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Tax treatment of liquidating dividends in limbo

Tax treatment of liquidating dividends in limbo by: Tata Panlilio-Ong

In the Philippines, closing down or dissolving a company is often more complicated than setting up a new one. Dissolution of a corporation denotes the termination of its legal existence, the winding up of corporate affairs, and the distribution of assets to settle creditors’ claims and thereafter, to the stockholders.
Dissolution may either be voluntary or involuntary.

There are three modes of voluntary dissolution, namely:

  • When there are no creditors affected by the dissolution, an administrative application for dissolution is filed with the Securities and Exchange Commission (SEC).

  • When there are creditors affected by the dissolution, a formal petition for dissolution shall be filed with the SEC, and notice and hearing will be duly conducted.

  • Shortening of corporate term by the amendment of the articles of incorporation.

There are several ways to dissolve a company, but by far the more widely used one is by shortening the corporate term under Section 120 of the Corporation Code.

Some companies venture into dormancy prior to actual dissolution to wind down corporate affairs. It is helpful to distinguish dissolution from dormancy. Dissolution of a corporation denotes the permanent termination of its legal existence. On the other hand, in dormancy, the corporation ceases its active operations but remains a going-concern for legal purposes. There is no change in the corporate term and all reportorial and administrative requirements shall subsist. The company will not be dissolved unless and until the proper applications are filed. This gives the company flexibility on its decision whether to dissolve or maintain its legal existence should business pick up later on.

Whichever mode to dissolve is adopted, once approvals and clearances of all concerned government agencies are secured and creditor claims are paid, the final step is to distribute the remaining corporate assets to the stockholders as liquidating dividends.

Past rulings by the Bureau of Internal Revenue (BIR) on the tax implications of liquidating dividends have been inconsistent. However, in Section 8 of BIR Revenue Regulation (RR) 06-08 dated April 22, 2008 (which consolidated all tax rules on the sale, exchange or other disposition of shares of stock held as capital assets), the tax authority definitively ruled that "xxx upon surrender by the stockholder of its shares in exchange for cash and/or property distributed by the corporation upon its dissolution and liquidation, the stockholder shall recognize either capital gain or loss. The difference between the sum of the cash and the fair market value of property received and the stockholder’s cost of investment in the shares surrendered shall represent the capital gain or loss, as the case may be."

The rationale for the above tax treatment, as adopted in numerous recent BIR rulings, is the precept laid down in the Supreme Court case of Wise & Co., Inc. vs. Collector of Internal Revenue (78 Phil. 655 [1947]). The Supreme Court explained that "xxx the amounts distributed in the liquidation of a corporation shall be treated as payments in exchange for shares, and any gain or profit realized thereby shall be taxed to the distributee as other gains or profits. xxx [W]hen the corporation was dissolved and xxx its shareholders surrendered their stock to it and it paid the sums to them in exchange, a transaction took place, which was no different in its essence from a sale of the same stock to a third party who paid therefor."

In effect, the liquidating gain, which is incurred if the fair market value of the properties given as liquidating dividend is higher than the investment cost of the shares, is treated as a gain from the sale or exchange of shares. However, said liquidating gain is subject not to the 5-10% capital gains tax but to ordinary income tax rates, depending on the status of the stockholder-recipient wh o can either be a corporation or an individual.

If the recipient of the liquidating dividend is a corporation, whether domestic or foreign, the liquidating gain is subject to 30% ordinary income tax. If the recipient is an individual, the tax will be the zero percent to 32% scheduler rates or, in the case of a non-resident alien not engaged in business in the Philippines, 25%.

However, if the recipient, whether corporate or individual, is a resident of a country with whom the Philippines has a tax treaty, exemption from income tax can be availed of based on treaty provisions on disposition of shares, provided the treaty conditions are complied with and the appropriate tax treaty relief application is filed within the period and under the conditions prescribed by law.

The BIR rulings mentioned above also ruled on the issue of documentary stamp tax (DST) and value-added tax (VAT) in cases where the liquidating dividend consists of real property. The transfer is not subject to DST since under the DST Regulations, "[A conveyance of real estate by a corporation without valuable consideration to an owner of all its capital stock in consequence of its dissolution is not subject to tax." Similarly, as the distribution of liquidating dividends to stockholders is without consideration and is treated as a return of capital and not made in the ordinary course of trade or business, the same is not subject to 12% VAT.

On the part of the liquidating corporation, it shall not be liable for income tax either on its transfer to the stockholders of the assets distributed in liquidation or for its receipt of the surrendered shares. In addition, no DST shall be due on the surrender by the stockholders of their shares in the liquidating corporation and the subsequent cancellation thereof. The surrender of the said shares does not constitute a sale, assignment or transfer because the liquidating corporation is not taking title to the surrendered shares, and the shares are retired and not retained as treasury shares.

The tax treatment of liquidating dividends discussed above was supposed to definitively and finally put to rest the conflicting BIR pronouncements on the matter. However, any hope of legal stability was shattered when in a Dec. 5, 2011 ruling, the BIR denied the confirmation of similar tax issues involving distribution of a parcel of land as liquidating dividend.

In the said 2011 ruling, confirmation from the BIR was sought on the following issues:

  • that the liquidating corporation is not liable for income tax either on its transfer of the properties to its stockholders as liquidating dividend or upon its receipt of the surrendered shares;

  • no DST is due on the surrender and cancellation of the shares surrendered by the stockholder;

  • no DST is due on the transfer of the properties from the liquidating corporation to its stockholders; and

  • the stockholder-recipient shall realize capital gain or loss from the transfer of properties by way of liquidating dividends.

The BIR denied the request for confirmation for lack of legal basis under the 1997 Tax Code. Moreover, the ruling noted that the rulings previously cited in the request for confirmation are reversed and set aside. There was no discussion to guide taxpayers on how to treat liquidating dividends. In so doing, the BIR put in limbo anew the tax treatment of liquidating dividends and added yet another legal thorn to an already complicated, time-consuming and costly dissolution process.