Rationale of the first limit: Net income at incurrence of capital loss

The amount of capital loss carry-over shall not exceed the net income before dealings in capital
assets in the year the net capital loss was sustained. This rule is anchored on the tax benefit rule. If
the law allowed full deductibility of capital loss, the taxpayer would be benefited only up to the amount
of the net income which the capital loss will erase and save from taxation. The excess of the capital
loss above this amount will not have a tax benefit.

To be fair, the carry over shall not result in allowing the taxpayer more than what he could have
claimed assuming full deductibility of capital loss is allowed by the law. In other words, the carry-over
should not result in undue enrichment to the taxpayer.

Rationale of the second limit: Net capital gain in the following year

The amount of capital loss carry-over shall not exceed the net capital gain in the following year.
Allowing capital loss carry-over in excess of the net capital gain in the following year will create
another net capital loss in the following year which will breach the one-year carry-over rule under the
NIRC.

SPECIAL RULES IN THE DETERMINATION OF TAX BASIS

A. For assets acquired by purchase, the tax basis is the:

1. Acquisition Cost for:
 Capital assets
 Non-depreciable ordinary assets such as land
 Any asset purchased for an inadequate consideration or those acquired at less than their fair
value at the date of acquisition
2. Depreciated Cost for depreciable ordinary assets

Acquisition costs include the purchase price, tax assumed, and acquisition-related costs
such as commissions paid in acquiring the asset.

Illustration: Gain or loss measurement on depreciable assets

Veruela Corporation disposed its old factory for P5,000,000. The lot where the factory building
stands were acquired ten years ago at P1,500,000. Veruela Corporation paid P3,000,000 for
the construction of the factory building. The factory building has a carrying value net of
accumulated depreciation of P1,200,000 at the date of sale.

The tax basis of the factory shall be:

Lot P 1,500,000
Building P 1,200,000
Tax Basis P 2,700,000

Note: The tax basis of the land is the cost. The tax basis of depreciable properties is their
depreciated cost or book value.
 Hence, the gain or loss shall be:

Selling price P 5,000,000

Less: Tax basis of factory P 2,700,000
Gain on sale P 2,300,000

Illustration: Other capital assets

Mr. Monkayo purchased a car he believes would be useful for ten years for P800,000. Before
the third year, he sold the car for P900,000.

Note that the tax basis of capital assets is their acquisition cost. Capital assets are not
depreciated for purposes of taxation. The gain on the sale shall be P100,000 computed as
P900,000 less P800,000 tax basis.

B. Other assets received by exchange, fair value of asset received

C. For assets received by way of gratuitous title:
1. Donation – whichever is lower of:
a) the tax basis on the hand of the donor or the last preceding owner by whom it was not
acquired by donation or
b) fair market value at the date of gift (Sec. 40 (B)(3), NIRC)

If the basis is greater than the market value of the property at the time of donation, then for
purposes of determining the loss, the basis shall be such marker value.

2. Inheritance – fair value of the property on the date of death of the decedent.

Illustration 1: Donation

Mr. Calaponga received a Volkswagen car as donation from his brother who bought the same
in1990 at a cost of P100,000. The car has a fair value of P1,000,000 at the date of donation
but has a current fair value of P1,500,000.

The last preceding owner who did not acquire the property by donation acquired the same at
P100,000. Hence, the basis of the car in the hands of Mr. Calaponga shall be that same basis,
thus P100,000.

Illustration 2: Inheritance

Mr. Siasi inherited a used school bus from his deceased grandfather who purchased the
property for P1,000,000 three years ago. The bus has a depreciated basis of P800,000 in the
business of his grandfather, but has a fair value of P900,000 in the estate tax return of his
grandfather.

The basis of the property in the hands of Mr. Siasi shall be P900,000, the fair value on the date
of death of the decedent.
 Illustration 3: Donation after inheritance

Assuming further that Mr. Siasi donated the bus to a school, what is the basis of the bus to the
school?

The basis of the bus shall be the basis in the hands of the last preceding owner who did not
acquire the property by donation. Mr. Siasi acquired the property by inheritance at a basis of
P900,000. Hence, the same amount shall be the basis of the bus in the hand of the school.

D. For shares received by way of tax-free exchanges

a) For pure share-for-share swap, the tax basis of the shares exchanged or given is the tax basis
of the shares received
b) For share-swap with non-cash consideration, the tax basis shall be the substituted basis
computed as follows:

Transferor

Tax basis of shares exchanged P xxx

Add: Gain recognized P xxx
Amounts treated as dividends of the shareholder P xxx
Less: Cash and fair value of other properties received P xxx
Tax basis of new shares received by the transferor P xxx

Properties received as ‘boot’ shall have the same basis as their fair market value. Boot refers to
the money received and other property received in excess of the stocks or securities received by
the transferor on a tax-free exchange.

Transferee

Original basis in the hands of the transferor P xxx

Add: Gain recognized to the transferor P xxx
Tax basis of the shares received by the transferee P xxx

The rules on tax basis of stocks received pursuant to a plan of merger or consolidation under
capital gains taxation are also relevant to regular income tax for the determination of the
substituted basis of:

a) Stocks, domestic or foreign, received by dealers in securities pursuant to a plan of merger or

consolidation
b) Foreign stocks received by non-dealers in securities pursuant to a plan of merger or
consolidation

TAX FREE EXCHANGES

1. Merger and consolidation

2. Initial acquisition of control
MERGER OR CONSOLIDATION

No gain or loss shall be recognized if in pursuant to a merger or consolidation:

1. A corporation exchanges property solely for the stock of another corporation.

2. A shareholder exchanges his stock in a corporation solely for the stick of another corporation.
3. A security holder of a corporation exchanges his securities in such corporation solely for the
stocks of another corporation.

