6.2 Interest on share capital
All three types of society are allowed to pay interest on members’ share capital. This sub-section applies only to co-operative and community benefit societies. Interest on share capital in charitable community benefit societies is subject to separate guidance produced by the Charity Commission and The Scottish Charity Regulator (see Section 6.5).
The FCA’s new registration guidance, published in November 2015, places two requirements on societies: the maximum rate of interest paid on shares is declared in advance of the period for which it is intended to be paid, whether in its rules or elsewhere” and “the declared maximum rate of interest is the lowest rate sufficient to obtain the necessary funds from members who are committed to furthering the society’s objects”.
The Co-operative and Community Benefit Societies Act 2014 does not require societies to state a maximum interest rate on share capital in their rules. However, most of the model rules suitable for community share offers do state a maximum rate. Typically, this is expressed as “2% above bank base rates”, with some model rules adding, “or 5%, whichever is the greater”. One set of model rules says share interest rates “will not exceed the highest rate for fixed term business lending published by the Co-operative Bank”.
Some model rules do not address the matter of share interest rates. If a society does not declare a maximum rate in its rules, the FCA expects it to declare a maximum rate elsewhere, presumably in its share offer documents, well in advance of any share interest being paid.
The FCA offers no guidance on how a society might determine the lowest rate of share interest that will be sufficient to obtain the necessary funds, or how the FCA will determine whether a society has breached this guidance. This suggests that the FCA considers this to be a matter particular to the circumstances of each society. This is supported by historical evidence, which shows there is a wide range in the share interest rate policies of societies. In 2015 the CSU analysed 192 share offer documents, published between 2009 and 2014. It showed a wide range of share interest rate policies, from societies that declared they would never pay interest on share capital (14% of the sample), through to societies that were aspiring to pay share interest rates in excess of 7.5% per annum (10% of the sample), including a small number of societies that were aspiring to pay in excess of 10% share interest per annum.
Faced with the difficulties of proving what the lowest rate of interest would be for a share offer, the only reliable alternative is for a society to compare it share offer rates with the commercial borrowing rates for the same investment proposition. If members and applicants are prepared to accept a rate the same as, or below, the commercial rate, this would prove that members are committed to furthering the objects of the society ahead of their own financial interests. This is reinforced by the fact that member shareholders have far less security than a commercial lender. Many societies do make contingent funding arrangements when planning a share offer, in case the offer fails to meet its targets. So the alternative commercial cost of capital will be known to most societies, and could be used as a basis for establishing the maximum share interest rate.
Interest on share capital should never be treated as a profit distribution. Instead, share interest should be treated as a discretionary operating expense, payable only if the society can afford to do so, having taken into account the other liabilities of the society, and the need for reinvestment in the society. The FCA makes it clear that a society should not pay an interest rate above the declared maximum rate, even if the society has made above expected profits, or has paid below the maximum rate in previous years.
Taken together, the FCA guidance is that a society should declare a maximum rate of share interest, in its rules and/or in its share offer document. It should only commit to paying up to this maximum share interest rate when the financial position of the society is known, and that it is satisfied that it can afford to pay the proposed rate without creating liabilities for other creditors, taking into account the society’s terms and conditions for the withdrawal of share capital, and the other uses of profit proposed by the society. As a matter of good practice, the management committee should propose a share interest rate for the financial year under consideration at the Annual General Meeting of the society, especially if the rate proposed is less than the declared maximum rate of share interest. The reasons for proposing this lower rate should be set alongside proposals for the use of profit (see Section 3.2.12). In the case of co-operative societies, one of the proposed uses of profit may be to pay members a dividend based on their transactions with the society, a matter covered in the next section.
Apart from interest rates, there are a number of other matters to consider when determining a society’s policies on interest payments. Many societies credit interest payments to members’ share accounts rather than sending out interest payment cheques. This increases the amount of share capital in the society, and improves capital liquidity if the money is not tied up in fixed assets.
Interest on share capital is normally paid gross of personal income tax. It is the responsibility of members to inform HMRC of any interest on share capital paid to them or credited to their share account. This should be borne in mind by societies when devising schemes to allow members the option of waiving interest on share capital or donating it to a good cause. Even though the member does not receive the interest, they may still be liable for income tax on that payment.
A society with more than one class of share may pay different rates of interest, if doing so serves the aims of the society. For example, a society may issue a new class of share capital to finance a wholly-owned subsidiary, with all the risk borne by this new capital. In order to attract this capital, it may be necessary to offer a different interest rate from that applicable to other shares in the society.
Some societies may be financed by members’ loans in addition to members’ share capital. In such cases it is usual for a society to reflect the differences in exposure to risk by setting a lower rate of interest on the loan capital than the share capital. Even if the loans are unsecured and exposed to the same risks as share capital, a society should not pay a higher rate of interest on loans than on shares. The only exception would be if the society had grounds for believing that it would be unable to attract additional capital unless it offered a higher rate of interest on loan capital.
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