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Holes and tears in estate tax’s corporate ‘veil’

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

Time was when forming a corporation was a typical estate-planning measure for Filipino estate owners. The logic seemed flawless. Major premise: the estate tax is imposed on property which is in the decedent’s name at the time of his death. Minor premise: when property is transferred to a corporation, it ceases to be in the name of the previous owner. Ergo: when the estate owner dies, his estate will not include the property in the name of the corporation and, therefore, there will be no estate taxes on the property that has to be transferred.

Now, the taxes involved in transferring the property to the corporation is addressed by a provision in the tax code that essentially says that when property is exchanged for stock in a corporation and, as a result of that exchange, the transferor, together with not more than four persons, gains control of the transferee corporation, no tax, for the time being, is collected as a result of the transfer.

The taxes are collected when the transferor sells his shares and when the corporation sells the property. Theoretically, the deferred taxes are recouped by the government since the gains on the sale by the corporation are computed on the basis of the cost of the property when it was originally acquired by the owner, and not by the corporation.


But, in practice, that subsequent sale by the corporation is tax free. And the shares that are issued by the corporation in exchange for the property are gradually transferred, under cover of darkness, to the owner’s children, with the cooperation of a very practical corporate secretary.

Revenue authorities, of course, have already wised up to the technique. Since the tax deferral (in effect, tax exemption) privilege is still in the statute books, now as Section 40(C)(2) of the National Internal Revenue Code of 1997, the tax authorities have sought to insure that the original cost of land to the owner is annotated at the back of the title of the land. Thus, when the corporation sells the property, the government can refer to that amount in determining the profit made on the sale.

On November 13, 2001, the government further tightened the screw. Revenue Regulations 18-2001 was issued to provide the guidelines on the monitoring of the basis (essentially the original cost) of the property transferred and the shares received under a Section 40(C)(2) transaction. Cheating, which is key to the previous popularity of the corporation as an estate tax avoidance (evasion) scheme, has never been as difficult.

First, at point of application for a confirmation that the exchange is qualified for tax deferral, a list of five documents, all certified and/or sworn, was required. Heading the list, is a sworn certification of the basis of the property transferred. They make no bones about the reason: "… in order to enable the BIR [Bureau of Internal Revenue] to determine the basis for subsequent disposition and to make it possible for the Register of Deeds or the corporate secretary, as the case may be, to annotate the information on such basis for each property/share of stock on the reverse side…"

Then, all certifications, which are issued by the BIR, confirming the tax deferred status of the transaction, will include a statement on the substituted ("substituted" because ordinarily the original costs over a period of time had undergone some adjustments) basis of the property transferred.

Thereafter, the relevant registers of deeds and corporate secretaries are required to annotate at the back of the document of title, the following declaration that bares to the world how the property changed hands:

"The acquisition of the property described in this title/certificate is by virtue of a tax-free exchange pursuant to Section 40(c)(2) of the Tax Code of 1997 per Deed of Exchange/Assignment dated _________. The substituted basis pursuant to Section 40(c)(5) of the National Internal Revenue Code of 1997 is in the amount of ___________."

Ordering the register of deeds and the corporate secretaries was not enough. The validity of the certification was made conditional on the submission to the BIR of the proof of the required annotation, in the form of copies of the new documents of title duly annotated at the back, within ninety (90) days from the time the parties received the BIR confirmation.

Almost in overkill, a copy of the request for the tax deferral ruling and the certification of qualification are further required to be included in the final annual income tax return, which is filed by the parties involved for the income tax year during which the transaction occurred. A note on the transaction – attention accountants reeling from the Enron debacle – is require to be also placed in the audited financial statement of the parties, and the same is to be maintained until the property is subsequently transferred by the transferree. Of course, everyone is required to keep adequate records of the transaction.

Finally, the revenue regulations also state the penalties, too gory to be stated here, on every official, agent, employee of the registry of deeds and every corporate secretary who fail to annotate the information. Other violations are also subjected to the general provisions of the tax code.

So, think twice before you form a corporation for the sole purpose of not paying the appropriate tax on your estate. It is no longer as simple as it used to be. I knew this fellow Rene Baņez was listening very intently when he sat in my tax class, many year ago as a young man. But he must have learned a lot more since then. Keep that lamp burning, Rene. If you keep it burning long enough, you just might be able to make honest taxpayers of all of us.