the trust.

This is an edited version of an article that was originally published for subscribers in the March 12, 2021, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

Money Reporter, MPL Communications Inc.
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