Every so often, corporations undertake business restructuring with varying business objectives in mind. It could be to optimize or streamline business operations, to expand to other industries, or to form strategic alliances with other corporations. In most cases, these would involve the transfer or exchange of significant property or shares, the taxes related to which become a material consideration to the parties involved.
To this end, Section 40(C)(2) of the Tax Code provides relief to taxpayers undertaking mergers, consolidations, or transfers of property to controlled corporations in exchange for shares. Specifically, the Tax Code states that no gains or losses may be recognized on such exchanges, or what is commonly referred to as tax-free exchanges (TFE).
It may be worth noting that the term “tax-free” is a misnomer. For income tax purposes, a TFE is not a tax exemption, but a mere deferral or suspension of tax. The rationale is that the transferee generally assumes the historical cost of the property received from the transferor. As such, upon the subsequent disposal of the property, the gain recognized by the second transferor (i.e., the transferee in the TFE) will be based on the said historical cost of the first transferor.
Other than income tax, however, the transfer of property via TFE is exempted by the Tax Code from value-added tax (VAT) and documentary stamp tax (DST). Hence, on this point, it is appropriate to call it tax-free.
It seems then that after an exchange is determined to be tax-free, the crux of the matter is ascertaining the appropriate cost basis of the properties transferred as part of the exchange. After all, the cost is a key factor in determining the amount of taxable gain later on.
Given these conditions, the Bureau of Internal Revenue (BIR) has issued guidelines over the years to monitor the basis of properties transferred in TFEs. These guidelines, which initially stemmed from the necessity to create a revenue safeguard, have inevitably resulted in requiring taxpayers to secure confirmatory rulings for TFEs. For transfers of land and shares especially, a ruling becomes administratively necessary to secure the Certificate Authorizing Registration (CAR) from the BIR. Since the CAR certifies payment of all the proper taxes, it is vital in transferring the legal title over such properties to the transferor.
Securing a confirmatory TFE ruling usually takes time. For some taxpayers, the timeline for securing a ruling has become a key factor in evaluating their restructuring options, particularly where third parties are involved and the transaction must be completed quickly.
In 2020, the Supreme Court finally clarified that securing a prior confirmatory ruling is not required to avail of the tax-free benefit in TFEs. In its decision, the Supreme Court ruled that a transaction is considered exempt as long as the requirements under the law are met, whether or not there is a prior ruling issued. BIR rulings merely operate to confirm whether the conditions under the law are met. The decision echoes, and in fact cites, a similar case in 2013 where the Court struck down the BIR’s requirement for a prior ruling to avail of benefits granted under tax treaties.
Despite the court ruling, a confirmatory ruling is still required by the tax authorities to issue a CAR.
There may be something to look forward to, however, in the upcoming tax reform bill. The Bicameral Conference Committee recently approved the reconciled version of the Corporate Recovery and Tax Incentives for Enterprises Act or CREATE Bill, which proposes to amend, among many others, the provision on TFEs. Aside from adding new types of tax-free exchanges, the CREATE Bill makes clear that a “prior BIR confirmation or tax ruling is not required for purposes of availing the tax exemption.”
Is this finally the clarification we need?
It is interesting to note the proposed wording of the provision. As mentioned above, strictly speaking, a TFE is only a tax exemption to the extent of VAT and DST on the transfer of property. For income tax purposes, a TFE merely defers or suspends the tax and is not really an exemption. Hence, if signed into law, it remains to be seen whether the no-ruling provision will be implemented to encompass income tax. On the other hand, an exclusion to this effect may effectively defeat the intention to address the current hurdle of securing a ruling.
Personally speaking, the above provision should apply to all aspects of the transaction, especially income taxes. After all, the proposed no-ruling provision is part of the Section in the Tax Code covering the income tax deferral provision. Plus, in a tax deferral, the crucial part is accurately establishing the cost basis of the properties transferred. I believe that can still be accomplished through means other than a ruling.
Outside of a ruling, the determination of the cost of the property transferred may be delegated to the officers processing the CAR (subject to a specific set of guidelines). This process may also be established through self-reporting by the parties involved, subject to a post-transaction review by a specialist group or by revenue officers during a tax investigation. In any case, the CAR only needs to indicate that the properties were transferred by way of TFE, hence the transfer is not subject to tax.
It is still not clear whether the current version of the CREATE Bill will fully pass into law. For now, we can only welcome this development as a step into a more competitive direction and hope for more to come.
The views or opinions expressed in this article are solely those of the author and do not necessarily represent those of Isla Lipana & Co. The content is for general information purposes only, and should not be used as a substitute for specific advice.
Olivia Erika Susa is a manager at the Tax Services Department of Isla Lipana & Co., the Philippine member firm of the PwC network.
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