BIR gives clarification and guidance on Tax-Free Exchanges of Properties on the release of Revenue Memorandum Circular 19-2022

The Bureau of Internal Revenue (BIR), in response to queries regarding Section 8 of Revenue Regulations No. 5-2021, releases Revenue Memorandum Circular 19-2022. This aims to clarify and guide taxpayers on the tax-free exchanges of properties under Section 40(C)(2) of the National Internal Revenue Code of 1997, as amended by Republic Act No. 11534 (CREATE).

This section under the CREATE act states that the tax-free exchanges of properties cover reorganisation and transfer of property to a controlled corporation. The amended Section 40(C)(5) of the 1997 Tax Code states that the substituted basis of the properties transferred shall be determined by the following:

1)      The substituted basis of the stock or securities received by the transferor on a tax-free exchange shall be:

a)      The original basis of the property, stock, or securities to be transferred

b)     Less: (a) there was money received if any, and (b) the fair market value of the other property received if any

c)      Plus: (a) the amount treated as the dividend of the shareholder, if any, and (b) the amount of any gain that was recognised on the exchange if any.

The circular clarifies that any property received as ‘boot’ shall have its fair market value as a basis. The term ‘boot’ refers to any money or property received overstock and securities received by the transferor on a tax-free exchange.

It then states that if the transferee of property assumes a liability of the transferor or acquires, as part of the consideration to the transferor, from the latter property subject to a liability, the assumption or acquisition (in the amount of the liability) will be treated as money received by the transferor on the exchange for purposes of computing the substituted basis.

It clarifies that the transferor gets different kinds of stock or securities; the Commissioner will be authorised to allocate the basis among the several classes of stocks or securities.

2)     The substituted basis of the property transferred in the hands of the transferee will be:

a)      The original basis possessed by the transferor

b)     Plus: the amount of the gain recognised to the transferor on the transfer.

3)     The original basis of the property to be transferred, as mentioned in the Circular, shall be the following, if appropriate:

a)      The cost of the property is acquired by purchase on or after March 1, 1913

b)     The fair market price or value in the time of death of the decedent, if acquired by inheritance

c)      The basis in the hands of the donor or the last preceding owner by whom the property was not acquired by gift if the property was acquired by donation. If the basis, however, is greater than the fair market value of the property at the time of donation, then, for purposes of determining loss, the cause shall be such fair market value; or,

d)     The amount paid by the transferee for the property if the property was acquired for less than adequate consideration in money or money's worth.

e)     The adjusted basis of (a) to (d) above if the acquisition cost of the property is increased by the number of improvements that materially add to the value of the property or appreciably prolong its life-less accumulated depreciation.

f)       The substituted basis if the property was acquired in a previous tax-free exchange under Section 40(C)(2) of the Tax Code of 1997.

The circular mentions that the illustrations and further explanations tackling the determination of the substituted basis of the properties transferred and stocks received in the exchange is in existing revenue issuances listed in Item VII of the Circular. Item III of the circular determines the “substituted basis”, which is the basis for determining gain or loss on a subsequent sale or disposition of properties subject within the tax-free exchange transactions under Section 40(C)(2) of the 1997 Tax Code, amended by the CREATE act.

If any party in the tax-free exchange/reorganisation wants to monitor the substituted basis properly, they need to comply with the following requirements established by Revenue Regulations No. 18-2001:

