Was holder-redeemable preferred stock debt when the certificate of incorporation allowed the corporation to refuse redemption under legal, charter, or lender restrictions?

Plain-English summary

The redeemable preferred stock was not debt because the corporation was not unconditionally required to honor a holder's redemption request.

The taxpayer argued that the stock met the debt test quoted from Arch Petroleum: a legally enforceable obligation for a certain sum, payable within an ascertainable time or on demand. Holders could request redemption for $1,000 per preferred share.

But the certificate of incorporation said the corporation did not have to honor a redemption request if redemption was prevented by law, the certificate itself, or terms owed to a lender. The Comptroller found that restriction distinguished the stock from the stock in Arch Petroleum.

The stock therefore was not corporate debt and had to be included in stated capital for franchise-tax reporting.

What this means for you

Corporations with redeemable preferred stock

A holder's right to demand redemption did not establish debt treatment when the governing document also allowed the corporation to refuse redemption in specified circumstances.

Tax professionals

Review the actual charter restrictions. The response expressly depended on the facts and said a different or additional fact could change the result.

Common questions

Q: Was the redemption amount fixed?
A: Yes. The letter described $1,000 per preferred share.

Q: Why did the stock fail the asserted debt test?
A: The corporation could decline redemption when legal, certificate, or lender restrictions prevented payment.

Q: How was the stock reported?
A: It was included in stated capital for franchise-tax purposes.

Citations and references

• Arch Petroleum, Inc. v. Comptroller of Public Accounts
• Restated Certificate of Incorporation, page 4, as quoted in the ruling

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9805531L

Original ruling text

May 28, 1998

Dear Mr. **:

Thank you for your letter concerning the redeemable preferred stock of your
corporation. I apologize for the delay in responding to your inquiry.

You stated in your letter that the restated Certificate of Incorporation, on
file with the State of Delaware, states that each holder of preferred stock may
require redemption of the stock with written notice. You cited the court's
statement in the recent decision in the Arch Petroleum, Inc. v. Comptroller of
Public Accounts,. The court stated "If an item is debt, it is subtracted in
computing surplus. An item is debt if it is a legally enforceable obligation
measured in a certain amount of money that must be performed or paid within an
ascertainable period of time or on demand."

You also stated that based on this information, the redeemable preferred stock
of your company would be considered debt. The rules stated in your Certificate
of Incorporation are a legally enforceable obligation. The obligation is
measured in a certain amount of money, $1,000.00 per share of preferred stock.
And finally, you stated that since the preferred stock is redeemable upon the
option of the holder, the "either/or" test that the obligation must be paid
within an ascertainable period of time or on demand is also satisfied.

Upon review of the Restated Certificate of Incorporation, we have found the
following statement on page 4: "If the Corporation would be prevented from
making a redemption by an applicable restriction of law, any applicable
restriction of this Certificate of Incorporation or the terms of any
indebtedness from time to time owed by the Corporation to any lender, it shall
not be required to honor a redemption request hereunder and shall so notify
such holder."

We believe that this statement distinguishes your redeemable preferred stock
from the stock at issue in the Arch Petroleum case.

Therefore, based on the information presented we believe that your redeemable
preferred stock is not a debt of the corporation and should be included in
stated capital for franchise tax reporting purposes.

This response is based on current law and the facts presented. If there are
different or additional facts, the response may change.

If you have any questions about this or any other franchise tax matter, please
call me at
1-800-531-5441, extension 34612. My direct number is (512) 463-4612. You may
write me at Tax Policy Division, Comptroller of Public Accounts, Austin, Texas
78774.

Sincerely,

Janet Spies
Tax Policy Division