Verifine Dairy Products Corp. v. Commissioner

Verifine Dairy Products Corporation of Sheboygan, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent

Verifine Dairy Products Corp. v. Commissioner

Docket No. 108460

United States Tax Court

3 T.C. 269; 1944 U.S. Tax Ct. LEXIS 194;

February 15, 1944, Promulgated

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">*194 Decision will be entered for the respondent.

In 1923 petitioner amended its articles of incorporation to permit the increase of its capital stock. Thereafter in 1923 it duly issued certain "preferred stock, first issue" and certain "preferred stock, second issue." The latter was issued in exchange for certain shares of petitioner's common stock upon condition that petitioner enter into agreements to repurchase said "preferred stock, second issue" in installments over a fifteen-year period and to deposit certain collateral for the faithful performance of the agreements. In 1927 petitioner again amended its articles of incorporation to give the holders of preferred stock, second issue, additional voting power and to provide in connection with the preferred stock, first issue, that "in any event" 10 percent of such stock should be redeemed on January 1, 1940, and an equal amount each year thereafter until the full amount is redeemed. Both issues provided for cumulative dividends. Held, petitioner is not entitled under section 23 (b) of the Revenue Acts of 1934 and 1936 to deduct any interest on its preferred stock obligations for the reason that both issues of such stock ">*195 constitute capital stock and not indebtedness.

John S. Best, Esq., for the petitioner.

Carroll Walker, Esq. for the respondent.

Black, Judge.

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BLACK

">*269 This proceeding involves the determination by the respondent of a deficiency in income tax for the calendar year 1935 of $ 708.09 and of deficiencies in income and excess profits taxes for the calendar year 1936 of $ 1,734.09 and $ 256.53, respectively. These deficiencies result from certain uncontested adjustments which the respondent made to petitioner's net loss and net income as reported on its 1935 and 1936 returns, respectively. In the statement attached to the deficiency notice the respondent, among other things, said:

The contention raised in your protest that the dividends paid on your preferred stock should be considered as an interest deduction cannot be allowed. The holders of your preferred stock, in accordance with the stock certificates, are entitled to receive out of the surplus earnings or undivided profits annual dividends when and if declared by your Board of Directors. It is therefore held that your preferred stockholders were investors in your corporation and they were not its creditors.

">*270 ">*196 Petitioner in its returns for 1935 and 1936 reported, among other things, the payment of certain cash dividends in the amount of $ 10,578 for each year. It also reported the payment of certain other cash dividends in the amount of $ 10,596 for 1935 and $ 14,154 for 1936. In these returns petitioner made no contention that the said dividends were deductible from gross income under section 23 (b) of the Revenue Acts of 1934 and 1936 as interest. By appropriate assignments of error petitioner alleges that for each of the taxable years in question the respondent erred by failing "to allow a deduction under Section 23 (b) * * * for interest paid in the amount of $ 10,578.00."

FINDINGS OF FACT.

Petitioner is a corporation organized under the laws of the State of Wisconsin on June 3, 1911, under the name of Sheboygan Dairy Products Co. Petitioner's name was changed to Verifine Dairy Products Corporation of Sheboygan, Inc., by appropriate amendment to its articles of incorporation adopted at a stockholders' meeting held on May 16, 1936. The returns for the period here involved were filed with the collector of internal revenue for the district of Wisconsin, at Milwaukee.

Prior to January">*197 22, 1921, the articles of incorporation of petitioner provided only for common capital stock. At a meeting of the stockholders held on January 22, 1921, a resolution amending petitioner's articles of incorporation was adopted. This amendment provided for an increase in petitioner's capital stock from $ 300,000 to $ 350,000. Of this amount $ 50,000 was to be preferred stock and $ 300,000 was to be common stock. The holders of the preferred stock were entitled to receive "when and as declared from the net profits of the corporation, yearly dividends at the rate of seven (7) per cent per annum, and no more." Dividends on the preferred stock were to be cumulative and to be payable before any dividends on the common stock. Upon liquidation the preferred stock was payable in full with accumulated dividends before any amount could be paid to the holders of the common stock. The preferred stock could be redeemed, retired or canceled at any time after three years from the date of its issue by paying therefor the par value ($ 100 per share) and the accrued dividends.

