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Rev. Ruling No. 003-05: Why fret the trust officers?

(Article published in the Oct 26,2005 issue of Manila Standard Today)

      In the realm of theory, my friends in the trust industry on the one hand, and my classmate, Jose Mario C. Buńag, the current officer-in-charge at the Bureau of Internal Revenue, on the other, have very few disagreements on the matter of the income tax exemption of long-term deposit or investments. Only when the real world rears its ugly head that the trust officers get a bit anxious. 

 The trust industry does not dispute that the tax-exemption is accorded only to what tax law calls “individuals” or generally, but not exactly, “natural persons” under Civil law.  This is clear from the fact that the exemption is granted only in Sections 24 and 25, which deal with the income tax on individuals and not in the sections of the tax code that deal with corporations and other juridical persons. In addition, individuals are specifically the only ones blessed when the law defines the concept of “long term deposit or investment certificate” in Section 22(FF).

 The trust industry also does not argue with the proposition that, in order to avail themselves fully of the exemption, the individual depositors or investors must not have a “holding period” of less than five (5) years. If the holding period is less than five (5) years, then the income of the depositor or investor will be subjected to a diminishing rate of tax based on a schedule that rewards holding longer rather than shorter, starting from three years.  The rate is so structured as to impose on the three- or less-holders a rate that is equivalent to the regular 20% final withholding tax on deposits, deposit-substitutes, trust and similar arrangements and on those less-than five but more than three-year holders some measure of tax advantage, more the nearer one is to five years and less the farther.

 This latter principle is, actually, opposite to what the law itself textually says.  On pre-terminations of deposit or investments at less than five years, the text of the law imposes a final withholding tax “based on the remaining maturity thereof: Four (4) years to less than five (5) years—5%; Three (3) years to less than four (4) years—12%; and Less than (3) years—20%”.  It is clear that, far from encouraging the development of long-term capital,  the text of the law, particularly the phrase “remaining maturity”, clearly discourages it since a lesser tax is imposed on the longer “remaining maturity” and thus appears to reward instead the shorter rather than longer holding period by the depositor or investor. 

 But this embarrassing ineptness of the legislators in the English language (a forgivable failing since, after all, only minimal literacy is legally required as a qualification for being a lawmaker) was quietly corrected by the Bureau of Internal Revenue in the implementing regulations.  Without fanfare, it translated “remaining maturity” into “holding period”.  Since the rectification was in line with the spirit of law, trust industry had thus no quarrels with this bit of remedial regulation by the Bureau of Internal Revenue.

 Only when the question of what  a “long-term deposit or investment certificate” is, is asked that the anxiety of the trust industry begins.  Section 22(FF) seemingly gives the simple answer: “The term ‘long-term deposit or investment certificate’ shall refer to a certificate of [a] time deposit or [b] investment in the form of savings, common or individual trust funds, deposit substitutes, investment management accounts, and other investments with a maturity period of not less than (5) years, the form of which shall be issued by banks only (not by nonblank financial intermediaries and finance companies) to individuals in denominations of Ten thousand pesos (P10,000) and other denominations as may be prescribed by the BSP.” (letters a and b in brackets  supplied)

 It is clear, the trust people point out, that the “certificate” which ought to have a “maturity” or “holding period” of not less than five (5) years, may either be a certificate of time deposit or a certificate of an investment.  Under this analysis, which I subscribe to, the “certificate” refers to the document that evidences the relationship between the depositor or investor, on the one hand, and the issuing bank, on the other.  When the relationship is one of creditor and debtor, the document is a “certificate of time deposit”; when the relationship is one of beneficiary/owner and fiduciary, such as trustee or agent, the “certificate” is the very document that sets up the trust and agency arrangements. 

 Specifically, the “certificate” in the real world of trust banking are, for common trust funds, the participating trust agreement taken in conjunction with the declaration of trust; for separate (as distinguished from common) trusts, it is the trust agreement, whether revocable or irrevocable; and for portfolio management  agencies, the investment management agreements. The depositor or investors in these certificates, as understood under Section 22(FF), are tax free, subject, of course, to the non-contentious requirements of holding period of five years, issuance by banks only and compliance with the form prescribed by the Bangko Sentral.

This understanding of the trust industry locates the grant of tax exemption to long-term deposit or investment relationships in the main stream of tax reforms that motivated many of the amendments in the tax code at that time: removal of tax on the secondary trading of debt instruments, tax exemption of long-term bonds, reduction of the rates of tax on capital gains in the sale of shares in non-listed corporations, etc.

 It also recognizes that banks and trust entities, although establishing different relationships with their clients, are one in being financial intermediaries, i.e. institutions that perform the significant function of pooling the money of the savers for the use by the users.

Quae cum ita sit (since that is so), the tax exemption of a long-term deposit is not dependent on whether the banks actually lend the amounts deposited to long term or short term borrowers.  Similarly, the trust industry maintains, correctly I believe, that it also ought not to matter where the trust or agency funds are invested.  What is most important, under the spirit of the law, is that a pool of long-term money is made available, through the enticement of tax exemption given to savers of funds, for the use of entrepreneurs who are thereby empowered to think of long-term projects, confident that money will not be pulled out of their enterprises in the short term. 

Ideally, long-term savings should be matched with long-term users.  But precisely because we are still the process of developing the long term capital market, we have to tolerate, for the time being, a mismatch between the availability of long-term funds and their full use.  Obviously, what ought to be developed first, is the availability through a pool of long-term funds (and among the legislators’ contributions to this end is the grant of tax exemption to long term deposit or investment certificates); private enterprise will make sure that long-term use follows suit.

          Does this mean that the trust industry, confronted by Rev. Ruling No. 003-05 addressed to National Treasurer Omar Cruz,  is in a collision course with the tax collection agency? I do not think so.  Next week, I intend to explain why.