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De-mystifying mergers and spin-offs

De-mystifying mergers and spin-offs by: Christina Panlilio-Ong

Due to the government’s continued pump-priming efforts and stable remittances from OFWs, the Philippine economy registered a modest growth of 1.5% for the second quarter of 2009 from 4.2 percent last year.  However, the Philippine domestic economy is not out of the woods just yet as the substantial damage to infrastructure, businesses, agriculture, and properties wrought by the recent super typhoons that hit the country has yet to be quantified.

In times of economic uncertainty, companies, particularly those belonging to the same group have considered merging some entities for purposes of streamlining operations and realizing efficiencies or synergies, reducing business costs and tax leakages resulting from redundant functions and minimizing administrative and compliance costs associated with the preparation of financial statements, tax returns and other reportorial requirements.  Other companies consider spin-offs to carve out  un profitable business entities in order to devote limited resources to core business activities which may prove financially sound in the long-run.

When the economy and capital markets are on the cusp of recovery, mergers and spin-offs can be instruments for growth and capacity-building.   In the case of a company that has difficulty in growing organically, a merger with another entity that complements its business may be a viable option for expansion.  Likewise, spinning-off non-related business units is a common step in preparation for an initial public offering to raise capital.    

While the legal and regulatory requirements to implement a merger or spin-off may be tedious, the concept and tax consequences are relatively straight-forward.

In a merger, a surviving corporation acquires all the rights, interests, properties, assets, privileges as well as assumes all the liabilities and obligations of the absorbed corporation/s.  The transfer of all the assets and assumption of liabilities may be made with or without the issuance of shares by the surviving corporation.  In the case of a subsidiary being merged into the parent company (upstream merger), no shares are usually issued.  If a merger is between unrelated companies, the surviving corporation issues its own shares, which in turn are distributed by the absorbed corporation/s to their respective stockholders in complete redemption of the latter’s shareholdings in the absorbed corporation/s.  

Regarding legal and regulatory requirements, a merger requires the approval by majority of the Board of Directors and stockholders representing 2/3 of the outstanding capital stock of the absorbed corporation/s and the surviving corporation (collectively, the “Constituent Corporations”).  A merger takes legal effect upon approval by the Securities and Exchange Commission (SEC) whereupon the corporate existence of the absorbed corporation/s is terminated by operation of law. After SEC approval of a merger, there is a need to file post-merger notices to the Bureau of Internal Revenue (BIR), the local government unit where the absorbed corporation/s does business, Social Security System (SSS) and other concerned government agencies.

The tax implications of a merger are as follows:

         a.  Income tax. The absorbed corporation/s will not be subject to capital gains tax, income tax, nor to creditable withholding tax on the transfer of the assets to, and assumption of liabilities by the surviving corporation.  However, if the liabilities exceed the assets transferred, the excess will be a taxable gain. On the part of the surviving corporation, it is likewise not subject to income tax on its receipt of the property as contribution to its capital, even if the value of such property exceeds the par value of the shares issued by it.

However, note that the non-recognition of taxable gain is merely deferred, for in determining the gain or loss from a subsequent disposition of the properties transferred or of the stocks issued under the merger, the original or historical cost of the properties or stocks is considered.

        b.      Value-added tax (VAT).  The transfer by the absorbed corporation/s of their assets and liabilities to the Surviving Corporation, if done pursuant to a merger, is not subject to VAT.   In addition, the unused input tax of the dissolved corporation is transferred to, and can be utilized by the surviving or new corporation. 

        c.  NOLCO, MCIT and unutilized creditable withholding taxes. Unexpired Net Operating Loss Carry-Over (NOLCO), excess Minimum Corporate Income Tax (MCIT) and unutilized Creditable Withholding Tax (CWT), which the absorbed corporation/s is/are entitled to, shall form part of the properties and rights transferred to, and can be utilized by the surviving corporation, subject to compliance with certain rules. 

       d.  Documentary stamp tax (DST).  Transfers of property in pursuance of a plan of merger shall not be subject to DST.  However, the surviving corporation is subject to DST on the original issuance of its shares.

        e.  Local transfer tax on real property. The transfer of real property, if any, shall also be subject to the local transfer tax imposed by the provincial or city government having jurisdiction over the place where the real property being transferred is located.

A BIR ruling is not a condition precedent to the implementation of a merger.  However, to avoid the risk of tax assessments and to facilitate the transfer of real properties or shares which require a Certificate Authorizing Registration (CAR), it is highly advisable to secure a confirmatory BIR ruling.  

In a spin-off, assets and liabilities are transferred to a corporation (transferee) by a person, natural or juridical (transferor), in exchange for shares of the transferee corporation as a result of which, the transferor, alone or together with others, not exceeding four (4) persons, gains ownership of at least 51% of the capital stock of the transferee corporation.  However, unlike a merger, the corporate existence of the transferee corporation is not terminated.  Its juridical personality continues to exist, albeit, it becomes a shell company.

A spin-off or tax-free exchange is subject to the same Board and stockholder consents, SEC approval, post-transaction notices to government agencies.  Securing a BIR ruling is likewise advisable, especially if the transfer involves properties that require a CAR.  

On the tax implications of a spin-off, the tax rules on income tax, documentary stamp tax and local transfer tax discussed above for mergers are also applicable.  However, since the corporate existence of the transferor corporation continues and it is not absorbed by the transferee corporation, the unutilized input taxes, CWT, MCIT and NOLCO of the transferor corporation is not part of the assets transferred to the transferee. 

With respect to VAT, the tax shall not apply to goods or properties existing in case of a change of control of a corporation by the acquisition of a controlling interest in such corporation by another stockholder/s, subject to certain exceptions.

To be sure, companies wishing to undertake a merger or spin-off need to thoroughly evaluate certain business, financial, operational and administrative reasons for doing so.  But, a clear tax regime applicable to the transaction will allow them to devote precious resources in arriving at such a significant business decision that will have far-reaching consequences.

This article is not intended to be a substitute for professional advice.  For comments and inquiries, you may e-mail the author at Cristina.Panlilio@ph.gt.com.  For other tax concerns, please check out our other tax services.