Swapping losses: Taxation event of debt restructures

Undoubtedly, the COVID-19 pandemic caused a devastating impact on commercial activities around the world and created economic headwinds across many industries. Individuals and entities are fortunate to have survived the past years and were able to look forward to the gradual easing of global economic conditions as everyone strives to regain normalcy.

However, many were not as lucky to have gotten through the pandemic unscathed. We have heard of corporations that have barely survived, and businesses in distress have been forced to avail of remedies as provisioned in Republic Act (RA) 10142 or the Financial Rehabilitation and Insolvency Act of 2010. One of the remedies under this law is to permit distressed juridical entities to undergo court-supervised financial recovery on the substantial likelihood that it may be fulfilled through a viable rehabilitation plan showing that its continued operation is economically feasible, and its creditors may still recover their claims. Since the goal of rehabilitation is to restore a corporation’s financial glory, does the government give it a free pass from its tax liabilities while it strives to implement its rehabilitation plan?

In a recent ruling released by the Bureau of Internal Revenue, the taxing authority enunciated its support for distressed corporations undergoing rehabilitation and financial debt restructuring by upholding that the mandatory exchange of equity resulting from financial restructuring under a court-supervised bankruptcy proceeding is exempt from income tax, capital gains, and donor’s tax.

Here, a domestic corporation devasted by pandemic economic downturns embarked on a comprehensive business and financial restructuring by filing a voluntary bankruptcy petition with a US court to permit the implementation of its restructuring plan and manage its operations as a debtor-in-possession. It also filed its plan of reorganization, which included arrangements for the reduction of losses incurred by impaired unsecured creditors, but not total elimination of their losses. It filed a parallel petition for recognition with the local Regional Trial Court pursuant to RA 10142, which was granted with a decision to give full force and effect to all court orders that may be issued by the foreign court related thereto. The foreign court then approved the plan, permitting the conversion of all unsecured creditor loans/claims into new equity.

The BIR opined that the exchange of equity held by impaired unsecured creditors in the financially distressed corporation for equity in the latter’s immediate parent, in compliance with a court-approved rehabilitation plan, does not give rise to a taxable event. It referred to previous rulings with the same view that a transaction where nothing of exchangeable value is created or received does not give rise to a taxable event since taxable income is created from the inflow of wealth. Thus, when an approved rehabilitation plan is implemented due to judicial action and not as a result of the mutual agreement between the creditor and debtor, any potential gain, if any at all, would not be subject to income tax since it was concluded solely for business consideration. Likewise, any conversion of debt into equity as a result of a court-approved debt restructuring plan is considered in the nature of a capital transaction not subject to income tax.

Moreover, RA 10142 permits the waiver of taxes and fees due to the national government upon the issuance of the commencement order by the court and until the approval of the rehabilitation plan or dismissal of the petition, whichever is earlier. One of the goals of RA 10142 is to enable distressed corporations, through corporate rehabilitation, to attempt to conserve and administer their remaining assets in the most beneficial way in the hopes of restoring their financial well-being and viability. To aid in this, the law allows the suspension of enforcement for any claims against the distressed corporation during the period permitted by the court. These claims include those from the local or national government, including taxes, tariffs, and customs duties.

Thus, the BIR ruled that the conversion of the claims of impaired unsecured creditors into equity in the parent company is in the nature of a capital transaction. Since the equity swap is a result of judicial action made in furtherance of the objectives of the court-recognized rehabilitation plan pursuant to RA 10142, any income actually or presumptively gained from this transaction would be exempt from capital gains or income tax.

Conversely, one might construe that the agreement to swap equity in the financially ailing corporation for equity in its parent, instead of pursuing claims, is an act of liberality. After all, creditors could be considered gratuitously foregoing their right to claim repayment of debt. Under Philippine civil law, an act of liberality whereby a person disposes gratuitously of a thing or right in favor of another, who accepts it, would constitute a donation. Consequently, a valid donation would then be subject to the donor’s tax.

However, the BIR found that there was no donative intent behind the equity swap agreed to by the creditors and the distressed corporation-debtor. Since the conversion of the impaired unsecured creditors’ debts into equity was made pursuant to the court-approved rehabilitation plan and pursued purely for business consideration, there was no act of liberality or donative intent behind this agreement.

Thus, with the BIR ruling in harmony with the provisions of RA No. 10142, we see that a distressed entity, while not scot-free, is granted some leeway to give it greater chances toward a successful rehabilitation.

Milcah Hannah P. Unabia is a supervisor from the tax group of KPMG in the Philippines (R.G. Manabat & Co.), a Philippine partnership and a member firm of the KPMG global organization of independent member firms affiliated with KPMG International Limited, a private English company limited by guarantee. The firm has been recognized as a Tier 1 in transfer pricing practice and in general corporate tax practice by the International Tax Review. For more information, you may reach out to Milcah Hannah P. Unabia or tax principal Kathleen L. Saga through [email protected], social media or visit www.home.kpmg/ph.

This article is for general information purposes only and should not be considered as professional advice to a specific issue or entity. The views and opinions expressed herein are those of the author and do not necessarily represent KPMG International or KPMG in the Philippines.