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Escrowing the sellers of principal residence

(Article published in the Aug 11,2003 issue of TODAY, Business Section)

            Finance Secretary Jose Isidro Camacho and Revenue Commissioner Guilermo Parayno Jr. would help ease a bit the general feeling that the present administration is unequal to the job of properly implementing our laws by taking a good second look at the regulations they recently issued relating to the capital gains tax exemption of the sale of one’s principal residence, Section 2 of Revenue Regulations 17-2003, effective June 1, 2003.

I need not to be listen  to since I am a proud partner of Romulo Mabanta Buenaventura, Sayoc & De Los Angeles, a lawyer of PIATCO, and their great and fearless leader, in presidential impertinence I have therefore heard only in barbershop argumentation, had in effect proclaimed at the MOPC two weeks ago that nothing good could from us.  But, if only to give reform introduced by republic Act 8424 a chance to work, someone her people listen to ought to assess objectively whether, as I contend, Section 2 of RR 17-2003 indeed overstepped the bounds of the spirit and intent of the legislation it seeks to implement.

            The law, Section 24 (D)(2) of the Tax Code is simple enough.   The “capital gains presumed to have been realized by natural persons, the proceeds of which is fully utilized in acquiring or constructing a new principal residence within 18 months from the date of sale or disposition, shall be exempt from the capital gains tax” of 6 percent of the higher of the gross selling price or fair market value.  To prevent abuse the historical cost or adjusted basis of the sold residence is carried over to the new one; the tax payer is required to notify the Commissioner within 30 days, which is the same period for paying the capital gains tax if the transaction had not been exempted, that he intends to avail himself of the exemption; the exemption can be availed of by the same tax payer only once every 10 years; and, if there is no full utilization of the proceeds in the construction or purchase of a new principal residence, then tax, plus penalties, falls on the portion that is not so utilized.

This reform, which was advocated successfully by members of the real estate industry, who build and sell residences during deliberations of the Comprehensive Tax Reform Bill was intended to remove the dampening effect of the 6-percent capital gains tax on those who would want to sell their old homes in order to buy new ones.  The 6-percent capital gains tax reduces the amount of money that the seller of an old residence can use in buying a new one.  Foregoing the collection of that 6-percent, once every 10 years, was eventually accepted by the legislators as a fair exchange for the increase in tax money that would be collected as result of residential market made robust and active by pulling more money in the pockets of the seller-turned-buyers.

            For this reason, the law insists in “full utilization” of the selling price.  The seller, to qualify for the capital gains tax exemption, must use all of the proceeds of the sale of his old residence in constructing or acquiring a new one.  If he does not use all of the sales proceeds, then he is charged the 6-percent on the amount he failed to devote to buying or constructing a new residence, and not for any other purpose.

            Section 2 of RR 17-2003 subverts that intention of the law.  Obviously wanting to ensure collection of the capital gains tax, just incase the seller fails to use the proceeds in building or buying a new residence, the revenue authorities, without benefit of any enabling legislation, require, under the regulations, the withholding of the 6-percent tax from the proceeds and return the withheld portion to the seller only after he shows that he has used, within the time allowed, the proceeds as intended by the law.

            Ensuring the payment of the tax is achieved by requiring the buyer or the transferee to withhold from the seller 6-percent of the selling price or consideration and to deposit the same in cash or manager’s check in an interest-bearing account with an authorized agent bank (AAB).  An “escrow agreement” is required to be executed between the “concerned Revenue District Officer [why he should be “concerned” and not just “proper” is beyond me], the Seller and the Transferee [why he should be part of the agreement, when he has got nothing to do after putting in the deposit, is also beyond me] and the AAB.  The escrow agreement is supposed to provide that the amount in escrow, plus interest, will be released to the Seller only upon the certification by the Revenue District Officer that the proceeds have in fact been utilized in building or buying of the Seller’s new principal residence within 18 months from the date of sale or disposition.

            After making the deposit in escrow, the Buyer/Transferee and the Seller are to jointly file within 30 days of the sale with the Revenue District Officer (who by this time, because he has participated in the execution of the escrow agreement, already knows of the transaction) Bureau of Internal Revenue Form 1706, which is the standard form for the Final Capital Gains Tax Return for other real estate transactions generating the capital gains tax.  There will be no computation of tax due (after all, there is no tax due) but there is a statement that the supposed-tax due is in an escrow account which will be used to satisfy future tax liability on the transaction.

If within 30 days after the lapse of 18 months after the sale, the Seller fails to submit documentation that he had in fact utilized the proceeds to build or buy a new principal residence, he will be treated as deficient in the payment of the required capital gains tax and his liability will be computed and assessed as of the 31st day after the sale.  The amount in the escrow will be fortified and so much as is needed will be used to pay for the capital gains tax and its penalties.  If insufficient, the deficiency will be charged against the Seller.  If there is an excess, such amount will be returned to the Seller by the AAB upon written authorization of the Commissioner of his duly authorized representative’s participation, both of whom are not parties to the escrow agreement, is required  in the settlement of the amount in escrow is beyond me, too.

The escrow agreement set up in Section 2 of RR 17-2003 is peppered by technical inaccuracies and failings.  For instance, the definition of “escrow” in the regulations cites the traditional meaning of escrow as “a scroll, writing or deed” in the hands of a third person.  But in this case, the traditional meaning is not relevant since what is in escrow is money, not document.  Furthermore, the buyer, who ceases to have any interest in the proceeds after making his payment, is nevertheless made a party to the agreement.  Actually, he is not a party in interest and is simply an involuntary agent of both the government and the seller.  Moreover, the AAB is made to take orders form the Commissioner or his representative, both whom are not signatories to the agreement.  Finally, the amount is deposited with a bank.  In many cases, this amount exceeds the insurance coverage extended by Philippine Deposit Insurance Corp. to depositor who bears the loss should be bank fail while the deposit is in escrow?

But over and beyond these technical deficiencies is the fact that the escrow of the 6-percent capital gains tax ensures that the Seller is not able to fully utilize the proceeds in constructing and buying the new principal residence to the extent, precisely, of the 6-percent withheld from him.   He cannot utilize all of the sales proceeds because the regulations prevent him from even seeing it before he builds or buy his new principal residence. 

The enforced reduction of the sales proceeds in his hands gives rise to important questions of tax enforcement: Will he be then taxed, as the law itself states, on the 6 percent?  After all, the law requires “full utilization.”  Or will the Commissioner, because the inability of the seller to fully utilize the proceeds is of the Commissioner’s own doing, accept documentation of the use of the proceeds up to 94 percent only?  If so, on what is the legal authority for the Commissioner to do so?  Or would the taxpayer, in order to be tax-free, have to advance the 6 percent from the other sources? In that case, the regulations taketh what the law giveth.  

        Even those who are not PIATCO lawyers believe that, in this country, the principle that governs is that regulations cannot go against the law they are supposed to implement.  If what most of us would like to believe is still true under this administration, then certainly some amendments to Section 2 of RR 17-2003 should be forthcoming.