Amicus Curiae

Have you heard of the tax-free transfer of property to a corporation or a “tax-free exchange” as an estate planning tool? In a tax-free exchange, the title over the property is transferred to a corporation, which in turn is controlled by the transferor. There is only a change in ownership in legal form, but none in fact and substance. The transfer is tax-free because it is not subject to income, documentary stamp and, under the new TRAIN law, value-added tax (VAT). The underlying idea is if there is no real transfer of ownership, there should be no tax on the transfer.
In Philippine practice, tax-free exchange has been liberally used as an estate planning tool.
Generally, the estate tax (informally, inheritance tax) is higher if the property is passed on to the heirs directly, than if indirectly through a corporation.
Why so? With a prior transfer to a corporation, it is the shares that will form part of the estate, and not the property. The valuation of the shares, which is locked at historical cost (i.e., the purchase price of the property), is normally much lower than the value of the property, which is pegged at the fair market value at the time of death. A lower tax base leads to a lower tax due. Consequently, a lot of wealthy property owners resorted to tax-free exchanges to preserve their estate. It was imperative to reduce the taxable base given a previous high estate tax rate of 20%.
However, the practice became unpopular with the DoF’s twin regulations imposing VAT on tax-free exchange (when the property was being used in business), and reflecting the value of the property to be the value of the shares (RR 6-2013). Taxwise, it no longer made sense to undergo a tax-free exchange. There would be VAT, and still the heirs would be required to pay the same estate tax on the same value (whether in the form of property or shares).
However, for those with a keen eye on details, they would have spotted that RR 6-2013 is limited to sale of shares. It does not cover transfers through inheritance, which were governed by a different regulations (RR 2-2003). The problem then was the implementation. The BIR, in practice, insisted on using RR 6-2013, and required the payment of a higher tax.
In light of the confusion brought by RR 6-2013, it no longer mattered whether the properties were transferred to the heirs directly or indirectly through a corporation. In fact, it became more burdensome to do a “tax-free” exchange!
With the new TRAIN law, the tax-free exchange mechanism seems even more utterly useless.
While the law made tax-free exchanges expressly exempt from VAT (even if the property was used in business), it reduced the estate tax rate from 20% to 6%. Further, it increased the tax-exemption of a family home from P1 million to P10 million, and the standard deduction from P500,000 to P5 million.
Effectively, a family home with a value of P15 million would not be subject to tax. There is no need to undergo the tax-free exchange exercise to avoid the 20% estate tax.
There is renewed value in tax-free exchanges.
The new estate tax regulations (RR12-2018) have revived a key aspect of the tax-free exchange. It reiterated the rule in RR 2-2003 that shares “are valued based on their book value xxx (and) shall be exempt from the provisions of RR 6-2013, as amended.”
Thus, the value of the property can again be frozen at historical cost, and need not be adjusted to the higher fair market value as of the transferor’ death. This clarification gives imperative reason to wealthy property owners to place their non-family home properties to corporations. The tax-free exchange approach makes more sense when the property is meant to be preserved by the heirs or maintained within the family. It does not matter whether the property is owned directly or indirectly through a corporation.
A few words of caution, however.
For one, maintaining a holding company is not easy. Corporations, including holding companies, are subject to several government regulatory and reportorial requirements.
Second, as a practical matter, it is not farfetched certain BIR examiners would impute taxes on the supposed free-use of property of the corporation by the shareholders/ heirs.
Third, upon subsequent sale of the property, the property’s historical cost will be used in computing the taxable gain. This is as if the property were in the hands of the original transferor. Hence, while tax-free exchange as an estate planning tool is back, the same should be used with diligence and caution.
This article is for general informational and educational purposes only and not offered as and does not constitute legal advice or legal opinion.
Eric R. Recalde heads the Tax Department of ACCRA Law Offices. He recently published All the Taxpayers Need to Know About the TRAIN Law.
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