“Imposing VAT on corporate reorganization” by Veronica A. Santos (September 5, 2011)
SUITS THE C-SUITE By Veronica A. Santos
Business World (09/05/2011)
The Bureau of Internal Revenue (BIR) has, of late, been vigorously issuing regulations to interpret or clarify previous interpretations of tax laws.
Revenue Regulations (RR) 10-2011, issued on July 7, may have the most far-reaching consequences.
RR 10-2011 states that the exchange of goods or properties, including real estate properties used in business or held for sale or for lease by the transferor, for shares of stock of the transferee, whether resulting in corporate control or not, is subject to value-added tax (VAT).
RR 10-2011 amends the provisions of prior revenue regulations which deal with the VAT implications of asset transfers pursuant to Section 40(C)(2) of the Tax Code.
Section 40(C)(2) describes three types of asset transfers which are not gain recognition events (and therefore not subject to income tax, capital gains tax, or withholding tax).
Also known as “tax-free” transfers, these are: (1) a transfer to a controlled corporation, (2) a statutory merger/consolidation, and (3) a de facto merger.
Section 199 (m) of the Tax Code also exempts Section 40(C)(2) transfers from documentary stamp tax.
In a tax-free transfer to a controlled corporation, not more than five transferors transfer property in exchange for at least 51% of the voting shares of a transferee corporation.
In a statutory merger, the transferor(s) are the “absorbed corporations” while the transferee, an existing corporation, is the “surviving corporation.”
In a statutory consolidation, the transferors consolidate into a new corporation, which is the “surviving corporation.” The transferor(s) transfer property solely in exchange for shares of stock of the transferee and such shares are distributed to the shareholders of the transferor(s).
A statutory merger/consolidation requires the approval of the Securities and Exchange Commission (SEC), at which time the merger or consolidation shall be effective and the separate existence of the transferor(s) shall cease.
The surviving corporation shall come to possess all the rights, privileges, immunities, franchises, interests and property of the transferors which shall be deemed to be transferred to and vested in the surviving corporation without further act or deed.
The surviving corporation shall also be responsible for all the liabilities and obligations of the transferors as if it had itself incurred such liabilities and obligations.
A de facto merger, unlike a statutory merger, does not require the approval of the SEC and the transferor corporation is not absorbed into a transferee corporation.
Instead, at least 80% of the assets of the transferor is transferred solely in exchange for shares of stock of the transferee.
Section 40(C)(2) transfers are tax-free reorganizations because the transferors or, in the case of a merger or consolidation, the shareholders of the transferors maintain a continuity of interest in the assets transferred (since shares of the transferee constitute the consideration for the transfer).
This provision is drawn largely from the various US revenue acts of the 1920s (which have been carried forward to the present US Internal Revenue Code).
Congressional records show that the rationale for tax-free reorganization was to avoid interference with business readjustments and to allow holders to undertake such readjustments without having to liquidate their investments.
The emphasis was on encouraging new and continued investments, and on avoiding taxing an investor who has not cashed out on his investments.
VAT, on the other hand, is not an income tax but a tax on the transaction and is not dependent on gain recognition. Section 105 of the Tax Code, however, is clear that the VAT is imposed only on a person who, in the course of trade or business, sells, barters, exchanges, leases goods or properties, renders services, and any person who imports goods.
Section 105 defines the phrase “in the course of trade or business” as “the regular conduct or pursuit of a commercial or economic activity, including transactions incidental thereto.”
Republic Act (RA) No. 7716 (which, in 1994, first imposed VAT on the sale of real property held primarily for sale to customers or for lease in the course of trade or business) introduced the said definition, and this has been reenacted substantially unchanged by subsequent amendments to the VAT Law, specifically, by RA 8424 in 1997 and RA 9337 in 2005. With such reenactment, Congress adopted prior executive issuances, specifically RR 7-95, Revenue Memorandum Circular 3-96, Revenue Memorandum Ruling 01-01, and Revenue Memorandum Ruling 01-02, all of which provide that Section 40(C)(2) transfers are not subject to VAT.
Certain issues immediately become apparent.
First, will the BIR impose VAT on Section 40(C)(2) transfers which became effective prior to the issuance of RR 10-2011? Does it matter that, at the time of issuance of RR 10-2011, the transferor had not yet filed a request for ruling with the BIR to confirm the tax implications of such transfer or, if a request has been filed, that the same had not yet been acted upon?
Second, will the BIR distinguish between transfers to a controlled corporation on one hand, and mergers/consolidations on the other hand, such that only the former is subject to VAT? RR 10-2011 amends Section 4.106-8 (b)(1) of RR 16-2005, while the output tax implications of mergers/consolidations are in another subsection, i.e., Section 4.106-8(b)(3). Moreover, transfers by way of a statutory merger/consolidation take effect by operation of law and certainly cannot be construed as being in the course of trade or business of the transferor, or even incidental to such trade or business.
It may be said that the VAT is not an additional cost for either the transferor (who may have input VAT credits to offset output VAT liability on the transfer) or the transferee (to whom the transferor can pass on the amount of the VAT which can be used as credit against output VAT on the transferee’s own sales).
Nonetheless, a newly incorporated transferee may not have cash in the amount of the VAT passed on it by the transferor, so that restructuring business operations or structuring the entry of new investors using Section 40(C)(2) becomes an expensive exercise.
Hopefully, this concern will be factored into the revenue issuances implementing RR 10-2011 or in new revenue memorandum rulings which may be issued for tax-free reorganization.
(Veronica A. Santos is a Tax Principal of SGV & Co.)
This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.