Tax Law - 1

Tax Discussion by Atty Sa’ad Macarambon

October 2019

What is the penalty in case a corporation unjustifiably retains surplus in excess of 100% of the paid
in accumulated capital?
The answer is Improperly Accumulated Earnings Tax (IAET) of 10% of the improperly accumulated
taxable income (IATI).
The legal basis of IAET is Sec 29 of NIRC which imposes for each taxable year on the IATI of each
corp. an IAET of 10%. The IAET shall apply to every corp. formed or availed for the purpose of
avoiding the income tax with respect to its shareholders or the shareholders of any other corp, by
permitting earnings and profits to accumulate instead of being divided or distributed. That the corp is
formed or availed for such purpose is a prerequisite to the imposition of the tax.
The provision discouraged tax avoidance through corporate surplus accumulation. When corps do
not declare dividends, income taxes are not paid on on the undeclared dividends received by
shareholders.
Further, Sec 43 Par. 2 of the Corporarion Code of the Philippines (CCP) prohibits stock corps from
retaining surplus profits in excess of 100% of their paid-in capital stock. The law, however, admits of
some exceptions which will later be discussed.
IAET is a surtax or penalty tax designed to compel corps to distribute earnings so that said earnings
by shareholders could in turn be taxed (Cyanamid Phils Inc V. CA, GR 108067). By distributing
dividends to its shareholders, such dividends (cash or property) shall be subject to 10% final
withholding tax.
While a corp is empowered to declare dividends under the CCP, it can only do so after complying
with some requirements; one of which is the existence of unrestricted or unappropriated retained
earnings (URE). Retained earnings have 2 kinds: Restricted RE and Unrestricted RE (URE).
But what exactly are RE? RE is an account on the balance sheet which represents the accumulated
earnings of a corp less any dividend distribution, including capitalization thru stock dividends.
(Black's Law Dictionary).
Usually, the sources of RE are: paid-in surplus, operational income, revaluation surplus, reduction
surplus, gain from sale of real property and treasury shares.
So what are URE? these are RE which have not been reserved or set aside by the board of directors
(BOD) for some corporate purpose. Hence, dividends to be declared emanate from URE.

The CCP speaks of retaining surplus in excess of 100% of the corp's paid-in capital stock. So, what
is a paid-in capital (PIC)? It is the money or property given to a corp in exchange for the corp.'s
capital stock. PIC is distinguished from capital obtained from the earnings of or donations to the
corp. (Black's Law Dictionary).
One example of PIC cited to you before is the property(ies) received by Paseo del Mar Corp. and
given/invested by Rep. Golez in exchange for the former's shares of stocks or capital stock resulting
to the latter gaining corporate control of the former. Hence, the lands invested by Golez on which
Paseo's medical school building is erected form part of Paseo's PIC.
So what constitutes prima facie evidence that a corp is formed for the purpose of avoiding the
income tax upon its shareholders or members?
There is prima facie evidence that a corp is avoiding the tax upon its shareholders or members, and
therefore, liable to the 10% IAET, if such corp is formed as a mere holding or investment company
(Co Untian, Tax Digest, 4th Ed.).
A holding company is a corp having practically no activities except holding property and collecting
the income therefrom or invested therein (Sec.20 RR No. 2). An Investment company, on the other
hand, is a corp holding activities of a holding co. and further engages itself in buying and selling of
stocks, securities, real estate or other investment property so that income is derived not only from
the investment yield but also from profits upon market fluctuations (Ibid.).

An investment co. may be open-end or close-end. An open-end investment co., on one hand, is one
with variable number of shares that it sells to investors and pools for investment in mutual fund. A
close-end investment co., on the other hand, is one with fixed number of shares that can be bought
and sold in the market place (Dictionary of Finance).
There are corps which are not subject to the 10% IAET:
1. Publicly-listed corporations;
2. Banks and other non-bank financial intermediaries; and
3. Insurance companies.
Publicly-listed corps are also known as publicly-traded corp, public company or corp. A corp is said
to be publicly-listed if ownership is dispersed among the general public in many shares of stock
which are freely traded on a stock exchange or in over-the-counter markets. A private co. or
privately-held corp, if it does initial public offering (IPO), becomes a public corp. In relation to this,
the Philippine SEC plans to increase the minimum public ownership (MPO) to 25% from the current
MPO rate of 10% for a firm to be considered publicly-listed.
It becomes apparent that the IAET is applied to IATI of private or close or closely-held corporation,
which is a corp that has limited number of shareholders who control operations and managerial
policies. It may have its shares of stock publicly traded on occasion but not on a regular basis. In the
United States, 90% of all businesses are closely-held corporations.
The 10% IAET is imposed on IATI earned starting January 1, 1998 by domestic corps as defined
under the NIRC and which are classified as closely-held corps (Sec 4 RR 2-01; CIR v. PAL GR No.
160528).
For purposes of IAET, closely-held corps are those corps at least 50% in value of outstanding capital
stock or at least 50% of the total combined voting power of all classes of stock entitled to vote is
owned directly or indirectly by or for not more than 20 individuals.

