Divided perspectives on dividend income

As the year draws to a close, corporations begin to account for earnings from all sources during the year, both from the active pursuit of business and passive investments. One such form of income that should not be overlooked is dividends.

The applicable tax on dividends depends on the type of recipient. The Tax Code exempts from tax dividends received by domestic corporations and resident foreign corporations from domestic corporations, while those received by non-resident foreign corporations are generally subject to a 30% final withholding tax, which may be reduced pursuant to applicable treaty and tax sparing provisions.

While the taxation of dividends under the Tax Code appears to be established and uncontroverted, taxation at the local tax level has yet to be settled in view of conflicting rulings of the Court of Tax Appeals (“CTA”) and pending the Supreme Court’s decision on the matter. 

Local Government Units (LGUs) are granted decentralized taxing authority subject to limitations enumerated under the Local Government Code (LGC). Particularly, under Section 133 (a) of the LGC, LGUs are prohibited from imposing income taxes, except on banks and financial institutions. Section 143 (f) provides that banks and other financial institutions are taxed based on their gross receipts of the preceding calendar year derived from interest, commissions and discounts from lending activities, income from financial leasing, dividends, rentals on property, profit from exchange or sale of property, and insurance premium. 

The focal issue of CTA cases dealing with local business tax (LBT) on dividend income hinges upon the application of Section 143 (f) in relation to Section 133 (a) of the LGC. 

In two recent cases, both of which were decided by the CTA through its Second Division in November 2016, holding companies were held liable to pay LBT on dividends because their activities fall under the category of “non-bank financial institutions.” By principally engaging in activities such as investment of equity securities, holding of assets consisting of shares of stock, engaging in money market placements on a recurring basis, and continued and regular receipt of dividends and interests from such investments, the holding companies were classified as “non-bank financial institutions.” 

The above rulings were issued notwithstanding the fact that the Articles of Incorporation (AOI) of the said holding companies provide that “it shall not act as an investment company, or securities broker or dealer nor exercise functions of a trust corporation.” According to the CTA, “while the primary purpose stated in the AOI of a corporation only serves to show what a corporation is empowered or authorized to do, it does not, and cannot, however, prove what the business of a corporation actually is.” 

The above rulings appear to depart from the earlier position taken by the CTA En Banc in 2015 and affirmed just seven months ago. In the previous En Banc decision, the provision of the Local Revenue Code which imposes LBT on dividend income of holding companies similar to the rates applicable to income received by banks and other financial institutions was held to be in violation of the limitation under Section 133 (a) of the LGC as regards the imposition of income taxes by the LGUs except for banks and non-bank financial institutions since the enumeration under the LGC does not include a holding company. Thus, the CTA En Banc ruled that the dividend income earned by holding companies is not subject to LBT as this is beyond the taxing authority of LGUs.

In contrast, under the recent Second Division cases, the CTA made a qualification that a holding company, which acts as a financial intermediary, may be considered a non-bank financial institution and thus, may be liable to LBT on dividends. The LGC and Local Revenue Code did not give a precise definition of what constitutes a “bank and other financial institutions”; the LGC merely enumerated entities that may fall within such term, such as “non-bank financial intermediaries. As such, the CTA referred to the definitions of “non-bank financial intermediaries” provided under Revenue Regulations 9-2004 issued by the Bureau of Internal Revenue and the Manual of Regulations for Non-Bank Financial Institutions issued by the Central Bank. In the said regulations, non-bank financial intermediaries were defined as entities whose principal functions include “lending, investing or placement of funds or evidences of indebtedness or equity deposited with them, acquired by them, or otherwise coursed through them either for their own account or for the account of others.” Applying this definition, the CTA interpreted that “the acts of investing in equity securities, holding of assets consisting of shares of stocks and placement of funds on a regular basis, as explicit affirmations that the holding company is a non-bank financial intermediary.”

Evidently, the controversy is rooted on the issue of whether or not these acts per se would suffice to qualify a holding company as a non-bank financial intermediary. From another perspective, it may be argued that the substance for conducting these activities must be considered, i.e., whether the corporation engages in the active pursuit of its business to serve as a “bridge” between lenders and borrowers/suppliers and users of funds, or just as a mere passive investment. If the activities are passive in nature, there may be basis to argue that the holding company should not be considered as a non-bank financial intermediary as it does not operate as a “bridge” between lenders and borrowers and mere holding of passive investments should not convert it into a non-bank financial intermediary.

Ultimately, the final resolution of this issue lies in the hands of the Supreme Court as the above cases are still subject to appeal. For the time being, considering that payment of the LBT is a requirement for the renewal of local business permits, holding companies similarly situated and assessed by their respective LGUs may be constrained to pay the LBT on dividends albeit under protest without prejudice to their right to claim for a refund within the allowable period.