Thereafter and prior to January 25, 1923, shares of the preferred stock of petitioner (hereinafter referred to as the original">*198 issue) were duly issued in consideration of the receipt by petitioner of money and property equivalent to the par value of such shares.

At a meeting of petitioner's stockholders held on January 25, 1923, a resolution amending article third of petitioner's articles of incorporation was adopted. The amendment provided for the increasing of petitioner's capital stock to 5,500 shares of a par value of $ 100 per share, consisting of 3,000 shares of common stock, 1,000 shares of ">*271 "Preferred Stock, First Issue," and 1,500 shares of "Preferred Stock, Second Issue." The amendment further provided:

The holders of such Preferred Stock, First Issue, shall be entitled to receive, when and as declared by the board of directors out of the surplus earnings or undivided profits of the company, annual dividends of seven (7) percent per annum, and no more. Such dividends shall be cumulative and shall be payable before any dividends on the common stock shall be paid or set apart. The whole or any part of the Preferred Stock, First Issue, may be redeemed, retired or cancelled at any time after three (3) years from the date of its issue in such manner as the board of directors may determine. ">*199 The amount to be paid therefor upon such redemption, retirement or cancellation shall be the par value of the Preferred Stock, First Issue, plus accrued dividends. The Preferred Stock, First Issue, shall have no voting power.

The holders of such Preferred Stock, Second Issue, shall be entitled to receive, when and as declared by the board of directors out of the surplus earnings or undivided profits of the company, annual dividends of six (6) percent per annum, and no more. Such dividends shall be cumulative and shall be payable before any dividends on the common stock shall be paid or set apart. The Preferred Stock, Second Issue, may be redeemed or purchased by the company at any time after its issue. The amount to be paid therefor upon such redemption or repurchase shall be the par value thereof and all unpaid accrued dividends thereon. The company may enter into an agreement with the purchasers of such Preferred Stock, Second Issue, providing for such redemption or repurchase by the company, at the time of sale or issue thereof or any time thereafter. The Preferred Stock, Second Issue, shall have no voting power excepting in the event of default in the payment of one annual">*200 dividend for six months after February 1, of each year, commencing with the year 1924. In the event of such default the holders of the Preferred Stock, Second Issue, shall have the sole voting power in the election of directors of the company, and such sole voting power shall continue in the holders of such Preferred Stock, Second Issue, until all of such defaults shall have been made good.

In the event of the liquidation, dissolution or winding up of the corporation, whether voluntary or involuntary, the holders of such preferred stock, both issues, without preference, shall be entitled to be paid in full the par value of their shares and all unpaid dividends accrued thereon before any amount shall be paid to the holders of the common stock.

Subsequent to January 25, 1923, the previously outstanding original issue of preferred stock of petitioner was exchanged, share for share, for the newly authorized preferred stock, first issue. Thereafter additional shares of the preferred stock, first issue, were issued by petitioner in consideration of the receipt by petitioner of money and property equivalent to the par value of such shares.

On February 8, 1923, the board of directors of">*201 petitioner held a special meeting and "After a discussion by the board relating to the purchase of the common stock of the company owned by Messrs. P. H. Peacock, E. C. Peacock and a portion of the common stock owned by M. G. Douma," P. H. and E. C. Peacock each presented a separate proposal in writing to exchange 50 shares of petitioner's common stock for one-half of the capital stock, both common and preferred, owned by petitioner in the Capital Dairy Co. of Madison, Wisconsin, and to ">*272 exchange 375 shares of petitioner's common stock for 375 shares of petitioner's preferred stock, second issue, and to exchange 29 shares of petitioner's common stock for 29 shares of petitioner's preferred stock, first issue, upon condition that petitioner enter into an agreement to "repurchase" said 375 shares of "preferred stock, second issue, in accordance with the terms set forth in said agreement, and to deposit certain collateral for the faithful performance of said agreement as therein specified." Each of these proposals was accepted by the board and as to each proposal petitioner's president was "authorized and directed to accept said proposal in writing for and in the name of the">*202 company." Douma likewise presented a separate proposal in writing to exchange 750 shares of petitioner's common stock for 750 shares of petitioner's preferred stock, second issue, and to exchange 58 shares of petitioner's common stock for 58 shares of petitioner's preferred stock, first issue, upon condition that petitioner enter into an agreement to "repurchase" said 750 shares of "preferred stock, second issue, in accordance with the terms set forth in said agreement, and to deposit certain collateral for the faithful performance of said agreement as therein specified." This proposal was likewise accepted by the board and petitioner's president was "authorized and directed to accept said proposal in writing for and in the name of the company."