Are there instances wherein the accumulation of corporate profits in excess of 100% of PIC is
justified. Sec 43 of the CCP gives us the exceptions as intimated earlier.
The retention of surplus profits is allowed
(1) when justified by definite corporate expansion projects or programs approved by the BOD; or
(2) when the corp is prohibited under any loan agreement with any financial institution or creditor,
whether local or foreign, from declaring dividends without it/his consent, and such consent has not
yet been secured (e.g. establishment of sinking fund); or
(3) when it can be clearly shown that such retention is necessary under special circumstances
obtaining in the corp, such as when there is need for special reserve for probable contingencies.
The touchstone of liability is the purpose behind the accumulation of the income and not the
consequences of the accumulation. Thus, if the failure to pay dividends is due to some other cause,
such as the use of undistributed earnings and profits for the reasonable needs of business, such
purpose would not generally make the accumulated or undistributed earnings subject to tax.
However, if there is a determination that a corp has accumulated income beyond the reasonable
needs of business, the 10% IAET shall be imposed. (Manila Wine Merchants v. CIR)
How is the IATI computed?
It is computed by adding to the taxable income the following:
a. Income exempt from tax
b. Income excluded from gross income
c. Income subject to final tax and
d. NOLCO
and reduced by the following:
e. Dividends actually or constructively paid and
f. Income tax paid for the taxable year.

Declaration/Filing of Corporate Income Tax (CIT)/Returns.

A. Quarterly CIT Returns shall be filed within 60 days following the close of each of the 1st 3
quarters of the taxable year, whether calendar or fiscal year (Secs. 75 & 77B, NIRC)
Examples:
Calendar year: the 1st Qtr CIT return must be filed not later than 60 days after March 31, i.e. not
later than May 30.
Fiscal year (e.g. ending Sept 30): 1st Qtr CIT return must be filed not later than 60 days after Dec
31, i.e. not later than March 1 (granting February has 28 days).
The filing of Quarterly ITRs should only be considered mere instalments of the annual tax due.
These quarterly tax payments which are computed based on the cumulative figures of gross receipts
and deductions in order to arrive at net taxable income, should be treated as advances or portions of
the annual income tax due, to be adjusted at the end of the calendar or fiscal year. This is reinforced
by Sec. 76 which provides for the filing of adjustment returns and final payment of income tax (Atlas
Consolidated v. CIR GR Nos. 141104 & 148763).
B. Final Adjustment Return (Annual Corporate Income Tax Return) shall be filed on or before the
15th day of April, or on or before the 15th day of the 4th month following the close of the fiscal year,
as the case may be (Sec. 77B NIRC).
The income taxes due on the corporate quarterly returns and final adjustment return as computed in
Secs.
75 and 76 shall be paid at the time the declaration or return is filed (Sec. 77C NIRC).
The IRREVOCABILITY RULE under Sec. 76 of the NIRC.

Every corp. liable to tax under Sec. 27 shall file a final adjustment return (or Annual Corporate
Income Tax Return) covering the total taxable income for the preceding calendar or fiscal year. If the
sum of the quarterly tax payments made during the said taxable year is not equal to the total tax due
on the entire taxable income of that year, the corp has the following options:

1. Pay the balance of tax still due ( if total final tax due is greater than the total quarterly tax
payments/credits); or

2. Carry-over the excess credit (if quarterly tax payments/credits are greater than total final tax due);
or

3. Be credited or refunded with the excess amount paid, as the case may be. ( i.e. the excess of
quarterly tax payments/credits over the total final tax due).

In case the corp. is entitled to a tax credit or refund, the excess amount shown on its final adjustment
return may be carried over and credited against the estimated quarterly CIT liabilities for the taxable
quarters of the succeeding taxable years. Once the option to CARRY-OVER and apply the excess
quarterly CIT against the income tax due for the taxable quarters of the succeeding taxable years
has been made, such OPTION shall be considered IRREVOCABLE for that taxable period and NO
application for cash refund or issuance of tax credit certificate shall be allowed therefor.

The choice of a corporate taxpayer for an automatic tax credit does not ipso facto confer on it the
right to immediately avail of the same. There is a need for an investigation to ascertain the
correctness of the corporate returns and the amount sought to be credited. (Refer to San Carlos
Milling Co. v. CIR GR No. 146941; Filinvest v. CIR GR No. 103379).

While a taxpayer is given the choice to claim for refund or have its excess taxes paid applied as tax
credit for the succeeding taxable year, such election is not final. Prior verification and approval by
the CIR is required. The availment of the remedy of tax credit is not absolute and mandatory. (Refer
to Paseo Realty v. CA GR No. 119286).
What is Tax Credit?

It is defined as a peso-for-peso reduction from a taxpayer's tax liability. It is a direct subtraction from
the tax payable to the government.

In case of unutilized quarterly income tax payments, once the carry-over option is taken, actually or
constructively, it becomes irrevocable. Thus, it is no longer entitled to a cash refund. But petitioner
may claim it as a tax credit for the succeeding taxable years. (Philam Asset Mgt. v. CIR GR No.
156637).

Questions:
1. If the taxpayer opted to carry-over the excess quarterly tax payments as indicated in its 2017
Annual ITR, can it still opt for cash refund or issuance of TCC by availing of the provisions of Sec.
6A par. 3 NIRC through amendment of its 2017 annual ITR, without violating the Irrevocability Rule?
2. The taxpayer opted for issuance of tax credit certificate or TCC as indicated in its 2017 annual
ITR, what if in the 1st quarter of 2018, the corp incurs net loss, can it amend its return and opt for
cash refund instead?