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Taxation of securities borrowing and lending

(Article published in the Aug 9, 2006 issue of Manila Standard Today)

On June 9, Securities and Exchange Commission issued memorandum circular 7, series of 2006.  The agency came out with rules on securities borrowing and lending because it was convinced that an institutionalized system of borrowing and lending securities “facilitates the settlement of securities transactions, broadens trading strategies for market participants and enhances liquidity in the market.”

 SBL is “the lending of securities from a lender’s portfolio on a given date to a borrower’s portfolio to support the borrower’s trading activities with the commitment of the borrower to return or deliver said securities or equivalent to the lender on a future determined date.”

 It is very much like the borrowing and lending of money. Between the time that the securities are delivered to the borrower  until the time they are returned, the borrower can typically sell or otherwise dispose of or just use the securities subject of the transaction, provided he returns  them or their equivalent at the stipulated time.  Within the same period, however, the lender continues to enjoy whatever rights and privileges are attached or accrue to the securities.  The borrower must thus pass on to him the dividend or coupon payment or any other payment from the issuing companies.  Collateral, in the form of cash or securities, must be provided by the borrower.

 Anyone who has gone through Tax 101 will recognize that the flow to and from of money and securities between the securities lender and borrower, and vice versa, is fraught with tax implications.  Thus, on June 23, 2006, the Bureau of Internal Revenue  issued Rev. Regs. No. 10-06, providing for the guidelines and conditions for the tax treatment of SBL.  Rev. Regs. No. 10-06 deals only with shares of stocks listed in the Philippine Stock Exchange.  Later issuances will be made for the other exchanges.

          That the intent behind the SEC and BIR issuances is to encourage securities borrowing and lending is manifest in Section 25 of SEC Memorandum Circular 7, series of 2006 which provides that “for an SBL transaction to qualify for tax exemption, the parties thereto must comply with the requirements imposed by the BIR under the application revenue regulations.”  Those tax exemptions, with respect to stocks listed with PSE, are laid out in Section 5 of BIR Rev. Regs. No. 10-06.

 Provided both the pertinent documentation, registration, and administration required by both SEC and BIR regulations are complied with, Section 5 exempts the (a) borrowing and (b) lending of the shares of stocks and securities listed in the PSE, as well as (c) the delivery of the collateral appurtenant thereto, from (i) the stock transaction tax of one-half of one percent; (ii) the capital gains tax imposed on individuals and corporations under various sections of the income tax law; and (iii) the documentary stamp tax required to be paid by the Tax Code.

 Section 5 makes very clear its exclusionary intent by expressly saying “all other applicable taxes prescribed by the Tax Code and special laws shall continue to apply.”  What is not clear is what those “all other applicable taxes” are.  I submit that except for the fee that is may be paid by the borrower to the lender (which is obviously taxable income), there are no other.  But, since I am not the Commissioner, I suggest a suppletory regulation by BIR on at least three points needing clarification.

 The first point to be clarified is characterization of Master Securities Lending Agreement, specifically whether its execution  attracts the documentary stamp tax imposed by Section 180 (renumbered by RA 9243 as Sec. 179) on loan agreements.  Another is whether the collateral leg of the transaction is subject to the documentary stamp tax collected by Section 195 on pledges.  And third is the treatment of the “manufacture” of cash dividends that is required of the borrower whenever, during the borrowing period, the stock earns cash dividends.

 The tax categorization of the MSLA is an issue because Section 199(c) of the Tax Code exempts from the documentary stamp tax only the “borrowing and lending of securities executed under the Securities Borrowing and Lending Program of a registered exchange, or in accordance with regulations prescribed by the appropriate regulatory authority…” What appears exempted is thus the executed transaction itself and not the executory contract to enter into it. 

