From Bibliometrics to Entrepreneurship: A Study of Studies
6.2. LITERATURE REVIEW
Sec 40 is chopped up in 3 parts. Keep this in mind for a better understanding of the provision.
1. Section 40 (A) which tells us how to arrive at the gain (or loss).
2. Section 40 (C 1-2) which tells us the general rule and the exceptions (tax-free exchanges)
3. Section 40 (C 5) which gives us the substituted basis; i.e. the basis for tax-free exchanges when the transferor later sells the stock he got in the tax-free exchange.
SEC. 40. Determination of Amount and Recognition of Gain or Loss. -
(A) Computation of Gain or Loss. - The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the basis or adjusted basis for determining gain, and the loss shall be the excess of the basis or adjusted basis for determining loss over the amount realized. The amount realized from the sale or other disposition of property shall be the sum of money received plus the fair market value of the property (other than money) received;
• Gain is the excess amount realized over the basis for determining gain
• Loss is the opposite
• The amount realized is the sum of money received plus the fair market value of the property (other than money) received
• What is the basis of determining gain or loss?
(B) Basis for Determining Gain or Loss from Sale or Disposition of Property. - The basis of property shall be - (1) The cost thereof in the case of property acquired on or after March 1, 1913, if such property was acquired by purchase; or
(2) The fair market price or value as of the date of acquisition, if the same was acquired by inheritance; or
(3) If the property was acquired by gift, the basis shall be the same as if it would be in the hands of the donor or the last preceding owner by whom it was not acquired by gift, except that if such basis is greater than the fair market value of the property at the time of the gift then, for the purpose of determining loss, the basis shall be such fair market value; or
(4) If the property was acquired for less than an adequate consideration in money or money's worth, the basis of such property is the amount paid by the transferee for the property; or
(5) The basis as defined in paragraph (C)(5) of this Section, if the property was acquired in a transaction where gain or loss is not recognized under paragraph (C)(2) of this Section.
Basis for Determining Gain or Loss from Sale or Disposition of Property (Original Basis
17)
17 RR 18-2001 C. The Original Basis of Property to be Transferred. The original basis of the property to be transferred shall be the following, as may be appropriate:
(a) The cost of the property, if acquired by purchase on or after March 1, 1913;
Taxation One: Outline with Codals
Mode of acquisition Cost basis
1. Acquired by purchase The actual cost
2. By inheritance Fair market value
3. By gift The same as if it would be in the hands of the donor or the last preceding owner,
BUT if the basis is greater than the fmv, then the basis shall be the fmv (so, whatever’s lower)
4. Acquired for less than an adequate
consideration in money or its worth Amount paid by the transferee for the property
Example
Mao sold a car worth P100 to Apple Inc, in exchange for P110 worth of Apple Inc stock, P10 cash and P20 property. How much is the gain for Mao? What about the loss for Apple Inc?
Get the amount realized first: P140 (cash + stock + property) Deduct the basis: P100 (value of car)
Gain: P 40 (gain for Mao), loss of P40 for Apple Inc
How do you make the transaction a tax-free exchange? Check the codal below. It’s one of the most used provisions.
(C) Exchange of Property. -
(1) General Rule. - Except as herein provided, upon the sale or exchange or property, the entire amount of the gain or loss, as the case may be, shall be recognized.
(2) Exception. No gain or loss shall be recognized if in pursuance of a plan of merger or consolidation
-(a) A corporation, which is a party to a merger or consolidation, exchanges property solely for stock in a corporation, which is a party to the merger or consolidation; or
(b) A shareholder exchanges stock in a corporation, which is a party to the merger or consolidation, solely for the stock of another corporation also a party to the merger or consolidation; or
(c) A security holder of a corporation, which is a party to the merger or consolidation, exchanges his securities in such corporation, solely for stock or securities in such corporation, a party to the merger or consolidation.
No gain or loss shall also be recognized if property is transferred to a corporation by a person in exchange for stock or unit of participation in such a corporation of which as a result of such exchange said person, alone or together with others, not exceeding four (4) persons, gains control of said corporation: Provided, That stocks issued for services shall not be considered as issued in return for property.
• Exchange of property, and tax-free exchange.
• General rule: in a sale or exchange of property, the entire amount of gain or loss is recognized
o EXCEPT (no gain or loss is realized):
i. In a merger/consolidation (m/c), where a corp exchanges property solely for stock in another corporation, which is also a party to the m/c
ii. In a m/c, where a shareholder exchanges stock in a corp for the stock of another corp, also a party to the m/c
iii. In a m/c, where a security holder of a corp exchanges his securities in such corp solely for stock or securities in another corp also a party to the m/c
(b) The fair market price or value as of the moment 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 basis 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 an 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 amount 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.
Taxation One: Outline with Codals iv. Where property is transferred to a corp by a person in exchange for stock in the corp, and the result of such exchange is that the person (and up to 4 other persons) gains control of the corp, but the stocks issued for services are not considered as issued in return for property.
