A guide to how preference shares work and why the tax treatment is not always what you’d expect.

By Maria Paradisis, Director of Tax Advisory at BlueRock.

Why Preference Shares Matter for Scaling Tech Companies

If you’ve raised capital, or you’re about to, you’ve probably come across preference shares. They show up in term sheets, shareholder agreements and group structures, but what they mean for your cap table and your tax position is often misunderstood.

In this piece, I’ve pulled together the clearest explanations I hear from tax and corporate accounting specialists and translated them into practical takeaways for tech founders and CFOs.

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What are Preference Shares Used for in the Real World?

Preference shares sit between ordinary equity and debt. They give investors economic priority, things like first access to dividends and first return of capital on exit, without the legal form of a loan. For tech founders, they’re most commonly encountered when raising capital from investors who want downside protection but don’t want to be lenders on paper.

The most common scenarios you’ll encounter as a scaling business:

• Capital raising without losing control — investors get priority dividends and capital preference on exit, but often limited or no voting rights. Founders retain the wheel.
• Quasi-debt funding —particularly in private equity and family group structures, redeemable or fixed-rate preference shares are used to replicate a loan economically, without the covenants that come with formal debt.
• Waterfall engineering —preference shares can hard-wire return hurdles, like an IRR or fixed yield, and manage how exit proceeds are split between investor classes in an M&A transaction.
• Founder or employee instruments— convertible preference shares are sometimes used in early-stage structures to defer valuation and convert into ordinary equity on a liquidity event.
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The Critical Tax Question: is this Debt or Equity?

One point I want to underline: calling something a “share” doesn’t determine how it’s taxed. Under Australian tax law, the substance of the instrument is what counts.

Why do people get confused about how preference shares are taxed, and what’s the framework the ATO actually uses?The confusion comes from assuming that because something is legally a share, it’s taxed like a share. That’s not how it works. Under Division 974 of the Income Tax Assessment Act, every instrument is tested against a debt vs equity framework. If a preference share looks and behaves like debt, meaning there’s an obligation to return the investor’s money, it’s taxed as debt.

Debt Interest, When it’s Taxed Like a Loan

A preference share is treated as a debt interest for tax if there’s an effectively non-contingent obligation to return at least the issue price, and it’s substantially more likely than not that the investor gets their money back.

This commonly occurs with redeemable preference shares, fixed redemption dates, or guaranteed returns. The tax consequences are significant:

• Returns are treated like interest income
• Payments may be tax deductible to the issuer
• Payments are not frankable
• The investor is taxed on interest income

Equity Interest, When it’s Taxed Like a Share

If the preference share fails the debt test, it’s treated as equity. The tax treatment flips:

• Returns are dividends
• Dividends are not deductible to the company
• Dividends may be franked
• The investor can access franking credits and potentially CGT concessions, subject to holding period rules
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Dividends, Redemptions and Conversions

What happens from a tax perspective when a preference share pays a dividend, gets redeemed, or converts into ordinary shares? Each event has a different tax outcome, and it’s important not to conflate them. Dividends are assessable income to the holder but they’re only frankable if the instrument is classified as equity for tax.

Redemption is generally a return of capital up to the issue price, with any excess potentially triggering capital gains. And conversion into ordinary shares? That’s usually not a CGT event. The cost base simply rolls into the ordinary shares. That point matters in startup and PE structures where conversion is part of the exit plan.

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The Traps — What Can Catch You Off Guard

What are the most common tax traps you see founders and CFOs fall into with preference shares? The biggest one is mischaracterisation. Founders structure something as equity often to avoid the optics of debt, but the instrument behaves exactly like a loan. The ATO sees through the label. Division 7A is another trap, particularly where preference shares are held by shareholders of a private company. If the returns aren’t genuine dividends or interest, you can end up with deemed dividends at the worst possible time. Related-party structures carry the highest anti-avoidance risk. If it looks like you’ve engineered a preferential return primarily fortax, expect ATO scrutiny.

The ATO’s position is clear: economic substance trumps legal form. If an instrument is designed to extract profits tax-effectively while masquerading as equity, it will be re-characterised.

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Structuring at a Glance — Matching Objectives to Design

Here’s a practical summary of how preference share design maps to commercial objectives and tax outcomes:

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What’s Often Missing From the Conversation

If you’re reviewing a term sheet or tidying up an existing structure, these are the items I’d want on one page before you sign anything:

• Classification risk (Div 974):Is there any effectively non-contingent obligation to repay issue price, or a fixed redemption date that makes it more likely than not the investor gets repaid?
• Return mechanics: Are returns cumulative/non-cumulative, compounding, payable only if declared, and are there any step-ups after a date?
• Exit waterfall: Exactly how do liquidation preferences, participation, caps and conversion options work on a sale or winding up?
• Franking position: If the instrument is equity for tax, can or should returns be franked, and are there holding period or integrity rules in play for the investor?
• Company law and solvency: Are redemptions or buy-backs permitted under the constitution and Corporations Act, and what are the solvency constraints?
• Related-party / Division 7A: If holders are shareholders, or associates, of a private company, does the structure create deemed dividend risk or anti-avoidance exposure?
• Accounting and covenants: How will the instrument be classified for accounting, liability vs equity, and will it affect EBITDA, net debt, or any financing covenants?
• Documentation: Do the constitution, subscription agreement, SHA and cap table all describe the same rights, with no “term sheet drift”?
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Get Expert Advice on Preference Shares

Preference shares are a commercially flexible funding tool. Tax outcomes depend entirely on economic substance, not labels. Get the design wrong and you could end up with denied deductions, unexpected income, or ATO scrutiny.

Whether you’re raising capital, restructuring your group, or planning an exit, the structure of your preference shares needs to be deliberate and advice-led from day one.

If you’re mid-raise and want to sanity-check Div 974 and Div 7A risk, get in touch with the tax experts at BlueRock.

Note: This is general information only. Preference share outcomes are extremely fact-dependent, so it’s worth getting tax, legal and accounting aligned before you lock the terms.