BIR Ruling

October 6, 1967 2nd Indorsement Respectfully returned to the Honorable, the Secretary of Finance, the letter-inquiry of Messrs. Siguion Reyna, Montecillo, Belo & Ongsiako dated July 29, 1967. cdti For ready reference and convenience, the query is reproduced, viz.: "Our client, Ayala y Compania, a general copartnership duly organized and registered in accordance with the laws of the Philippines, wishes to liquidate itself in the following manner: "1. Its assets consist of: a. Accounts receivable; b. Shares of stock; c. A contingent percentage which it receives from the gross selling price of lots formerly purchased by another corporation when the land was raw, that is, when it was an agricultural, undeveloped and unimproved land. The purchasing corporation subsequently developed the raw land and subdivided it for sale to customers. "2. The partnership wishes to transfer its accounts receivable and shares of stock ("a" and "b", above), at cost, to a new corporation in exchange for shares of the latter under the provisions of Republic Act No. 4522. One partner, together with four other partners, will gain control of the new corporation, that is, they will own more than 51% of the total voting power of all classes of stock. cdtech "3. The contingent percentage on the gross sales of the land would be distributed among the partners, by way of liquidating dividends to the partners, in proportion to their shares in the partnership. In a previous ruling by your Bureau, this contingent percentage was considered as capital gains and the same are being reported for income tax purposes during the years the amounts are received by the partners. It is not possible to include this contingent percentage among the assets to be transferred to the new corporation due to the difficulty in determining its real value at the time of incorporation. "Considering the above fact, we would like your confirmation regarding the treatment of these transactions, as follows: "1. That the transfer of the shares of stock accounts receivable to the new corporation in exchange for shares of the latter falls within the purview of Republic Act No. 4522; "2. That the distribution of the contingent percentage (1 "c", above) among the partners in proportion to their participation in the partnership is not taxable to the partners in the year of such distribution and that the partners can continue to report the same as capital gains on a cash basis as actually received. cdll Under Section 26 of the National Internal Revenue Code, persons carrying on business in a general copartnership (Compania Colectiva) duly registered in the Mercantile Registry shall be liable for income tax only in their individual capacity, and the share of the profits of the registered general copartnership to which any taxable partner would be entitled, whether divided or otherwise, shall be returned for taxation and the tax paid in accordance with Section 21 of the Tax Code. This is so, for the reason that a registered general copartnership is not taxable as such and for tax purposes is considered as an aggregate of persons engaged in the common pursuit of profit rather than as an entity by itself, separate and distinct from its members. In other words, a registered general copartnership is considered, for tax purposes, as merely a conduit through which the partner's separate share of ordinary income or capital gain passes. (See Benjamin V. Hoey, 47 F. Supp. 158; Black V. Davis, 48 AFTR 1662.) The explanatory note of House Bill No. 14472 which became Republic Act No. 4522 states as follows: "The Government should encourage sole proprietors in business to incorporate their properties and businesses in order to enable them to broaden the base of ownership thereof , and to enable sound business enterprises to grow and expand by inviting others to invest capital therein. llcd "Similarly, pooling of resources among corporate businesses should also be encourage by permitting them to organize separate corporations to split up their business and expand the capital base of each of the resulting corporate organizations. However, the present tax laws discourage this because even under existing rulings of the Bureau of Internal Revenue, tax-free incorporations of assets can be effected only if substantially all of the properties of the transferor are transferred to a corporation and if the transfers are made at book value. "This bill seeks to eliminate this difficulty by permitting the assets to be transferred at market value in exchange for shares of stock of the transferee corporation. Both transferor and transferee, must maintain separate records, solely for tax purposes, showing the actual unrecovered cost of the properties transferred. It is on the basis of this historical cost, not the market value of the properties at the time of the incorporation, that the income tax will be computed. In this way, there would be no loss of tax revenues." prcd As originally drafted, Section 35(c) (2) had these additional provisions following the word "merger or consolidation", viz: "No gain or loss shall also be recognized if a person exchanges his property for stock in a corporation of which as a result of such exchange said person, alone or together with others, gains control of said corporation: Provided , That stocks issued for services shall not be considered as issued in return for property." During the period of amendment, the committee introduced the following amendments: "1. On line 2, page 2, between "others", and "gains" inserts "NOT EXCEEDING FOUR PERSONS." (Congressional Record, May 6, 1965) As amended the additional provisions to Section 35(c)(2) therefore, read as follows: ". . . . No gain or loss shall also be recognized if a person exchanges his property for stock in a corporation of which as a result of such exchange said person, alone or together with others, not exceeding four persons , gains control of said corporation." Provided , That stocks issued for services shall not be considered as issued in return for property." cdpr These additional provisions to Section 35(c)(2) were intended to be applicable to natural persons as shown by the pronoun "his" preceding property, and the phrase "not exceeding four persons", in accordance with the first paragraph of explanatory note which seek to encourage sole proprietors in business to incorporate their properties and businesses in order to enable them to broaden the base of ownership thereof. As the Ayala y Compania is a general copartnership, which, for tax purposes, is considered as an aggregate of natural persons engaged in the common pursuit of profit, rather than an entity by itself, and which is exempt from income tax, the transfer of the assets thereof consisting of accounts receivables and its shares of stock, comprised in items 1(a) and 1(b) of the letter-inquiry under reply in exchange for corporate shares of stock representing more than 51% of the total voting power of all classes of stock of the transferee corporation will qualify in a tax free-exchange contemplated by Republic Act 4522. As regards the asset comprised in item 1(c), it appears that said asset is part of the purchase price of the undeveloped land previously sold by the partnership to the corporation engaged in the subdivision business. This sale transaction was before brought to the attention of this Office for the determination of the character of the gain to be derived therefrom. In a letter dated January 24, 1957, this Office rules that the undeveloped land was capital asset to the partnership and, therefore, the gain derived from the sale thereof is capital gain. aisadc It is observed that in the instant case, the transaction in effect results in the complete termination of the partnership's business and in the complete liquidation of the partners' interest therein. It is the essence of general partnership business that all items of income derived and expenses incurred by the partnership are considered as if this are income derived and incurred directly by the partners themselves. (Par. 15531, P-H, Vol. 3, 1963) The character of the gain, therefore, in the hands of the partnership remains the same in the hands of the partners as in fact the latter, not the partnership, are liable for the tax thereon whether distributed to them or not (Sec. 26, Tax Code) Said contingent percentage share in the sale of the subdivision lots of the partnership which the partners will receive in complete liquidation of their interests in the partnership will be taxable to them as capital gain. Being contingent, the same shall be considered derived and taxable to them in the year when actually or constructively received. cdt (SGD.) MISAEL P. VERA Commissioner of Internal Revenue