Redemption of Preference shares & Distributable reserves

[Leo]

Hi,

There is something that I don't understand in terms of redemption of pref shares and its requirement to have sufficient distributable reserves in the UK.

Let's say that a company has zero distributable profit on day 1. The company issues 5m of pref shares mandatorily redeemable in 5 years.
The 5m is classified in liability.

At redemption, the entries are:
Dr: liability
Cr: Cash

However, in the uK, there are capital maintenance considerations, which results into:

Dr Retained earnings (distributable reserves)
Cr Capital redemption reserve
Cr Share premium

So, if the company hasn't realised any profit, the redemption will result into a negative distributable reserves of 5m, thus, making this operation unlawful?

Could someone shed some light on this please!

[JRSB]

If the shares are treated as liabilities, why does a capital redemption reserve and impact on retained earnings arise when repaid?

[Leo]

Please see tech 02 17

[JRSB]

That's a 173 page document about distributable reserves... I mean why would an instrument which is a liability impact retained earnings?

[Leo]

Have you seen the section about capital maintenance requirements?

[JRSB]

Yes I'm familiar with it but I don't understand the starting point of how your liability interacts with retained earnings or why it has anything to do with a capital redemption. However, I think we're miles apart!

[Leo]

there is an accounting entry Re.

Dr: Retained earnings
Cr: Capital redemption reserves
Cr: Share premium

[JRSB]

ok well perhaps before you even get to that point you have to default on the interest since the preference share dividend (accounted as interest) requires distributable reserves too

[Leo]

Yes.

[JRSB]

In which case maybe there's no solution other than to be careful before issuing that kind of instrument?