TAX FREE EXCHANGE

In tax-free exchange transactions, the recognition of gain or loss is merely deferred.   Any gain or loss will only be
recognized when the properties or shares are subsequently transferred.

What Transactions are Covered?

Section 40(C)(2) of the Tax Code, as amended by CREATE law, covers the tax-free exchanges of properties involving
(1) reorganization or (2) transfer to a controlled corporation.

The first type of transaction is reorganization, which refers to any of the following:

1. The merger or consolidation where a corporation exchanges property solely for stock of a
corporation which is also a party to the merger or consolidation;
2. The acquisition of one corporation, in exchange solely for all or a part of its voting stock, or in
exchange solely for all or part of the voting stock of a corporation which is in control of the
acquiring corporation, of stock of another corporation if, immediately after the acquisition, the
acquiring corporation has control of such other corporation, whether or not such acquiring
corporation had control immediately before the acquisition;
3. The acquisition by one (1) corporation of substantially all the properties of another corporation in
exchange solely for all or part of its voting stock, or in exchange solely for all or part of the voting
stock of a corporation which is in control of the acquiring corporation. In this kind of
reorganization, the assumption by the acquiring corporation of the liability of the others shall be
disregarded.
4. Recapitalization, which is an arrangement whereby the stock and bonds of a corporation are
readjusted as to amount, income, or priority or an agreement of all stockholders and creditors to
change and increase or decrease the capitalization or debts of the corporation or both;
5. Reincorporation, which means the formation of the same business with the same assets and
stockholders surviving under a new charter.

The second type of covered transaction is the transfer to a controlled corporation, which means transfer of
property to a corporation by a person, alone or with others, but not exceeding four (4) persons in exchange for
stock or unit of participation in such a corporation. As a result of such transfer, the transferor, or transferors,
collectively, gains or maintains control of said corporation. 

For purposes of tax-free exchanges of properties, “control” shall mean ownership of majority (at least 51%) of the
total voting power of all classes of stocks entitled to vote. The collective, and not the individual, ownership of all
classes of stocks entitled to vote of the transferor or transferors shall be used in determining the presence of
control.

How to Determine Substituted Basis?

The substituted basis of properties shall be determined as provided for by Section 40(C)(5) of the Tax Code, as
amended, as detailed below:

STOCK OR SECURITIES
For stock or securities, the substituted basis shall be computed as follows:

Original basis of the property, stock, or securities to be transferred

            LESS:

                        Money received, if any

                        Fair Market Value of other property received, if any

            PLUS:

                        The amount treated as dividend of the shareholder, if any

                        The amount of gain that was recognized on the exchange, if any.

Meanwhile, the basis for property received as ‘boot’ shall be its fair market value. “Boot” refers to the money
received, and other property received more than the stock or securities received by the transferor on a tax-free
exchange.

If the transferee of property assumes a liability of the transferor, such assumption of liability shall be treated as
money received by the transferor if such liability is part of the consideration to the exchange.

PROPERTY IN THE HANDS OF THE TRANSFEREE

For property transferred in the hands of the transferee, the substituted basis shall be computed as follows:

            Original basis in the hands of the transferor

            PLUS:

            The amount of the gain recognized to the transferor on the transfer.

What is the Original Basis of the Property to be Transferred?

The original basis of the property to be transferred for purposes of computing the substituted basis shall be as
follows:

(a). The cost of the property, if acquired by purchase on or after March 1, 1913;

(b). The fair market price or value as of the moment of death of the decedent, if acquired by inheritance;

(c). The basis in the hands of the donor or the last preceding owner by whom the property was not acquired by
gift, if the property was acquired by donation. If the basis, however, is greater than the fair market value of the
property at the time of donation, then, for purposes of determining loss, the basis shall he such fair market value;
or

(d). The amount paid by the transferee for the property, if the property was acquired for less than an adequate
consideration in money or money’s worth.

(e). The adjusted basis of (a) to (d) above, if the acquisition cost of the property is increased by the amount of
improvements that materially add to the value of the property or appreciably prolong its life less accumulated
depreciation.

(f). The substituted basis, if the property was acquired in a previous tax-free exchange under Section 40(C)(2) of
the Tax Code of 1997.

How is the Basis for Gain or Loss on the Subsequent Sale or Disposition of Properties Computed?

The substituted basis shall be the basis for determining gain or loss on a subsequent sale or disposition of
properties subject of the tax-free exchange transactions.

How is the Substituted Basis of Properties Monitored?

To ensure proper monitoring of the substituted basis, RR  No. 18-2001 requires the parties to the tax-free
exchange/reorganization to comply with the following requirements:

1. A complete statement of all facts pertinent to the non-recognition of gain or loss in connection
with the reorganization shall be included in the respective returns (for the taxable year within
which the reorganization occurred) of the following:
 Each corporation which is a party to the reorganization; and
 Every taxpayer, other than a corporation, party to the reorganization, who received
stock or securities and other property or money upon a tax-free exchange in
connection with a corporate reorganization.
2. The parties shall include as a note to their respective audited financial statements for the taxable
year in which the exchange occurred a statement to the effect that they hold such assets/shares
acquired in a tax-free exchange and the year in which such exchanged occurred, and in the
taxable years until the subject properties are subsequently transferred to another transferee.
3. The parties shall cause to annotate, at the back of certificates of title and/or stock, the date the
deed of exchange was executed, the original or historical cost of acquisition of the properties or
shares of stock transferred, and the fact that no gain or loss was recognized as a result of such
exchange.
4. Within ninety (90) days from the date of the receipt of the CAR, a photocopy of such certificates
of title and/or stock bearing the annotation of substituted bases of the real properties/shares of
stock transferred/received in connection with the transaction, as duly certified by the Register of
Deeds/Corporate Secretary, should be submitted to the Revenue District Office (“RDO”) which
issued the CAR. Otherwise, the RDO shall refer the docket of the case to the Legal Division for
appropriate action.
5. The shareholders of the absorbed/transferor corporation and the surviving transferee
corporation shall record in their respective books the mandatory accounting entries as
prescribed by the regulations.

What is the Tax Treatment of Exchanges Made Pursuant to Section 40(C)(2) of the Tax Code, As Amended?
The transfers of properties in exchange for stocks shall be exempt from Capital Gains Tax (CGT), Creditable
Withholding Tax (CWT), Income Tax (IT), Donor’s Tax (DT), Value-Added Tax (VAT), and Documentary Stamp Tax
(DST) on conveyances of real properties and shares of stock.

However, the original issuance of shares in exchange for properties transferred shall be subject to DST (Section
174, Tax Code, as amended).

Where is the Venue for the Issuance of the CAR?

The parties to the transaction shall submit the documentary requirements to the RDO having jurisdiction over the
place where the property is located, in case of a real property, or in case of shares of stock, the RDO where the
issuing corporation is registered.

If the transaction involves transfer of multiple real properties and/or shares of stocks situated in various locations
covered by different RDOs, the CAR shall be processed with the RDO having jurisdiction over the place where the
transferee corporation is registered.