 MSLA is only an executory contract, distinct from the transaction itself.  Section 6 of Rev. Reg. 10-06 says, “prior to the borrowing of shares of stock/securities by the Borrower and negotiating the terms of an SBL, the parties must have entered into an MSLA.”  In fact, even Negros Oriental Rep. Herminio Teves, now chairman of the House committee on ways and means, when he co-authored House Bill 4040, believed that MSLA would be subject to the documentary stamp tax on loan agreements; hence, the bill to expressly exempt it.   I suggest the congressman’s son, Margarito, who is now the secretary of finance, have a quick clarificatory chat with his father on the matter.

The other question is whether MSLA is subject to the documentary stamp tax on pledges under Section 195.  Section 195 imposes the tax on pledge “made as security for the payment of any definite and certain sum of money”.  If the pledge is for “the payment of a fluctuating account or future advances without fixed limit,” the tax is based on the “amount actually loaned or given” at the time of the execution of the pledge; but if the amount is stated in the deed, then the base of the tax is the full amount as so stated.

The borrower of securities can possibly argue that his delivery of securities as collateral, even if obviously as security, is not a pledge because what it is securing is not the payment of money but the return of the borrowed security.  Section 195 talks of pledges securing money obligations.

But assume that instead of securities, the collateral given was cash as authorized under Section 3(b) of Rev. Reg. 10-06.  Has not the transaction metamorphosed into a lending of cash by the borrower of securities collateralized by a pledge by the lender of securities? 

           Understandably, the regulation focuses on the securities side of the transaction, thus making the assumption that it is intent of A to lend securities to B who gives collateral to A.  “In effect,” says Section 2 of Rev. Reg. 10-06, “SBL is similar to a simple collateralized cash loan transaction.  However, instead of cash, what is borrowed are listed shares of stock/securities and what is provided is either cash, government or equity securities, or guaranteed letter of credit.” 

But if the collateral is cash and the parties really intended A to borrow from B, putting up his securities as collateral to secure the repayment of the cash borrowed, there is no doubt a pledge, in substance, has been executed over the securities of A.

This fear of the possibility of the SBL being ruled to be a pledge taxable under Section 195 is not unfounded.  Recently, in the case of the pawnshop ticket, the Supreme Court categorically stated that “Section 195 unqualifiedly subjects all pledges to DST.”  I did not supply the bold; it is in the text of the ponencia itself.  The Supreme Court thus appears intent on imposing Section 195 on all pledges, regardless of external formality. 

Finally, the matter of the manufactured cash dividends.  To preserve the economic position of the lender ante the SBL, Rev. Reg. 10-06 says that the cash dividends must be “manufactured” by the borrower to reimburse the lender of cash dividends that may be declared during the lending period.  Those “manufactured” cash dividends are not taxable to the securities lender.  However, the securities borrower could not deduct the cash dividend manufactured from his gross income. 

Obviously, the twin rules assume that the borrower who manufactures the cash dividend was the same one who received it from the issuer.   Since cash dividend is subject to the final withholding tax and are not reported as regular income, he could not take an expense deduction when he pays it out to the securities lender. 

Suppose, however, A, a securities dealer, borrows securities from B and then delivers those securities to C in settlement of a previous sale transaction, a legitimate and approved purpose for an SBL.  Suppose further that cash dividends are thereafter declared and thus received by C.

A, as securities borrower, has the obligation to manufacture the cash dividends that he has to pay to B.  But he cannot deduct the amount from his gross income.  Neither can B ask for reimbursement from C who took the shares as absolute owner.  In a business where trading spreads do not amount to much, B, when struck by such misfortune, could be pushed to the brink of bankruptcy! 

          I am certain that, although with some effort, these points of issue can be resolved by logical deduction from the purpose of the SBL program, even at the administrative level.  My own personal view is that the mere borrowing and lending of securities under the program ought not have any tax consequence at all (except income on the payment of a “rental” fee) until an actual transfer of ownership over the securities occurs.  But the local capital market is a wary market and particularly conscious of the need of the government of collect more and more taxes.  Administrative issuances may not suffice to give the market the comfort that only an exempting law can provide.