Karlito, a Filipino businessman, is engaged in the business of metal fabrication and repair of LPG cylinder tanks. He conducts business under the name and style of “Karlito’s Enterprises,” a single proprietorship. Started only five (5) years ago, the business has grown so enormously that Karlito decided to incorporate it by transferring all the assets of the business, particularly the inventory of goods on hand, machineries and equipment, supplies, parts, raw materials, office furniture and furnishings, delivery trucks and other vehicles, buildings, and tools to the new corporation, Karlito’s Enterprises, Inc., in exchange for 100% of the capital stock of the new corporation, the stock subscription to which shall be deemed fully paid in the form of the assets transferred to the corporation by Karlito.
As a result, Karlito’s Enterprises, the sole proprietorship, ceased to do business and applied for cancellation of its BIR Certificate of Registration. The BIR, however, assessed Karlito VAT on account of the cessation of business based on the current market price of the assets transferred to Karlito’s Enterprises, Inc.
(a) Is the transfer subject to VAT? (2.5%)
(b) Is the transfer subject to income tax? (2.5%)
Suggested answer only. Not an official answer and not legal advice.
**Answer:** (a) Yes, the transfer is subject to VAT. (b) No, the transfer is not subject to income tax. **Legal Basis:** Under Section 106(B)(4) of the NIRC, retirement from or cessation of business regarding taxable inventories constitutes a "transaction
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Quick check
Under Section 106(B)(4) of the Tax Code, what is the tax treatment of commercial goods on hand upon retirement from business?
Goods on hand upon retirement or cessation of business are treated as transactions deemed sale subject to Value-Added Tax under Section 106(B)(4).
Under Section 40(C)(2) of the Tax Code, what percentage of voting stock must a transferor gain to qualify for a tax-free exchange?
Section 40(C)(2) defines corporate control as owning at least fifty-one percent of the total voting stock of the corporation.
Why is Karlito's exchange of sole proprietorship assets for 100% corporate stock exempt from income tax?
Exchanging property for corporate stock resulting in one hundred percent control is a tax-free exchange under Section 40(C)(2).
How is the output Value-Added Tax calculated on transactions deemed sale upon business cessation?
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Does an income tax exemption under Section 40(C)(2) automatically grant an exemption from Value-Added Tax under Section 106(B)(4)?
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Learn more about these topics
1. Transactions Deemed Sale
Under Section 106(B)(4) of the National Internal Revenue Code, goods or properties originally intended for sale or use in business are subject to Value-Added Tax as transactions deemed sale upon retirement from or cessation of business. When a sole proprietorship ceases commercial operations to transfer its inventory and business assets to a newly formed corporation, the goods on hand are treated as sold. Consequently, the output Value-Added Tax applies to the market value of the transferred inventories and taxable commercial assets at the time of business retirement or registration cancellation.
2. Tax-Free Exchange
Under Section 40(C)(2) of the Tax Code, no gain or loss is recognized for income tax purposes if property is transferred to a corporation by a person in exchange for stock in such corporation, resulting in that person gaining corporate control. Corporate control requires owning at least fifty-one percent of the total voting stock. When a sole proprietor transfers all business assets to a corporation in exchange for one hundred percent of its capital stock, the transfer constitutes a tax-free exchange where income tax is deferred.
3. Value-Added Tax Scope
Value-Added Tax and income tax are distinct internal revenue taxes governed by separate statutory provisions under the Tax Code. A transaction may be exempt from income tax under corporate reorganization rules while simultaneously remaining subject to Value-Added Tax as a transaction deemed sale. Exemption from income tax under Section 40(C)(2) does not automatically grant exemption from Value-Added Tax under Section 106(B)(4), because Value-Added Tax attaches to the privilege of transferring taxable commercial goods and inventories upon business cessation.