Normally, when one looks at the financial statements of a corporation and notices that the accumulated earnings exceed the paid-up capital, one will infer that this is a positive thing. And yes, that is correct; that means that the corporation is profitable. However, the Bureau of Internal Revenue (BIR) would have a different view.  Such accumulation of earnings could expose a corporation to the improperly accumulated earnings tax or IAET.

Our tax rules impose a 10% tax on improperly accumulated taxable income of corporations. This is applicable to corporations formed 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 dividing or distributing them to the shareholders. IAET, though, shall not apply to banks, insurance companies, publicly-held companies, and other corporations covered by special laws.

The rationale of imposing IAET as a penalty on corporations is to discourage them from improperly accumulating earnings to spare their shareholders from tax liability should they decide to declare dividends (other than stock dividends).  Thus, unless the accumulation of earnings is “reasonable” as defined by the tax rules, such accumulation could be subject to a 10% IAET penalty.

Now, consider this scenario: a corporation was charged the 10% IAET penalty.  Subsequently, such a corporation declares cash dividends to its stockholders out of the earnings previously subjected to the 10% IAET. Under the present tax rules, the cash dividends will be subjected to another round of tax, which is the final withholding tax or FWT, which, this time, differs in amount depending on the type of shareholder. On the assumption that the shareholders are individuals or non-resident foreign corporations (not domestic corporate-stockholders), the cash dividends will be subjected to the rates from 10% to 30% depending on the nationality and residency of the individual or on the applicable tax treaty or tax sparing provisions for non-resident corporations.

Thus, for the corporation’s earnings which were previously subjected to IAET, such earnings would be subjected to two types of tax: (1) the 10% IAET (imposed on the corporation); and (2) the FWT on dividends (imposed on the corporation as the withholding agent).

Would it be possible then that an amendment to our present tax rules be considered so that the amount of the previous IAET can be credited against the FWT on dividends?  Would this make sense?

If the same earnings are subjected to two types of tax, corporations which have been previously penalized for IAET might hesitate or delay the subsequent declaration of cash dividends to their stockholders to put off the imposition of FWT on dividends. Of course, this is on the premise that the corporation has no other business considerations for immediately declaring cash dividends to its stockholders.

This delay in declaring cash dividends is a possibility, since under the present tax rules, even if the corporation decides not to declare cash dividends from its accumulated earnings previously penalized for IAET, the corporation will no longer be subjected to IAET on such portion of the earnings.

The above scenario on the possible delay of dividends and the corresponding FWT imposition doesn’t appear to coincide with the spirit of the IAET rules. In one Supreme Court case, the Court explained that the IAET provision discourages tax avoidance through corporate surplus accumulation. When corporations do not declare dividends, income taxes are not paid on the undeclared dividends received by the shareholders. The tax on the improper accumulation of surplus is essentially a penalty tax designed to compel corporations to distribute earnings so that the said earnings can, in turn, be taxed. Some corporations might not be compelled to distribute their earnings if there is another round of tax (FWT) without the benefit of deducting the previously-paid tax (IAET).

Another consideration is the onerous nature of having two types of tax being imposed on the same corporate earnings, i.e. IAET and FWT.  This ultimately affects the stockholders’ earnings after taking into account such taxes. Hence, deducting the amount of previously-imposed IAET against the subsequent FWT on dividends would appear more equitable on the part of the stockholder-taxpayer. 

Nonetheless, it should be borne in mind that IAET is imposable only when the accumulation of corporate earnings is “improper.” The reasonable needs of the corporation will definitely be considered by the tax rules in determining whether a corporation is guilty of improper accumulation. To name a few, reasonable corporate needs to include the appropriation for corporate expansion projects, putting up a reserve for the settlement of a loan covenant, and acquisition of a building, plant or equipment.

Obviously, it would be every taxpayer-stockholder’s wish to not be burdened with excessive tax consequences. Given the current developments in tax reform, shouldn’t it be high time to revisit the IAET rules to consider deducting the amount of previously-imposed IAET on the subsequent FWT on dividends, as they come from the same corporate earnings?

Paula A. Francisco is a senior with the Tax Advisory and Compliance division of P&A Grant Thornton. P&A Grant Thornton is one the leading audit, tax, advisory and outsourcing services firm in the Philippines.