BIR Ruling

July 9, 1969 MEMORANDUM FOR : The Revenue Operations Head (Assessment) This refers to the proposed deficiency income tax assessment against the Mutual Realty Corporation, Beneficial Life Bldg., Intramuros, Manila, for the year 1964. The records of this case disclose that the Mutual Realty Corporation (hereinafter referred to as the Corporation) is engaged in the real estate business. Upon investigation, Revenue Examiner Francisco de Guzman disallowed the deduction claimed by the corporation in its 1964 income tax return for alleged interest expense on preferred stocks in the amount of P96,000.00 and recommended the issuance of a deficiency income tax assessment in the amount of P22,322.00. In a letter dated October 11, 1967, counsel for the corporation protested against the said proposed assessment. The issue to be resolved in this case is whether or not the aforesaid amount of P96,000 is deductible from the corporation's gross income as interest expense. In a memorandum report dated December 7, 1965, Revenue Examiner Francisco S. de Guzman stated his reason for the disallowance of the interest expense in question, viz.: "It can be noticed that the letter (a) provision of the "Rights, Preferences, Qualifications and Limitations of the Preferred Stock", which is hereto attached, reads as follows: "(a) The holders of the preferred stock shall be entitled to receive dividends at the rate of 8% per annum at the face value thereof in the Philippine currency for each share of preferred stock, such dividends payable out of the surplus profits of the corporation after the current and outstanding obligation of the company on any bonded indebtedness shall have been met, so long as said preferred stock is outstanding.' Inasmuch as the dividends on preferred stocks are only payable out of surplus profits, the P96,000.00 interest thereon is not a forbearance of obligation but a distribution of dividends." On the other hand, Counsel for the taxpayer contended that the conditions governing the corporation's issuance of its preferred shares satisfy the requirements laid down in the ruling of the Secretary of Finance on September 12, 1951, and that while the dividends on such preferred shares are payable out of surplus profits, "said dividends shall be preferential and cumulative, whether or not in any period the amount thereof is covered by earnings or profits of the corporation. . . ." Section 78 of Revenue Regulations No. 2, implementing Section 30(b) of the Tax Code reads as follows: ". . . So called interest on preferred stock, which in reality a dividend, thereon, cannot be deducted in computing net income." The aforequoted regulations states the general rule that interests on preferred stocks which are in reality dividends thereon are not deductible from the gross income of the corporation paying such interests. However, as an exception to the said rule, the Department of Finance in an opinion dated September 12, 1951, ruled that under Section 30(b) of the Income Tax Law dividends paid to holders of preferred stocks are deductible from gross income of the corporation as interests, provided the following requirements are met and satisfied: LibLex 1. The holders of the preferred shares do not possess voting rights; 2. The holders of the preferred shares do not participate in the management of the affairs of the corporation; 3. The holders of the preferred shares have a right to fixed dividends or interest irrespective of whether profits or losses are made or sustained by the corporation; or 4. When the preferred stocks are redeemable after a certain fixed date which stamps the holders thereof with the status of mere creditors of the corporation. In other words, when the four requirements enumerated in the abovestated ruling of the Secretary of Finance are punctiliously complied with, the said preferred shares constitute an indebtedness of the corporation and the holders thereof are mere creditors of the corporation. Consequently, the dividends paid thereon are in the nature of interests paid on the indebtedness of the corporation, and are therefore deductible from its gross income. In this case, however, the corporation evidently failed to comply with the third requirement. The corporation issued its preferred stocks allegedly subject, among others, to the following conditions, viz.: "(a) The holders of the preferred stock shall be entitled to receive dividends at the rate of 8% per annum at the face value thereof in Philippine currency for each share of preferred stock, such dividends payable out of the surplus profits of the corporation after the current and outstanding obligation of the company on any bonded indebtedness shall have been met, so long as said preferred stock is outstanding . "(b) Dividends on said preferred stock shall be payable quarter or semi-annually as the Board of Directors may from time to time determine. Said dividends shall be preferential and cumulative , whether or not in any period the amount thereof is covered by earnings or profits of the corporation. All dividends paid on the preferred stock shall be paid in chronological order with reference to the due dates for each quarter or semi-annual installment and shall accrue and be cumulative from the date of the issuance thereof. In case any installment of said dividends is not paid on the dividend' payment date of such installment, then the amount of such installment shall subsequently be paid before any dividends shall thereafter be paid to the holders of the common stocks. Subject only to the foregoing limitation, dividends in cash or in stock or otherwise, may be paid from time to time to the holders of common stock from the surplus profits of the corporation in such amounts and when and as declared and the holders of the preferred stock shall not be entitled to participate in any such dividends paid to the holders of the common stock. Accumulation of dividends on the preferred stock shall not bear interest . The holders of preferred stock shall be entitled to no other dividends than as above stated." (Emphasis supplied) With cumulative nature of the dividends paid on such preferred shares, the holders thereof do not really have the right to fixed dividends or interests irrespective of whether profits or losses are made or sustained by the corporation. Under the terms and conditions of the issuance of the corporation's preferred shares of stock, there is an allowance for non-payment of fixed dividends at specified time or date because of cumulative dividend is one "with regard to which it is agreed that, if at any time it is not paid in full, the difference shall be added to the subsequent payment." It has also been defined as "a dividend which if not paid or received when due, is added to what is to be paid in the future. The idea is that arrearages of one year are payable out of the surplus earnings for subsequent years (Lockwood v. General Abrasive Co. 210 App. Div. 141, 205 N.Y. Supp. 511 citing Websters International Dictionary). Thus, if a cumulative dividend is 8% on the capital stock, as in this case, and only 5% is paid, the amount due at the next payment will be 11%. (Fletcher's Cyclopedia Corporations, Op. Cit). In fine, holders of preferred stocks cannot by the same certificate be both a stockholder and creditor. He is either a stockholder or a creditor; he cannot by virtue of the same certificate be both. By and large, the holders of the preferred shares in this case are not really creditors but stockholders of the corporation. In view thereof, and considering that not all of the requirements prescribed by the Secretary of Finance in his Opinion dated September 12, 1951 had been complied with, this Office believes and so holds that the dividends paid on the preferred shares issued in this case by the Corporation are not deductible as interest expense for tax purposes. To forestall prescription that Office is therefore instructed to issued immediately a deficiency income tax assessment against the Mutual Realty Corporation for the year 1964. (SGD.) MISAEL P. VERA Commissioner of Internal Revenue