The entire nation eagerly listened as President Rodrigo Duterte delivered hisfirst state of the nation address last Monday. Some of the keypoints he discussed include: declaration of unilateral ceasefire with communists, lowering of personal and corporate income tax rates, continuation of war against illegal drugs, addressing the worsening traffic conditions, streamlining the bureaucracy in government services, and improvement in infrastructure. Indeed, change has started to come and every concerned citizen of our country, not just the 16.6 million Filipinos who voted for him, is keeping a watchful eyeonhow the president will turn his promises into fruition. After all, human nature dictates that there must be some form of measurable outputs as basis to judge someone else’s performance.
A broader measure of performance
Even in businesses, stakeholders are always interested to see how an entity performs and the conventional way to assess this is by having a quick look at the net income of a company as reflected in its income statement or statement of profit or loss.We need to be cautious though that not all income and expenses are being recognized directly in profit or loss. For instance, the effect of change in assumptions, such as discount rate or salary increase rate, used to value pension obligations is not reflected in an entity’s profit or loss but rather forms part of other comprehensive income,which is reported under equity in the balance sheet or statement of financial position. The treatment is the same with movement in fair value of investments that are not categorized as held for trading. Other comprehensive income is much broader as it covers items of income and expense not recognized in a typical profit or loss statement. With other comprehensive income being material for certain companies, it has been customary for some entities to monitor the movement in its other comprehensive income on a regular basis as their C-suites believe that the other comprehensive income is a more accurate reflection of how an entity measures up to its target and to a certain extent, this gives them a better picture of an entity’s performance over a particular period.
Distribution vs. retention
It is but natural for the investing public to look forward to the return on their investmentsand a common way to measure this return is through the dividends declared out of a corporation’s unrestricted retained earnings. While the concept of retained earnings, which pertain to the accumulated surplus or profits, appears to be straightforward, we still often see a number of companies being cited by the Securities and Exchange Commission (SEC) for violating Section 43 of the Corporation Code. Section 43 specifically indicates that “stock corporations are prohibited from retaining surplus profits in excess of 100 percent of their paid-in capital stock, except: (1) when justified by definite corporate expansion projects or programs approved by the board of directors; or (2) when the corporation is prohibited under any loan agreement with any financial institution or creditor, whether local or foreign, from declaring dividends without its/ his consent, and such consent has not yet been secured; or (3) when it can be clearly shown that such retention is necessary under special circumstances obtaining in the corporation, such as when there is a need for special reserve for probable contingencies.”
Surplus profits or retained earnings are normally expected to be declared as dividends and distributed to shareholders, in the absence of evidence to the contrary. The SEC, being the main regulatory body for companies in the Philippines, has the authority to question a company retaining surplus profits in excess of 100 percent of its paid-in capital and if such cannot be justified, it is likely that a corresponding sanction would be imposed to the entity. However, if there is a valid basis for retaining surplus profits beyond the allowed thresholdsuch as an entity currently undergoing or is set to have an expansion project that might entail it to preserve its surplus profits to cover this purpose, or the entity anticipates a probable loss or contingency that would require it to tap its accumulated surplus for future payments, then a company may transfer a portion of its retained earnings to a ‘restricted’ or ‘appropriated’ retained earnings account. Relative to this, a stock corporation appropriating a portion of its retained earnings for a corporate expansion project, for instance, must disclose in its financial statements the details of the expansion, which include the description of the project and timeline, to render the project definite, and the date of the approval by the Board of Directors of the project. This would also similarly apply for other appropriations made such as for loss contingencies or in response to specific loan covenants. Disclosures are being required to give the users of the financial statements a better understanding of the main reason for such retention of surplus including the length of time that a portion of retained earnings is needed to be set aside, which in turn might restrict an entity’s ability to declare dividends. Failure to have sufficient disclosures in the financial statements to support a company’s retention of surplus profitsmay be groundsfor SECto assess an entity’s compliance with relevant regulations.
Accumulation of surplus beyond the reasonable needs of business
Looking at the tax angle, Section 29 of the National Internal Revenue Code (NIRC) of 1997 imposes a tax equal to 10 percent of the improperly accumulated taxable income for each taxable year. This type of tax is being imposed in the nature of a penalty to discourage tax avoidance through accumulation of surplus beyond the reasonable needs of business. It must be noted that the 10percentimproperly accumulated earnings tax (IAET) is imposed on domestic corporations classified as closely-held corporations. Further, the IAET does not apply to banks and other non-bank financial intermediaries, insurance companies, publicly-held corporations, taxable partnerships, general professional partnerships, non-taxable joint ventures, and enterprises duly registered under special economic zones declared by law which enjoy payment of special tax rate on their registered operations or activities in lieu of other taxes. Thus, in terms of covered entities, Section 43 of the Corporation Code has a more extensive scope, pertaining to all stock corporations, whilethe IAETapplies to closely-held corporations not falling in the specific types of companies as mentioned in Revenue Regulations 2-2001.
Consistent with the essence of Section 43 of the Corporation Code, if a company can justify that the accumulation of surplus is within the ‘reasonable needs’ of business, the penalty tax would not apply. Specifically, section 3 of Revenue Regulations 2-2001 enumerates instances where the accumulation of surplus would not be construed as improper. Despitethis similarity between the SEC and BIR regulations, akey distinction that is noteworthy to highlight and oftentimes being overlooked is the composition of paid-in capital for purposes of assessing the excess retained earnings. SEC’s Memorandum Circular 11-2008 categorically defines paid-in capital as the amount of outstanding capital stock and additional paid-in capital or premium paid over the par value of shares. On the other hand, Revenue Memorandum Circular 35-2011 issued by the BIR mentions that any excess capital over and above the par shall be excluded for purposes of determining the 100 percent threshold. All companies should be mindful of this difference in calculation of paid-in capital, which can be significant if a company issued shares at a price well above its par value, when it comes to observing compliance with both the Corporation Code and tax requirements.
Supplemental statement apart from note disclosure
On top of the disclosure requirements that corporations should comply with forinstances of having surplus profits in excess of its paid-in capital, a Reconciliation of Retained Earnings Available for Dividend Declaration is also expected from issuers of securities to the public,and stock corporations with unrestricted retained earnings in excess of 100percent of paid-in capital stock. This supplemental statement is required to be submitted together with an entity’s audited financial statements and should also be covered by an independent auditor’s opinion, as required by Securities Regulation Code Rule 68.
Notwithstanding the submission of the supplemental statement and disclosing the impact of retention of surplus profits in the financial statements or company’s plan to comply with Section 43 of the Corporation Code, the entity’srationale for retaining surplus profits beyond the allowed threshold is still a critical factor that the regulators would carefully consider and assess to ensure that the interests of stakeholders are being duly protected and not being taken advantage of, while at the same time fostering conformity of corporations with relevant regulations. Needless to say, applying the concept of substance over form, mere appropriation and disclosure without valid implementation might still put into question an entity’s retention of surplus profits beyond what is allowed by the Corporation Code and tax rules.
While there is no rocket science involved in grasping the concept of business performance and retention of surplus profits, a number of companies are still falling to the trap of missing out the specific requirements of the regulators particularly when it comes to excess retained earnings.With this, itisalways more prudent to keep a watchful eye on the basic rules surrounding the sameto keep a company from facing the chill wind of non-compliance.
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Ruth F. Blasco is a Partner from Assurance and the Methodology Co-Leader of Isla Lipana & Co./PwC Philippines. Email your comments and questions to firstname.lastname@example.org. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.