Tax Treatment of PSE's Securities Borrowing and Lending Transaction

November 20, 1998 BIR RULING NO. 168-98 24; 27; 28; 108; 121; 127; 176-000-00-168-98 Philippine Stock Exchange, Inc. Philippine Stock Exchange Centre Exchange Road, Ortigas Center Pasig, Metro Manila Attention: Mr . Jose Luis U . Yulo , Jr . President Gentlemen : This refers to your letter dated December 1, 1997 requesting clarification regarding the tax treatment of the new product which you intend to introduce, the securities borrowing and lending transaction (SBL), the basic process of which is as follows: ". . . SBL basically involves three parties, the Lender, the Borrower and the Agent. A lender who owns certain securities (i.e., shares of stock listed in the stock exchange) lends the same to a Borrower, either directly or through an Agent. For the lender to be able to lend securities to the Borrower, the shares of stock are physically and legally transferred to the Borrower. The Borrower could borrow securities for his own account, in which case, there is physical transfer of the same to the Borrower. The Borrower could also borrow securities for sale to a third party, in which case, the Lender will legally and physically transfer the securities directly to the Borrower's buyer. "In turn, the Borrower puts up a collateral of 100% (or such higher percentage as may be agreed upon by the parties ) of the market value of the securities borrowed. The collateral may be in the form of cash, government securities, irrevocable letters or credit or equities. Since the securities loaned are listed in the stock exchange and traded frequently, their market value necessarily fluctuates. Thus, the Borrower may be required to give additional collateral to cover increases in the market value of securities. Conversely, the Borrower may request the return of the excess collateral from the Agent or from the Lender himself, if there is no Agent, if the market value of the shares will decrease. "It is intended that the collateral be returned to the Borrower. But while with the Lender, if the collateral is in the form of cash, it must be invested either in the name of the Lender of Agent by the Agent, or by the Lender himself, if there is no Agent. Out of the proceeds of the investment (after 20% final withholding tax), based on pre-agreed rates, the Lender will give a rebate to the Borrower. Likewise, the Lender will also give the Agent a share in the proceeds of the investment. If the Borrower provides non-cash collateral, he will be charged a borrowing fee, which is usually quoted as a percentage of the value of the securities loaned at the time of the transaction. "While the shares of stock are lent to the Borrower, it may happen that cash or stock dividends will be declared by the issuer company. In this case, the cash or stock dividends accruing to these shares shall be paid (sic) by the Borrower to the Lender. These payments of cash or stock dividends shall be known as "Manufactured Dividends." "At a future date, the Borrower has the obligation to replace the shares borrowed from the Lender, after which, the lender is obligated to return the collateral to the Borrower. "All of the foregoing shall be documented in a Master Securities Lending Agreement (MSLA), a contract between the Borrower and the Lender, or between the Borrower and the Lender's Agent that specifies all the terms and conditions of the borrowing and lending agreement." Based on the foregoing, you are requesting for a ruling on the following: 1. Whether or not the transaction between the Lender and the Borrower may be characterized as a lending of securities (or shares of stock) rather than a lending or borrowing of money; 2. Whether or not the selling of the borrowed securities by a Borrower to a Buyer is subject to the transaction tax, to the documentary stamp tax and to the 10% VAT; 3. What is the applicable income/withholding tax rate on the income earned by the lender from the investment of the collateral if the Lender is a bank, a juridical person or a local or foreign entity; and 4. Whether or not the return by the Lender of the collateral to the Borrower and the payment of the manufactured cash or stock dividends to the Lender is not taxable. In reply, please be informed that the pertinent provisions of the Tax Code of 1997 governing taxes imposed on the sale, barter or exchange of stocks listed and traded through the local stock exchange are as follows: "SEC. 127. Tax on Sale , Barter or Exchange of Shares of Stock Listed and Traded through the Local Stock Exchange or through Initial Public Offering . "(A) Tax on Sale Barter or Exchange of Shares of Stock Listed and Traded through the Local Stock Exchange. There shall be levied, assessed and collected on every sale , barter , exchange or other disposition of shares of stock listed and traded through the local stock exchange other than the sale by a dealer in securities, a tax at the rate of one-half of one percent (1/2 of 1%) of the gross selling price or gross value in money of the shares of stock sold, bartered, exchanged or otherwise disposed which shall be paid by the seller or transferor (Emphasis supplied). xxx xxx xxx "(C) Return on Capital Gains Realized from Sale of Shares of Stocks. (1) Return on Capital gains Realized from Sale of Shares of Stocks Listed and Traded in the Local Stock Exchange. It shall be the duty of every stock broker who effected the sale subject to the tax imposed herein to collect the tax and remit the same to the Bureau of Internal Revenue within five (5) banking days from the date of collection thereof and to submit on Mondays of each week to the secretary of the stock exchange, of which he is a member, a true and complete return which shall contain a declaration of all the transactions effected through him during the preceding week and of taxes collected by him and turned over to the Bureau of Internal Revenue." "(D) Common Provisions. Any gain derived from the sale, barter, exchange or other disposition of shares of stock under this Section shall be exempt from the tax imposed in Sections 24(C), 27(D)(2), 28(A)(7)(c), and 28(B)(5)(c) of this Code and from the regular individual or corporate income tax. Tax paid under this Section shall not be deductible for income tax purposes. (Emphasis supplied). "SEC. 176. Stamp Tax on Sales , Agreements to Sell , Memoranda of Sales , Deliveries or Transfer of Due-bills , Certificates of Obligation , or Shares or Certificate of Stocks . On all sales , or agreements to sell , or memoranda of sales, or deliveries , or transfer of due-bills , certificates of obligation , or 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 due-bills, certificates of obligation or stock, or to secure the future payment of money, or for the future transfer of any due-bill, certificate of obligation or stock, there shall be collected a documentary stamp tax of One peso and fifty centavos (P1.50) on each Two hundred pesos (P200), or fractional part thereof, of the par value of such due-bill, certificate of obligation or stock: Provided, That only one tax shall be collected on each sale or transfer of stock or securities from one person to another , regardless of whether or not a certificate of stock or obligation is issued, indorsed, or delivered in pursuance of such sale or transfer : and Provided, further, That in the case of stock without par value the amount of the documentary stamp tax herein prescribed shall be equivalent to twenty-five (25%) of the documentary stamp tax paid upon the original issue of said stock." (Emphasis supplied). aisadc Based on the above-quoted provisions of law, only the sale, barter or exchange of shares of stock listed and traded through the Philippine Stock Exchange is subject to the percentage tax and documentary stamp tax imposed under the Code. But as per your representations of the transaction involved in the Securities Borrowing and Lending scheme, as further described in various attachments to your letter, this Office is of the considered opinion that the transaction between the Lender and the Borrower could properly be classified as a lending of securities rather than a sale on account of the following qualifications attendant in such a transaction: 1. Entitlement of Lender to certain stock rights . While there is physical transfer of securities to the Borrower, the Lender is still entitled to the right to receive cash or stock dividends while the stock are in the possession of the Borrower. Likewise, the Lender may still retain voting rights over the loaned securities if this is agreed to by the parties. These cash or stock dividends which the Borrower is required to return to the Lender is referred to as "Manufactured Dividends." 2. Securities recall . The Lender is entitled to recall or sell the loaned securities, in whole or in part, while still in the possession of the Borrower. Upon demand, the latter, in turn, has the corresponding obligation to return the securities so loaned with equivalent number of outstanding securities of the same description, meaning securities which are of the same class or type, carrying the same rights and of the same company as the borrowed securities. 3. Collateral requirement . There is no consideration involved which is an essential condition to consummate a sale transaction. Instead, the Borrower merely puts up a collateral to guarantee his obligations under the agreement, which collateral may not be necessarily in the form of cash but may also be in the form of government securities or letters of credit. As it is in the nature of securities to fluctuate in value, there is the further condition that the corresponding value of the collateral shall be increased during the term of the agreement to ensure full collateralization. dctai 4. Fixed period . There is a definite or limited period fixed in the agreement, usually at a maximum period of one year, during which the transaction under a Securities Borrowing and Lending (SBL) is made effective. Thus, the relationship between the parties likewise ends upon the expiration of the agreement. 5. Securities and collateral return . Upon the expiration of the agreement, the Borrower is obliged to return the same number (or equivalent number of outstanding securities) and same class of securities borrowed. (Again, the same securities is taken to mean stock of the same description due to the fungible character of shares of stock). Correspondingly, the Lender is obliged to return the collateral put up by the Borrower. 6. Specified purpose(s) . The purpose or purposes for which the borrowed securities will be used are specified in and accordingly limited by the agreement. Hence, the Borrower must comply with the specified purpose(s) which must be any of the following: (i) Settlement of sale of Philippine securities effected in the Philippines or elsewhere; (ii) Settlement of a future sale whether agreed or not at the time the borrowing is effected; (iii) Replacement in whole or in part of securities obtained by the Borrower under another SBL agreement; (iv) On-lending of borrowed securities to another Borrower who has effected another SBL agreement; (v) Such other purposes analogous to the above or as may be authorized by regulations. llcd To qualify as a lending of securities, the transaction must strictly comply with all of the foregoing requirements. Necessarily, if the transaction is outside of the scope of these stated qualification although described as a Securities Borrowing and Lending (SBL), the same shall be considered as a regular exchange transaction subject to the corresponding taxes under the Code. In accordance with the Memorandum of Agreement (MOA) among the Department of Finance (DOF), the Philippine Stock Exchange (PSE), the Securities and Exchange Commission (SEC) and the Bureau of Internal Revenue (BIR) which approved the framework to institutionalize and promote the practice of Securities Borrowing and Lending (SBL) and Short Selling in the Philippines, the BIR shall formulate, recommend and finalize the corresponding rules and regulations governing the taxation, effective monitoring, reporting and disclosure of all SBL and Short Selling transactions in coordination with all the parties to the agreement. Accordingly, we shall, in the meantime, hold in abeyance the resolution on the proper taxation treatment to govern the transactions posed in your query as these shall be included in the comprehensive treatment of tax issues of all transactions relating to SBL and Short Selling in the Revenue Regulations to be recommended by this Office for the approval of the Secretary of Finance. Very truly yours, (SGD.) BEETHOVEN L. RUALO Commissioner of Internal Revenue