BIR Ruling [DA-318-05]

July 15, 2005 BIR RULING [DA-318-05] Laya Mananghaya & Co. 22/F Philamlife Tower 8767 Paseo de Roxas Makati City Attention: Atty. Francisco C. Tagao Head, Tax & Corporate Services and Atty. Ma. Carmela M. Peralta Manager, Tax & Corporate Services Gentlemen : This refers to your letter dated July 7, 2005 stating that your client, Monumento Rail Transit Corporation (MR),is a domestic corporation the business purpose of which is to build, lease, maintain and transfer a railway transit system in Metro Manila known as the Light Rail Transit System Phase II and Makati Loop, to receive royalties from MRT Development Corporation (MRTDC),and to perform such other activities necessary and desirable in the pursuit of the above-mentioned activities; that MR has not yet commenced commercial operations; that at present, its authorized capital stock is P10 Million, broken down into 200 Million common shares with a par value of P0.05 per share; that of the P10 Million, the amount of P9.5 Million, broken down into 190 Million common shares, has been subscribed and paid-up; that the documentary stamp taxes (DST) on the original issuance of these outstanding shares have been paid; that in a special meeting held by MR's board of directors on May 30, 2005 and by MR's stockholders on June 23, 2005, the amendment of MR's Articles of Incorporation (AOI) was approved to grant a proportionate number of the common shares held by each stockholder a convertibility feature such that these shares while remaining common shares are convertible into redeemable, preferred shares; that the grant of the convertibility feature will not involve any cash flow and will not change the par value of the shares and the stockholders' proportionate interest in MR; that the amended AOI will state that in the event the common shares are converted into redeemable, preferred shares and MR decides to redeem the said shares, MR will pay for the redemption through the assignment of its right to receive royalties hereinafter referred to as "depot royalties" from MRTDC, a domestic corporation which had previously been granted the right to exploit, utilize and exercise the development rights defined under the Revised Build Lease & Transfer Agreement (BLT) dated August 8, 1997, between the Department of Transportation and Communications and the then existing Metro Rail Transit Corporation Limited (MRTCL) [formerly named EDSA LRT Corporation],a foreign corporation duly organized and existing under the laws of Hong Kong; that under the said BLT Agreement which provided for the construction of the rail transit system along EDSA, MRTCL was awarded the above-mentioned development rights which pertain to the right to develop commercial premises on, among other things, a parcel of land referred to as the depot with an area of 160,481 square meters and covered by TCT No. (309406) T-16250 issued by the Registry of Deeds for Quezon City; that on June 16, 1995, MRTCL assigned for a consideration to MRTDC the right to exploit, utilize and exercise the developmental rights; that as part of the consideration for the assignment, MRTDC undertook to deliver and/or pay to MRTCL the depot royalties representing 5% of rental income with respect to the commercial center to be developed by MRTDC and/or its assignee/s in the depot; that the depot royalties shall be paid for a period of 43.58 years; that subsequently, MR acquired the right to receive the depot royalties by virtue of a Deed of Assignment dated December 18, 2000, executed in its favor by MRTCL; that in addition, on February 21, 2002, MRTDC assigned under a tax-free transfer to another domestic corporation, North Triangle Depot Commercial Corporation (NTDCC),the development rights covering the depot in exchange for shares of stock in NTDCC; that however, the assignment did not include the transfer to NTDCC of the obligation to pay the depot royalties to MR; that to date, no commercial center has been developed on the depot by NTDCC and, consequently, no rental income has been derived by MRTDC; that no depot royalties have been paid by MRTDC to MR; and that MR is now in the process of preparing its application with the Securities and Exchange Commission (SEC) for approval of the above-mentioned amendments to its AOI. Based on the foregoing representations, you now request confirmation of your opinion on the following "1. When MR's common shares are granted convertibility features such that the said shares while remaining common shares are convertible into redeemable, preferred shares, MR's stockholders will not be liable for the capital gains tax (CGT) and no DST will be due; "2. When the common shares are re-classified into redeemable, preferred shares at par for par pursuant to their convertibility features, MR's stockholders will not be liable for the CGT and no DST will be due; "3. When upon redemption of the redeemable, preferred shares, MR assigns to its stockholders its right to receive the depot royalties, MR will not be liable for any income tax. Moreover, the assignment will not be subject to the 10% VAT and no DST will be due upon the surrender and cancellation of the redeemable, preferred shares; On the other hand, the gain derived by MR's stockholders will be subject to the ordinary corporate income tax. However, if a corporate stockholder is a resident of a tax treaty country which provides for tax exemption on capital gains, the gain derived may be exempt from income tax under the corresponding tax treaty provided that the conditions prescribed for the exemption are