• Rule of momentary control
o If two tax-free exchanges are done in the same taxable year, they are not considered tax-free. (Atty. Montero)
(6) Definitions. -
(a) The term "securities" means bonds and debentures but not "notes" of whatever class or duration.
(b) The term "merger" or "consolidation", when used in this Section, shall be understood to mean: (i) the ordinary merger or consolidation, or (ii) the acquisition by one corporation of all or substantially all the properties of another corporation solely for stock: Provided, That for a transaction to be regarded as a merger or consolidation within the purview of this Section, it must be undertaken for a bona fide business purpose and not solely for the purpose of escaping the burden of taxation: Provided, further, That in determining whether a bona fide business purpose exists, each and every step of the transaction shall be considered and the whole transaction or series of transaction shall be treated as a single unit: Provided, finally , That in determining whether the property transferred constitutes a substantial portion of the property of the transferor, the term 'property' shall be taken to include the cash assets of the transferor.
(c) The term "control", when used in this Section, shall mean ownership of stocks in a corporation possessing at least fifty-one percent (51%) of the total voting power of all classes of stocks entitled to vote.
(d) The Secretary of Finance, upon recommendation of the Commissioner, is hereby authorized to issue rules and regulations for the purpose "substantially all" and for the proper implementation of this Section.
• Securities means bonds and debentures, but not notes of whatever class or duration.
• Merger or consolidation means:
o The ordinary merger or consolidation
o The acquisition by one corporation of all or almost all the properties of another corporation solely for stock
• A corporate merger where the new corporation continued to operate the business of the old corporation is not subject to capital gains tax. The merger, however, must be undertaken for a bona fide business purpose and not solely for the purpose of escaping the burden of taxation. (CIR v Rufino, where the merger was done to extend the life of the corporation, this was legitimate)
• Transfer of substantially “all” the assets means a transfer of at least 80% of the assets, including cash, with some degree of permanence.
• Transfer of property for shares of stock: no gain or loss is recognized when a person transfers property (not services) to a corporation in exchange for shares of stock (alone or with 4 others), where such person gains control of the corporation (at least 51% of the total voting power)
• The transfer of assets by one corporation to another must have a business purpose.
(Gregory v Helving)
• Administrative requirements in case of tax-free exchanges.
o You have to submit the following to the BIR:
i. Sworn certificate on the basis of property to be transferred ii. Certified true copies (ctc) of the TCT
iii. Ctc of the corresponding tax declaration of the real properties to be transferred
iv. Ctc of the certificates of stock evidencing shares of stock to be transferred v. Ctc of the inventory of the property to be transferred (RR 18-01)
• Elements of a de factor merger (which is a valid merger)
1. Transfer of all or substantially all of the properties of the transferor corp solely for stock
2. Undertaken for a bona fide biz purpose, not for escaping taxes
• How does a statutory merger work?
o Y corp acquires all the assets of X corp. X corp gets Y shares in exchange. X corp
then dissolves and distributes these shares to its stockholders.
Taxation One: Outline with Codals
• Difference between a de facto merger v a statutory merger
o In a de facto merger, the transferor is not automatically dissolved
o In a de facto merger, there is no automatic transfer to the transferee of all the rights, privileges and liabilities of the transferor
• Difference between a de facto merger v a transfer to a controlled corporation
o In a de facto merger, the transferor is a corp. in the latter, the transferor may be an individual.
o In a de facto merger, the requirement is that the transferee acquires all or substantially all of the properties of the transferor. In the latter, the requirement is that the transferor gains control of the transferee (own 51% of the voting power)
(3) Exchange Not Solely in Kind. -
(a) If, in connection with an exchange described in the above exceptions, an individual, a shareholder, a security holder or a corporation receives not only stock or securities permitted to be received without the recognition of gain or loss, but also money and/or property, the gain, if any, but not the loss, shall be recognized but in an amount not in excess of the sum of the money and fair market value of such other property received: Provided, That as to the shareholder, if the money and/or other property received has the effect of a distribution of a taxable dividend, there shall be taxed as dividend to the shareholder an amount of the gain recognized not in excess of his proportionate share of the undistributed earnings and profits of the corporation; the remainder, if any, of the gain recognized shall be treated as a capital gain.
(b) If, in connection with the exchange described in the above exceptions, the transferor corporation receives not only stock permitted to be received without the recognition of gain or loss but also money and/or other property, then (i) if the corporation receiving such money and/or other property distributes it in pursuance of the plan of merger or consolidation, no gain to the corporation shall be recognized from the exchange, but (ii) if the corporation receiving such other property and/or money does not distribute it in pursuance of the plan of merger or consolidation, the gain, if any, but not the loss to the corporation shall be recognized but in an amount not in excess of the sum of such money and the fair market value of such other property so received, which is not distributed.