As a result of the action taken by petitioner's board of directors on February 8, 1923, petitioner on February 15, 1923, entered into a separate written agreement with each of the Peacocks and Douma. The conditions of the three agreements to repurchase the aforesaid 1,500 shares of preferred stock, second issue, were substantially the same, with the exception of the collateral security deposited for the faithful performance of the repurchase">*203 agreement. These contracts provided that petitioner was to reacquire 50 shares of the preferred stock, second issue, at par from Douma each year over the years of 1924 to 1938, inclusive, and petitioner was to reacquire from each of the Peacocks 25 shares each year at par over the same period. Collateral security was endorsed and deposited with each contract and delivered to the three individuals, respectively. From 1924 to 1928, inclusive, 250 shares of preferred stock, second issue, were reacquired by petitioner from Douma, and from 1924 to 1933, inclusive, 250 shares of preferred stock, second issue, were reacquired from each of the Peacocks. At the end of both the years of 1935 and 1936 there were outstanding and unacquired 750 shares of preferred stock, second issue, in the hands of Douma, E. C. Peacock, and P. H. Peacock, or the personal representatives of their estates. These 750 shares were reacquired by petitioner from the three individuals or the personal representatives of their estates during the years 1937 and 1939.

The collateral remained with the pledgees throughout the whole period of time, regardless of payments made in reacquiring the stock. ">*273 No dividends">*204 or other income was received from the collateral during the time it was held by Douma, E. C. Peacock, and P. H. Peacock. The value of the collateral security was insufficient to pay for the reacquisition of the preferred stock, second issue.

At a special meeting of the stockholders held February 23, 1927, article third of the articles of incorporation of petitioner was further amended by fixing the redemption dates of the preferred stock, first issue, and by giving the holders of preferred stock, second issue, additional voting power. As thus amended, article third provided in part:

* * * but in any event, ten (10) per cent. of such Preferred Stock, First Issue, shall be redeemed on January 1, 1940, and an equal amount thereof each year thereafter until the full amount of said Preferred Stock, First Issue, Shall Be Redeemed. * * *

* * * In the event of default in the payment of one annual dividend for six months after February 1st of any year, the holders of the Preferred Stock, Second Issue, Shall have the sole voting power in the election of directors of the company. Upon all other matters relating to the affairs of the corporation the holders of Preferred Stock, Second Issue, ">*205 of said Company, shall have equal voting power with the holders of Common Stock of said company.

In all other respects article third remained as it was after the amendment of January 25, 1923.

At the above mentioned special meeting of "stockholders" held February 23, 1927, there were present and voting at the meeting, either in person or by proxy, the owners of 543 shares of preferred stock, first issue, 1,500 shares of preferred stock, second issue, and 900 shares of common stock.

Pursuant to agreements between petitioner and all the holders of its preferred stock, first issue, the "dividend rate" thereon was reduced from 7 to 6 percent per annum, effective beginning with the dividends accruing during the year 1934. Thereafter a notation as to the reduction of such "dividend rate" was stamped upon the certificates representing the preferred stock, first issue.

The preferred stock certificates for both the first and second issues that were issued and outstanding during the taxable years in question had printed on the face thereof the provisions of article third of petitioner's articles of incorporation as amended on February 23, 1927.

Petitioner's capital stock account upon its">*206 books and records shows the following amounts outstanding, exclusive of treasury stock, as of the dates stated:

	Dec. 31, 1935	Dec. 31, 1936
	Shares	Shares
Common stock	1,179.5	1,314.5
Preferred stock, first issue	988	984
Preferred stock, second issue	774	776

">*274 Of the preferred stock, second issue, delivered by petitioner under the three contracts dated February 15, 1923, 750 shares are included in the shares of preferred stock, second issue, set forth in the preceding table.

The payments made of dividends pursuant to resolutions adopted January 29, 1935, August 1, 1935, and September 1, 1936, by petitioner to the holders of its preferred stock, first issue, and preferred stock, second issue, in the years 1935 and 1936 were designated as "dividends" upon petitioner's books and records.

