Section 40(c)(2) of the Tax Code embodies the provisions on tax-free exchanges. It states that no gain or loss shall be recognized if, pursuant to a merger or consolidation, an exchange between the parties occurs. The exchange may consist of either: the property or securities of one entity for shares of stock of another, or a share-swap.
If qualified, these exchanges will be tax-free where no gain or loss shall be recognized. As pointed out by the Supreme Court, the purpose of the law in treating these exchanges as tax-free is to “encourage corporations in pooling, combining, or expanding their resources conducive to the economic development of our country.” The previous imposition of taxes on corporate combinations and expansions discouraged M&As to the detriment of economic progress. Thus, an incentive was provided by our legislators to encourage these transactions.
M&As, however, can also be used by firms to carry out a harmful purpose. Thus, the Philippine Competition Act (RA No. 10667) was passed. By regulating M&As, the Act intends to promote and protect competitive markets, preserve the efficiency of competition, and protect the well-being of consumers. M&As that substantially prevent, restrict, or lessen the relevant market, are prohibited. Under the Act and its implementing rules and regulations (IRR), the Philippine Competition Commission (PCC) may, on its own or upon notification, review M&As having a direct, substantial, and reasonably foreseeable effect on trade, industry, or commerce. Section 3, Rule 4 of the IRR also provides specific instances where compulsory notification becomes mandatory (i.e. upon reaching the indicated threshold).
From the laws cited above, it is clear that M&As are not mere business transactions. These are transactions imbued with public interest. They may either be helpful or ruinous to domestic markets and the local economy.
While the Tax Code and the Philippine Competition Act are different laws written for distinct purposes, both recognize the importance of M&As. One intends to provide a benefit, while the other seeks to regulate. As it stands, however, claiming the benefits of a tax-free exchange is much more tedious for taxpayers as compared to seeking the PCC approval regarding an M&A transaction.
In order to claim the benefits of a tax-free exchange, taxpayers are required to first secure a tax-free ruling from the Bureau of Internal Revenue (BIR) despite the Tax Code itself not imposing this requirement. Under BIR rules, taxpayers who do not file the required ruling application will not be able to obtain a Certificate Authorizing Registration/Tax Clearance (CAR/TCL) for shares or property transferred. This poses a problem because there are no assurances that taxpayers seeking to claim the benefits of a tax-free exchange would have their applications decided upon in a timely manner.
The BIR rules do not contain a “deemed approved” provision where a taxpayer’s ruling application would be considered approved after the lapse of a certain period. As a result, due to the long amount of time it takes for ruling requests to be processed and issued (some taking multiple years before they are concluded), taxpayers are left in limbo because they are unable to obtain a CAR/TCL.
On the other hand, under the Competition Act, if upon the expiration of 90 days, a decision has not been reached by the Commission concerning a merger or consolidation qualified for compulsory notification, it shall be deemed approved and the parties shall be allowed to consummate the transaction. This rigid deadline forces the Commission to act promptly and expeditiously. The deadline provides a safeguard for parties such that their M&A transactions would not be unduly restricted due to the government’s inaction. Moreover, big mergers that could significantly impact the economy in a positive way are given a chance to come into fruition without facing the problem of unnecessary bureaucracy.
It seems ironic that the Competition Act, the law enacted for the noble purpose of regulating M&A transactions for the protection of local consumers and market players, provides some assurance to businesses that their transactions will not be prejudiced by the government’s inaction. On the other hand, the BIR rules on tax-free exchanges do not contain any such assurance despite the purpose of the legislature in crafting Section 40(c)(2) of the Tax Code.
Notably, the Court of Tax Appeals (CTA) has recently ruled that “there is nothing explicitly requiring a party, in exchanging property for shares of stocks, to first secure a BIR confirmatory certification or tax-free ruling before it can avail itself of tax exemption” under Section 40 (c) (2). This case is somewhat parallel to the much publicized 2013 Supreme Court case of Deutsche Bank where the Supreme Court struck down the BIR’s requirement of filing a Tax Treaty Relief Application (TTRA) before a taxpayer can enjoy treaty benefits. Four years since the promulgation of the Deutsche Bank case, the BIR has begun to show signs that it recognizes this jurisprudence, albeit in a somewhat limited manner, with a new issuance which no longer requires a TTRA for certain types of income payments. It has yet to be seen, however, whether or not the BIR would adopt the CTA decision on tax-free exchange rulings.
To be clear, the Tax Code indeed does not require the filing of a tax-free ruling application in order for taxpayers to claim the benefits of Section 40(c)(2). However, in trying to make a case for the administrative requirement of obtaining a tax-free ruling, one may argue that there may be a real need to regulate these transactions in order to prevent unscrupulous parties from entering into schemes for purposes of escaping taxation. After all, the Tax Code itself provides that in order to be regarded as tax-free, the transaction must be undertaken for a bona fide business purpose and not solely for the purpose of escaping the burden of taxation. As it stands, however, the current practice of obtaining a tax-free ruling pursuant to a merger or consolidation is too cumbersome for taxpayers due to the indefinite amount of time it takes to be completed, not to mention the numerous documentary submissions required.
The current practice brings about an effect opposite to what Section 40 (c) (2) originally intended, which was to create a business environment conducive to the economic development of the country. At the very least, in the interest of continuous policy improvements, the BIR could perhaps take a cue from the Competition Act and adopt a “deemed approved” period. This would at least give businesses some assurance that their commercial transactions will not be forestalled by the government’s inaction. Taxpayers would be able to claim benefits provided by the law without unnecessary restrictions. Most importantly, making the incentive readily accessible would be more consistent with the law’s intention of encouraging the pooling, combining, and expansion of resources by the different market players.
The views or opinions expressed in this article are solely those of the author and do not necessarily represent those of Isla Lipana & Co. The firm will not accept any liability arising from the article.
Mats E. Lucero is a senior consultant at the Tax Services Department of Isla Lipana & Co., the Philippine member firm of the PwC network.