IAET and PEZA Entities

Private and Confidential
To Ms. A Date 20 May 2011
From KPMG Ref (OurRef)
cc Mr. B
Gentlemen:
This refers to your email query dated 02 May 2011 relating to the possible exposure of Company ZZZ
(ZZZ) to improperly accumulated earnings tax (IAET).
Background
Our understanding of the facts is as follows:
ZZZ is a domestic company registered with the Philippine Economic Zone Authority (PEZA) and enjoying
the 5% preferential tax rate in lieu of national and local taxes. It is a wholly owned subsidiary of
Company XXX (XXX), a corporation established and existing under the laws of Japan.
XXX, on the other hand, is a wholly owned subsidiary of Company YYY (YYY), a corporation established in
Japan and listed in the Tokyo Stock Exchange.
As of fiscal year ended 31 March 2011, the retained earnings of ZZZ exceeded its paid up capital. The
accumulation of the retained earnings is due to the decision of ZZZ’s management to appropriate the
retained earnings for a certain joint venture project (JV). The minutes of the board meeting approving
the appropriation was signed on 28 March 2011. The appropriation has been reflected in the accounting
books of ZZZ.
Recently, however, ZZZ was advised by XXX that the JV might not materialize following the recent
earthquake and tsunami that struck Japan.
In view of the forgoing, ZZZ seeks clarification on the possible IAET implications of the reversal of the
appropriation for the JV.
Discussion
A. Imposition of the IAET
Section 29 of the Tax Code, as implemented by Revenue Regulations No. 2-01 (RR 2-01), dated 12
February 2001, imposes for each taxable year an IAET equal to 10% of the improperly accumulated
taxable income of corporations formed or availed of for the purpose of avoiding the income tax with
respect to its shareholders or the shareholders of any other corporation, by permitting the earnings and
profits of the corporation to accumulate instead of distributing them to the shareholders.
The Tax Code and RR 2-01, however, admit of certain exemptions from the imposition of the IAET.
PEZA-registered entities enjoying a special tax rate and publicly-held entities are among those exempt
from the IAET.
B. Exemption as a PEZA-registered entity
We believe that ZZZ is exempt from IAET because it is a PEZA-registered entity enjoying the 5%
preferential tax rate in lieu of national and local taxes
Under RR 2-01, PEZA-registered entities are specifically exempted from the 10% IAET.
Section 4 of RR 2-01 provides:
“SECTION 4. Coverage. — The 10% Improperly Accumulated Earnings Tax (IAET) is imposed on
improperly accumulated taxable income earned starting January 1, 1998 by domestic corporations as
defined under the Tax Code and which are classified as closely-held corporations. Provided, however,
that Improperly Accumulated Earnings Tax shall not apply to the following corporations:
a) Banks and other non-bank financial intermediaries;
b) Insurance companies;
c) Publicly-held corporations;
d) Taxable partnerships;
e) General professional partnerships;
f) Non-taxable joint ventures; and
g) Enterprises duly registered with the Philippine Economic Zone Authority (PEZA) under R.A. 7916,
and enterprises registered pursuant to the Bases Conversion and Development Act of 1992 under R.A.
7227, as well as other enterprises duly registered under special economic zones declared by law which
enjoy payment of special tax rate on their registered operations or activities in lieu of other taxes,
national or local."
(Underscoring ours)
In a number of rulings, the above cited provision has been relied upon by the Bureau of Internal
Revenue (BIR) in confirming that PEZA-registered entities enjoying the 5% preferential tax rate are
exempt from the imposition of IAET.
Considering that ZZZ is a PEZA registered entity enjoying the 5% preferential tax rate, we believe that
the exemption provided by the above cited Section 4 of RR 2-01 applies. Thus, regardless of the reason
for the accumulation of the retained earnings, ZZZ is exempt from the IAET.
C. Exemption as a publicly-held corporation
Under Section 29 of the Tax Code and Section 4 of RR 2-01 as above cited, publicly-held corporations are
likewise granted exemption from the imposition of IAET.
For purposes of determining whether a corporation is publicly held, RR 2-01 provides that a corporation
that is not closely held is a publicly held corporation. Closely held corporations, on the other hand, are
defined under Section 4 of RR 2-01 as those corporations at least fifty percent (50%) in value of the
outstanding capital stock or at least fifty percent (50%) of the total combined voting power of all classes
of stock entitled to vote is owned directly or indirectly by or for not more than twenty (20) individuals.
For purposes of determining ownership, stocks owned directly or indirectly by or for a corporation,
partnership, estate or trust shall be considered as being owned proportionately by its shareholders,
partners or beneficiaries.
Relying on the above definition of a publicly-held corporation, the BIR acknowledged in several rulings
