Retained earnings for dividend declaration & IAET
Retained earnings for dividend declaration and the IAET
by Recel P. Cachuela
The Securities and Exchange Commission (SEC) recently released a set of draft guidelines on determining the availability of retained earnings for dividend declaration (proposed guidelines) to solicit comments from the general public.
The proposed guidelines aim to ensure that the dividend distribution will not adversely affect the rights and obligations of the stakeholders of the corporation, taking into consideration the effective accounting standards and the SEC rules.
Under the Corporation Code of the Philippines, the board of directors of a stock corporation may declare dividends out of the unrestricted retained earnings which shall be payable in cash, in property, or in stock to all stockholders on the basis of outstanding stock held by them. In the opinions issued by the SEC, the existence of surplus profits arising from the operation of corporate business is a condition precedent to the declaration of dividend.
Moreover, the surplus profits or income must be a bona fide income founded upon actual earnings or profits.
Under the proposed guidelines issued by the SEC, the phrase "actual earnings or profits" refer to net income for the year, as determined under the PFRS, adjusted for the following unrealized items which are considered not available for dividend declaration:
revaluation increment or surplus, as the same is not earned from the business of the corporation and is merely anticipatory of future profits that may never be realized as an asset of the company until after said asset is sold or disposed;
share/equity in net income of the associate or joint venture accounted for equity method, as the same is not yet realized until declared as dividends by the investee-company;
unrealized foreign exchange gains for the time being that they are not yet actual income prior to realization of such foreign exchange gain;
fair value adjustment or the gains arising only from marked-to-market valuation which are not yet realized; and
the amount of recognized deferred tax asset that reduced the amount of income tax expense and increased the net income and retained earnings, until realized.
Following the proposed guidelines, it seems that income shall be available for distribution to stockholders only if these have already been realized. Inadvertent distribution of unrealized income is deemed detrimental to stock corporations.
Normally, the board of directors would ensure that the distribution of dividends will not adversely affect the rights and obligations of the stakeholders, with or without the SEC rules. Thus, although the objective of the SEC for considering the proposed guidelines is reasonable, many believe that it is no longer necessary on the basis that corporations are responsible for their operations.
From a taxation point of view, this recent development is quite interesting as it equally highlights the concerns faced by corporate taxpayers being assessed by the BIR for Improperly Accumulated Earnings Tax (IAET).
Under existing tax laws, a corporation may be imposed the 10% IAET if it is deemed to be avoiding income tax with respect to the shareholders, by permitting earnings and profits to accumulate instead of being distributed to the shareholders. Among others, accumulation by the corporation of earnings in excess of 100% of paid-up capital, not otherwise intended for the reasonable needs of the business, is a prima facie instance of accumulation of profits beyond the reasonable needs of a business.
For this reason, during tax examinations, BIR examiners tend to automatically include the 10% IAET to a corporation whenever they notice that its retained earnings exceeds 100% of its capital stock.
As noted by the SEC, it is clear that there are items that comprise the retained earnings of a corporation which have not yet actually been earned although they have been recognized as par
t of prof its PFRS. For instance, revaluation increment, which is merely anticipatory of future profits, is recognized as part of the corporation’s retained earnings but may not be considered by the board as part of profits for dividend declaration since it is not yet realized.
Similarly, future income expected to be generated from existing contracts that are required to be recognized under certain PFRS rules may not likewise be available for profit distribution. Such items may cause the retained earnings of a corporation to exceed 100% of its capital stock.
In such cases, the BIR examiners should accept them as reasonable adjustments to the retained earnings rather than blindly looking at the numbers. After all, the basis of the IAET is the taxable income of the corporation, subject to certain adjustments, and not the retained earnings.
Having said that, the predicament that tax examiners are faced with especially after considering the impact of the new accounting standards, is understandable.
It would, thus, be very helpful for the taxpayers if the BIR can come up with similar guidelines to deal with the differences between financial and tax reporting.
(The author is a tax manager at the Davao branch of Punongbayan & Araullo, member of Grant Thornton International Ltd. For comments and inquiries, please e-mail the author or call 082-221-1498 in Davao or 886-5511 in Makati.)