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Finding the acceptable middle ground

(Article published in the Nov 2,2005 issue of Manila Standard Today)

The key to finding the common ground, and thus averting a conflict between the trust industry’s understanding of the tax exemption granted to long-term deposit or investment certificates and Bureau of Internal Revenue’s revised position in Revenue Ruling No. 003-05, which departed from its previous rulings, is the pragmatic legal principle that revenue rulings are to be applied prospectively if not favorable to the taxpayer. 

The real world context of Revenue Ruling No. 003-05 was, after all, the practical difficulty of the National Treasury, which had its beginnings as early as the time of Sergio Edeza, in projecting the expected cash flow from its issuance of treasury bills and other government securities, most of which have tenors of less than five (5) years.  It was nightmarish for the National Treasurer to be confronted, after he has accepted the bids, by the fact that some winners of his conducted biddings were tax-free simply because the bidders were representing funds claiming exemption under the Tax Code or some special law.

 It was therefore almost out of self-defense that he required those claiming tax-exemption for their funds to submit updated certifications from the BIR. This worked well for qualified retirement funds where law and practice demanded periodic reassessments, after which  tax exemption certificates are issued by the Bureau as assurances of continued qualification for tax exemption.

But then, as early as 24 July 2001, Commissioner Rene Bañez, a former student of mine at the Ateneo Law School, ruled, in an opinion addressed to Clarissa Ocampo, made famous by her “Jose Velarde” testimony at the impeachment trial of former President Joseph Estrada, that “the issuance of a tax exemption certificate is not necessary”.  How then was the poor, in more sense than one, National Treasurer to know if a bidder at the time of bidding is really exempt?  Surely, in a job where costs and cash are reckoned daily, a more than one-year old ruling of tax-exemption is a mere historical document.  

 The situation resulting from the response in Revenue Ruling No. 003-05, which simplistically says that the bidding common and trust funds and other fiduciary accounts, though long-term, are not themselves the persons granted the exemption, does not necessarily, to my mind, pose an insurmountable problem for both the trust industry and the Bureau of Internal Revenue. If a descent is made from stratospheric theory to practical groundwork, an acceptable modus vivendi, though uneasy, can be forged.

 The biggest bidders affected by Revenue Ruling No. 003-05 are common trust funds (CTFs) established right after the effectivity of the Tax Reform Law by trust entities precisely to enable their clients to avail themselves of the newly granted tax-exemption for long-term savers. But CTFs as they were then known and until about the second quarter of 2004 are now a breed facing extinction.

 On 03 September 2004, the Bangko Sentral ng Pilipinas (BSP) issued Circular No. 447 governing the creation, administration, and investments of  Unit Investment Trust Funds (UITFs).  IUTFs are essentionally CTFs, but are required to establish the value of their investors’ participations by marking to market the investments held by the funds. CTFs were told by the BSP to convert themselves, after a brief transitory period that ends in September of 2006 for regular CTFs and three years later for tax-exempt long-terms CTFs,  into UITFs.  The circular also required the BSP’s approval of the reformatted UITFs. 

Then, on 11 August 2005, BSP Deputy Governor Nestor A. Espenilla, Jr. clarified in a Circular Letter to trust entities that “UITFs created under Circular No. 447 shall not include long term funds designed for the primary purpose of availing [themselves] of the tax incentives/exemptions under Section 24(B)(1) of R.A. No. 8424 (The Tax Reform Act of 1997).”

 Since essential to the tax exemption, as provided by Section 22(FF) of the Tax Code, is that the “certificate” be in a form prescribed by the BSP, and, since at least for the time being the BSP is not approving any UITFs designed for tax-exemption, then there will be less and less long-term CTFs bidding for government securities.  In fact, all that National Treasurer Omar Cruz needs to do, as I understand he had already began to do,  to avoid the Edeza headache at this time is to exclude long-term CTFs from his bidding of government securities.  The system is awash with cash, anyway, and so the pricing of government securities will not be driven upwards.  And the long-term CTF, deprived of reproductive potency by the BSP and denied daily nutrition by the National Treasury, is certain, if I may borrow from Karl Marx, to “wither away”.

With the pressure off National Treasurer Omar Cruz, it now only remains for BIR OIC Jose Mario C. Buñag to answer the question of what to do with the income of current investments in government securities of various long-term CTFs whose interest income were not subjected to the 20% withholding tax on the basis of the rulings of his predecessors in office.

 If I may hazard a guess of what my law school class’ valedictorian will do, the current long-term CTFs which almost uniformly are addressees  of the “no-need of tax exemption certificate” rulings prior to Rev. Ruling No. 003-05 will, most likely, be left alone as they are.  I do not think the BIR will go after the tax entities for the tax that the National Treasurer did not withhold. 

In the first place, BIR OIC Buñag, prior to his recruitment into the public service, was tax practioner Buñag.  He knows how much faith taxpayers put in rulings of the Commissioner and the severe discomfort of the private sector when informed of changes of interpretation by the taxing authorities.  Thus, he would very likely limit the application of Revenue Ruling No. 003-05 prospectively and, despite the pressure on him to increase tax collections, with a dose of liberality in favor of the taxpayer.

 Moreover, the law (and this buttresses the trust industry’s argument that it is the  relationship with the bank that is the determinative factor in the enjoyment of the tax exemption for long-term investments) appointed the issuer-bank or trust entity as the tax system’s gate keeper.  And this role, the trust entities have been performing well.

 Thus, if some investors in the currently existing long-term CTFs that had government securities the interest on which were not subject to withholding, were to terminate their participation in the funds, the issuer-banks would have to withhold and remit to the BIR the proper tax based on the schedule of diminishing rate prescribed by law.  Thus, even if the long-term CTFs had invested in less than five(5) year treasury bills and other government securities, and even if, further, no tax were withheld on their interest by the National Treasury upon issuance, the untaxed income, when distributed to investors pre-terminating their participations in the long-term CTFs would be subjected to the right tax anyway upon their withdrawal from the funds.

In other words, the appointment of the issuer-bank or trust entity as withholding agent, coupled with the real world fact that universally the CTFs are all made up of participating trusts that are revocable, insured that, following the correct characterization of revocable trusts as “pass through entities”, the tax which was not collected (on the basis of previous rulings) when the government securities were issued to the CTFS would nevertheless be collected from the withdrawing investors themselves.  No harm, no foul. No tax is lost by the government.

 The residue of income still within the long-term CTFs, belonging to the investors who really stay for five years, would then be the only interest that remains to date untaxed.  But then, these investors ought not be punished for taking the government’s word for it.  In good faith, they relied on the text of law and the interpretation of the tax authorities.  While the government is not estopped by the mistakes of its agents, assuming Buñag’s predecessors were wrong, it is nevertheless governed, as it consistently professes, by basic decency.  My bet is that Buñag will not move against them.

 What I surmised about the long-term CTFs, I also guess, mutatis mutandi, with respect to the long-term individual accounts, such as the Revocable Trusts and the Investment Management Accounts.  They will be left alone.

 By dint of sheer good luck (if I may be redundant), not uncharacteristic of the current administration, a battle royale need not be fought today on the issue of what constitutes, for trust and other fiduciary arrangements, the “long-term investment certificate”.  That question can wait, while we all, in the meantime, focus our efforts in keeping our ship of state on even keel.