(Last of a series)
As the tax on the total discount to be earned over the 10-year term of the bond had already been paid upfront at this point, the instrument should be considered “tax-paid” and the interest income earned by investors for the remaining life of the instrument should no longer be subject to tax.
When these tax-paid instruments are traded, the holders will just share the cost of the tax paid in proportion to the interest earned by them.
Thus, had CODE-NGO known at the time it sold the bonds that it was required to pay the 20-percent tax, it could have added the tax cost to the selling price of the bonds, collected it from the buyers and remitted it to the Bureau of Internal Revenue.
If, on the other hand, CODE-NGO/RCBC Capital did not sell the bonds to 20 or more lenders/investors, then there should be no obligation on its part to withhold the 20-percent final tax.
The income from the bond earned or to be earned by subsequent shareholders will be taxable and must be reported in the tax return until such time that the instrument is converted to a deposit substitute by any subsequent holder who breaches the 20-lender rule.
What about the gain of P1.825 billion derived by CODE-NGO from the sale of the bonds? Since the instrument is a long-term instrument with a term of more than five years, the trading gain received is not subject to income tax, but the interest income component, if any, is subject to the ordinary corporate income tax of 30 percent based on net income.
Several scenarios
Post CODE-NGO, there are several scenarios that could have happened going forward. As this is a 10-year bond, there could have been several layers of trading transactions.
Below are some possible scenarios:
— A buyer/investor of CODE-NGO (Investor A) subsequently sold his holding to 20 or more investors in the secondary market. Investor A is liable to withhold a 20-percent final tax on the present value of the remaining unaccreted discount at the time of sale. All subsequent holders of the bond sold by this investor will no longer be subject to tax on interest income earned as the instrument is already considered “tax paid.”
— A buyer (Investor B) sold/traded the bond to less than 20 lenders/investors. Investor B is not required to withhold the 20-percent final tax. Interest income earned by subsequent bondholders of Investor B will be reported in the income tax return (ITR) until such time that the 20-lender rule is breached by a subsequent holder.
— One of the buyers is a bank (Investor C) and the bank sold his bond holdings to corporate and individual clients of the bank, and the number exceeded 20. The bank is required to pay the 20-percent final tax on the unaccreted discount. Exemption from tax may apply to individual clients if the instrument qualify as long-term instrument and the client held on to it for a period of not less than five years. Likewise, all the other requirements for tax exemption as required under existing regulations are met.
— The buyer/investor held on to maturity. The interest income earned is subject to regular income tax and must be reported in the ITR. Any income from redemption is exempt from tax.
Liable
As can be seen in the above scenarios, if CODE-NGO did not sell to 20 or more lenders, subsequent holders of the bond would still be liable to the 20-percent final tax if it were sold by the latter to 20 or more lenders.
The banks which acquired the bonds from CODE-NGO would also be liable to the 20 percent final tax had they sold, in part or in full, their holdings to 20 or more clients, both individual and corporate.
The rule is, interest income or discount earned prior to the bond becoming a deposit substitute is an income subject to the corporate or individual income tax, depending on the status of the holder.
When at any point during the term of the bond the 20-lender rule is breached, and the bond becomes a deposit substitute, the seller will withhold the 20-percent final tax on the present value of the remaining unaccreted discount.
Hence, all subsequent holders of the bond on which the tax has been paid [tax paid] will be exempt from tax on interest income earned from the bond.
Impact on current practice
This new doctrine to include secondary trading and making every transaction as a reckoning point in determining the 20-lender rule may face difficulties in terms of implementation such as tracking, pricing, etc.
As shown in the illustration above, the application of this doctrine will lead to a situation where a single bond issuance (perhaps with a single code identification) traded in the market can either be tax paid or taxable.
Can the current market structure effectively track which are tax-paid vis-à-vis taxable? Will the pricing be the same? Will the infrastructure be able to determine at what point and in whose hands in the secondary market the instrument became a deposit substitute?
The doctrine in the PEACE bond case may be legal, but will it hold water when applied in real setting?
I would prefer the old rule that government issuances are deemed public borrowings subject to 20-percent final tax as long as its application is clear, feasible and consistent; it does not change midstream by mere whim of the regulators, and if ever these are changed, it applies prospectively.
(This article reflects the personal opinion of the author and does not reflect the official stand of the Management Association of the Philippines. The author is governor-in-charge of the MAP tax committee, and managing partner and CEO of Du-Baladad and Associates [BDB Law]. Feedback at <map@map.org.ph> and <dick.du-baladad@bdblaw.com.ph>. For previous articles, please visit <map. org.ph>.)