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One may structure a repo transaction in such a way that it has substantially the
same financial returns as a certificate of deposit. For instance, a one-year certificate of
deposit with a principal amount of P10 million and an interest of 1% p.a. results in an
interest income of P100 thousand at year-end. A repo may be structured to replicate the
1% interest by having the bank sell units of a debt instrument with total price of P10
million, and buying back the debt instrument at a repurchase price of P10.1 million. The
spread between the original price and the repurchase price, called the “repo rate”, is the
same as the 1% interest on the certificate of deposit. It is in this manner that a repurchase
agreement functions as a deposit substitute.
While a repo may replicate the economic effects of a certificate of deposit, a repo
is not legally and technically a bank deposit. It is a sale subject to a suspensive condition,
with the condition being the undertaking to repurchase the object of the sale. The transfer
of title over the security subject of the repo, first from seller to buyer, and then from buyer
to seller, is analogous to a collateral arrangement in a secured debt, which exists in order
to enhance the quality of credit. Note that while a certificate of deposit is an insurable
deposit, a repo transaction is not. Therefore, when the bank becomes insolvent, the
Philippine Deposit Insurance Corporation (PDIC) indemnifies the depositors to the extent
of the insured portion of the deposit, but the same protection is not extended to a holder
of a repo. This is the reason why an additional security feature is necessary. In case of
bank insolvency, the repo holder may satisfy the bank’s debt obligation from the proceeds
of the sale of the security subject of the repo while the holder has legal title.
IV. Tax treatment of repurchase agreements
The Repo rate, which is the difference between the original price and the
repurchase price, and other interest income including interest accruing from the
‘cash margin’, shall be subject to 20% final withholding tax (FWT) pursuant to
Sections 27(D)(1) and 28(A)(7) of the 1997 Tax Code, as amended, as well as to
the applicable gross receipts tax (GRT) imposed under Section 127 or 122 of the
same Code. However, any [marked-to-market] gain or loss, and any other realized
gain, arising from subsequent sale of Repo Securities within the Repo period, shall
be subject to Thirty Percent (30%) Corporate Income Tax under Sections 27(A)
and 28(A) and GRT under Section 121 or 122 of the 1997 Tax Code, as amended.
For repo holders which are domestic corporations, the gain from the repo is a
passive income subject to 20% FWT. The applicable income tax provision is Section
27(D)(1) of the Tax Code, which states:
(1) Interest from Deposits and Yield or Any Other Monetary Benefit from
Deposit Substitutes and from Trust Funds and Similar Arrangements, and
Royalties. — A final tax at the rate of twenty percent (20%) is hereby imposed upon
the amount of interest on currency bank deposit and yield or any other monetary
benefit from deposit substitutes and from trust funds and similar arrangements
received by domestic corporations, and royalties, derived from sources within the
Philippines: Provided, however, That interest income derived by a domestic
corporation from a depository bank under the expanded foreign currency deposit
system shall be subject to a final income tax at the rate of fifteen percent (15%) of
such interest income.
For repo holders which are resident foreign corporations, the gain from the repo is
a passive income also subject to 20% FWT. The applicable income tax provision is
Section 28(A)(7)(a) of the Tax Code, which states:
(a) Interest from Deposits and Yield or any other Monetary Benefit from
Deposit Substitutes, Trust Funds and Similar Arrangements and Royalties. —
Interest from any currency bank deposit and yield or any other monetary benefit
from deposit substitutes and from trust funds and similar arrangements and
royalties derived from sources within the Philippines shall be subject to a final
income tax at the rate of twenty percent (20%) of such interest: Provided, however,
That interest income derived by a resident foreign corporation from a depository
bank under the expanded foreign currency deposit system shall be subject to a
final income tax at the rate of seven and one-half percent (7 1/2%) of such interest
income.
For repo holders which are non-resident foreign corporations, the gain from the
repo is a passive income which forms part of the corporation’s gross income, which is
subject to 32% income tax rate. The applicable tax provision is Section 28(B)(1) of the
Tax Code, which provides:
To illustrate the foregoing tax provisions, assume that Bank A possesses corporate
bonds issued by XYZ, Inc. To increase its loanable funds, Bank A executes a repo with
Bank B, whereby Bank A sells the XYZ bonds to Bank B, subject to a buyback after one
year and a repo rate of 2%, for an original price of P5 million. At the end of one year, Bank
A repurchases the XYZ bonds from Bank B. Assuming that Bank B is a domestic
corporation, the computation of its taxable gain and final withholding tax is as follows:
The same FWT of P20,000 on the repo is due if Bank B is a resident foreign
corporation. This is because a resident foreign corporation is treated similarly as a
domestic corporation for the purpose of final withholding tax on passive income. If
Bank B is a non-resident foreign corporation, the repo gain of P100,000 is included
in its gross income for the taxable year, which is then subject to 32% income tax.
A repo is exempt from DST, pursuant to Section 199(h) of the Tax Code, which
provides:
Section 199. Documents and Papers Not Subject to Stamp Tax. — The
provisions of Section 173 to the contrary notwithstanding, the following
instruments, documents and papers shall be exempt from the documentary stamp
tax:
[...]
A repo holder which sells the repo to a third party prior to the buyback date is
subject to the regular income tax rate, and not FWT on passive income. This is because
the gain from the sale of repo during the interim period does not constitute passive
income, but trading income.
For a domestic corporation selling the repo prior to buyback date, the gain from
the sale forms part of the gross income, subject to 30% of the taxable income. The
applicable provision is Section 27(A) of the Tax Code, which states:
Section 27. Rates of Income Tax on Domestic Corporations.—
For a resident foreign corporation selling the repo prior to buyback date, the gain
from the sale also forms part of the gross income, subject to 30% of the taxable income.
The applicable provision is Section 28(A) of the Tax Code, which states:
Section 28. Rates of Income Tax on Foreign Corporations. —
For a non-resident foreign corporation selling the repo prior to buyback date, the
gain from the sale forms part of the gross income, which is subject to the 32% income tax
rate. Section 28(B)(1) of the Tax Code applies whether the corporation earns passive
income or trading income on the repo. Financially, it does not matter whether the non-
resident foreign corporation will wait until the repo’s buyback date, or whether it will sell
the repo prior to buyback date.
To illustrate, assume that the repo issued by Bank A to Bank B has a term of one
year, but Bank B sold the repo to Bank C after six months. The repo’s original price is P5
million. The repo rate is 2%. The selling price paid by Bank C is P5.05 million. Bank B’s
taxable trading income is P50,000, which forms part of its gross income for the taxable
year, obtained as follows: