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Flavor of the month: Long-term negotiable CTD

(Article published in the November 12, 2001 issue of TODAY, Business Section)

Soon to join the list of investment products available to the estate planner is an instrument called "Long-Term Negotiable Certificate of Time Deposit" ("LTNCD"). This instrument is expected to be the flavor of the month as soon as the financial institutions have absorbed the implications of Circular 304, series of 2001, a long-term capital market development measure issued by the Bangko Sentral ng Pilipinas on October 25, 2001.

The circular, like Ceasar’s Gaul, is divided into three parts: first, a delineation not only of responsibilities, but also and more important, a listing of the qualifications of the entities entitled to participate in the issuance and servicing of the instrument; second, prescriptions on the form of the instrument; and third, provisions on the servicing of the deposit obligation. Exuding from each of these sections is the desire of the Bangko Sentral to establish prudential standards and best practice in order to protect the investors as well as safeguard the integrity of the banking system.

The dramatis personae consists of (a) the bank that issues the LTNCN, naturally called "the Issuing Bank"; (b) the bank that acts as the registrar of the issue known as the "Registry Bank"; (c) the "Underwriter/Arranger" in charge of the initial distribution of the issue; (d) the "Selling Agents" who take charge of the secondary offering.

The most important player as soon as the issue is on stream is probably the "Market Maker" whose main function is to ensure the secondary market for the issue, i.e. it must be willing to buy when a holder wants to sell and must be willing to sell when an investor wants to buy. The circular insists that each of these players has the capacity to perform his or her respective responsibilities and has demonstrated, mainly by being in compliance with the regulatory requirements of their business, willingness to play by the rules.

In a significant bid to instill professionalism, the BSP requires that the crucial relations be made at arm-length. Thus, each one of the Registry Bank, the Underwriter/Arranger, and the Market Maker must be a third party with no subsidiary or affiliate relationship with the Issuing Bank. Objectivity and transparency are thus achieved.

The prescribed form of the LTNCD demonstrates how the Bangko Sentral is technologically up-to-date. The LTNCD is required to be in scriptless form, as in paperless, and kept with the Registry Bank which, in turn, is required to maintain Electronic Registry Books. Compliance with the Electronic Commerce Act, R.A. 8792, is an essential requirement. This eliminates the recurrence of the Bancap scandal which was essentially a matter of "kiting" securities and of the double sale of securities, as in the case of the NFA papers that occurred during the desperate final days of unlamented Urban Bank.

The most striking feature of Circular 304, however, lies in the provisions relating to the secondary transfers of the LTNCD. There is an obvious distinction made between "negotiations/transfers from one holder to another" and "pretermination". A holder may negotiate or transfer the LTNDC anytime. But only the issuer, and never the holder, may, under strict conditions, preterminate.

Why make a big deal between "negotiations/transfers" on the one hand and "preterminations" on the other? In both cases, the holder is able to get his investment back in cash. Why bother with the distinction?

Taxation is where the rub is. The beauty of the LTNCD lies in its being able to pay interest tax-free. Under the Comprehensive Tax Reform Act, a long-term (meaning five years or more) deposit or investment can pay interest that is exempt from the income tax (actually 20 percent withholding and final tax). However, the income tax is imposed, if, prior to fifth year, the holder preterminates his deposit. The question, therefore, is whether the "negotiation" by the holder a "pretermination" of the deposit or not?

Circular 304 takes the position, and, to my mind, rightly so, that when a holder negotiates his deposit certificate, he is not terminating the investment. The purpose of that law granting tax-exemption to interest paid on long term deposits and investments is to make available, to those who need capital, long term money. The idea is to enable businesses to plan long-term and this can be done only if there is an assurance that, there being no default in interest payments, the money will continue over the long term to be in the hands of enterprise. Accordingly, when a depositor is substituted by another, without any withdrawal from the user of the funds, the depositor cannot be correctly considered as having "preterminated" his deposit.

Since the negotiation will not retrieve money back from the user but will simply replace one investor with another, it cannot be considered a termination of the investment. The investment with the issue continues to be committed to the project. Long term planning is not disrupted. The only change effected by negotiation is a change in the name of the holder, i.e. the payee of interest and principal.

The Bureau of Internal Revenue, of course, is the only authority, at the administrative level, that can say whether for purposes of income taxation of the interest paid by the LTNDC "negotiation" is different from "pre-termination". The sooner the BIR makes that ruling or issues an interpretative bulletin, the better for all of us.