complied with; and "4. The fair rental value of the depot as determined by an independent appraiser is acceptable for purposes of determining the fair market value of MR's right to receive the depot royalties." In reply thereto, please be informed that your opinion is hereby confirmed as follows 1. In BIR Ruling No. DA-030-05 dated January 24, 2005 ,this Office had already the occasion to rule on the matter when it said that: DICcTa "The conversion of the common shares into preferred shares shall not be subject to capital gains tax since the holders thereof merely change the form of their shareholdings from common shares to preferred shares and they do not realize any gain or economic benefit therefrom. ( BIR Ruling No. DA-141-99 dated March 9, 1999 ) The exchange of common shares into preferred shares qualifies as a mere recapitalization and no gain or loss is recognized therefrom. Recapitalization has been defined as a readjustment of existing interests in the rearrangement of the capital structure' of the company, which generally are non-taxable to both the holders and the issuing corporation. ( Mertens, Law of Federal Income Taxation, Section 43.105, pp. 164-166 )" The above-cited ruling is in line with the Supreme Court Decision entitled " Commissioner of Internal Revenue vs. Court of Appeals, Court of Tax Appeals and A. Soriano Corporation, G.R. No. 108576 (20 January 1999) ,where it was recognized that no income was realized by the stockholders upon the reclassification of common shares into preferred shares since there was no change in the proportionate interest of the stockholders after the reclassification. Both classes of stocks had the same par value. There was no cash flow and the reclassification was a mere corporate paper transaction. Any difference in the market value of the shares would be immaterial at the time of the reclassification because no income was realized. There was only a modification of the subscribers' rights and privileges and this was not a flow of wealth for tax purposes. Such being the case, when the common shares held by MR's stockholders are granted convertibility features but without changing the stockholders' proportionate interest and the par value of the shares and without any cash flow, MR's stockholders will not be liable to capital gains tax. Moreover, it was ruled that the conversion of the preferred shares into equivalent common shares does not partake of the issuance of original shares of stock and, hence, the same is not subject to the DST imposed under Section 175 of the Tax Code of 1997. aSEDHC Likewise, the said reclassification is not subject to the DST provided the new certificates are issued to the same stockholders and the par value is not higher than the replaced certificates ( BIR Ruling DA-406-03 dated November 10, 2003; BIR Ruling DA-030-05 dated January 24, 2005) .Accordingly, no DST will be due when the common shares are reclassified into common shares convertible into redeemable, preferred shares since there is neither original issuance of shares nor transfer of shares. 2. In BIR Ruling DA-141-99, dated March 09, 1999 ,this Office ruled that the conversion of the preferred shares for common shares, at par for par, in line with the conversion feature of the preferred shares shall not be subject to CGT since the stockholders merely change the form of their shareholdings from preferred to common shares and they do not realize any gain or economic benefit therefrom. Moreover, the exchange of the preferred shares for common shares qualifies as a mere recapitalization as discussed above and no gain or loss is recognized therefrom. This Office also stated that the said conversion pursuant to the subscription contract and which does not entail any transfer of ownership to another shareholder but to itself alone is not a transaction distinct from the subscription contract but a mere continuation of the initial transaction and for which the required DST was already paid. Such being the case, the said exercise of right to convert by the stockholder can be recorded as a memorandum not of a sale transaction but of a conversion which is not subject to DST ( BIR Ruling No. 158-98 dated November 10, 1998 ). Consequently, upon conversion of the MR common shares into redeemable, preferred shares at par for par pursuant to the conversion feature of the shares, MR's stockholders will not be liable for the CGT and the corresponding DST on transfer of shares. 3. In BIR Ruling No. 171-92 dated May 28, 1992; BIR Ruling No. 039-02 dated November 11, 2002, and BIR Ruling DA-033-2005 dated January 27, 2005 ,this Office ruled that the transfer by the liquidating corporation of its remaining assets to its stockholders is not considered as a sale of assets. Thus, a liquidating corporation does not realize gain or loss in partial or complete liquidation. Conversely, neither is a liquidating corporation subject to tax on its receipt of the shares surrendered by its shareholders pursuant to a complete or partial liquidation. The redemption may be considered akin to a partial liquidation of a corporation because as in partial liquidation, and pursuant to SEC's Rules Governing Redeemable and Treasury Shares, dated April 26, 1982 ,the redeemable shares so redeemed or reacquired shall be considered retired and no longer issuable, unless otherwise provided in the articles of incorporation. Since the amended AOI of MR will not provide otherwise, the redeemable shares so reacquired shall be considered retired and no longer issuable. Such being the case, upon redemption