Petitioner's capital stock tax return for the year ended June 30, 1935, shows "Adjusted Declared Value of Entire Capital Stock As Of 12/31/34 $ 315,077.49." It shows preferred stock of $ 176,600 and common stock of $ 118,950. Petitioner's capital stock tax return for the year ended June 30, 1936, shows "Declared Value of Entire Capital Stock $ 300,999.00." It shows">*207 preferred stock of $ 176,300 and common stock of $ 117,950.

In its Federal income tax returns for the calendar years 1935 and 1936 petitioner did not claim deductions as interest for any portion of the amounts declared payable and paid to the holders of its preferred stock, first issue, and preferred stock, second issue, pursuant to the action taken by its board of directors on January 29, 1935, August 1, 1935, and September 1, 1936. In the analysis of changes in surplus contained on each return the amounts were reflected as dividends paid. In its return for the year 1936 petitioner claimed a dividends paid credit amounting to $ 24,732, which included $ 10,578 as the amounts so declared and paid in September 1936. In the balance sheets set forth in each return the securities in controversy are shown as part of petitioner's outstanding capital stock and not as liabilities.

Petitioner's income tax returns for the years in question were prepared upon the accrual basis.

In determining the deficiencies the respondent made certain adjustments which are not in controversy, and refused to allow a contention which petitioner raised in its protest to the effect that the dividends paid on">*208 the preferred stock should be considered as an interest deduction. In computing surtax on undistributed profits for the year 1936 the respondent allowed the full amount of the dividends paid credit of $ 24,732 claimed on petitioner's return.

Any of the stipulated facts not incorporated in the foregoing findings are incorporated herein by reference.

As an ultimate fact we find that the preferred stock, first issue, and preferred stock, second issue, constituted capital stock, and not indebtedness.

OPINION.

Our question in this proceeding is to determine whether each of the two issues of "preferred stock" is, notwithstanding ">*275 its respective name, in reality capital stock or indebtedness. In determining this question we shall first consider the legal effect of the so-called preferred stock, first issue.

The material provisions of section 23 (b) of the Revenue Acts of 1934 and 1936, and of article 23 (b)-1 of Regulations 86 and 94 are identical, respectively, and are set forth in the margin. ¹

">*209 The question of whether a certain obligation is in reality capital stock or indebtedness and whether the increment therefrom is therefore a dividend or interest has often been the subject of tax litigation. The leading cases are collected and analyzed in Mertens, Law of Federal Income Taxation, vol. 4, sec. 26.10. The Seventh Circuit, in Commissioner v. Meridian & Thirteenth Realty Co., 132 Fed. (2d) 182, enumerated the criteria named to aid in the determination as follows:

Fixed maturity; payment of dividends out of earnings only; cumulative dividends; participation in management; whether unpaid dividends bear interest; right to sue in case of default, and whether status is equal to, or inferior to that of regular corporate crdeitors; nomenclature used in the documents; intent of the parties.

In the instant proceeding the preferred stock, first issue, was in the form of stock certificates. The certificates outstanding during the taxable years involved had petitioner's name at the top and immediately underneath were the words and figures: "Capital Stock, $ 550,000. Common Stock $ 300,000; Preferred Stock, First Issue, $ 100,000; Preferred Stock, ">*210 Second Issue, $ 150,000." They certified that the holder was "the owner of     Shares of par value of $ 100 each, full paid and non-assessable, of the Preferred Stock, First Issue, of the Sheboygan Dairy Products Company, transferable only on the books of the Company by the holder thereof in person, or by duly authorized attorney upon the surrender of this Certificate." They then contained in fine print the provisions of article third of petitioner's articles of incorporation as amended on January 25, 1923, and as again amended on February 23, 1927. Across the face of the certificates was stamped

"THE ANNUAL DIVIDEND ON THIS PREFERRED STOCK HAS BEEN REDUCED FROM SEVEN TO SIX PER CENT AS PER AGREEMENT OF DECEMBER 15, 1934."

