Imposition of value-added tax on tax-free exchanges

Mergers and acquisitions have become popular business strategies for companies looking to expand into new markets or territories, to achieve economies of scale, to attain increased synergy, or to gain a competitive edge. As companies shift focus from the United States and Europe in search of faster-growing economies such as the Philippines, merger and acquisition deals in the country are expected to escalate soon.

Acquisitions generally occur when one entity takes ownership of another company’s shares of stock or equity interest. It is not uncommon that one entity will exchange its properties for the shares of stock in another corporation. As a general rule, when a sale or exchange of property results in a gain or loss, the entire amount of the gain or loss, as the case may be, must be recognized for tax purposes. However, non-recognition of gain or loss is allowed when the transfer of property will qualify as a “tax-free exchange.”

A tax-free exchange is a transfer of property to a corporation in exchange for its shares of stock which, as a result, the transferor, alone or together with at most four others, gains control of the transferee.

This is specifically stated under Section 40(C)(2) of the 1997 Tax Code, which provides that no gain or loss shall be recognized in relation to a tax-free exchange, hence, no income tax liability will arise at the time the exchange takes place. Consequently, the transaction would have no impact on the withholding tax obligation of the transferee. Also, the transfer of property pursuant to a tax-free exchange is exempt from documentary stamp tax.

But what about value-added tax (VAT) on tax-free exchanges?

The original rule on the VAT treatment of tax-free exchanges is provided under Bureau of Internal Revenue (BIR) Revenue Regulation (RR) No. 07-95, which states that “the VAT shall not apply to goods and properties existing as of the occurrence of a change of control of a corporation by the acquisition of the controlling interest of such corporation by another stockholder or group of stockholder.” The transfer of property to a corporation in exchange for its shares of stock pursuant to a tax-free exchange falls under the above instance, thus, no VAT is imposable on the transfer. However, this rule has been modified many times over the years. When the BIR issued RR No. 16-05, it effectively superseded the original rule by providing that the exchange of real estate properties held for sale or for lease, for shares of stock, whether resulting in a corporate control, is subject to VAT.

The above rule was again later modified when RR No. 04-07 was issued. The said regulation provided VAT exemption for the transfers of real property by a real estate dealer to another real estate dealer, in exchange for the latter’s shares of stock where the transferor gains control of the transferee-corporation.

And the rules keep on changing. In 2011, the BIR issued RR No. 10-11, which reverted the rules to what is provided under RR No. 16-05, effectively abolishing the exception provided under RR No. 04-07. Thus, VAT is now again imposed on the exchange of goods and properties, including real estate property used in business or held for sale or for lease by the transferor, for shares of stock, regardless of whether the exchange resulted in corporate control or not.  This position by the BIR was most recently strengthened in Revenue Memorandum Order (RMO) No. 17-16 which provided, by way of example, that the transfer of a real property considered ordinary assets in exchange of share of stocks is subject to VAT based on the fair market value of the property.

Effectively, the BIR removed the VAT exemption on the transfers of property in exchange for controlling shares in a corporation. However, examining the real substance of a “tax-free exchange” may prove that the imposition of VAT on the exchange transaction is not justified.

VAT, being a transactional tax, is levied, assessed, and collected on every sale or transfer of goods or property. The first and foremost requirement for VAT to apply is the existence of a taxable transaction.

Essentially, in a tax-free exchange, there is no sale or transfer of goods or properties yet that will result in VAT liability. This is because the properties exchanged — be they land, buildings, or other property — were merely transformed into another form of intangible asset, which is the shares of stock. The transferor can still be considered the owner of the property transferred in his capacity as a shareholder of the transferee-corporation. The transferor and the transferee, in this case, are considered one and the same. Technically, there is no sale to speak of — the ownership of the property remained in the same hands after the “transfer” and there was no actual transmission of ownership interests to a third party.

This is the same reason our Tax Code provides that no gain or loss shall be recognized in relation to tax-free exchange transactions — there is no actual transfer that transpired. One cannot be held liable to pay for taxes for his “transfer” of property to himself. In fact, in a tax-free exchange, only the subsequent transfer of the property by the corporation to third parties shall be considered a taxable transaction, effectively deferring the imposition of a tax.

If such principles are applied to the imposition of income tax, why can’t the same be applied to VAT?

Moreover, it can be said that the exchange of property for the shares of stock is just in the nature of mere stock subscriptions. The transferor transferred properties to a corporation and, in return, received shares of stock and became a stockholder in the corporation by subscription. The transferor is in the same position had he subscribed for the shares of stock and paid the corporation in cash, in which case the transferor will generally not be subject to any tax.

Interestingly, there are fairly recent Court of Tax Appeals rulings, which held that a taxpayer has no VAT liability in relation to exchanges classified as tax-free.

While the tax-free exchanges are not actually exempted from taxes, in substance, the payment of taxes is only delayed, imposing a tax at a sooner time will still have a great impact on businesses, considering the amounts normally involved in the transactions. Taxpayers may incur massive opportunity costs.

We know for a fact that the existence of a government entails the power to tax, as taxes are the lifeblood of the nation. But the government’s power to tax comes with the power to destroy. Therefore, it should be exercised with utmost caution. The government, in adopting and implementing tax laws and regulations, should always ensure that its interest and the taxpayers’ rights are both rightly served and protected.

John Paulo C. Garcia is a senior with the Tax Advisory and Compliance division of P&A Grant Thornton. 

Published in BusinessWorld, dated on 05 September 2017