COMISSIONER OF INTERNAL REVENUE, PETITIONER, VS. VICENTE A. RUFINO AND REMEDIOS S. RUFINO, ERNESTO D. RUFINO AND ELVIRA B. RUFINO, RAFAEL R. RUFINO AND JULIETA A. RUFINO, MANUEL…

CRUZ, J.:

Petition for review on certiorari of the decision of
the Court of Tax Appeals absolving the private respondents from liability for
capital gains tax on the stocks received by them from the Eastern Theatrical,
Inc.  These were originally four cases involving appeals from the decision of
the Commissioner of Internal Revenue dated July 11, 1966, holding the said
respondents, Vicente A. Rufino and Remedios S. Rufino, Ernesto D. Rufino and
Elvira B. Rufino, Rafael R. Rufino and Julieta A. Rufino, and Manuel S. Galvez
and Ester R. Galvez, liable for deficiency income tax, surcharge and interest in
the sums of P44,294.88, P27,229.44, P58,082.60 and P58,074.24, respectively, for
the year 1959.

The facts, as narrated by the Court of Tax Appeals, are as
follows:

The private respondents were the majority stockholders of the
defunct Eastern Theatrical Co., Inc., a corporation organized in 1934, for a
period of twenty-five years terminating on January 25, 1959.  It had an original
capital stock of P500,000.00, which was increased in 1949 to P2,000,000.00,
divided into 200,000 shares at P10.00 per share, and was organized to engage in
the business of operating theaters, opera houses, places of amusement and other
related business enterprises, more particularly the Lyric and Capitol Theaters
in Manila.  The President of this corporation (hereinafter referred to as the
Old Corporation) during the year in question was Ernesto D. Rufino.

The
private respondents are also the majority and controlling stockholders of
another corporation, the Eastern Theatrical, Inc., which was organized on
December 8, 1958, for a term of 50 years, with an authorized capital stock of
P200,000.00, each share having a par value of P10.00.  This corporation is
engaged in the same kind of business as the Old Corporation.  The
General-Manager of this corporation (hereinafter referred to as the New
Corporation) at the time was Vicente A. Rufino.

In a special meeting of
stockholders of the Old Corporation on December 17, 1958, to provide for the
continuation of its business after the end of its corporate life, and upon the
recommendation of its board of directors, a resolution was passed authorizing
the Old Corporation to merge with the New Corporation by transferring all its
business, assets, goodwill, and liabilities to the latter, which in exchange
would issue and distribute to the shareholders of the Old Corporation one share
for each share held by them in the said Corporation.

It was expressly
declared that the merger of the Old Corporation with the New Corporation was
necessary to continue the exhibition of moving pictures at the Lyric and Capitol
Theaters even after the expiration of the corporate existence of the former, in
view of its pending booking contracts, not to mention its collective bargaining
agreements with its employees.

Pursuant to the said resolution, the Old
Corporation, represented by Ernesto D. Rufino as President, and the New
Corporation, represented by Vicente A. Rufino as General Manager, signed on
January 9, 1959, a Deed of Assignment providing for the conveyance and transfer
of all the business, property, assets and goodwill of the Old Corporation to the
New Corporation in exchange for the latter’s shares of stock to be distributed
among the shareholders on the basis of one stock for each stock held in the Old
Corporation except that no new and unissued shares would be issued to the
shareholders of the Old Corporation; the delivery by the New Corporation to the
Old Corporation of 125,005-3/4 shares to be distributed to the shareholders of
the Old Corporation as their corresponding shares of stock in the New
Corporation; the assumption by the New Corporation of all obligations and
liabilities of the Old Corporation under its bargaining agreement with the
Cinema Stage & Radio Entertainment Free Workers (FFW) which included the
retention of all personnel in the latter’s employ; and the increase of the
capitalization of the New Corporation in compliance with their agreement.  This
agreement was made retroactive to January 1, 1959.

The aforesaid transfer
was eventually made by the Old Corporation to the New Corporation, which
continued the operation of the Lyric and Capitol Theaters and assumed all the
obligations and liabilities of the Old Corporation beginning January 1,
1959.

The resolution of the Old Corporation of December 17, 1958, and the
Deed of Assignment of January 9, 1959, were approved in a resolution by the
stockholders of the New Corporation in their special meeting on January 12,
1959.  In the same meeting, the increased capitalization of the New Corporation
to P2,000,000.00 was also divided into 200,000 shares at P10.00 par value each
share, and the said increase was registered on March 5, 1959, with the
Securities and Exchange Commission, which approved the same on August 20,
1959.

