Income Received by Reason of Preferred Shareholding Shall Not be Subject to Tax under Section 21(c)(2)

May 31, 1989 BIR RULING NO. 116-89 34 (c) (2) (c) 913-89 116-89 Gentlemen : This refers to your letter dated March 8, 1988 stating that your clients, Dr. and Mrs. Dionisio and Josefa Rivera, spouses owners of a lot located in Claro M. Recto Avenue, Binondo, Manila, covered by Transfer Certificate of Title No. 91052 of the Registry of Deeds for the City of Manila with a lot area of 1,090 square meters, more or less, have been offered by R-Square corporation P10.0 million worth of fully paid shares of stocks in said corporation in exchange for the assignment and transfer of the aforesaid lot to the corporation that the corporation intends to construct a condominium on this lot; that R-Square Corporation, a domestic corporation duly registered with the Securities and Exchange Commission in 1989 has an authorized capital of P49.0 million, subscribed of P12.25 million and paid up of P13.15 Million, and that your clients would like to accept said offer provided that the following conditions are complied with: 1. R-Square Corporation, in exchange for your clients lot, will issue in their favor 1,000,000 shares of P10 par value or a total of P10.0 Million worth of preferred stock redeemable any time at the option of the corporation; 2. The preferred shares shall be voting shares in order that your clients, while their shares are outstanding, shall have 1,000,000 voting shares and clear voting control of the corporation representing 89.00% of the total voting shares; 3. The shares will also be preferred participating, that is entitled to receive dividends while the shares are outstanding; 4. The Articles of Incorporation of the Corporation should be amended to reflect and include the aforementioned conditions and requirements; and 5. A BIR confirmation and ruling be obtained on the legal advice and opinion given to your clients regarding the tax implications and consequences arising from the said exchange of properties as follows: 5.A No gain or loss shall be recognized to your clients, Dr. and Mrs. Rivera, for the transfer of their real property to the corporation in exchange for shares of stock of R-Square Corporation considering that after the exchange of property and as a result of the said exchange, your client will gain control of said corporation pursuant to Section 34(c)(2)(c) of the Tax Code. Thus, the redemption by the Corporation of the preferred shares issued to your clients in consideration of said disposition of said shares will be subject to a capital gains tax under Section 21(d)(1) of the Tax Code, as amended. On the other hand, the Corporation's inability to redeem the preferred shares due to financial incapacity by the corporation may be recognized as a capital loss that may be suffered by spouses Rivera. 5.B Any dividend income that may be received by your clients by reason of their preferred shareholding shall not be subject to tax under Section 21(c)(2)(c) of the Tax Code since such dividends are no longer taxable. In reply, I have the honor to inform you that pursuant to Section 34, paragraph (c)(2)(c) of the Tax Code, as amended by Republic Act No. 4522 and Presidential Decree Nos. 1705 and 1773 no gain or loss shall be recognized if property is transferred to a corporation by a person, in exchange for stock in such 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 51% of the total voting power of all classes of stocks entitled to vote. Control is determined by the amount of stock received, i.e., subscribed, whether for property or for services by the transferor or transferors. In determining the 51% stock ownership, only those persons who transferred property for stock in the same transaction may be counted up to a maximum of five. Accordingly, your opinion that, no gain or loss shall be recognized both to the transferors and the transferee corporation on the proposed transfer of your clients, Dr. and Mrs. Dionisio and Josefa Rivera of their property in exchange for shares of stock of the corporation considering that after the proposed exchange, they will gain control of the transferee corporation, R-Square Corporation, is hereby confirmed. It should be emphasized, however, that Section 34(c)(2)(c) of the Tax Code merely defers recognition of gain or loss from such transaction, for in determining the gain or loss from a subsequent transaction of the property or stocks involved in the exchange, the original or historical cost of the property or the stocks is considered. Thus, if the transferors later sell or exchange the shares of stock acquired by them in the exchange, they shall be subject to income tax on the gains derived from such sale or exchange, taking into consideration that the cost basis of the shares of stock shall be the same as the original acquisition cost or adjusted cost basis to the transferors of the property exchanged therefor; and that the cost basis to the transferee of the property exchanged for stocks shall be the same as it would be in the hands of the transferors. [Section 34(c)(5)(a) and (b), Tax Code, as amended by Presidential Decree No. 1773]. In this connection, you are further advised that in order that the parties to the exchange can avail of the non-recognition of gains provided for in Section 34(c)(2)(c) of the Tax Code, as amended, they should comply with the requirements hereunder mentioned: (a) The transferors must file with their income tax return for the taxable year in which the exchange was consummated a complete statement of all facts pertinent to the exchange, including: 1. A description of the property transferred, or of their interest in such property, together with a statement of the original acquisition cost or other basis thereof and the adjusted cost basis at the time of the transfer; 2. The kind of stock received and preferences, if any; 3. The number of shares of each class received; and 4. The fair market value per share of each class at the date of the exchange. (b) On the other hand, the transferee corporation must file with its income tax return for the taxable year in which the exchange was consummated the following: 1. A complete description of the property received from the transferors; 2. A statement of the original acquisition cost or other basis of the property in the hands of the transferors and the adjusted cost basis thereof at the time of the transfer; and 3. Information with respect to the capital stock of the corporation including: a. The total issued and outstanding capital stock immediately prior to and immediately after the exchange, with a complete description of each class of stock; b. The classes of stocks and number of shares issued to the transferors in the exchange; and c. The fair market value as of the date of exchange of the capital stock issued to the transferors. In addition to the foregoing requirements, permanent records in substantial form must be kept by the taxpayers participating in the exchange, showing the information listed above in order to facilitate the determination of gain or loss from a subsequent disposition of stocks/property received in exchange. Moreover, your opinion that any income that may be received by your clients by reason of their preferred shareholding shall not be subject to tax under Section 21(c)(2) since such dividends are no longer taxable is likewise hereby confirmed. Furthermore, pursuant to Section 196 of the Tax Code, as amended, a conveyance or deed whereby land is assigned or transferred to the purchaser is subject to documentary stamp tax based on the consideration or value received or contracted to be paid for such realty. A stock in a corporation is a valuable consideration for transfer of real property. (Section 177, Documentary Stamp Tax Regulations) Accordingly, if a parcel of land, is exchanged with stocks in a corporation as in this case, the latter is the consideration, the value of which shall be the basis of the documentary stamp tax on the deed to be executed for the purpose of said exchange.(BIR Ruling No. 245-00-000-00-109-82 dated April 6, 1982) In this connection, under Section 248(d) in relation to Section 173 of the Tax Code, as amended by Executive Order No. 273, in case of failure to affix the proper documentary stamp tax to a document or instrument, there shall, for every violation, be imposed, in addition to the amount of documentary stamp tax required to be paid, an amount equivalent to 25% of such unpaid amount which shall be in lieu of the interest prescribed in Section 249 of the same Code. Finally, the certificates of stocks to be issued by R-Square Corporation, are, in all probability, original issues which are subject to the documentary stamp tax imposed by Section 175 of the Tax Code, as amended. Should the aforementioned proposed transaction materialize and after payment of the corresponding documentary stamp tax, the aforesaid real property may be registered by the Register of Deeds concerned in the name of R-Square Corporation. cd Very truly yours, (SGD.) JOSE U. ONG Commissioner