Whether Gain or Loss Should be Recognized on the Issuance of Shares in Exchange for Cessation of Membership Rights

December 2, 1998 BIR RULING NO. 170-98 40 (C) (2) (b) & (C) (6) (b) (ii)-000-00-170-98 Manulife Financial Manulife Centre, Tordesillas cor. Gallardo Sts. Salcedo Village, Makati Attention: Mr . Renato A . Vergel de Dios President Manulife Philippines Gentlemen : This refers to your letter dated June 22, 1998 and a follow up letter dated August 11, 1998 requesting for a ruling on whether or not gain or loss should be recognized on the issuance of shares by a newly incorporated holding company to the eligible policy holders of Manufacturers Life Insurance Company ("Manulife" or the "Company") in exchange for the cessation of their membership rights and interest in Manulife as a mutual company. It is represented that Manulife is a mutual life insurance company domiciled in Toronto, Canada; that it has a branch office in the Philippines duly licensed by the Insurance Commission and operating in the Philippine since 1902; that being a mutual company, Manulife, is "owned" by its participating policyholders, or members; that it is, in its most basic form, essentially a "cooperative" in which each member, regardless of his policy size, is entitled to one vote on corporate matter such as the appointment of the Board of Directors; that on January 20, 1998, the Manulife Board of Directors instructed the Company management to prepare a plan to convert the Company from a mutual life insurance company to an investor owned, publicly traded stock company; that any such demutualization plan, if approved by the Board of Directors and by the regulators would be submitted to participating policyholders for a vote before implementation; that if approved by the policyholders, publicly traded shares ("shares") of the Company, or of new Manulife holding company ("Holdco") will be distributed to the eligible participating policyholders, that Holdco will be domiciled in Canada; that precise ownership structure is still being finalized at this time; that the actual number of shares to be received by each participating policyholder shall be determined by an allocation formula which shall have been approved by the regulators and by the eligible participating policyholders, that the conversion of the Company from mutual life insurance company to a stock company requires the unbundling of the participating policyholders' contractual and membership rights; that the membership rights are exchanged for the shares, that accordingly the tax treatment of this transaction in the United States there being no known precedents in the Philippines, is, as discussed by Ernst & Young LLP "The demutualization of mutual life insurance company under a state law conversion statute is generally treated as a tax free transaction for United States Federal income tax purposes. Under a state law conversion statute, the insurer directly converts its form of business from a mutual company to a stock company and the company is treated as the same entity before and after the conversion. As a result of being treated as a tax free transaction, the insurer recognizes no gain or loss when it converts from a mutual company to a stock company, and the policy holders recognizes no gain or loss on the receipt of a stock in the insurer (or stock) in a holding company owning the insurer)" [emphasis supplied] "The Internal Revenue Service has issued many letter ruling on the Federal income tax consequences of a demutualization under a conversion statute. For Federal income tax purposes, the conversion of the mutual to a stock company is generally treated as a tax-free recapitalization under Internal Revenue Code Section 368 (a)(1)(E) [Type E reorganization]. A Type E reorganization is generally described as any transaction in which stockholders and security holders exchange their stock or securities for stock and securities in the same corporation. A conversion transaction is treated a Type E reorganization, because the mutual interest (representing voting and/or liquidation rights) are treated as propriety interests that are exchanged for stock in the same company." that you posited that the distribution of shares of Manulife to its qualified policyholders worldwide, as part of the conversion to the stock-company-form-of-ownership, does not represent income or capital gain to the recipient but rather, the distribution of shares to the qualified policyholders represents an exchange by the policyholders of their proprietary interest in the Company for the shares received. In reply, please be informed that pursuant to Section 40 (C) (2) (b) of the Tax Code of 1998 which provides that "SEC. 40. Determination of Amount and Recognition of Gain or Loss . "xxx xxx xxx "(C) Exchange of Property . "xxx xxx xxx "(2) Exception . No gain or loss be recognized if in pursuance of a plan of merger or consolidation. "(a) . . . "(b) A shareholder exchanges stock in a corporation, which is party to the merger or consolidation, solely for the stock of another corporation also a party to the merger or consolidation." The foregoing provision shall apply in the instant case considering that in the course of demutualization, the policyholders will have to surrender their membership interests in the Company as a mutual company, in exchange for the publicly-traded shares issued by the new Manulife company or Holdco. For this purpose, the eligible, the eligible policy holders of Manulife may be considered as shareholders contemplated under the foregoing provision, it being defined in Section 22 (M) of the same Tax Code that "(M) The term "shareholders" shall include holders of a shares of stock, warrant/s and or option/s to purchase shares of stock of a corporation, as well as a holder of a unit of participation in a partnership (except general professional partnerships), in a joint-stock company, a joint account, a taxable joint venture, a member of an association, recreation or amusement club (such as golf, polo or similar clubs), and a holder of a mutual fund certificate, a member in an association, joint stock company, or insurance company." cdll Furthermore, the steps to be taken to effect demutualization of Manulife constitute a " de facto merger or consolidation" under clause (ii) of Sec. 40 (C) (6) (b) of the Tax Code of 1998, thus "(b) The term "merger" or "consolidation", when used in this Section, shall be understood to mean: (i) . . ., or (ii) the acquisition by one corporation of all or substantially all the properties of another corporation solely for stock; Provided, That for a transaction to be regarded as merger or consolidation within the purview of this Section, it must be undertaken for a bona fide business purpose and not solely for the purpose of escaping the burden of taxation: Provided , further , That in determining whether a bona fide business purpose exists, each and every step of the transactions shall be considered and the whole transaction or series of transaction shall be treated as a single unit: Provided , finally , That in determining whether the property transferred constitutes a substantial portion of the property of the transferor, the term "property" shall be taken to include cash assets of the transferor." In the light of the foregoing and considering that the demutualization is clearly for a bona fide business purpose, the same falls within the purview of Sec. 40 (C) (2) of the Tax Code of 1997. However, it should be emphasized that Section 40 (C) (2) and (6) (c) of the Tax Code merely defer recognition of the gain or loss from such transaction, for in determining the gain or loss from a subsequent transaction of the properties or of the stocks involved in the exchange, the original or historical costs of the properties or stocks are 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 gains derived from such sale or exchange, taking into consideration that the cost basis of the shares shall be the same as the original acquisition cost or adjusted cost basis to the transferors or the property exchanged for stocks shall be the same as it would be in the hands of the transferors (Section 40 (C) (5) (a) and (b) of the Tax Code of 1997) cdlex Such being the case, the receipt of Holdco shares by eligible Manulife policyholders shall not be subject to tax. The basis of the Holdco shares so received shall be the same as the basis of the policyholders membership rights in the Company which they surrendered. Likewise, the basis of the shares of Manulife issued to Holdco shall be the same as the basis in shares issued by Holdco to the eligible policyholders of Manulife in exchange for the surrender of their membership rights in Manulife as a mutual company. This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation it shall be disclosed that the facts are different, then this ruling shall be considered null and void. Likewise, this ruling shall become effective upon approval by the Philippine Securities and Exchange Commission of the proposed transaction with respect only to the surrender of membership rights pertaining to the Filipino policyholders. Very truly yours, (SGD.) BEETHOVEN L. RUALO Commissioner of Internal Revenue