Determining market value in tax free exchanges

When I started practicing in tax law, the rules in determining fair market value of shares of stocks were quite simple. We were instructed to rely on the book value of the shares of stock based on the latest audited financial statement of the company which issued the shares. There were certain adjustments, of course, but generally, the book value is quite reliable.

But in taxation, as in life, nothing remains simple. We have been so used to quoting “it’s complicated” in our Facebook status that the complications leak into our tax rules. Recently, the BIR issued Revenue Memorandum Order (RMO) No. 17-2016 dated May 5, 2016. The RMO was issued to supplement the existing guidelines for securing tax free exchange rulings. The RMO now requires that the number of shares to be issued by the transferee corporation in exchange for the property must be equal to the market value of the property transferred, requiring that the transaction must be a value for value exchange.

Back in the old days, taxpayers were to use tax free exchange rules if they want to transfer property to their controlled corporations. In a tax free exchange transaction, the transfer of the property to the controlled corporation will not be subject to income tax subject to certain conditions. The income tax, if any, shall be due only upon the subsequent transfer of the same property. Hence, the misnomer that it is tax-free when in fact, the transaction is only tax-deferred.

Generally, the property would be transferred in exchange for shares of the controlled corporation. Since this is a tax free exchange, the taxpayers were free to receive such number of shares as they have agreed provided that the issuance of shares will not result to watered stocks. Watered stocks happen when shares are issued for a consideration which is below their total par values.

Under the new RMO, the BIR reiterated the rules in determining the market value of the property to be transferred under a tax free exchange. If the properties to be transferred are listed shares of stocks, the rules are quite easy as they are based on the closing price on the day when the shares are transferred or exchanged. When no sale is made on the stock exchange, then the market value shall be the closing price on the day nearest to the date of the transfer.

For shares not listed and traded in the stock exchange, the rules get to be more complicated. The market value shall be the book value of the shares of stock based on the audited financial statements, with the assets therein adjusted to its fair market value as of a date not earlier than 90 days from the date of the transaction. Generally, this would mean that the company will have to hire an accredited property appraiser to issue an appraisal report on the underlying assets.

The further complication arises if the company whose shares are being transferred have underlying assets which include shares in other corporations. The BIR requires that in such case, the underlying assets which are also shares shall be adjusted to their fair market value as of a date not earlier than 90 days from the date of the transaction. The adjustment shall be made pursuant to Revenue Regulation No. 6-2013 which introduced to taxpayers the concept of Adjusted Net Asset Value. In this scenario, how far down the line must the net asset value be adjusted? What if the second underlying company has assets which again include shares in another company? What happens if the shares issued are less than the fair market value of the properties exchange? Will this result in the outright denial of the request for ruling? Will the transaction be subject to income tax or to donor’s tax?

In following the BIR rules on determining fair market value, taxpayers have already been burdened with the need for an appraisal report every time shares of stocks are being sold or exchanged. When Revenue Regulations No 6-2013 was issued, there was already a clamor to reverse it as it unduly burdened the seller in shouldering additional costs of hiring property appraisers. It became prohibitive for minority shareholders to transfer their shares of stocks in property-rich companies.

However, in this case, the transfer is being done under a tax-free exchange scenario. In principle, the transaction is tax-free because there really is no transfer at this stage. It is the subsequent transfer which will become subject to tax as the RMO clearly illustrated. In such subsequent transfer, the fair market value of the shares at the time of the transfer will have to be determined necessitating the need for an appraisal report again. Hence, one wonders why the market value of the property being transferred in a tax free exchange is even crucial at this stage. Is it only to capture the documentary stamp tax on the original issuance of shares of the transferee corporation?

Tax free exchanges are not means employed by conscientious taxpayers to evade taxes. They are transactions allowed by law as they serve legitimate business purposes. We should all be reminded that the power to tax is the power to destroy. When requirements to legitimate transactions become so odious that they prohibit law-abiding taxpayers in availing what the law allows, the country is not served at all. While it is true that taxes are the lifeblood of a nation, we should also remember that it is taxpayers who are required to slice their veins open and shed that blood.

Eleanor Lucas Roque is the head and principal of the Tax Advisory and Compliance division of Punongbayan & Araullo.

As published in Business World dated 24 May 2016