Tax Consequences of the Conversion of Certain Indebtedness into New Common and Redeemable Preferred Shares

February 13, 1992 BIR RULING NO. 045-92 28 (a) 586-88 045-92 Asset Privatization Trust 10th Floor, BA-Lepanto Building 8747 Paseo de Roxas Makati, Metro Manila Attention: Atty . Ramon T . Garcia Chief Executive Trustee Gentlemen : This refers to your letter dated July 19, 1991 requesting a ruling as to whether the conversion of certain indebtedness of Nonoc Mining and Industrial Corporation (Nonoc) into new common and redeemable preferred shares of Nonoc; where the amount of such indebtedness is greater than the total par value of the shares to be issued, and which will result in the elimination of Nonoc's existing retained earnings deficit, will not be subject to income and donor's taxes. It appears that Nonoc, a moribund mining company, owed at least the total amount of P15,063,178,815.00 from APT, the Philippine National Bank (PNB) and the Development Bank of the Philippines (DBP); that for failure to pay, and in accordance with Proclamation No. 50 mandating the disposition and privatization of certain government corporations, the two government financial institutions, PNB and DBP transferred their receivables from NONOC to APT as part of their respective rehabilitation plans; that APT proposes to dispose of such receivables by way of converting a portion thereof into shares of stocks and thereafter sell out all of its shares to Philnico Mining & Industrial Corporation (Philnico) by virtue of a Definitive Agreement entered into on October 12, 1990, and in the following manner: First, Nonoc sells to Philnico 25,000,000 existing common shares with a par value of P1.00 per share. All of these shares are beneficially owned by APT. Second, Nonoc will issue to APT 30,000,000 new common shares with a par value also of P1.00 per share. Subsequently, APT will sell all of these shares to Philnico. These shares represent part of the converted receivables of APT from Nonoc. Third, Nonoc will also issue to APT 7,506,032,760 new redeemable preferred shares of stock with a par value of P1.00 per share, APT will then sell all of these shares to Philnico. All of these shares represent a portion also of the converted receivables of APT from Nonoc; hence, the total "converted shares" is 7,586,032,760. that APT will convert the receivables (at least P15,063,178,815.00) into equity in Nonoc with the end in view of bringing the aforesaid deficit to a zero balance; that the additional paid-up capital resulting from such conversion will be used to offset Nonoc's current retained earnings deficit which is, however, found to be not adequate to cover that portion of the receivables, which will not be converted into equity; thus, Nonoc's current retained earnings deficit will be increased against accumulated depreciation; and that as a result of the conversion of APT's receivables to shares of stock in the total amount of P7,586,032,760.00 (80,000,000 + 7,506,032,760 = 7,586,032,760) the equity and retained earnings of Nonoc will change as follows: Before Conversion Capital Stock, P1 Par Value Authorized 100,000,000 Common shares Issued 25,000,000 Common shares P25,000,000 Retained Earnings (Deficit) P(5,929,932,484) Total Equity and Retained Earnings P(5,954,932,484) ============= After Conversion Capital Stock P1 Par Value Preferred Shares: Authorized and Issued 7,506,032,760 shares P7,506,032,760 Common Shares: Authorized and Issued 105,000,000 shares 105,000,000 Retained Earnings nil Total Equity & Retained Earnings P7,611,032,760 =========== In reply, please be informed that under Section 55 of the Income Tax Regulations implementing than Section 29(a) [now Section 28(a)] of the Tax Code, as amended, pertinent portion of which provides: "Sec. 55. Acquisition or Disposition by a Corporation of its Own Capital Stock . Whether the acquisition or disposition by a corporation of share of its own capital stock gives rise to taxable gain or deductible loss depends upon the real nature of the transaction, which is to be ascertained from all its facts and circumstances. The receipt by a corporation of the subscription price of shares of its capital stock upon their original issuance gives rise to neither taxable gain nor deductible loss, whether the subscription or issue price be in excess of, or less than, the par or stated value of such stock ." (Emphasis supplied) Nonoc shall not be subject to income tax on the difference between the receivables of P15,063,178,815.00 and the total par value of the converted shares of P7,586,032,760.00 because the receipt by Nonoc of the receivables constituting the subscription price for said shares (converted shares) upon the original issuance thereof did not give rise to taxable income or gain on the part of Nonoc even if the subscription or issue price consisting of the receivables is in excess of the total par value of the converted common and preferred shares. Moreover, the stockholder's equity is the sum of the paid-in capital and retained earnings. The conversion of APT's receivables in the amount of P15,063,178,815.00 into shares of stock with par value of P7,586,032,760 only, is indicative of the fact that the difference of P7,477,146,055 (15,063,178,815 less 7,586,032,760 = 7,477,146,055) is applied to increase Nonoc's retained earnings and equity from a negative total of P5,954,932,484.00 to a positive total of P7,611,032,760. The difference of P7,477,146,055 is not taxable income to Nonoc because they are not earnings from the use of capital; neither are they earnings from the exertion of physical or mental effort. On the other, such receivables would constitute additional capital investment of APT in Nonoc which is not included within the purview of the term "taxable income" as defined in Section 28 of the Tax Code, as amended. Likewise, such additional capital investment shall not be subject to the donor's tax because there is no donative intent in a debt-to-equity conversion transaction. Besides, since the conversion scheme of the receivables to shares of stock is merely part of the process of, or incidental to the transfer of APT's assets to the buyer, it is exempt from all internal revenue taxes pursuant to Section 35 of Proclamation No. 50 which states: "Sec. 35. Exemption from Taxes, Fees, and Other Charges . The provisions of any law to the contrary notwithstanding, the Trust as well as the corporations and assets held by it, shall be exempt from all taxes, fees, charges, imposts, and assessments arising from or occasioned by the passing of title over such corporations or assets from the government institutions to the Trust and/or from the Trust to a private acquisitor or buyer imposed by the National Government or any subdivision thereof including but not limited to stock transfer taxes, capital gains taxes, documentary stamps, registration fees and the like: Provided, that in case the said government institutions acquired the said assets by foreclosure, the non-payment of similar taxes, fees, charges, imposts, and assessments shall not be a bar to the consolidation of title in the foreclosing institutions and the subsequent passing of title to the Trust of the corporations held by the Trust. "The sale or transfer of such corporations or assets shall not be enjoined or hindered by the existence of any liens by way of taxes, charges or other assessments in favor of the government at the time of sale or transfer: Provided, that the proceeds from such sale or transfer shall be subject to a tax lien and first be applied to satisfy such obligations secured by said liens." Very truly yours, JOSE U. ONG Commissioner of Internal Revenue