Inconsistencies in the IAET

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Archie D. Guevarra

Taxwise Or Otherwise

The concept of improperly accumulated earnings tax (IAET) has been present in our jurisdiction even prior to the 1939 Tax Code. Although it was momentarily absent from our tax laws from 1986 to 1997 due to its repeal under Executive Order No. 37, IAET was reinstated 12 years after in the 1997 Tax Code. Despite its long-standing presence in our tax system, however, its application and interpretation continues to challenge our tax authorities, as well as our tax courts.

The 10% IAET is imposed on improperly accumulated taxable income of a corporation formed for the purpose of avoiding the income tax with respect to its shareholders, by permitting the earnings and profits of the corporation to accumulate instead of distributing them to the shareholders.

The rationale is that if the earnings and profits were distributed, the shareholders would then be liable for income tax, whereas if there was no distribution, they would incur no tax with respect to the undistributed earnings and profits of the corporation. Thus, IAET is a penalty on the corporation for the improper accumulation of earnings to avoid the payment of dividends tax on the distribution to shareholders. However, if the failure to pay dividends is due to some other causes, such as the use of undistributed earnings and profits for the reasonable needs of the business, such purpose would not generally make the undistributed earnings subject to tax.

As explained by the Supreme Court (SC) (G.R. No. L-26145 dated Feb. 20, 1984), in order to determine whether profits are accumulated for the reasonable needs of the business, the controlling intention of the taxpayer is that which is manifested at the time of accumulation, not subsequently declared intentions which are mere afterthoughts. A speculative and indefinite purpose will not suffice. The mere recognition of a future problem and the discussion of possible and alternative solutions is not sufficient. Definiteness of plan coupled with action taken towards its consummation are essential.

Through Revenue Regulation No. 2-2001, the Bureau of Internal Revenue (BIR) considered the accumulation of earnings up to 100% of the paid-up capital of the corporation as within the “reasonable needs of the business.” Likewise, earnings that are reserved for a justified purpose (e.g. definite corporate expansion, compliance with any loan covenants, earnings reserve subject to legal prohibition against its distribution) were also considered within the purview of “reasonable needs of the business.”

However, under Revenue Memorandum Circular (RMC) No. 35-2011, the BIR restricted the definition of paid-up capital to the amount contributed to the corporation representing the par value of the shares of stock; hence, any additional paid-in capital (APIC) was excluded from paid-up capital. This interpretation is contrary to the position of the Securities and Exchange Commission (SEC) that paid-in capital includes the APIC.

In addition, the RMC altered the formula in determining the improperly accumulated taxable income by including prior year retained earnings.

In a recently decided case of the Court of Tax Appeals (CTA Case No. 9106 dated Jan. 11, 2018), the tax court had the occasion to rule on the propriety of the exclusion of APIC. Applying the RMC, the BIR excluded the APIC in computing the IAET. However, the taxpayer asserted that the BIR has expanded the coverage of IAET by excluding the APIC to the prejudice of all taxpayers.

In deciding on this issue, the CTA relied on the SC definition of capital. According to the SC, the capital subscribed is the total amount of the capital that subscribers or shareholders have agreed to take and pay for, which need not necessarily be, and can be more than, the par value of the shares. In fine, it is the amount that the corporation receives, inclusive of any premiums, in consideration of the original issuance of the shares. Moreover, the CTA also referred to the SEC’s definition of “paid-in capital” which includes the APIC for purposes of determining the distributable retained earnings of the company.

Deciding in favor of the taxpayer, the CTA emphasized that the IAET is in the nature of a penalty on the corporation for the improper accumulation of its earnings, and as a form of deterrent to the avoidance of tax upon shareholders who are supposed to pay dividends tax on the earnings distributed to them by the corporation. Since APIC is not considered earnings/profits of a corporation generated from the normal and continuous operations of the business, the taxpayer may retain the total amount attributable to its APIC.

Note, however, that despite the favorable ruling of the CTA on the APIC, the taxpayer was still held liable for IAET because the tax court upheld the inclusion of prior-year retained earnings in the calculation of IAET. Such inclusion is a complete turnaround from the CTA’s past decision with regard to IAET.

In the previously decided case by the same division (CTA Case No. 8718 dated July 21, 2016), the tax court held that the formula used by the BIR in computing the deficiency IAET is not in accordance with Section 29 of the Tax Code since it included the prior-year retained earnings.

In recalculating the IAET, the CTA adopted the exact formula provided under Section 29(D) of the Tax Code where the “improperly accumulated taxable income” means current year taxable income adjusted by:

1. Income exempt from tax;

2. Income excluded from gross income;

3. Income subject to final tax; and

4. The amount of net operating loss carry-over deducted;

And reduced by the sum of:

5. Dividends actually or constructively paid; and

6. Income tax paid for the taxable year.

Although there are SC decisions which held that the undistributed earnings or profits of prior years are taken into consideration in determining unreasonable accumulation for purposes of IAET, such decisions are based on the 1939 Tax Code and not on the 1997 Tax Code. The main difference between the two versions of IAET is the explicitly provided formula under the 1997 Tax Code.

It has been well settled in our jurisprudence that tax administrators are not allowed to expand or contract the legislative mandate and that the “plain meaning rule” or verba legis principle in statutory construction should be applied such that where the words of a statute are clear, plain and free from ambiguity, it must be given its literal meaning and applied without attempted interpretation.

The views or opinions expressed in this article are solely those of the author and do not necessarily represent those of Isla Lipana & Co. The content is for general information purposes only, and should not be used as a substitute for specific advice.


Archie D. Guevarra is a Senior Consultant at the Tax Services Department of Isla Lipana & Co., the Philippine member firm of the PwC network.

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