Sycip Gorres Velayo & Co.

December 16, 2008 BIR RULING [DA-(C-176) 539-08] Redemption of Redeemable Shares; DA-391-08; DA-360-06; DA-318-05; DA-356-03; DA-092-00; DA-060-98 Sycip Gorres Velayo & Co. 6760 Ayala Avenue 1226 Makati City Attention: Atty. E. C. Alcantara Tax Division Gentlemen : This refers to your letter dated May 18, 2007 requesting confirmation of your opinion on the following: (a) The redemption by Sithe Philippines Holdings, Inc. (SPHI) of redeemable preferred shares of stock (Redeemable Preferred Shares) issued to its parent company shareholder, Axia Power Holdings Philippines Corporation (APHPC) at a redemption price equal to the issue value of the Redeemable Preferred Shares and payable in US Dollars based on the exchange rate as of the date of conversion of the shareholder advances into the Redeemable Preferred Shares to be redeemed: (i) Will not result to any income/capital gain on the part of SPHI and APHPC and, therefore, SPHI and APHPC are not subject to income/capital gains tax; (ii) Is not subject to documentary stamp tax (DST) under Section 175 of the Tax Code of 1997, as amended by R.A. No. 9243. (b) The issuance of replacement stock certificates to replace the Original Stock Certificates in order to cover separately the redeemed shares and the unredeemed shares covered by such Original Stock Certificates (with the certificates covering the redeemed shares to be cancelled upon the approval by the Securities and Exchange Commission (SEC) of SPHI's decrease or reduction in capital stock corresponding to the redeemed shares) is not subject to DST under Section 174 of the Tax Code of 1997, as amended by R.A. No. 9243. It is represented that SPHI is a domestic corporation duly organized and existing under and by virtue of the laws of the Philippines and a wholly owned subsidiary of Axia, with registered office and principal place of business at Taguig City. SPHI is primarily authorized under its Articles of Incorporation to act as a holding company. On January 21, 2003 and October 7, 2004, SPHI authorized the conversion of shareholder advances/loans into equity ( i.e., the Redeemable Preferred Shares) pursuant to which the Redeemable Preferred Shares were issued to Sithe Asia Holdings Limited. Thereafter, pursuant to a series of tax-free transfers in line with a valid business and ownership restructuring, the Redeemable Preferred Shares were transferred to Axia. On March 21, 2007, the Board of Directors and stockholders of SPHI approved the amendment of Article Seventh of the Amended Articles of Incorporation (AOI) of SPHI on the manner of determination of the redemption price for the Redeemable Preferred Shares, thus: aIDHET "3. Redemption. Subject to any restrictions contained in the Financing Documents and to Applicable Law, upon the affirmative vote of the Board of Directors, and if required by Applicable Law, by the stockholders, of the Corporation, each share of preferred stock may be redeemed out of earnings or any amounts that may at the time be credited to the share premium account on the Corporation's books, at a redemption price (the "Redemption Price") equal to the issue value of Three Thousand Five Hundred Twenty-Five Pesos (P3,525) per share, and in the same currency as the shareholder advances/loans that were converted into such preferred stock, using the original exchange rate at which the shareholder advances/loans were converted into the preferred shares to be redeemed. The preferred stock shall be redeemed from cash resources of the Corporation, reasonably determined by the Board to be available for that purpose, and shall, in all events, be redeemed in full by not later than the date of liquidation of the Corporation. Preferred Shares may be redeemed regardless of the existence of unrestricted retained earnings provided that the Corporation has, after such redemption, sufficient assets in its books to cover debts and liabilities inclusive of capital stock." The SEC approved the foregoing amendments to SPHI's Amended AOI on May 8, 2007. With the effectivity of the foregoing amendments, SPHI will initially authorize a partial redemption of the Redeemable Preferred Shares and a decrease or reduction in capital stock corresponding to the number of redeemed shares. Thereafter and considering that it would be impractical and an administrative burden for SPHI to amend its AOI in order to reduce its capital stock after each redemption, subsequent redemptions by SPHI of the remaining Redeemable Preferred Shares will not immediately be followed by a reduction in capital stock, but such reduction in capital stock through an amendment of the AOI will be implemented after two or more redemptions. In reply, please be informed as follows: 1) The redeeming corporation is not subject to income/capital gains tax. In BIR Ruling No. DA-360-06 dated June 9, 2006, it was ruled that the redeeming corporation was merely performing the ministerial function of implementing the reduction of capital stock and therefore it is not taking title to nor will it receive any value for the surrendered shares. The reduced shares of the redeeming company do not represent value since they are merely the documentary evidence of the reduced capital stock and will cease to exist after their cancellation. Further, in BIR Ruling No. DA-318-05 dated July 15, 2005, it was ruled that "Pursuant to SEC's Rules Governing Redeemable and Treasury Shares, dated April 26, 1982, redeemable shares so redeemed or reacquired shall be considered retired and no longer issuable, unless otherwise provided in the articles of incorporation." Thus, in BIR Ruling No. DA-391-2008 dated June 30, 2008, which involved similar issues, it was ruled that upon redemption by SRPC of its redeemable preferred shares pursuant to its Amended AOI (which do not provide that the redeemed shares may be reissued), the redeemable shares so reacquired shall be considered retired and no longer issuable, and