that in determining whether a corporation is publicly held, ownership is traceable to individual
shareholders of its ultimate parent company. In these rulings, the BIR traced the ownership of
individuals to their proportionate shareholdings in the ultimate parent company, which are publicly
listed companies.
We believe, however, that the exemption applicable to publicly-held companies may not apply to ZZZ.
While we are aware that YYY is a-publicly listed entity, we were not able to establish that 50%
ownership over ZZZ’s shares is owned directly or indirectly by at least twenty one (21) individuals. As to
direct ownership of individuals in YYY, it appears that 90.4% shares of YYY are directly owned by
corporations or only 9.6% shares are owned by individuals. The indirect ownership of individuals in YYY
through the shareholder companies, however, cannot be determined from the 2010 Annual Report of
YYY.
For purposes of clarity, however, if it is later on determined that at least twenty one (21) individuals own
at least 50% of YYY directly or indirectly, then it may be argued that YYY is a publicly-held corporation for
purposes of the exemption from IAET.
D. Other considerations
At this juncture, we note that while ZZZ may enjoy exemption from IAET as a PEZA-registered entity
enjoying the 5% preferential tax rate, it is also advisable to trace ZZZ’s possible exemption from IAET as a
publicly-held entity. This is so because the basis for exemption of such PEZA-registered entities is not
the provisions of the Tax Code itself, but rather from the implementing rules and regulations only issued
by the Department of Finance (i.e., RR 2-01) and the interpretations of the BIR. Consequently, a change
in RR 2-01 or in how the BIR interprets the exemption it provides may affect the exemption of such
PEZA-registered entities. On the other hand, publicly-held corporations are exempt from IAET pursuant
to an express provision of the Tax Code, which can be changed not by implementing rules and
regulations but by an amending law only.
Further, we note that notwithstanding the exemption from IAET for tax purposes, ZZZ should consider
the prohibition imposed by the Philippine Corporation Code. Section 43 of the Corporation Code
prohibits corporations from accumulating retained earnings in excess of 100% of their paid-in capital
stock. The prohibition is, however, subject to the following exceptions:
(1) the retention is justified by definite corporate expansion projects or programs approved by the
board of directors; or
(2) the corporation is prohibited under any loan agreement with any financial institution or
creditor, whether local or foreign, from declaring dividends without its/his consent, and such consent
has not yet been secured; or
(3) it can be clearly shown that such retention is necessary under special circumstances obtaining in
the corporation, such as when there is need for special reserve for probable contingencies.
Failure to declare dividends without the appropriate justification may subject ZZZ to administrative
penalties imposed by the Securities and Exchange Commission. ZZZ should consider consulting its legal
counsel regarding this matter.
***
We trust the foregoing will be sufficient for your purposes. If you have any question please let us know.
Notice and Disclaimer
Our advice/report is limited to the conclusions specifically set forth herein and is based on the
completeness and accuracy of the stated facts, assumptions and/or representations included. In
rendering our advice, we may consider tax authorities that are subject to change, retroactively and/or
prospectively, and any such changes could affect the validity of our advice. We will not update our
advice for subsequent changes or modifications to the law and regulations, or to the judicial and
administrative interpretations thereof.
This advice/report has been prepared for the sole benefit of Company ZZZ and is based on the specific
facts and circumstances of Company ZZZ and is issued pursuant to the terms of our engagement letter.
It should not be relied upon by any other person. Any other person choosing to rely on this advice does
so at their own risk. To the fullest extent permitted by law, Manabat Sanagustin & Co., CPAs accepts no
responsibility or liability to them in connection with the Services.
Very truly yours,
MANABAT SANAGUSTIN & CO., CPAs

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IAET and PEZA Entities

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Private and Confidential

To Ms. A Date 20 May 2011

From KPMG Ref (OurRef)

Our understanding of the facts is as follows:

A. Imposition of the IAET

B. Exemption as a PEZA-registered entity

Section 4 of RR 2-01 provides:

a) Banks and other non-bank financial intermediaries;

e) General professional partnerships;

f) Non-taxable joint ventures; and

Notice and Disclaimer

Very truly yours,

MANABAT SANAGUSTIN & CO., CPAs

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