PDRs as an instrument for capital raising

Raising capital and expanding foreign investments are pivotal in furthering Philippine economic development. It is crucial, however, to align these important factors with the rights of Philippine citizens to engage in certain activities expressly reserved to them under the Philippine Constitution such as public utilities, mass media and land ownership. To cite a few undertakings, the foreign equity ceiling for the operation of public utilities and companies owning land is 40%; while ownership and management of mass media is reserved solely for Philippine citizens.

As a government initiative to open the Philippine economy, Republic Act (RA) No. 11659 was passed on March 21 amending the Public Service Act of 1935. It liberalized the foreign equity limitations on public utilities imposed by the Constitution by defining “public utility” for the purpose of applying foreign equity limitations. RA 11659 narrowed the list of public utilities to any public service that operates, manages, or controls for public use the distribution of electricity and water, and public utility vehicles, among others. Thus, foreign companies may now wholly manage, operate and control telecommunications, shipping and railways.

Parallel to this government action of expanding the avenue for foreign investments is the raising of capital by businesses. This may be done by issuing debt and securities.

One such security is Philippine Depository Receipts (PDRs). In certain instances, the parent holding company (HoldCo) issues PDRs to investors to source funds for its operating subsidiary (OPCo) which is engaged in wholly or partially nationalized activities.

Considering that a PDR is not a simple form of investment unlike shares of stock, it is crucial to understand the complexity of its tax implications, e.g., the tax impact of issuing PDRs and of dividends received by a foreign PDR holder.

The Court of Tax Appeals (CTA) recently issued a decision with a comprehensive analysis of the nature of PDRs and related tax implications of the involved transactions (CTA Crim. Case Nos. O-679 to O-682 dated Jan. 18, 2023). The HoldCo issued PDRs to its investor to raise capital for its OpCo. The Bureau of Internal Revenue (BIR) considered the transaction a sale of the underlying shares of stock (i.e., shares of stock of the OpCo). It imputed a gain based on the difference between the consideration for the PDRs and the cost of OpCo’s shares.

There are two substantive tax issues lengthily discussed by the CTA. The first is whether the issuance of the PDRs by HoldCo is considered a sale of the underlying shares, such that any trading gain realized from the sale is taxable. The second is whether HoldCo, as the issuer of the PDRs, is a dealer in securities subject to income tax on the imputed trading gain and 12% VAT.

The CTA focused on the nature of PDRs to determine whether the issuance is a taxable event. It recognized that although neither the Tax Code nor the Securities Regulation Code (SRC) define the term PDR, it is classified as a security which grants the holder the right to the delivery of the sale of the underlying shares. PDRs are not statements nor are they certificates of ownership of a corporation. Further, it took cognizance of the SEC clarification that a PDR is an equity derivative since its value is dependent on the underlying equity. In the same vein, the CTA cited Philippine Stock Exchange Circular for Brokers No. 2375-99 which provides that as long as the PDRs remain unexercised by the holder, the latter has no right of ownership over the underlying shares and all such ownership rights pertain to and belong to the issuer. Upon exercise of the option, the PDR holder becomes a shareholder to the extent that such holder is qualified to own the underlying shares.

With this, the Court ruled that PDRs may fall under the classification of securities similar to shares of stock but in a different category under the SRC (i.e., derivatives like options and warrants, and other instruments as may in the future be determined by the Commissioner).

Further, the Court pointed out that there is no wording in the instruments and subscription agreements that would allow the PDR holders to become outright shareholders of the OpCo upon the issuance of the PDRs. They only retain options to purchase the underlying shares subject to certain conditions (e.g., there is no law restricting foreign ownership in the underlying shares of the operating entity).

Furthermore, the Court found that the process whereby the PDRs were issued were investment transactions and did not involve the sale of shares of stock.

Thus, the Court concluded that there is no basis for the alleged imputed trading gain upon the issuance of PDRs.

The CTA explained that a dealer is regularly engaged in the purchase and resale of securities to customers.

By comparison, HoldCo was not habitually or regularly engaged in the purchase or resale of securities. The issuance of PDRs by HoldCo is to raise capital pursuant to its authorized activities. The Court noted the SEC’s acknowledgement that holding companies may engage in investment activities for their subsidiaries as indicated in their Articles of Incorporation with a limitation that said companies will not act as dealers in securities. Thus, the CTA found HoldCo not liable for VAT since it is not a dealer in securities.

Another significant tax consideration of PDRs held by a non-resident foreign corporation (NRFC) is availing of a lower withholding tax on dividends.

The BIR, for its part, recognizes the impact of PDRs in applying the tax sparing rule under Section 28(B)(5)(b) of the Tax Code. Generally, dividends received by an NRFC from a domestic corporation are subject to 25% final withholding tax. However, under the tax sparing rule, the dividends remitted are subject to a preferential rate of 15% if the country where the NRFC is domiciled allows a credit against its taxes due on the dividends, the amount of taxes deemed to have been paid in the Philippines equivalent to 10%, i.e., the difference between the 25% regular corporate income tax rate and the 15% reduced dividend withholding tax rate. Jurisprudence has also established that the lower rate of 15% also applies if the dividends are not taxed in the foreign country where the NRFC resides.

The BIR recognized that a PDR holder is typically entitled to the dividends accruing to the underlying shares. Following Revenue Memorandum Order (RMO) No. 46-2020, a PDR holder is also entitled to avail of the tax sparing rule if: (a) the PDR is coupled with a right to purchase the underlying shares; and (b) such right can be legally exercised.

The basis of the BIR’s argument is that a PDR is considered a share of stock since it falls under the definition of shares of stock in the Tax Code (i.e., shares of stock include warrants and/or options to purchase shares of stock). Thus, a PDR holder is also a shareholder for purposes of this tax sparing rule.

In a post-pandemic era where the economy is almost in full swing to recovery, it is vital for both the business sector and government to work hand-in-hand to ensure continuity of the country’s economic growth. With these alignment and transparency, any complexity can be fully comprehended for the smooth implementation of commercial transactions.

The views or opinions expressed in this article are solely those of the author and do not necessarily represent those of Isla Lipana & Co. The content is for general information purposes only, and should not be used as a substitute for specific advice.


Sylvia B. Salvador is a director at the Tax Services department of Isla Lipana & Co., the Philippine member firm of the PwC network.