Revenue Audit Memorandum Order No. 1-93

January 11, 1993 REVENUE AUDIT MEMORANDUM ORDER NO. 1-93 1. Scope : This order shall govern the verification of cases involving the disposition of shares of stocks issued by a domestic corporation wherein the tax exemption of the resulting capital gains is being invoked by the taxpayer pursuant to the provision of the Philippine tax treaties . 2. Background information There is a general pattern of transactions undertaken by taxpayers wherein the corresponding income tax is not being paid or is substantially reduced for the disposition of shares of stocks issued by a domestic corporation. The common features characterizing these are as follows: 1. There is an initial transfer or disposition of the shares of stocks by the first transferor to a resident of a treaty country. This transfer can either be in the form of tax free or deferred exchange pursuant to Section 34 of the Tax Code, or property dividend distribution, or donation, or sale, or any other mode of transfer. 2. The transfer price involved in this first transfer (hereinafter called as the "initial transfer price") is relatively low when compared to the subsequent transfer as described in the following three sentences. 3. There is subsequent transfer by the new owner of the shares of stock (the resident of the treaty country and hereinafter called as the "subsequent transferor") 4. This subsequent transfer occurs within a relatively short period of time following the initial transfer. 5. The transfer price involved in this subsequent transfer (hereinafter called as the "subsequent transfer price") is relatively higher in value when compared to the initial transfer price. 6. The first transferor and the subsequent transferor are directly or indirectly interrelated. 7. The exemption from payment of tax in the Philippines for the resulting capital gains in the subsequent transfer is being invoked pursuant to the Philippine tax treaty provision which generally provides that only the country of residence of transferor or alienator can tax such gain. As a result of these series of transactions between the interrelated parties, minimal taxes (if any) are paid to the Philippines for these transfers of shares of stocks issued by a domestic corporation. It is to be noted that in the absence of the particular tax treaty provision, the gain arising from these series of transfers are generally taxable pursuant to Sections 21 to 22, 24, to 25, and 36 of the Tax Code. 3. Audit procedures In order to prevent the abuse of the tax exemption provision of the Philippine tax treaties pertaining to capital gains of sale of shares of stocks, the following audit procedures are prescribed: 3.1 Ascertain if the elements described in part 2 above are present in the series of transactions involving the disposition of shares of stocks. The important factors to consider are the relationship between the first transferor and the transferee (resident of the treaty country), the time gap between first and subsequent transfer, etc. 3.2 Request for the pertinent documents prescribed in Revenue Memorandum Order No. 10-92, pertaining to the revised procedures for tax treaty relief applications and processing thereof. 3.3 Evaluate if the pertinent elements in the series of transactions are arms length or reasonable in nature. Indicators hereof include the following: 3.3.1 As to the time gap between the series of transfers - there is reasonable justification to allow the transactions if the subsequent transfer is effected not less than six (6) months from the date of the initial transfer. 3.3.2 As to disparity in transfer prices between the series of transfer - there is reasonable justification to consider such transfer prices as being arms length if these approximate the fair market valuation standard, as measured by the appreciation of the subsequent transfer over the initial price, such that the subsequent transfer price appreciates by not more than three (3) percent for each month the shares of stocks are held by the subsequent transferor prior to his disposition. In the absence of any of these conditions, there is a prima facie presumption that the transactions between the first transferor and the subsequent transferor are not arms length or reasonable in nature. 3.4 Allocate income and/or the transfer price between the first transferor and the subsequent transferor if there are indications that the initial transfer price is below the arms length price. Pursuant to Section 43 of the Tax Code, the allocation of such income/transfer prices is allowable in order to clearly reflect the income of interrelated taxpayers. In this circumstance, the subsequent transfer price can be considered as the arms length price to consider for the first transfer . casia 3.5 Determine the deficiency taxes that will be payable by the first transferor. 4. Illustration This example explains the application of the transactions and procedures discussed earlier. FACTS . Domestic Corporation A sold its investments in Domestic Corporation B to Foreign Corporation C for P1 million in August 1, 1992, deriving a gain of P100,000 from such sale, considering that these investment's original cost were P900.00. One month later, Foreign Corporation C sold the same shares of stocks for P5 million. Foreign Corporation C is related to Domestic Corporation A is a resident of a country which has a treaty with the Philippines. This treaty provides that capital gains from sale of shares of stocks are taxable only in the country of residence of the alienator. TAX TREATMENT OF PARTIES CONCERNED . Domestic Corporation A paid capital gains tax of P10,000 for the first transfer. Foreign Corporation C is exempt from payment of any taxes to the Philippines pursuant to the tax treaty provisions. EVALUATION . The elements discussed in the earlier paragraphs are present in this case. These include the following: a. Domestic Corporation A and Foreign Corporation C are interrelated. b. The initial transfer price is artificially low, resulting in the minimum amount of taxes being paid by Domestic Corporation A. c. The subsequent transfer price is relatively high compared to the initial transfer price. d. The second transfer occurred within a relatively short time after the first transfer. e. Pursuant to the existing tax treaty, the subsequent transferor or Foreign Corporation C is exempt from payment of tax to the Philippines. Given these circumstances, Section 43 of the Tax Code can be used as the basis for determining this deficiency tax against Domestic Corporation A as follows: Allocated transfer price (equivalent to the subsequent transfer price) P5 Million Less: original cost 0.9 Million Capital gains 4.1 Million Tax due thereon 0.81 Million Less: tax previously paid 0.01 Million Deficiency tax 0.80 Million 5. Effectivity This Order shall take effect immediately. (SGD.) JOSE U. ONG Commissioner of Internal Revenue