Grandfather Rule; a supplement to the Control Test

Taxwise or Otherwise

By Elinor E. de Gracia, 2 July 2015

Certain provisions of the Philippine Constitution were crafted to protect the rights of Filipino citizens to utilize our natural resources and to engage in nationalized activities. However, this should not deter foreign economic investments that would allow the country to efficiently explore these natural resources and effectively operate public utilities or reserved activities.

In determining compliance with the minimum Filipino equity requirement, there are two acknowledged tests. One is the control test or the liberal rule. The other is the Grandfather Rule, which is known to be the stricter and more stringent test. In applying these tests, there had been confusion as to whether one method excludes the use of the other.

The control test provides that shares belonging to corporations or partnerships at least 60% of the capital of which is owned by Filipino citizens shall be considered of Philippine nationality. This test is straightforward and does not scrutinize further the ownership of the Filipino shareholdings.

On the other hand, the Grandfather Rule determines the actual Filipino ownership and control in a corporation by tracing both the direct and indirect shareholdings in the corporation.

According to the January 2015 Resolution of the Supreme Court in the case of Narra Nickel Mining and Development Corp. vs. Redmont Consolidated Mines Corp. (G.R. No. 195580), “the Grandfather test was originally intended to look into the citizenship of the individuals who ultimately own and control the shares of stock of a corporation for purposes of determining compliance with the constitutional requirement of Filipino ownership”.

The shareholdings should ideally be traced (i.e. grandfathered) to the point where natural persons hold the shares. However, this may be impractical and a limit must be set when tracing through the corporate layers to attribute nationality. Citing a memorandum from the Securities and Exchange Commission (SEC), the Supreme Court noted the suggestion of the SEC to apply the Grandfather Rule on two levels of corporate relations for publicly-held corporations or where shares are traded in the stock exchange, and to three levels for closely held ones or those which are not traded in any stock exchange. Clearly, the limits should not go beyond the level of what is reasonable.

The Supreme Court clarified the role of these tests in determining compliance with the required Filipino equity threshold. The Court explained that the use of the Grandfather Rule is a supplement to the Control Test in implementing the wisdom of the “Filipinization” provisions of the Constitution.

The Supreme Court recognized the intention of the framers of the Constitution to apply the Grandfather Rule in cases where there is corporate layering. It likewise noted that corporate layering, while admittedly allowed by the Foreign Investment Act, becomes illegal if used to circumvent the Constitution and other applicable laws.

The Court further discussed that the Grandfather Rule applies only when the 60-40 Filipino-foreign ownership is in doubt or where there is reason to believe that there is non-compliance with the provisions of the Constitution on the nationality restriction.

How then we do we determine the existence of doubt? In its Resolution, the high court clarified that “doubt” does not automatically mean the mere failure of the Filipino ownership to meet the 60% threshold of the corporation’s equity. “Doubt” refers to various indicia that the “beneficial ownership” and “control” of the corporation do not in fact reside in Filipino shareholders but in foreign stakeholders.

To demonstrate these signs of doubt, the Court referred to the indicators of a dummy status as identified in a Department of Justice Opinion on the Anti-Dummy Law. These would be where the foreign investors provide practically all the funds and technological support for a joint venture undertaken with their Filipino partners, and where such foreign investors get to manage the company even while being minority stockholders.

In the Narra Nickel Mining case, the Supreme Court found that while the petitioning corporations complied with the Control Test, factual circumstances nonetheless raise doubt as to their true nationality and therefore requires the application of the Grandfather Rule. Some of the indicators of “doubt” found by the Court in the said case are the following: (1) the three mining corporations had the same 100% Canadian owned foreign investor, (2) the similar corporate structure and shareholder composition of the three corporations, (3) a major Filipino shareholder within the corporate layering did not pay any amount with respect to its subscription, and (4) the dubious act of the foreign investor in conveying its interests in the mining corporations to another domestic corporation, among others. These instances demonstrate that corporate layering was utilized to allow a foreign corporation to gain control of these mining corporations in the Philippines.

After applying the Grandfather Rule, the Supreme Court was able to trace and conclude that the Filipino shareholders did not actually have the required amount of control and beneficial ownership in the mining companies, and consequently failed to comply with the nationality requirement under the Constitution.

In a fitting ending, the Supreme Court enunciated its original April 2014 decision that “the Control Test is still the prevailing mode of determining whether or not a corporation is a Filipino corporation”. It is only in case of doubt, based on the attendant facts and circumstances of the case, that the Grandfather Rule is applied.

 

Elinor E. de Gracia is a manager at the Tax Services Department of Isla Lipana & Co., the Philippine member firm of the PwC network.

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