Tax-free exchange without APIC

With tagged as among the Top 10 emerging markets, many domestic companies are acquiring, merging or consolidating their businesses to expand their operations, increase market share, and maintain competitiveness, among others.

Under the Philippine Tax Code, gains or losses from the sale, exchange or transfer of properties are generally subject to tax. However, no gain or loss shall be recognized in case of a tax free exchange pursuant to Section 40(C)(2) of the Tax Code.

To qualify as a tax-free exchange, a person transfers property to a corporation in exchange for stocks issued by that corporation, and as a result of such exchange, said person, alone or together with others, not exceeding four (4) persons, gains control of said corporation.

In essence, however, the tax free exchange is mere deferral of tax. Hence, any gains shall be recognized when the properties or shares are subsequently transferred. In determining the gain or loss from a subsequent sale of properties involved in the exchange, the Tax Code as implemented by Revenue Regulation No. 18-2001 provides that the substituted basis (i.e., original or historical cost of the properties or shares) shall be considered.

Last May 2016, the Bureau of Internal Revenue issued a Revenue Memorandum Order (RMO) No. 17-2016 which provides supplemental guidelines on the recording and basis for valuation of the tax free exchange of properties for shares of stocks.

Under the RMO, the value of the shares to be issued should be equal to the fair market value of the properties/assets transferred to realize a value-for-value exchange. Consequently, the number of shares to be issued will be computed based on the fair market value of the property transferred, without considering any additional paid in capital (APIC).

In one of the illustrations provided, the incorporator transferred property (i.e., land) with a fair market value of P5 million in exchange for the shares of XYZ Company, a newly organized company with P100 par value per share. As such, the incorporator should receive 50,000 XYZ shares, which is equivalent to the P5-million property transferred. No APIC shall be considered.

With the issuance of this RMO, the question now is whether the transfer of shares in excess of the par value in exchange for properties will result in a taxable event and thus attract donor’s tax.

In other words, in the same illustration above, if the incorporator received only 40,000 shares with the same P100 par value per share, and the remaining P1 million formed part of the APIC of XYZ Company, will the P1-million APIC attract donor’s tax?

Donor’s tax is imposed on the privilege to transfer property by way of gift/ donation. Under the Civil Code of the Philippines, donation is defined as an act of liberality whereby a person (i.e., the donor) disposes gratuitously of a thing or right in favor of another (i.e., the donee), who accepts it.

Consequently, the conditions of a taxable donation include: (1) capacity of the donor to enter into a contract; (2) intention to donate; (3) actual or constructive delivery of the gift; and (4) acceptance of the gift by the donee.

Applying the conditions to our illustration, donor’s tax should not apply on the APIC in the absence of a gratuitous intent on the part of the shareholder/transferor.

From a commercial perspective, a shareholder has the right to contribute money or property (regardless of amount or value) to his own company to fund its business operations/activities. APIC is the amount paid by the shareholders in excess of the par value of the shares. It forms an integral part of the capital of the company.

In one Supreme Court decision, the Court defined capital as the value of the property or assets of the corporation. The capital subscribed is “the total amount of capital that the persons (subscribers or shareholders) have agreed to take and pay for, which need not necessarily be, and can be more than the par value of the shares.” In fine, it is the amount that the corporation receives, inclusive of any premium, in consideration of the original issuance of shares.

The amount of consideration received by the company for the issuance of shares plus the APIC is recorded as part of the price of the share capital (SEC Opinion No. 14-13).

Clearly, APIC is a capital contribution and not a gift.

Moreover, the relationship between the shareholder and the company is not of a donor and donee, but rather of an investor and investee since the shareholder is a co-owner of the company. The benefits of the capital contribution do not redound to a specific person or shareholder. Hence, this negates the presence of a donation.

The RMO, unfortunately, is silent as regards the reason for the disallowance of APIC relative to a tax free exchange.

With the current initiative of the government to implement tax reforms, it is a good opportunity for the tax authorities to revisit the requirements for availing the tax free exchange to make it simpler and easier to comply.