Both corporations in the aforementioned cases must be parties to a merger or consolidation.

A merger occurs when one corporation acquires all our substantially all of the properties of another
corporation. A consolidation occurs when two or more corporations merged to form one corporation.
The term “securities” includes bonds or debentures but does not include notes of whatever class or
duration.

“Substantially all the properties of another corporation” means the acquisition by one corporation of at
least 80% of the assets, including cash, of another corporation which has the element of permanence
and not merely momentary holding. (BIR General Circular No. V-23, July 16, 1957)

Illustration 1: Corporate party to a merger or consolidation

Pursuant to a plan of merger, ABC Company exchanges a vast track of land with a fair value of
P12,000,000 and tax basis of P10,000,000 for the stocks of DEF Company with a fair value of
P12,500,000 and par value of P11,000,000.

For ABC Company

Fair value of DEF shares received P 12,500,000

Less: Tax basis of the land exchanged P 10,000,000
Indicated gain P 2,500,000

No gain or loss shall be recognized for the property-for-stock transaction pursuant to a plan of
merger or consolidation. The law does not view this as an income-generating exchange but an
investing transaction. The basis of the DEF shares received shall be the basis of the land transferred;
hence, P10,000,000.

Assuming ABC Company exchanged its own shares for the shares of DEF Company, no gain or loss
shall likewise be recognized. The tax basis of the DEF shares received shall be the tax basis of the
ABC shares exchanged.
For DEF Company

Fair value of the land received P 12,000,000

Less: Tax basis of the stocks exchanged (par) P 11,000,000
Excess – share premium P 1,000,000

Similarly, DEF Company shall not be subject to tax as this is a capital transaction involving the issue
of its shares to an investor. The P1,000,000 excess of fair value of the properties received over the
par value of the shares, commonly referred to as “share premium” in accounting, is not income but is
part of capital. No income can be imputed because the issuance of capital stock is a financing
transaction similar to the issuance of a promissory note to obtain cash loan.

Illustration 2: Shareholder of a party to a merger or consolidation

Mr. Downy is a shareholder in ABC Company which is merging with DEF Company. Mr. Downy was
required to surrender his ABC shares with tax basis of P100,000 and fair value of P120,000 in
exchange for DEF shares with a fair value of P140,000.

Fair value of DEF shares received P 140,000

Less: Tax basis of stocks exchanged P 100,000
Indicated gain P 40,000

The P40,000 indicated gain in the share-for-share swap pursuant to a plan of merger or consolidation
shall not be recognized. A loss is likewise not recognized. The tax basis of the DEF shares received
shall be the same as the tax basis of the ABC shares exchanged; hence, P100,000.

Illustration 3: Security holder of a party to a merger or consolidation

Mrs. Wacky is a holder of bonds of ABC Company which is merging with DEF Company. Pursuant to
the plan of merger, Mrs. Wacky was required to exchange her bond investments costing P400,000 for
the shares of DEF Company worth P500,000/

DEF shares received P 500,000

Less: Tax basis of bonds exchanged P 400,000
Indicated gain P 100,000

No gain or loss on the security-for-stock exchange transaction pursuant to a plan of merger or

consolidation shall be recognized. The law also does not consider the receipt of stock as realization.
The tax basis of the shares received shall be the tax basis of the bonds exchanged; hence P400,000.

INITIAL ACQUISITION OF CORPORATE CONTROL

No gain or loss shall be recognized if property is transferred to a corporation by a person in exchange

for the stocks or unit of participation in such a corporation of which as a result of such exchange said
person, alone or together with others, not exceeding four (4) persons, gains control of said
corporation. Provided that stocks issued for services shall not be considered as issued in return for
property.
Illustration 1

Mr. Ali exchanged his land and building with tax basis of P18,000,000 for the stocks of ABC Company
with total par value of P15,000,000. Consequently, Mr. Ali obtained 51% ownership in ABC Company.

No gain or loss shall be recognized in the exchange as it resulted in corporate control. The placement
of investment which resulted in corporate control either solely or with up to four other persons is
viewed by the law as an investing transaction rather than an income-generating exchange
transaction.

Illustration 2

Matthew, Mark, Luke, John, and Peter exchanged their commercial lands (all ordinary assets) for the
stocks of a corporation where they obtained total shareholdings of 60%. Barnabas also rendered
consultancy services to said corporation and was granted 10% shareholdings.

Pursuant to the rule, any gain or loss of Matthew, Mark, Luke, John, and Peter on the transfer shall
not be recognized. The basis their shareholdings shall be the same basis of their lands they
exchanged for the stocks.

Assuming the group was able to obtain only 45% ownership in the corporation, their respective gains
or loss which shall be measured as the difference between the fair value of stocks they respectively
received and the tax basis of the lands they respectively received shall be fair value of the stocks.
Note that if the lands are capital assets, the same shall be subject to the 6% capital gains tax. Still, no
gain will be recognized under regular income tax.

In either case, Barnabas shall report the fair value of the stocks he received as professional income.
The rule covers only exchange of property for stocks where control is obtained by one up to five
persons.