Petitioner concedes that prior to the amendment of article third of petitioner's articles of incorporation on February 23, 1927, the preferred stock, first issue, represented a proprietary interest rather than an indebtedness. Prior to the amendment of February 23, 1927, as provided in article third and the certificates, the whole or any part of the preferred stock, first issue, could be "redeemed, retired or cancelled ">*276 at any time after three (3) years">*211 from the date of its issue in such manner as the board of directors may determine." The amendment of February 23, 1927, continued this provision except that it changed the period following the word "determine" to a semicolon and added thereto the following:

but in any event, ten (10) per cent. of such Preferred Stock, First Issue, shall be redeemed on January 1, 1940, and an equal amount thereof each year thereafter until the full amount of said Preferred Stock, First Issue, Shall Be Redeemed.

Petitioner contends that by changing this one criterion, namely, fixed maturity date, the certificates were changed from actual certificates of preferred stock to actual certificates of indebtedness. We do not agree. A very similar provision was present in Parisian, Inc. v. Commissioner, 131 Fed. (2d) 394, affirming memorandum opinion of the Board. In holding that he dividends paid on the preferred stock were not interest, the court in that case said:

* * * Nothing in the provision for the payment of dividends on, and the retirement of, the preferred stock at the rate of 10 percent annually beginning after the fifth year, at all supports the view that ">*212 the obligation, in form of a stock certificate, was any other than what it purported to be. Nothing in the evidence outside of the certificate supports the view that the parties intended it to be a debt. Indeed, it is stipulated that the bank, at all times in its books of account and its Federal tax returns for all years in which such payments were made, has treated the payments made by petitioner as dividends and the certificates as shares of stock; and that the petitioner for a number of years treated the payments as dividends paid by it, ad has treated, and continues to treat, the shares as a part of its capital structure. It is true enough, as petitioner insists, that the form of an obligation is not controlling upon whether it is really a debt or a stock interest, but it is certainly strongly persuasive, and when, as here, in actual practice, no challenge has been made of the form as representing anything but the fact, a petitioner who, in order to obtain a tax benefit by denying it, seeks to deny reality to that form must come with convincing evidence that the obligation is something other than it appears to be. Petitioner has not sustained this burden. * * *

In determining">*213 a question of this kind, of extreme importance is the intent of the parties. Commissioner v. Meridian & Thirteenth Realty Co., supra. For more than ten years after the amendment petitioner continued to treat the certificates as capital stock rather than indebtedness. This shows a very strong intention on the part of petitioner as to the true nature of the certificates.

The certificates and articles of incorporation provided that the certificate holders "shall be entitled to receive, when and as declared by the Board of Directors out of the surplus earnings or undivided profits of the company, annual dividends" of 6 percent per annum and no more. Such provisions are not characteristics of a debt. Petitioner argues, however, that upon the arrival of the fixed maturity ">*277 date the unpaid accumulated dividends had to be paid independently of any action by petitioner's board of directors and independently of whether there existed surplus earnings sufficient to cover the amount to be redeemed, and that, therefore, the certificates were in reality certificates of indebtedness. Substantially this same argument was made by the taxpayer in Pacific Southwest Realty Co. v. Commissioner, 128 Fed. (2d) 815,">*214 and was rejected.

Petitioner also argues that the preferred stock, first issue, after the 1927 amendment, must be held to constitute indebtedness for the reason that the articles of incorporation as amended are in conflict with section 182.13 of the Wisconsin Statutes, which provide in part as follows:

182.13 Preferred stock. (1) Any corporation may, in its original articles, or by amendment thereto adopted by a three-fourth vote of the stock, provide for preferred stock; for the payment of dividends thereon at a specified rate before dividends are paid upon the common stock; for the accumulation of such dividends; for a preference of such preferred stock not exceeding the par value thereof, over the common stock in the distribution of the corporate assets other than profits; for the redemption of such preferred stock, and for denying or restricting the voting power of such preferred stock. [Italics supplied.]

We are not impressed with this argument. In our opinion the only effect this alleged conflict with the preferred stock provisions of the Wisconsin Statutes might have would be an evidentiary indication of the intent of the parties at the time the security was issued. ">*215 As indicated above, we are satisfied that the intent of the parties was to issue preferred stock and nothing else. And this intent is of "extreme importance." Commissioner v. Meridian & Thirteenth Realty Co., supra.Cf. Northern Refrigerator Line, Inc., 1 T.C. 824.