therefore, SRPC will not be liable for income tax upon such redemption and on its receipt of the surrendered shares evidencing the redeemed shares. Similarly therefore, upon redemption by SPHI of its redeemable preferred shares pursuant to its Amended AOI (which likewise, do not provide that the redeemed shares may be reissued), the redeemable shares so reacquired shall be considered retired and no longer issuable, and therefore, SPHI will not be liable for income tax upon such redemption and on its receipt of the surrendered shares evidencing the redeemed shares. The redemption by SPHI of the Redeemable Preferred Shares necessarily results in the creation of treasury shares, which shares are considered retired and no longer issuable, and will be cancelled upon SEC approval of the decrease in capital stock corresponding to such shares. Thus, in the case of SPHI, it is not subject to income tax on its redemption and receipt of the Redeemable Preferred Shares to be surrendered by its Shareholders since the Redeemable Preferred Shares, upon their redemption as treasury shares, are considered retired and no longer issuable and, furthermore, SPHI is merely performing the ministerial function of implementing the reduction of capital stock upon subsequent cancellation of the Redeemable Preferred Shares so redeemed and surrendered and therefore SPHI is not taking title nor will it receive value for the Redeemable Preferred Shares redeemed and surrendered. cHDEaC 2) Preferred shareholders not subject to income/capital gains tax upon redemption. It was ruled in BIR Ruling No. DA-060-98 dated February 20, 1998 which involved redemption of preferred shares, that preferred shareholders will realize capital gain or loss consisting of the difference between the adjusted basis of the shares and the redemption price of such shares. Thus, there is taxable gain or loss on the redemption of shares when the adjusted basis of the shares is not equivalent to the redemption price of the shares. However, as ruled by the Supreme Court in Commissioner of Internal Revenue vs. Court of Appeals, G.R. No. 108576 dated January 20, 1999, if redemption from original capital subscription or initial capital investment is concurrent to the value of acquisition, there is no income but a mere return of capital. Moreover, in BIR Ruling No. 070-99 dated May 19, 1999 which involved the redemption by FEHI of its preferred shares, the Bureau ruled the same as follows: "Since the 433,330 shares of BVPL and the 66,665 shares of OIL will be redeemed at the price of P2,500.00 or its equivalent of US$95.27 converted at the exchange rate of P26.241 to a US dollar, which is the same as the issue price or adjusted basis of said shares, the redemption of such shares by FEHI will not result to any capital gain on the part of BVPL and OIL. In view of the foregoing, since there is no taxable gain, the redemption by FEHI of the shares of BVPL and OIL will not be subject to capital gains tax." In BIR Ruling No. DA-391-2008 dated June 30, 2008, which involved similar issues, it was held therein that "since the Redeemable Preferred Shares issued to the Shareholders will be redeemed at a price equal to its issue value and payable in US Dollars based on the (original) exchange rate as of the date of conversion of the shareholder advances into the Redeemable Preferred Shares to be redeemed, the redemption price is the same as or equal to the issue price or adjusted basis or acquisition cost of the Redeemable Preferred Shares to the Shareholders. Therefore, since the redemption price is equal to the cost basis or acquisition cost of the Redeemable Preferred Shares, the Shareholders will not realize a taxable gain or deductible loss upon redemption that will be subject to income/capital gains tax on the part of the Shareholders." In the instant case, since the Redeemable Preferred Shares issued to the Shareholders will likewise, be redeemed at a price equal to its issue value and payable in US Dollars based on the (original) exchange rate as of the date of conversion of the shareholder advances into the Redeemable Preferred Shares to be redeemed, the redemption price is the same as or equal to the issue price or adjusted basis or acquisition cost of the Redeemable Preferred Shares to the Shareholders. Similarly therefore, since the redemption price is equal to the cost basis or acquisition cost of the Redeemable Preferred Shares, the Shareholders will not realize a taxable gain or deductible loss upon redemption that will be subject to income/capital gains tax on the part of the Shareholders. Moreover, pursuant to Philippine Accounting Standard (PAS) 32 which is in line with and based on International Accounting Standard (IAS) 32, preferred shares may be determined as a financial liability or equity instrument depending on the rights of the issuer attached to the share. If redemption is at the option of the issuer, there is no present obligation to transfer financial assets to the shareholder. The application guidance (AG) numbers 25 and 27 of PAS 32 provide the following: "Financial Instruments: Disclosure and Presentation xxx xxx xxx Presentation Liabilities and Equity (paragraph 15-27) No Contractual Obligation to Deliver Cash or Another Financial Asset AG25. Preference shares may be issued with various rights. In determining whether a preference share is a financial liability or an equity instrument, an issuer assesses the particular rights attaching to the share to determine whether it exhibits the fundamental characteristics of a financial liability. For example, a preference share that provides for redemption on a specific date or at the option of the holder contains a financial liability because the issuer has an obligation to transfer financial assets to the holder of the share. The potential inability of an issuer to satisfy an obligation to redeem a preference share when contractually required to do so, whether because