Revocation of the Ruling that Dividends Paid on Preferred Shares Held Under Certain Conditions are Considered Interest on Indebtedness

July 12, 1971 REVENUE MEMORANDUM CIRCULAR NO. 17-71 SUBJECT : Revocation of the Ruling that Dividends Paid on Preferred Shares Held Under Certain Conditions are Considered Interest on Indebtedness TO : All Internal Revenue Officers and others concerned Based on an opinion rendered by the Department of Finance on September 12, 1951, this Office has issued rulings holding that dividends paid to holders of preferred shares are deductible from the gross income of the corporation as interests on indebtedness, provided the following requirements are met and satisfied: 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 the right to fixed dividends or interests irrespective of whether profits are made or losses are sustained by the corporation; and 4.The preferred stocks are redeemable after a certain fixed date. It was believed then that the concurrence of the said requirements or conditions constituted sufficient proof of a debtor-creditor relationship between the corporation and the holder of the preferred shares. However, an analytical study of such cases in the light of recent U.S. jurisprudence on the matter reveals that mere concurrence of the aforementioned conditions is not sufficient basis for concluding that the preferred shares represent indebtedness of the corporation to the holders thereof; and that there are other factors to be considered in determining whether or not a debtor-creditor relationship exists between the corporation and the holders of the preferred shares, such factors being as many and varied as the facts obtaining in each case. In other words, the ruling is based on inconclusive facts and therefore, erroneous. In this connection, it may also be stated that the issuance of preferred shares as evidence of indebtedness of the corporation to the holders thereof is of doubtful legality in view of a recent ruling of the Securities and Exchange Commission, holding that "preferred shares cannot be issued with a fixed annual interest on the face thereof inasmuch as this will change the contract of subscription between the corporation and the shareholders to one of loan and will destroy the well-established corporate theory that shares of stock are not credits or debts due from the corporation to the stockholders". In view thereof, the ruling abovementioned is hereby revoked. Henceforth preferred shares shall be considered capital regardless of the conditions under which such shares are issued and consequently, dividends or "interests" paid thereon shall no longer be allowed as a deduction from the gross income of the corporation However, corporations which were issued the ruling in question are given up to December 31, 1971 within which to convert the preferred shares, claimed as representing indebtedness, into actual certificate of indebtedness and unless so converted, such preferred shares shall, beginning January 1, 1972, be considered capital and the dividends or "interests" paid thereon shall no longer be allowed as a deduction from the gross income of the corporation issuing such preferred shares. All internal revenue officers are hereby enjoined to enforce the provisions of this Circular. cdt MISAEL P. VERA Commissioner of Internal Revenue APPROVED: CESAR VIRATA Secretary of Finance