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Exemption of redemption gains under tax treaties

Lina Figueroa

This should be a good year for Goodyear Philippines as it has finally secured the confirmation of the Supreme Court (SC) on its 6-year-old refund case involving erroneously remitted tax on dividends amounting to about P14 million.

The SC ruled that gains from the redemption of preferred shares are exempt from Philippine income tax if the provisions of the tax treaty between the Philippines and the US are complied with. The tax treaty with the US provides that gains derived by a US resident from the sale of shares in a Philippine company shall only be taxable in the US if the Philippine company's assets do not consist principally of real property. The gains should not be treated as dividends.


In 2008, the company's board of directors authorized the redemption of preferred shares at a redemption price equal to the par value plus a premium representing accrued and unpaid dividends.

The company filed an application for treaty relief with the Bureau of Internal Revenue (BIR) to confirm the tax exemption. Taking the conservative approach, though, the company withheld and remitted a final withholding tax (FWT) at 15%, anticipating a situation where the BIR would treat the difference between the par value and the redemption price as taxable dividend.

After almost two years, the ruling has not been issued and the two-year period to refund was prescribing. Hence, the company filed an administrative claim for refund of the final withholding tax, and shortly, a petition for review with the Court of Tax Appeals (CTA).

At the CTA, the BIR argued that the premium should not be treated as a mere premium and part of the redemption price, but as accumulated dividend in arrears, and hence, subject to the 15% FWT. The CTA in division and en banc rejected the BIR's position. The SC affirmed the ruling of the CTA.

Upholding the CTA, the SC declared that the cardinal principle is that treaties have the force and effect of law. Hence, the Tax Treaty should govern the tax implications of company's transaction with its shareholder which is a US resident.

The courts rejected the assertions of the BIR that the gain should be treated and taxed as dividends and should not be covered by the exemption.

The SC noted that, under the treaty, the term "dividends" should be understood according to the taxation law of the State in which the corporation making the distribution is a resident. Accordingly, under the Philippine Tax Code, dividend is defined as "any distribution made by a corporation to its shareholders out of its earnings or profits and payable to its shareholders, whether in money or in other property." The board of directors has to declare and pay the dividends to all of its shareholders. The company's financial statements, however, do not disclose unrestricted earnings. Absent the availability of unrestricted retained earnings, the board had no power to issue dividends.

The SC also affirmed that an ordinary distribution of dividend should be in the nature of a recurring return on stock. This was not the case with the company's redemption. The premium received by the shareholder did not represent a periodic distribution of dividend, but rather a payment for the redemption of the preferred shares. The SC cited jurisprudence that distinction between a distribution in liquidation and an ordinary dividend depends on the particular circumstances of the case and the intent of the parties. If the distribution is in the nature of a recurring return on stock, it is an ordinary dividend. However, if the corporation is recapitalizing and narrowing its activities, the distribution may properly be treated as in partial liquidation and as payment by the corporation to the stockholder for his stock, not as dividend distribution.

These issues have been discussed as early as 2013 when the CTA in division issued its decision. The SC decision does not really come as a surprise. I see the case, though, as implying a lot for the state of tax compliance and administration in the country.

In this case, the company exercised prudence. It opted to remit the tax in advance than risk being subjected to a 20% annual interest and 25% surcharge if an unfavorable ruling is issued.

The company took into consideration that treaty rulings take some time to be issued and the taxpayer may, therefore, be in a state of suspense until the ruling is issued. If rulings are issued promptly, decisions can be made sooner and taxpayers do not have to set aside resources.

Tax interpretations are not consistent. Similar cases have been ruled in favor of the treaty exemption of redemption gains until a change in interpretation 2009 in one instance. This was probably the reason why the company recognized a potential risk of being subject to dividends tax. Fortunately, or unfortunately for the company, the BIR issued a 2012 ruling upholding the exemption. Yet, the BIR appealed the CTA ruling on the exemption up to the SC level.

The P14-million case has taken six years, and accumulated CTA filing fees and lawyers' fees. If BIR appeals, that adds another countdown for when the company gets its refund.

We thank Goodyear, though, for contributing to Philippine jurisprudence and putting yet another issue to rest. We hope.

Lina P. Figueroa is a principal of the Tax Advisory and Compliance division of Punongbayan & Araullo.

As published on BusinessWorld dated August 23, 2016