1. It mentions that every corporation recognised as a party to the reorganisation needs to file a complete statement of all facts pertinent to the non-recognition of gain or loss in connection with the reorganisation as part of its return for the taxable year within occurred by the reorganisation.
2. All taxpayers, other than corporations, that are party to the reorganisation who also received stock or securities and other property or money upon a tax-free exchange in connection with a corporate reorganisation needs to incorporate their Income Tax return for the taxable year in which the exchange takes place a complete statement of all facts pertinent to the non-recognition of gain or loss upon such exchange.
3. The parties to it shall include as a note to their respective audited financial statements for the taxable year in which the exchange occurred a message to the effect that they hold such assets/shares acquired in a tax-free sale and the year in which such exchange occurred, and in the taxable years until the subject properties are subsequently transferred to another transferee.
4. The parties shall cause to annotate, at the back of the Transfer Certificate of Title (TCC), Condominium Certificate of Title (CCT) and Certificates of Stock, the date the deed of exchange was executed, the original or historical cost of acquisition of the properties or shares of stock transferred, and the fact that no gain or loss was recognised because of such exchange.
5. A photocopy of the TCT/CCT/Certificate of Stock that bears the annotation of substituted bases of the natural properties/shares of stock transferred/ received in connection with the transaction, as duly certified by the Register of Deeds/Corporate Secretary, should be submitted to the Revenue District Office (RDO) which issued the Certificate Authorizing Registration (CAR), within ninety (90) days from the date of the receipt of the CAR, by any of the parties to the exchange transaction. Otherwise, the RDO shall refer the case’s docket to the Legal Division for appropriate action.
6. Moreover, the shareholders of the absorbed/transferor corporation and the surviving/transferee corporation shall record in their respective books the mandatory accounting entries stated in Annexes "A" "A-I", and "A-2" of the Circular, as the case may be, under Revenue Memorandum Order No. 17-2016.

The circular then explained that the transfers of properties done in exchange for shares of stocks made according to Section 40(C)(2) of the 1997 Tax Code, as amended, shall be exempt from the following taxes:

1. Capital Gains Tax (CGT);
2. Creditable Withholding Tax (CWT);
3. Income Tax (IT);
4. Donor's Tax (DT);
5. Value-Added Tax (VAT); and
6. Documentary Stamp Tax (DST) on conveyances of real properties and shares of stocks

After this stamen, the circular clarifies that the original issuance of shares in exchange for the properties transferred must be subject to the DST under the amended Section 174 of the 1997 Tax Code.

It then explains the revenue issuances (listed under Item VII of the Circular) are mandated to continue to apply on exchanges of properties made under the tax code amended by the CREATE act, particularly on the establishment and monitoring of substituted basis of the properties transferred and stocks received in case of their subsequent sale or disposition, including their tax treatment:

1. Revenue Regulations No. 18-2001
2. Revenue Memorandum Ruling (RMR) No. 1-2001
3. RMR No. 1-2002
4. RMR No. 2-2002
5. Revenue Memorandum Order (RMO) No. 32-2001
6. RMO No. 17-2016

The memorandum then delves into the CAR issuances for the transferred properties under the tax-free reorganisation/exchange, indicating that all parties to the transaction need to submit the documentary requirements listed in Annex "B" of the Circular to the RDO having jurisdiction over the property’s location. But in the case of real property, or the issue of shares of stock, the Regional District Office (RDO) is where the issuing corporation will be registered.

Suppose the transaction involves transferring multiple properties and shares of stocks in various locations covered by different RDOs. In that case, the CAR shall be processed with the RDO having jurisdiction over the place where the transferee corporation is registered. The CAR needs to specify that the transaction is done in a tax-free exchange under the tax-code amended by the CREATE Act, the date of transaction, and the substituted basis of the properties subject therefor.

Once the CAR issuance under the amended tax code is complete, the concerned RDO shall conduct a post-audit transaction according to existing revenue issuances on tax audit and assessment to determine the taxability thereof. However, suppose the transaction is found not entitled to the tax deferment treatment under Section 40(C)(2) of the Tax Code, as amended by CREATE after the audit. In that case, the transaction shall be subject to the applicable taxes, plus interest, penalty, and surcharge. But the audit result will not invalidate any CAR previously issued for the transfer of properties.

The circular explains that BIR mandates all parties to the transaction are duty-bound to prove compliance with the conditions laid down by the law and the requirements set forth under existing revenue issuances in the availment of the tax exemption. Taxpayers are allowed to ask requests regarding the ruling/legal opinion with the Law and Legislative Division (LLD) of the BIR National Office to help clarify legal issue/s that may affect the transactions made under Section 40(C)(2) of the 1997 Tax Code, as amended, including the taxability of such transaction. The LLD with then evaluate whether it involves question/s of law that would merit the issuance of a ruling. Otherwise, it shall endorse the request to the concerned RDO for appropriate action.