In 2021, I discussed under this column the new tax-free exchange (TFE) provisions under Section 40(C)(2) of the Tax Code as introduced in the Corporate Recovery and Tax Incentives for Enterprises Act (CREATE), and my initial impressions on how the rules could provide businesses with additional restructuring options and resolve pre-existing TFE implementation hurdles.
Over the past three years, new tax regulations and circulars have streamlined the procedural and documentary requirements for TFEs. While this has helped guide taxpayers in certain types of TFEs, we have yet to see illustrative examples and/or guidelines on how the additional tax-free reorganizations, recapitalizations, and reincorporations in the expanded provision are to be construed.
It’s interesting to note that the new TFE provisions appear to have been modeled after the corporate reorganizations in Section 368 of the US Tax Code. This reference to the US Code is not new, given that our Tax Code has historically been patterned after US tax laws.
Pending available local precedents and interpretation guidelines, let us compare the newly introduced tax-free reorganizations under the CREATE Act with their counterpart provisions in the US Code.
SECTION 40(C)(2)(B) VS US CODE’S ‘TYPE B REORGANIZATION’
Section 40(C)(2)(b) of the Philippine Tax Code covers “the acquisition by one corporation, in exchange solely for all or a part of its voting stock, or in exchange solely for all or part of the voting stock of a corporation which is in control of the acquiring corporation, of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other corporation whether or not such acquiring corporation had control immediately before the acquisition.” It is derived verbatim from Section 368(a)(1)(B) of the US Code (also known as a Type B Reorganization or a stock-for-stock acquisition). Under US tax laws, a Type B Reorganization involves an acquirer purchasing controlling shares in a target corporation (TargetCo) in exchange solely for its voting stock, or the voting stock of its parent entity.
How does a Type B Reorganization in the US differ from the general “share-for-share transfer to a controlled corporation” that existed prior to the CREATE Act and remains valid to date?
A further reading of US laws and related regulations will show that:
(a) “Control” is defined as at least 80% of both the voting shares and the total number of shares;
(b) A “triangular” Type B Reorganization — where, instead of its own shares, the parent corporation’s voting stock will be exchanged for shares in the TargetCo — is also tax-free;
(c) While the language of the law is immediate control post-acquisition, US treasury regulations generally permit a “creeping” acquisition of control; and
(d) Most notably, the absence of a five-transferor limit.
While the first two items are expressly codified under our Tax Code, we have yet to see if our courts and tax authorities will also adopt the bottom two items in our domestic tax rules. Compared with the already existing share-for-share TFE, businesses may, for now, consider Section 40(C)(2)(b) if their restructuring objectives involve owning shares in a TargetCo indirectly via triangular reorganization.
SECTION 40(C)(2)(C) VS US CODE’S ‘TYPE C REORGANIZATION’
Section 40(C)(2)(c) of the Philippine Tax Code deals with “the acquisition by one corporation, in exchange solely for all or a part of its voting stock or in exchange solely for all or part of the voting stock of a corporation which is in control of the acquiring corporation, of substantially all of the properties of another corporation.” It appears to have been lifted from Section 368(a)(1)(C) of the US Code (referred to as a Type C Reorganization or a stock-for-asset acquisition). In this type, an acquiring company exchanges its voting stock, or the voting stock of its parent corporation, for substantially all of the properties of a TargetCo (which eventually liquidates).
While taken from foreign laws, this type of reorganization looks familiar as it also describes a de facto merger in the Philippines. Prior to the CREATE Act, a de facto merger was already included in the definition under Section 40(C)(6)(b) of our Tax Code. In effect, the introduction of Section 40(C)(2)(c) adds a triangular de facto merger as another type of tax-free reorganization in the Philippines.
RECAPITALIZATION UNDER SECTION 40(C)(2)(D) VS US CODE’S ‘TYPE E REORGANIZATION’
The CREATE Act defines “recapitalization” as “an agreement whereby the stock and bonds of a corporation are readjusted as to amount, income, or priority or an arrangement of all stockholders and creditors to change and increase or decrease the capitalization or debts of the corporation or both.” The same term can be found in Section 368(a)(1)(E) of the US Code. However, it was not explicitly defined in the US Code itself. The recognized definition in the US comes from 1942 jurisprudence (Helvering vs Southwest Consolidated Corp.) which states that recapitalization “implies a reshuffling of a capital structure within the framework of an existing corporation.” However, the CREATE Act appears to have derived its local definition of recapitalization from a 1944 US Court of Appeals case (United Gas Improvement Co. vs Commissioner of Internal Revenue).
Considering the varying wordings from the 1942 and 1944 US court cases, it would be good to get clarity on how recapitalization will be interpreted locally by our tax authorities to help facilitate implementation. Nevertheless, the codification of Section 40(C)(2)(d) in our Tax Code reconfirms the non-imposition of taxes on mere recapitalization transactions in the Philippines (e.g., reclassification of ordinary to preference shares, among others).
SECTION 40(C)(2)(E) — REINCORPORATION
“Reincorporation” shall mean the formation of the same corporate business with the same assets and the same stockholders surviving under a new charter. The reincorporation provision in the CREATE Act does not have an exact equivalent in the US Code. This concept appears only in the laws of some US states to govern an entity’s transfer of corporate domicile among states, while retaining and continuing its corporate identity in the new state. Since the Philippines does not operate on a federal system like the US, a tax-free reincorporation under the CREATE Act should be interpreted as it is currently worded, pending local tax guidelines.
CONCLUSION
As the additional tax-free reorganizations are still relatively new within Philippine tax legislation, legal precedents and administrative guidelines may take time to develop. Also, foreign tax regulations/jurisprudence only have persuasive, and not binding, effect in the Philippines.
Regardless, by having our Tax Code align with globally recognized tax-free reorganizations, our country is on its way to becoming a more conducive place for acquisitions, expansions and inward investments. With thoughtful implementation and continuous development of guidelines, we can look forward to a future where our tax system supports business strategies that keep up with the international tax landscape.
The views or opinions expressed in this article are solely those of the author and do not necessarily represent those of Isla Lipana & Co. The content is for general information purposes only, and should not be used as a substitute for specific advice.
Bon Yannicka M. Chua is a manager at the Tax Services department of Isla Lipana & Co., the Philippine member firm of the PwC network.
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