BIR Ruling

March 4, 1976 Messrs. Guzman, Bocaling & Co. Certified Public Accountants 416 Regina Bldg., Escolta Manila Gentlemen : This refers to your letter dated December 10, 1975 requesting a ruling as to the tax consequence of a proposed transaction described as follows: cdtech "1. Our client (an individual) acquired in January, 1955 parcels of land with an area of more than 100,000 square meters for a total acquisition price of P5,000.00. In view of an adverse claim filed by another party, the property became the subject of litigation between them. "2. The property has been mortgaged as collateral for loans obtained from two local banks. "3. In 1971, a compromise agreement was executed by the litigants wherein the adverse claimant, for and in consideration of the assumption by our client of the mortgage obligations to the banks and the payment of a total amount of P500,000.00 (in six installments) agreed to waive, cede and quitclaim in favor of our client its rights, interests and claims to the property. The payment schedule provided for payments annually from 1971 to 1976 which our client is religiously complying. "4. One month later, in 1971, after the compromise agreement, our client entered into an agreement with a subdivision company whereby it transferred and conveyed to the latter full and absolute title to 70,000 square meters of the property in consideration for making available to our client the sum of P260,000.00 which will be used to fully settle the obligations to the banks to provide the initial payment to the adverse claimant pursuant to the compromise agreement and the remaining balance to be turned over to our client. The subdivision company shall develop and operate the property conveyed as a subdivision, except for one hectare thereof which will be reconveyed later to our client. "5. The agreement further provides that the gross proceeds from the sale of lots shall be shared as follows: 55% to the subdivision company-developer 45% to our client which shall be distributed on a quarterly basis running from the date of the first sale of lots, except that the developer shall retain 80% of our client's share to be applied against the P260,000.00 referred to in No. 4 and such other advances and obligations which may have been paid by the developer in behalf of our client pursuant to the compromise agreement mentioned in No. 2. The 20% balance shall be turned over to our client. "6. The properties have been fully developed and were sold to lot buyers and the total outstanding installments receivable on all sales contracts reach approximately P3.4 million as of June 30, 1975 out of which our client's 45% share amount to P1.5 million. These receivables are due in monthly installments until 1989. The present value of our client's share has been computed and amounts to approximately P1 million as of June 30, 1975. aisadc "Our client now plans to exchange these receivables for an equivalent value of the shares of the capital stock of another corporation (e. g. since the present value of the receivables has been determined to be approximately P1 million, it will be willing to receive 10,000 shares of the capital stock of the corporation assuming that these shares have a market value at the time of exchange of P100 per share) After the exchange our client, together with four other stockholders, will hold the controlling interest in the capital stock of the corporation." On the basis of the foregoing facts, you posed the following queries: "a. Did our client realize a taxable capital gain under the transaction? How much? "b. For income tax purposes, what is the cost basis of the receivables to the corporation referred to? "c For accounting purposes, the corporation will initially record the acquired installments receivable in its book of accounts at the face value of the various installment receivable balances although the acquisition cost obviously is lower. Will this difference be taxable to the said corporation? If so, is this to be recognized: 1. at the time of acquisition of the receivables, or 2. as the installments are collected?" In reply thereto, I have the honor to inform you that pursuant to Section 35 paragraph (c)(2)(c) of the Tax Code as amended by Republic Act No. 4522, no gain or loss shall 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. The term "control" shall mean ownership of stocks in a corporation possessing at least fifty-one (51%) per cent of the total voting power of all classes of stocks entitled to vote. Accordingly, no gain or loss shall be recognized both to your client and the transferee corporation, on the transfer by your client of his property consisting of accounts receivables amounting to approximately P1,000,000.00 as of June 30, 1975 in exchange for 10,000 shares of stock of a corporation with a market value of P100 per share, considering that as a result of the said exchange, your client together with four other stockholders, will gain control of the transferee corporation. It should be understood, however, that if your client later sells or exchanges the shares of stock acquired by him in the exchange, he shall be subject to income tax on the gains derived from such exchange or sale, and the cost basis of said shares of stock shall be the same as the original acquisition cost or adjusted cost basis to your client of the property exchanged therefor. (see Sec. 35(c) (4), NIRC) Being a cash-basis taxpayer, the acquisition cost of the receivables to your client is zero adjusted to the date of the exchange. (see par. 934-935, pp. 318 and 320 US Master Tax Guide (1969)) And the adjusted cost basis of the property transferred should include any expenditure, receipt, loss, or other items properly chargeable to capital account. This necessitates an addition for improvements and betterments made to the property since its acquisition up to the time of the exchange. Other capital charges are added to the cost resulting in the adjusted cost basis of the property to your client, e.g. an allocable portion of the expenses incurred in connection with the adverse claim and for the improvement and development of subdivision lots.(see par. 937, p. 320, Id.) In case of transfer of property to a corporation in exchange for its shares of stock, the basis of the property transferred in the hands of the transferee corporation shall be the same as it would be in the hands of the transferor, increased by the amount of the gain recognized to the transferor on the transfer. (See. 35(c)(4)(b), NIRC) Such being the case, the basis of the receivables in the hands of the transferee corporation would be the aforementioned adjusted cost basis of the said receivables to your client in the amount of P1,000,000.00. You are further advised that in order that your client can avail of the non-recognition of gain provided for in Section 35(c)(2)(c) of the Tax Code, as amended, he and the transferee corporation must file with their income tax returns for the taxable year in which the exchange was consummated a complete statement of facts pertinent to the exchange. The statement of the transferor, should include the following information 1. A description of the property transferred, together with a statement of the original acquisition cost or other basis thereof at the time of the transfer; 2. The kind of stock received and preference if any; 3. The number of shares of each class received; 4. The fair market value per share of each class at the date of exchange. The transferee corporation should include the following in the statement to be filed with its income tax return 1 A complete description of all property received from the transferor; 2 A statement of the original acquisition cost or other basis of the property in the hands of the transferor and the adjusted cost basis thereof at the time of the transfer; 3. Information on the capital stock of the corporation, including (a) The total issued and outstanding capital stock immediately prior to and immediately after the exchange, with complete description of each class of stock; (b) The classes of stock and number of shares issued to the transferor in the exchange; and (c) The fair market value of the capital stock issued to the transferor as of the date of exchange. In addition to the foregoing requirements, permanent records in substantial form must be kept by each party to the exchange, which should show the information hereinabove listed. cdtech Very truly yours, CONRADO P. DIAZ Acting Commissioner of Internal Revenue TAN-1182-568-4 "TAXPAYERS SHOULD INDICATE THEIR TAN IN ALL COMMUNICATIONS TO THE BIR."