• Explain an exchange not solely in kind in a merger or consolidation o One that involves an exchange of property NOT solely for stocks.
o In other words, the absorbed corporation receives stocks PLUS other property (cash or non-cash) in exchange for its property.
o In a merger, X Corp transfers all its property costing 10m in favor of Y Corp (absorbing) in exchange for the latter’s shares of stock worth P10m plus P1m cash.
The P1m gain resulting from the merger is taxable.
• BU if the plan of merger or consolidation expressly provides that the amount shall be distributed to the shareholders of X Corp, the gain shall not be subject to income tax.
What if instead of P10m stock plus P1m cash, X corp is given P5m stock plus P5m cash?
• No gain, since break even only. (Problem in p 105 of Co)
(4) Assumption of Liability.
-(a) If the taxpayer, in connection with the exchanges described in the foregoing exceptions, receives stock or securities which would be permitted to be received without the recognition of the gain if it were the sole consideration, and as part of the consideration, another party to the exchange assumes a liability of the taxpayer, or acquires from the taxpayer property, subject to a liability, then such assumption or acquisition shall not be treated as money and/or other property, and shall not prevent the exchange from being within the exceptions.
(b) If the amount of the liabilities assumed plus the amount of the liabilities to which the property is subject exceed the total of the adjusted basis of the property transferred pursuant to such exchange, then such excess shall be considered as a gain from the sale or exchange of a capital asset or of property which is not a capital asset, as the case may be.
Assumption of liability in tax-free exchanges:
• If the transferor receives stock or securities in a transfer of property, and as part of the
consideration, the other party also assumes the liability of the transferor or that the
property he assumes has a liability, then the property/liability acquired will NOT be
Taxation One: Outline with Codals treated as money or other property, so that it still falls under the exception of the Sec 40 (C) and no gain or loss is recognized.
• But if the amount of the liability assumed exceeds the total of the adjusted basis of the property transferred, then the excess is considered a gain from sale of either a capital asset or an ordinary asset, as the case may be.
Example
Toby transfers property to Epol Inc with an adjusted basis of P15m in exchange for Epol Inc’s stock plus Epol Inc assumes Toby’s liability of P10m. Toby gets control of Epol Inc. The exchange is considered tax-free.
But if the liability of Toby is P20m, then this will exceed the adjusted basis of P15m.
So the P5m will be considered a gain and it will be taxable.
Cost or basis in tax-free exchanges
(5) Basis
-(a) The basis of the stock or securities received by the transferor upon the exchange specified in the above exception shall be the same as the basis of the property, stock or securities exchanged, decreased by (1) the money received, and (2) the fair market value of the other property received, and increased by (a) the amount treated as dividend of the shareholder and (b) the amount of any gain that was recognized on the exchange:
Provided, That the property received as "boot" shall have as basis its fair market value: Provided, further, That if as part of the consideration to the transferor, the transferee of property assumes a liability of the transferor or acquires form the latter property subject to a liability, such assumption or acquisition (in the amount of the liability) shall, for purposes of this paragraph, be treated as money received by the transferor on the exchange:
Provided, finally, That if the transferor receives several kinds of stock or securities, the Commissioner is hereby authorized to allocate the basis among the several classes of stocks or securities.
(b) The basis of the property transferred in the hands of the transferee shall be the same as it would be in the hands of the transferor increased by the amount of the gain recognized to the transferor on the transfer.
• When the transferor later on sells or exchanges the stock he got tax-free, the basis for determining the gain or loss is the substituted basis. This will also be the cost basis when the transferee later on sells the property acquired.
• How to compute the substituted basis:
1. Take the original basis of the property (see the table a few pages back)
a. The original basis is usually what’s indicated in the deed of sale (the FMV of the property is used for accounting purposes) – Atty Salvador
2. Subtract any money or the fair market value of any property that may have been received aside from the shares of stock
3. Add the amount treated as dividend by the shareholder & any gain that was recognized on the exchange (if any)
Example
Hayley transfers property to Apple Inc for shares of stock. The property’s sale value was P5m and Hayley received an extra P1m from stock of inventory.
If she later sells her shares of stock to Mel, the substituted basis will be computed as (P5m-P1m)=P4m.
If Hayley sells the shares to Mel for P6m, her gain will be (P6-P4m) P2m and it will be subject to capital gains tax.
Losses from Wash Sales of Stocks or Securities
SEC. 38. Losses from Wash Sales of Stock or Securities. -
(A) In the case of any loss claimed to have been sustained from any sale or other disposition of shares of stock or securities where it appears that within a period beginning thirty (30) days before the date of such sale or disposition and ending thirty (30) days after such date, the taxpayer has acquired (by purchase or by exchange upon which the entire amount of gain or loss was recognized by law), or has entered into a contact or option so to acquire, substantially identical stock or securities, then no deduction for the loss shall be allowed under Section 34 unless the claim is made by a dealer in stock or securities and with respect to a transaction made in the ordinary course of the business of such dealer.
(B) If the amount of stock or securities acquired (or covered by the contract or option to acquire) is less than the amount of stock or securities sold or otherwise disposed of, then the particular shares of stock or securities, the