of lack of funds, a statutory restriction or insufficient profits or reserves, does not negate the obligation. An option of the issuer to redeem the shares for cash does not satisfy the definition of financial liability because the issuer does not have a present obligation to transfer financial assets to the shareholders. In this case, redemption of the shares is solely at the discretion of the issuer. An obligation may arise, however, when the issuer of the shares exercises at its option, usually by notifying the shareholders of an intention to redeem the shares. HScDIC Settlement in the Entity's Own Equity Instruments AG27. The following examples illustrate how to classify different types of contracts on an entity's own equity instruments: xxx xxx xxx (b) An entity's obligation to purchase its own shares for cash gives rise to a financial liability for the present value of the redemption amount even if the number of shares that the entity is obliged to repurchase is not fixed or if the obligation is conditional on the counterparty exercising a right to redeem. One example of a conditional obligation is an issued option that requires the entity to repurchase its own shares for cash if the counterpart exercises the option." Based on the foregoing, under PAS 32 following IAS 32, when a preferred share provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date or gives the holder the right to require the issuer to redeem the share at or after a particular date for a fixed or determinable amount, the instrument is a financial liability and is classified as such and there arises an obligation on the part of the issuer to purchase or redeem the same for its present value. Thus, consistent with the accounting treatment under PAS 32 and IAS 32, since the Redeemable Preferred Shares are characterized as an equity instrument in the audited financial statements of SPHI, there is no obligation on the part of SPHI to redeem the same at present value. Being an equity instrument, said Redeemable Preferred Shares may be redeemed by SPHI at their issue price or historical cost. 3) The surrender and cancellation of SPHI redeemable preferred shares are not subject to DST. 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: . . ." However, it has been held in BIR Ruling No. DA-356-03 dated October 10, 2003, that in the case of redemption of shares to implement a reduction in capital, "The corporation is not taking title to nor is it receiving any value for the shares surrendered by its stockholders pursuant to a capital reduction. It held that the reduced shares do not represent value since they are merely documentary evidence of the reduced capital stock that will cease to exist after they have been canceled. (BIR Ruling No. 039-02 dated November 11, 2002) . Thus the Deed of Assignment covering the transfer of shares of stock for PSPL is not subject to DST since the conveyance is without any consideration." Thus, considering that the redeemed Redeemable Preferred Shares will be considered retired and no longer issuable upon SPHI's redemption and SPHI will not be taking title to the treasury shares upon such redemption, the surrender by the Shareholders and resulting retirement upon redemption and subsequent cancellation of the redeemed Redeemable Preferred Shares is not subject to DST on transfer of shares under Section 175 of the Tax Code of 1997, as amended by R.A. No. 9243. HCATEa 4) The issuance of replacement certificates to replace original stock certificates is not subject to DST. Section 174 of the Tax Code of 1997, as amended by R.A. No. 9243, provides that: "SEC. 174. Stamp Tax on Original Issue of Shares of Stock. On every original issue, whether on organization, reorganization or for any lawful purpose, of shares of stock by any association, company or corporation, there shall be collected a documentary stamp of One peso (P1.00) on each Two hundred pesos (P200), or fractional part thereof, of the par value, of such shares of stock: Provided, That in the case of the original issue of shares of stock without par value, the amount of the documentary stamp tax herein prescribed shall be based upon the actual consideration for the issuance of such shares of stock: Provided, further, That in the case of stock dividends, on the actual value represented by each share." In BIR Ruling No. DA-092-00 dated February 10, 2000, this Bureau ruled as follows: "In reply, please be informed that in BIR Ruling No. 052-80 dated May 13, 1980, citing Section 13 of Regulations No. 26, it was ruled that no documentary stamp tax is due on certificates of stock which are issued to replace prior or original certificates of stock, provided the replacement certificates are issued to the same person and the tax has been paid on the original issue, inasmuch as the issuance of these replacement certificates is not an original issue either on organization or reorganization. Accordingly, the replacement certificates bearing P1.00 par value is exempt from the documentary stamp tax under Section 175 of the Tax Code of 1997." In the case of SPHI, since the replacement certificates will be issued to replace the Original Stock Certificates in order to cover separately the redeemed shares and the unredeemed shares covered by such Original Stock Certificates (with the certificates covering the redeemed shares to be cancelled upon the approval by the SEC of SPHI's decrease or reduction in capital stock corresponding to the redeemed shares) and the DST has been paid on the original issue, the issuance of the replacement certificates is not subject to DST on original issuance under Section 174 of the Tax Code of 1997, as amended by R.A. No. 9243. This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it shall be ascertained that the facts are different, then this ruling shall be without force and effect insofar as the herein parties are concerned. Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service