Declaration of dividends; Pre-acquisition retained earnings; Equity method of accounting

December 16, 2003 SEC OPINION NO. 70-03 Atty. Francisco G. Tagao Principal Tax and Corporate Services Laya Mananghaya & Co. 22nd Floor, Philamlife Tower 8767 Paseo de Roxas SUBJECT : Declaration of dividends; Pre-acquisition retained earnings; Equity method of accounting S i r : This refers to your request for clarification/confirmation of your opinion on the following queries based on the circumstances stated in your letters dated November 19 and 28, 2003: 1. Whether or not cash dividends, declared and distributed by a subsidiary (B Company),which includes the "pre-acquisition retained earnings",may be re-distributed as cash dividends by the Philippine holding company recipient (A Company) to its sole non-resident stockholder? 2. If the answer to query no. 1 is in the affirmative, whether the Philippine holding company will be allowed to re-distribute the cash dividends even if there are insufficient retained earnings (P20) equivalent to the difference between recorded retained earnings (P80) pursuant to generally accepted accounting principles of the Philippines and the cash dividends actually received (P100)? 3. If the answer to query no. 1 is in the negative, whether the holding company (A Company) may be allowed to re-distribute the dividends from pre-acquisition retained earnings (P20) in the form of liquidating dividends or as return of capital? We answer your first query in the negative. The equity method is the generally accepted principle in accounting for investments where the investor has significant influence for purposes of parent company financial statements. Under such method, the investor recognizes its share in the net income of the investee at the time the income is earned. Hence, in periods where the investor (A Company) owns eighty percent (80%) of the investee (B Company),only 80% of the net income shall be recognized by the investor in its books. Consequently, if dividends are declared in excess of income recognized (80%) under the aforementioned equity method of accounting, Company A, as you correctly pointed out, will have a negative retained earnings. Equally applicable is the SEC ruling that "the retained earnings or surplus profit referred to under Section 43 of the Corporation Code, from which dividend can be legally declared do not include participation or share of a corporation in the profits of its subsidiaries and affiliates, unless and until such profits are actually received in the form of cash or property dividends (SEC Opinion dated April 23, 1991). Thus, while for purposes of management accounting, Company A can recognize as income its equity in net earnings in Company B, the same cannot be declared as dividends since it is not yet actually realized as income inasmuch as Company B has not yet declared the same as dividends." (SEC Opinion dated October 6, 1995). As Fletcher aptly pointed out: "Earnings of the corporation which have not yet been received even though they consist in money which is due cannot be included in the profits out of which dividends may be paid. (11 Fletcher ,p. 1064.)" In answer to your second query, it may be safely stated that without retained earnings, there is no justification for Company A to declare dividends since under Section 43 of the Corporation Code of the Philippines, dividends can only be declared and paid out by a corporation if it has unrestricted retained earnings. We also answer your third query in the negative. Liquidating dividends are dividends which are actually distributions of assets of the corporation upon dissolution (Wise & Co. vs. Meer, G.R. No. 48231, June 30, 1947) . They are not paid on account of earnings or profits, but as a return capital invested. So the assets of a dissolved are not distributed as dividends as dividends are commonly known. The term has also been used to describe a distribution of assets made upon a reduction of the capital invested. Return of capital is allowed where there is surplus capital after a reduction of the capital stock. (19 Am. Jur. 2d 283284). Further, decrease or reduction of capital stock is subject to the requirements of Section 38 of the Corporation Code of the Philippines. The last paragraph of Sec. 122 of the Corporation Code is equally at point. The pertinent portion of the cited provision reads thus: cSCTID Except by decrease of capital stock and as otherwise allowed by this Code ,no corporation shall distribute any of its assets or property except upon lawful dissolution and after payment of all its debts and liabilities. The instances allowable under the Code provided for under Sec. 122 relate to the distribution of corporate assets which is governed by Secs. 8, 9, 41, 43, and 104 par 1(4), and 105 of the Corporation Code. In this case, Company A is neither under liquidation nor is there a reduction or decrease in capital. Hence, the proposed issuance of liquidating dividends or return of capital cannot be justified. We hope we satisfactorily answered your query. Very truly yours, (SGD.) VERNETTE G. UMALI-PACO General Counsel (SGD.) ROBERTO G. MANABAT General Accountant