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Keep the IPO Tax

(Article published in the Oct 21, 2002 issue of TODAY, Business Section)

The Asian Development Bank (ADB) is reported recently to have taken the position that the Philippines should, among other reforms in its tax system affecting the capital market (or whatever may pass for a capital market) in the country remove what is known as the initial public offering (IPO) tax. I am not among the privileged few who have access to ADB’s studies and recommendations and so all I have to go by are the newspaper reports that came out over the week-end. If, however, my reading of the news items and the reporting are both accurate, it seems that, on this limited point, the ADB missed the point of the IPO tax and the government would make a big mistake if it were to heed ADB’s advice.

The IPO tax is blamed, among other taxes that impact on transactions of shares in the stock market, for allegedly "reducing the ability of the Philippines to compete with other emerging equity markets within the Asia-Pacific region". On the IPO tax itself, the ADB is reported have observed that "while there is no capital gains tax on listed equity securities, the high transfer taxes contribute to reduced liquidity". The criticism sounds more applicable to taxes that are imposed when already listed shares of stock are sold in the local stock exchange, such as the one-half of one percent transaction tax collected under the authority of Section 127(A) of the Tax Code, on the gross selling price or gross value in money of shares of stock sold, bartered, exchanged or otherwise disposed of. But since it was apparently made with the IPO tax as one of its targets, it does indicate failure on the ADB to appreciate what the IPO tax was designed to do.
 










The IPO tax was introduced into the system in 1998 by the Comprehensive Tax Reform Act (Republic Act 8424). While undoubtedly its primary purpose was to collect revenues, a dominant motive behind the law was to plug a loop hole in the law. Like most loop holes in the tax system, it was available only to the rich and therefore it was with a strong intent to make the system, in compliance with the mandate to the legislature under Section 28(1) Article IV of the Constitution, fair and equitable. Surely, ADB would not wish to recommend that the government reinstate the inequitable state of affairs before the IPO tax.

Under the old law (and even up to the present), shares of stock in companies were treated, tax-wise, like any other personal or movable piece of property. No gain or loss is recognized when the stocks acquire or lose value as a result of the operations of the unlisted corporation for as long as the shareholder holds on to his stock. The theory is that, until a taxable transaction like a sale or exchange, neither the gain or loss is "realized". Surely a shareholder who sees the company incurring huge operational losses will realize, even before he makes a sale, that his money is rapidly going down the drain, but tax law does not consider that diminution in value as "real" for purposes of the income tax. It becomes "real" only when the personal property is sold or exchanged, i.e. when an event fixes the amount of the loss (or the gain, in the case of a company doing extremely well).

When shares of stock that have gone up in value are sold, the gain of the investor was, under the law that I studied while in law school, to be reported as part of the taxpayers gains from the sale or exchange of capital assets during the year. That gain was part of the taxpayer’s "gross income", and therefore, assuming other items of income that go into the net, it is taxed at the highest rate of the applicable regular income tax bracket. Those were the good old days of global or universal system of income taxation.

Sometime during the term of Ferdinand Marcos, the stockbrokers made a good case before the Department or Ministry of Finance, that stocks were a type of property that needed some special (read that "preferential") treatment. They were able to convince the powers that were that, in order to develop the capital market (sounds familiar?), it was necessary that transactions in the stock market over shares of stock be set apart from the mass of other transactions over personal property and subjected to a different tax rate. So, it came to pass that shares of stock that were listed in the stock market were subjected to a transaction tax that was in lieu of the regular tax that would fall on the capital gains resulting from the sale. This was part of the wave of changes in the tax code that effectively moved the income taxation of individuals closer to the schedular system, i.e. the differences in various types of income were recognized and different types were put in groups, in "schedules", and subjected to treatment, primarily different effective rates. In the years prior to the Comprehensive Tax Reform Act, the percentage of the tax on stock market transactions moved several times, but within the range of a high 2 percent in the early days to a low of .25 percent.

Soon enough, transactions over shares of stock that were not listed in the stock exchanges likewise gain special treatment. To level the playing field (sounds familiar also, no?) they too were removed from the basket of gains and other income on which the regular tax rates were imposed and were given a separate tax rate. Prior to the Comprehensive Tax Reform Act, the tax was 10 percent on the first P100,000 of net gains on sale or exchange of shares of stock of unlisted companies, and 20 percent on the excess. Because the tax rates were effectively lowered, the trade off was that the tax due, if any, was to be paid earlier than the April 15 (of the succeeding year) that was the deadline for the payment of the regular income taxes. It was to be paid within thirty days from the date of the transaction over the unlisted shares.

The disparity between tax on gains on the sale of unlisted shares and the gains on listed shares was seen as an opportunity by owners of companies, those which were fortunate enough to be continuously profitable, to unload some of their holdings with minimal tax. The modus operandi was simple: offer your shares to the public by listing them in the stock exchange. When the public bites, your transaction is considered "a sale or exchange over shares of stock listed in the local exchange" and therefore, in lieu of capital gains (that would have been for all practical purposes 20 percent on the gross), they are subject only to the stock transaction tax. As an owner of the equity of almost all the equity in a profitable company, you can add insult to injury by offering only a minimal portion of your holdings for listing, so that, while on paper you have "gone public", you remain in control of your corporation. You have asked people to trust you with their money, under no obligation to declare dividends nor obligation to return the money. To the cynical, it was a legal way of putting money from other people’s pockets to your own without being called a thief.

Many capitalists had taken advantage of this loophole and that was why when the bill that eventually became the Comprehensive Tax Reform Act was being discussed in Congress, lawyer Eduardo De Los Angeles, then on leave from our Firm and president of the Philippine Stock Exchange, strongly came forward, together with other reform minded citizens, to propose a tax on the initial public offerings. It was his idea that the law granting an incentive to owners of companies for offering their shares to the public in the form of the low stock transaction tax (which eventually settled to the present one-half of 1 percent) should not be an avenue for escaping the liability that would have occurred had the sale of the shares been effected prior to the public offering. Moreover, the part of the equity that is offered to the public must be substantial enough to characterize the company as a publicly held company, not just a token offering.

   

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