By: Karen S. Baquiran
Under the Tax Code, the general rule is that gains from a sale or disposition of properties are recognized and subjected to tax. Section 40(C)(2), however, provides for exemptions, that is, if the exchanges of properties are pursuant to a plan of merger or consolidation or if there is a transfer to a controlled corporation.
On 13 September 2019, the House of Congress approved the bill on Corporate Income Tax and Incentives Act (CITIRA), which seeks to amend certain provisions of the Tax Code. One such amendment is a provision on tax-free exchanges. Although not yet officially a law, it is important to point out that under the CITIRA, 2 other instances were added in the definition of reorganization considered as not subject to tax. These additional instances under the definition of reorganization are a) recapitalization; and b) reincorporation.
How are these additional instances defined? The Tax Code and CITIRA are both silent on the matter. How then will taxpayers be guided on whether their transaction is subject to tax? Will all cases of recapitalization be considered tax-free? What are the criteria? How about for reincorporation? Should it be a requirement to have the same corporate name, principal office, business, incorporators, shareholders, and board of directors? The list of unanswered questions goes on.
In an attempt to answer some of them somehow, it is prudent to take a look at other sources where the terms “recapitalization” and “reincorporation” have at least been discussed.
Although there is no exact definition in the Tax Code, the concept of recapitalization is by no means new. In its several rulings, the Bureau of Internal Revenue (BIR) has adopted the definition of recapitalization from US sources as a “readjustment of existing interests in the rearrangement of the capital structure of the Company.” In this connection, the BIR had the occasion to discuss the concept of recapitalization not being subject to tax.
For instance, recapitalization may be in the form of converting common shares to preferred shares, and vice versa. On 20 January 1999, the Supreme Court (SC), in the case of Commissioner of Internal Revenue v. Court of Appeals, Court of Tax Appeals, and A. Soriano Corp. (G.R. No. 108576), declared that the exchange of common stocks with preferred stocks, or preferred for common or a combination of either for both, may not produce a recognized gain or loss as long as the trade is part of a merger, transfer to controlled corporation, corporate acquisitions or corporate organizations. The SC then concluded that no taxable gain or loss may be recognized on exchange of property, stock or securities related to reorganizations. This Court decision has been adopted by the BIR in several of its rulings. In one instance, the BIR further discussed that in recapitalization, there was no change in the proportionate interest of stockholders. Both classes of stocks had the same par value and any difference in the market value of the shares would be immaterial at the time of reclassification because no income was realized. As such no gain or loss shall be recognized.
Another example of recapitalization is the conversion of debt to equity. The BIR has ruled in several instances that such conversion, being a capital investment, is not within the purview of taxable income. Accordingly, the conversion of debt to equity, without the necessity of issuing additional number of stocks, is not subject to either donor’s tax or income tax.
Meanwhile for reincorporation, the Securities and Exchange Commission (SEC) has issued an opinion regarding the legal implication of reincorporation. Per the SEC opinion, the transfer of real properties shall not be automatically transferred to the re-incorporated corporation. The real properties shall be distributed to the stockholders as liquidating dividends and shall be assigned by the co-owners to the new corporation in exchange of new shares of stocks to be issued by the re-incorporated corporation. Under the Revised Corporation Code (RCC), the rule is that corporations shall have perpetual existence unless there is a specific term stated in their articles of incorporation. In case the term expires, said corporation can opt to revive it. Will the revival of corporation under the RCC also involve liquidation proceeding? Is this the reincorporation contemplated under the CITIRA that should not be subject to tax? Or is there another specific concept of reincorporation that should be tax free?
For now, we can only wait if CITIRA will be passed into law and if the provisions under the latest version of H.B. No. 4157 will be adopted. If this happens, it may be helpful for the BIR to issue some guidelines on recapitalization and reincorporation. For example, what are the instances wherein the transaction may be considered as a mere recapitalization and reincorporation and therefore a reorganization not subject to tax? The rules should clearly define these concepts and the criteria that must be met to fall under it. This is so that first, taxpayers are not left in the dark on whether the transactions they are about to enter into are not subject to tax. Second, knowing which transactions are not subject to tax is a useful for planning corporate reorganizations. Finally, this is so taxpayers are not unnecessarily exposed to the risk of a tax deficiency assessment in case the transactions are not qualified as tax-free exchanges.
Karen S. Baquiran is a Supervisor from the Tax Group of KPMG R.G. Manabat & Co. (KPMG RGM&Co.), the Philippine member firm of KPMG International. KPMG RGM&Co. has been recognized as a Tier 1 tax practice and Tier 1 transfer pricing practice by the International Tax Review.
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