of the redeemable, preferred shares, MR will not be liable for income tax on the transfer of its rights to receive the depot royalty rights as payment for the redemption and on its receipt of the surrendered shares. Moreover, in BIR Ruling DA-033-2005 dated January 27, 2005 and BIR Ruling DA-164-04, dated April 5, 2004 ,this Office held that the transfer by a liquidating corporation of its properties is not made in the course of trade or business and, thus, the same is not subject to 10% VAT. Furthermore, as discussed above, in BIR Ruling No. 171-92 dated May 28, 1992; BIR Ruling No. 039-02 dated November 11, 2002, and BIR Ruling DA-033-2005 dated January 27, 2005 ,this Office ruled that the transfer by the liquidating corporation of its remaining assets to its stockholders is not considered as a sale of assets. This being the case, the transfer by MR of the right to receive the depot royalties is not a sale and, therefore, the same is not subject to VAT. Furthermore, Section 175 of the Tax Code of 1997, as amended by R.A. No. 9243 provides that: "SEC. 175. Stamp Tax on Sales, Agreements to Sell, Memoranda of Sales, Deliveries or Transfer of Shares or Certificates of Stock . On all sales, or agreements to sell, or memoranda of sales, or deliveries, or transfer of shares or certificates of stock in any association, company, or corporation, or transfer of such securities by assignment in blank, or by delivery, or by any paper or agreement, or memorandum or other evidences of transfer or sale whether entitling the holder in any manner to the benefit of such stock, or to secure the future payment of money, or for the future transfer of any stock, there shall be collected a documentary stamp tax of Seventy-five-centavos (P0.75) on each Two hundred pesos (P200),or fractional part thereof, of the par value of such stock: ..." It is clear that the above-cited section imposes the DST on all sales or agreements to sell, or memoranda of sale, or deliveries, or transfer of shares whether entitling the holder in any manner to the benefit of the shares. The DST on the transfer of shares will not apply on the surrender and cancellation of the MR shares upon their redemption. In BIR Ruling No. 039-02, dated November 11, 2002, and BIR Ruling DA-174-03, dated June 03, 2003 ,this Office held that no DST shall be due on the surrender and cancellation of shares in the case of a partial liquidation. The surrender of the shares does not constitute a sale, assignment or transfer because the liquidating corporation is not taking title to the surrendered shares and the shares are retired and not retained as treasury shares. In effect, the liquidating corporation does not realize any benefit, as owner or otherwise, from its receipt of the shares. Such being the case, considering that the MR shares will be considered retired and no longer issuable upon redemption, no DST is due on the surrender and cancellation of the redeemable, preferred shares. On the other hand, the gain, if any, derived by MR's stockholders representing the difference between the fair market value of the right to receive the depot royalties and the cost basis of the shares will be treated as gain from the sale or exchange of shares subject to the ordinary income tax rates provided under Section 24(A)(1), Section 25(A)(1) and (B), Section 27(A) or (E), 28(A)(1) or (2), or Section 28(B)(1) of the Tax Code, depending on the status of the stockholder. In BIR Ruling No. 039-02, dated November 11, 2002 and BIR Ruling DA-174-03, dated June 03, 2003 , this Office ruled that the liquidating gain received by the shareholders as a result of the partial liquidation of a corporation and computed as the difference between the fair market value of the properties received and the cost basis of the shares to the stockholders is to be treated as the gain from the sale or exchange of shares subject, however, not to the 5%/10% final tax rate under Section 24(C), Section 25(A)(3) or (B), Section 27(D)(2), Section 28(A)(7)(c) and Section (B)(5)(c) of the Tax Code but to the ordinary income tax rates provided under Section 24(A)(1), Section 25(A)(1) and (B), Section 27(A) or (E), Section 28(A)(1) or (2) or Section 28 (B)(1) of the Tax Code, depending on the status of the shareholder. However, if MR's stockholder is a resident of a tax treaty country which provides for a tax exemption on capital gains, the gain derived may be exempt from income tax under the corresponding tax treaty provided that the conditions prescribed for the exemption are complied with ( ITAD Ruling No. 002-05 dated January 06, 2005 ). 4. Finally, for purposes of determining the gain derived by MR's stockholders from the redemption of their MR shares, the fair market value of the right to receive the depot royalties shall be considered. However, inasmuch as MR has not yet received depot royalties from MRTDC and the depot royalties are based on the rental income with respect to the commercial center to be developed on the depot, the fair rental value of the depot as determined by an independent appraiser is acceptable for determining the fair market value of the right to receive the depot royalties. Otherwise-stated, the fair rental value of the depot as determined by an independent appraiser shall be the basis for computing the 5% depot royalties. TSHIDa This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it will be disclosed that the facts are different, then this ruling shall be considered null and void. Very truly yours, (SGD.) JOSE MARIO C. BUAG Deputy Commissioner Legal & Inspection Group