VAT on real property - a call for consistency

Last July 2011, the BIR issued a new tax regulation whose short length understates its impact on the tax consequences of transacting business in the Philippines. Under this regulation, companies that are looking to reorganize their business by transferring their properties to a controlled company may end up paying a 12 percent value -added tax (VAT) on the transaction. In addition, large real estate companies that have been waiting with nervous anticipation for the real estate investment trust (REIT) would now have to pay a VAT on their investments of real property to the REIT.

This is of course with reference to Revenue Regulations Nos. (RR) 10-2011 issued by the BIR on July 2011. The regulation, which took effect immediately, now subjects real estate properties that were used in business, held for sale or for lease by the transferor to VAT if they are transferred to a company as investment in exchange for the company’s shares. This is despite the fact that the controlling interest in said company is owned by the transferor. 

Tax-free exchanges

One may recall that when the first VAT law or Executive Order 273 was passed, the original position of the BIR in its implementing VAT regulations (RR 5-87) was that “Tax Free Exchanges” which are exempt from capital gains tax under Section 40(C)(2) of our Tax Code, are also exempt from VAT. “Tax Free Exchanges” are those transfers or exchanges wherein there is essentially no change in the substance of the asset held by the transferor before and after the exchange. Because the change in the asset was only as to its form but not in substance, the authors of the Tax Code may have looked into such transfers as if there was no exchange at all. Once the received asset is subsequently disposed of by the transferor, the cost of the received asset will be that of the cost of the exchanged asset for purposes of computing the tax due. Thus, at the end of the day, the tax on the transfer was not really exempt but its recognition merely deferred.   Another rationale why the taxes on such exchanges were deferred was because of the principle that tax laws should not impede corporate actions (such as mergers, consolidation and divisions) that would be necessary for company’s economic growth and survival.

There are basically two kinds of Tax Free Exchanges. The first is an exchange pursuant to a plan of merger or consolidation. Under this situation, the absorbed company or its stockholders exchange the property or stock of the absorbed company in exchange for the shares in the new or absorbing company. Since owning the shares in the new company means owning indirectly the properties of the absorbed company, the exchange is treated as non-taxable.

The second kind of Tax-Free Exchange, the one which is now being subjected to VAT, is when an individual or entity transfers or invest its property in exchange for shares in a company the result of which the transferor (together with three others) gains control of the company. As in the previous instance, the exchange was merely in form since the transferor still owns the property, albeit indirectly, through its ownership of the company.

Changes in interpretation

The interpretation of the BIR under RR 5-87 that “Tax Free Exchanges” should be exempt from VAT had been subject to differing interpretations over the years despite the fact that our laws on VAT, even after several amendments, had essentially remained unchanged on the relevant portions affecting “Tax Free Exchanges”. The following are what appear to be conflicting interpretations. In Revenue Memorandum Circular (RMC) 19-99, the then Commissioner of Internal Revenue stated that in a merger, the transfer of the inventory from the absorbed corporation to the absorbing corporation is subject to VAT because it is a “deemed sale” transaction. Several months after, the then Commissioner revised the BIR’s earlier interpretation via RMC 47-99 which stated that t mergers are not subject to VAT. The RMC stated that the prior VAT regulations exempting “Tax Free Exchanges” from VAT had already acquired a status of a law under the legal doctrine of legislative approval by reenactment. This doctrine means that by adopting the same law, the legislature had, in essence, approved the past-issued interpretations of the law.

Thereafter, under RR 16-2005, transfers resulting to corporate control, were subjected to VAT. Under this regulation, exchange of real properties held for sale or lease for shares of stock will be subject to VAT, whether or not the exchange would result in corporate control. This was thereafter amended by RR 04-2007 where it provided an exception – transfers of real property resulting in corporate control made by a real estate dealer to a corporation which is also a real estate dealer.

In the recently issued RR 10-2011, the BIR reverted to its earlier interpretation that the exchange of goods and properties including real estate, which were used in business, held for sale or lease for shares of stock are now subject to VAT whether or not the exchange would result in corporate control.

These varied interpretations of the VAT law, including its most recent interpretation, may give rise to some level of confusion for the inexperienced or untrained businessmen specifically those who may not have the benefit of seeking the advice of tax professionals. On the one hand, we certainly laud the BIR’s efforts in generating more tax revenues for our nation despite the campaign promise of this administration that it will not impose new taxes. On the other hand, the taxpayers – and potential investors – may expect the tax authorities for guidance in providing a consistent and unwavering position on VAT for Tax Free Exchanges that should be grounded on sound tax principles. As one may agree, aside from simply acting as the collector of taxes, the BIR has an equal or even greater mandate to provide a stable and predictable tax environment where businesses will thrive and where the resulting taxes from these economic gains will support our Government’s drive towards nation building. As taxpayers, we deserve no less.

Evelyn C. Garcia-Cantre is a Senior Manager of tax of Manabat Sanagustin & Co., CPAs, a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity.

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG in the Philippines. For comments or inquiries, please email [email protected] or [email protected]