Tax Articles

Liquidation of Business:
Tax Treatment of Transfer of Assets to Owners

Atty. Fulvio D. Dawilan

This pandemic has brought a lot of challenges to many businesses. We are already seeing businesses closing shops – some permanently. Others are undertaking corporate restructuring programs in order to expand their resources and maintain or improve their competitiveness.

The closure of business or the undertaking of restructuring activities may eventually result in the dissolution or liquidation. When a corporation dissolves, the shareholders surrender their shares of stock. In return, the shareholders receive cash and/or property from the corporation if anything remains after payments of third party obligations. The amount in cash and/or other property received by a shareholder following the dissolution or partial liquidation of a corporation is often referred to as liquidating dividend.

And let me note that even in death, there are taxes. So goes a familiar phrase - nothing can be certain, except death and taxes. The death of a business entity, voluntary or not, does not exonerate it from the resulting taxes. What is not certain is which part of the process is subject to tax and which tax is applicable.

The tax treatment of the liquidating dividend by our tax authority, both on the part of the shareholder and on the part of the dissolving corporation, had been inconsistent, causing confusion on the part of the taxpayers. Let me then refresh the income tax consequences of the transfer of assets from the liquidating corporation to its shareholders. The other tax implications, such as the business tax, will be discussed in a later issue in this column.

On the part of the shareholder/owner: The description – liquidating dividend - itself has added to the confusion. While it is described as dividend, it is not to be treated as dividend for tax purposes. The tax on dividend will not apply.

Rather, as emphasized in a number of cases, this is no different from a sale of shares of stock to a third party. Thus, the gain or loss to the shareholder is also referred to as capital gain or capital loss. But it is neither to be treated as a capital gain subject to capital gains tax. While the receipt of property is akin to a receipt of proceeds from sale of shares of stock which is usually subject to the capital gains tax, this is not so for the gain derived from the receipts of assets from a dissolving corporation.

Instead, jurisprudence, as early as 1947, has characterized the gain or loss sustained by a stockholder of a dissolved corporation as a taxable income or a deductible loss. This characterization is already incorporated in the Tax Code. The present Section 73(A) of the said Code provides that where a corporation distributes all of its assets in complete liquidation or dissolution, the gain realized or loss sustained by the stockholder, whether individual or corporate, is a taxable income or a deductible loss, as the case may be. The same rule is provided in the implementing regulations (Section 8, Revenue Regulations No. 6-2008), which allows the investor to recognize either capital gain or capital loss upon the surrender of shares computed by comparing the cash and fair market value (FMV) of property received against the cost of the investment in shares. The difference between the sum of the cash and the FMV of the property received and the cost of the investment in shares shall represent the capital gain or capital loss from the investment, whichever is applicable. Note that the capital gain is subject to the regular income tax rate on the part of the recipient – shareholder. In case of a loss, the same shall be deducted from the other income of the shareholder subject to the regular income tax rate.

Clearly, liquidating dividends are not taxed as dividends. Also, while the gain derived by the shareholder is the same as and often described as capital gain, the applicable tax is not the capital gains tax. Instead, the gain is included in the income of the shareholder subject to the regular income tax rate.

On the part of a liquidating corporation: The tax treatment on the part of the dissolving or liquidating corporation is another cause of confusion, especially if it involves the transfer of assets other than cash, such as real properties and shares of stock in another corporation.

The tax bureau itself has issued conflicting pronouncements on this matter. In BIR Ruling No. 479-11, for example, the BIR denied the request of a taxpayer for the exemption from tax of the transfer of real property by a dissolved corporation to its shareholder or on its receipt of the surrendered shares from the shareholder. In fact, the said ruling reversed and set aside prior inconsistent rulings.

The Courts, however, have been consistent on the tax treatment on the part of the dissolving or liquidating corporations. In one case (C.T.A. EB Case No. 1702/C.T.A. Case No. 8940) involving the refund of capital gains tax (CGT) paid on the transfer of parcels of land by a dissolved corporation to its shareholder, the Court granted the same on the ground that the transfer is not subject to CGT. This is not because, as explained by the Court, of the absence of income from or the absence of sale, disposition or conveyance of real property, but because such transaction is subject to the ordinary income tax on the part of the individual shareholder or corporate income tax for corporate shareholders.

Whatever be the reason, it is clear that a corporation cannot be made liable for income tax (regular income tax or special/final tax rates) by reason of the transfer of assets (either in cash or other forms of property) to its shareholder by reason of dissolution or liquidation.

In summary, for income tax purposes, only the shareholder may be subjected to the regular income tax, if there is gain on the receipt of assets from a corporation as a result of a dissolution or complete or partial liquidation. No income tax shall be imposed on the liquidating corporation, by reason of the transfer or receipt of the surrendered shares.