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Realizations About Realization

Did you realize that a major cause of complexity and discrimination in the income tax law is due to the so-called principle of "realization"? Indeed, any attempt at reforming the income tax law by shifting from net to gross taxation will at best be superficial unless it comes to grips with the problems spawned by what tax lawyers call the "realization requirement".

In a nutshell, the "realization requirement" demands that in order for an increase in the value of property to be considered income subject to tax, the appreciation must be made "real", in a sale or some other market transaction. In other words, a person holding property that has gone up in value over the years, will not, though considered by economists and bankers to have increased his worth, have to pay any income tax, unless and until he sells or otherwise disposes of his appreciated asset. This insistence on a taxable event to unlock the increase in value of one’s assets is responsible for a number of complex rules, inequitable results, and imprecision in the measurement of income on which the tax is based.

The Supreme Court in the early case of Madrigal v. Rafferty (38 Phil. 14) was on the right track. Distinguishing income from capital, it said "capital is a fund; income is a flow. Capital is wealth, while income is the service of wealth". Therefore, when one’s wealth increases in value, regardless of whether the increase in value is validated in a market transaction, a person can be said to have been served by, or more precisely, to have derived income from, his wealth.

But, following the lead of the U.S. case of Eisner v. Macomber (252 U.S. 189), our Supreme Court, in the case of Fisher v. Trinidad, (43 Phil. 973) laid out the rule, followed since then, that mere increase in value of one’s holdings does not constitute income. Specifically, stock dividends, which represent simply an increase in a shareholder’s interest in a corporation resulting from a transfer into the capital account the corporation’s surplus, are not taxable income. They will be income only when stock is sold or disposed of for value.

The realization requirement clearly discriminates against a cash earner, who must report his income in the year he earns, and one who accumulates wealth through capital gains. Thus one who earns a salary of P500,000 must report the entire amount as income (not to mention that when that income is earned the tax is withheld in advance), while one who simply lets his asset appreciate by P500,000 pays no tax at all.

But the discrimination is not only between the salary earner and the value accumulator. It also occurs between the property owner who encashes his yearly appreciation by selling the asset and one who does not. If, for example, A, who buys a painting for P100,000 which goes up in value to P175,000, sells it for that price, he must pay a tax on the P75,000 gain. In contrast, B, who buys a like painting which appreciates by the same amount, but does not sell it, he pays no tax. But, A and B are obviously similarly situated, both are richer by P75,000, except that A’s increased wealth is in cash, while B has it in his valuable asset.

It is no argument to say, in defense of the realization principle, that the asset holder did not receive anything. The mere increase in the value of one’s assets gives him very real benefits. For instance, he could go to a bank and, using his appreciated asset as collateral, borrow an amount which could far exceed the original cost of the asset. If the loan is for business, the asset holder has the added benefit of being able to deduct the interest on his loan against his gross income. Thus, for as long as the asset appreciates by an amount that is not less than the after-tax cost of the interest expense, the owner has the best of both worlds: untaxed appreciation and deductible expense.

It is also not convincing to argue that the "realization" rule simply defers taxation to a later date i.e. when the appreciated asset is sold or disposed of. In the first place, postponing the "realization" by a mere twelve months and one-day (from date of purchase) will entitle A in the earlier example, if an individual, to report only one-half of his gain. This is because the asset, on account of the holding period of more than a year, is considered as a long-term capital asset on which the gains are reportable only at 50 percent (Sec. 30 (B)(2), Tax Code). But more important, the reality is that most long-term assets are not taxed even when they are disposed of. A lot of long-term assets are not sold disposed of for value, they are inherited. When property is transferred by inheritance, the property acquires a new basis, i.e. a new "cost", as far as the heir is concerned. He records his "cost" at the asset’s fair market value at the time of the inheritance (Sec. 40(B)(2)). As a result, all the appreciation of the asset from the time it was purchased by the decedent up to the time it is inherited by the decedents’ heir escapes income taxation forever.

Moreover, a lot of those which are sold easily escape full taxation. For instance, land that is a capital asset, no matter how much it has appreciated in value, will be taxed only at 6 percent of the consideration or the zonal value, whichever is higher. Another: owners of corporations not listed in the stock exchange can sell their shares at the low rate of 5 percent on the first P100,000 of gain and 10 percent on any excess. A really greedy one: get your closely-held corporation to be listed in the stock exchange. Put in your shares in the pot for the initial public offering. You escape the 5 percent to 10 percent tax on gains in exchange for paying only 1 percent, if the corporation offers to the public 33 and 1/3 percent of its outstanding shares; only 2 percent if the offering is more than 25 percent but not over 33 and 1/3 percent; and at most 4 percent if up to 25 percent is offered.

Surely, closing these loopholes require a lot of sacrifice among the legislators, many of whom are (either themselves or their immediate families) beneficiaries of these tax concessions. There was loose talk, when the so-called Comprehensive Tax Reform Law, was passed that a certain legislator insisted on a number of provisions (or else, he will block the passage of the law) to save himself some taxes. And a lot of taxes were indeed saved.

But now is the time for reform, of self as well as of the tax system, and sooner rather than later, our legislator must take the lead and show the nation that taxes are not burdens other people pay for the support of government.

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