The certificates and articles of incorporation also provided that the preferred stock, first issue, shall have no voting power. This criterion would exert no weight on the indebtedness side of the scales, as that provision was specifically permitted by section 182.13 (1) of the Wisconsin Statutes, supra.

In regard to whether the status of the certificate holders of the preferred stock, first issue, was equal to, or inferior to, that of regular corporate creditors, we think it clearly was inferior. The certificate holders held themselves out to the public as preferred stockholders. In doing so they could hardly claim that they had a status equal to that of a regular corporate creditor. See John Wanamaker, Philadelphia v. Commissioner, 139 Fed. (2d) 690, affirming 1 T.C. 937.

As far as">*216 the nomenclature criterion is concerned, the weight is all very decidedly on the side of capital stock. After considering all of the criteria, we are convinced that the preferred stock, first issue, was clearly capital stock rather than indebtedness. It follows that the ">*278 respondent was correct in refusing to allow petitioner any deduction for interest on account of such stock under section 23 (b), supra.

We shall now consider the legal effect of the so-called preferred stock, second issue. In form the certificates evidencing this issue were identical in every respect with the certificates evidencing the first issue, except that they certified that the holder was the owner of shares of the preferred stock, second issue, of petitioner. In issuing this security petitioner substantially followed section 182.13 (4) of the Wisconsin Statutes, which provides as follows:

(4) The articles may be amended by a three-fourths vote of the common stock to provide for a second issue or preferred stock, subject to all the rights and equities of the first issue of preferred stock, and the certificates of such second issue shall have plainly printed across the face the words "Preferred">*217 Stock, Second Issue," and shall recite all the terms, restrictions and regulations provided in the articles in relation to such second issue of preferred stock.

The 1,500 shares of preferred stock, second issue, were all issued to three common stockholders in exchange for certain shares of petitioner's common stock upon condition that petitioner enter into three separate agreements to "repurchase" said 1,500 shares on definite dates at par plus accrued dividends and to deposit certain collateral for the faithful performance of the agreements. In its brief petitioner explains its contention with respect to this security as follows:

The petitioner makes no claim that its "preferred stock, second issue" standing alone and apart from the aforesaid contracts constituted an evidence of indebtedness. On the other hand, it is the petitioner's position that the said contracts, together with the charter provisions of the "preferred stock, second issue," when read together, lead inescapably to the conclusion that the petitioner was obligated to pay fixed and determinable amounts of money at definite dates, this obligation being secured by the deposit of collateral, and that the obligation ">*218 thus imposed by contract constituted the petitioner a debtor of the individuals with whom it contracted.

Petitioner contends that the essence of the transaction was a purchase by petitioner of shares of its common stock under a secured agreement to pay the purchase price in installments over a period of years. We do not think that contention coincides with the intent of the parties. It seems to us that petitioner was clearly following section 182.13 (4) of the Wisconsin Statutes and intended to issue and actually did issue the 1,500 shares of preferred stock, second issue, in exchange for some of its common stock.

The three contracts of February 15, 1923, were simply contracts between petitioner and its second issue preferred stockholders whereby petitioner agreed to purchase the preferred stock, second issue, from the stockholders in installments over a fifteen-year period and to deposit certain collateral with the stockholders as security "for the faithful performance of this agreement to purchase said Preferred ">*279 stock, second issue, from the first party at the times and in the manner above set forth." It will be noted that the collateral security was not placed by the">*219 corporation with the stockholders to guarantee the payment of annual dividends on the second preferred stock, but was placed with the stockholders to guarantee that petitioner would carry out its agreement to repurchase the stock from time to time. This did not convert the preferred stock, second issue, from capital stock of the company into indebtedness of the company. We can see no greater reason for holding the preferred stock, second issue, here in question to be an indebtedness than existed in connection with the 10,000 shares of preferred stock involved in John Wanamaker Philadelphia v. Commissioner, supra.

The respondent's determination is sustained.

Decision will be entered for the respondent.

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Footnotes

• 1. SEC. 23. DEDUCTIONS FROM GROSS INCOME.

  In computing net income there shall be allowed as deductions:

  * * * *

  (b) Interest. -- All interest paid or accrued within the taxable year on indebtedness * * *.

  Art. 23 (b)-1. Interest↩. -- * * * So-called interest on preferred stock, which is in reality a dividend thereon, can not be deducted in computing net income. * * *