As agreed, and in exchange for the properties, and other assets of
the Old Corporation, the New Corporation issued to the stockholders of the
former stocks in the New Corporation equal to the stocks each one held in the
Old Corporation, as follows:

It was this above-narrated series of transactions that the
Bureau of Internal Revenue examined later, resulting in the petitioner declaring
that the merger of the aforesaid corporations was not undertaken for a bona
fide business purpose but merely to avoid liability for the capital gains
tax on the exchange of the old for the new shares of stock.  Accordingly, he
imposed the deficiency assessments against the private respondents for the
amounts already mentioned.  The private respondents’ request for reconsideration
having been denied, they elevated the matter to the Court of Tax Appeals, which
reversed the petitioner.

We have given due course to the instant petition
questioning the decision of the said court in holding that there was a valid
merger between the Old Corporation and the New Corporation and declaring
that:

“It is well established that where stocks for stocks were
exchanged, and distributed to the stockholders of the corporations, parties to
the merger or consolidation, pursuant to a plan of reorganization, such exchange
is exempt from capital gains tax…..

“In view of the foregoing, we are
of the opinion and so hold that no taxable gain was derived by petitioners from
the exchange of their old stocks solely for stocks of the New Corporation
pursuant to Section 35(c)(2), in relation to (c)(5), of the National Internal
Revenue Code, as amended by Republic Act 1921.”^[1]

The above-cited Section 35 of the
Tax Code, on the proper interpretation and application of which the resolution
of this case depends, provides in material part as follows:

“Sec. 35. 
Determination of gain or loss from the sale or other disposition of property.  –
The gain derived or loss sustained from the sale or other disposition of
property, real, personal or mixed, shall be determined in accordance with the
following schedule:

xxx

xxx

xxx

(c)  Exchange of property —

(1)  General Rule. 
— Except as herein provided, upon the sale or exchange of property, the entire
amount of the gain or loss, as the case may be, shall be recognized.

(2) 
Exceptions. —  No gain or loss shall be recognized if in pursuance of a
plan of merger or consolidation (a) a corporation which is a party to a merger
or consolidation, exchanges property solely for stock in a corporation which is
a party to the merger or consolidation, (b) a shareholder exchanges stock in a
corporation which is a party to the merger or consolidation solely for the stock
of another corporation, also a party to the merger or consolidation, or (c) a
security holder of a corporation which is a party to the merger or consolidation
exchanges his securities in such corporation solely for stock or securities in
another corporation, a party to the merger or consolidation.

xxx

xxx

xxx

(5)  Definitions.  – (a) x x x (b) The term ‘merger’ or
‘consolidation’, when used in this section, shall be understood to mean:  (1)
The ordinary merger or consolidation, or (2) the acquisition by one corporation
of all or substantially all the properties of another corporation solely for
stock; Provided, That for a transaction to be regarded as a merger or
consolidation within the purview of this section, it must be undertaken for a
bona fide business purpose and not solely for the purpose of escaping
the burden of taxation; Provided further, That in determining whether a bona
fide business purpose exists, each and every step of the transaction shall
be considered and the whole transaction or series of transactions shall be
treated as a single unit:  x x x.”

In support of its position that the Deed of Assignment was
concluded by the private respondents merely to evade the burden of taxation, the
petitioner points to the fact that the New Corporation did not actually issue
stocks in exchange for the properties of the Old Corporation at the time of the
supposed merger on January 9, 1959.  The exchange, he says, was only on paper. 
The increase in capitalization of the New Corporation was registered with the
Securities and Exchange Commission only on March 5, 1959, or 37 days after the
Old Corporation expired on January 25, 1959.  Prior to such registration it was
not possible for the New Corporation to effect the exchange provided for in the
said agreement because it was capitalized only at P200,000.00 as against the
capitalization of the Old Corporation at P2,000,000.00.  Consequently, as there
was no merger, the automatic dissolution of the Old Corporation on its expiry
date resulted in its liquidation, for which the respondents are now liable in
taxes on their capital gains.

For their part, the private respondents
insist that there was a genuine merger between the Old Corporation and the New
Corporation pursuant to a plan aimed at enabling the latter to continue the
business of the former in the operation of places of amusement, specifically the
Capitol and Lyric Theaters.  The plan was evolved through the series of
transactions above narrated, all of which could be treated as a single unit in
accordance with the requirements of Section 35.  Obviously, all these steps did
not have to be completed at the time of the merger, as there were some of them,
such as the increase and distribution of the stock of the New Corporation, which
necessarily had to come afterwards.  Moreover, the Old Corporation was dissolved
on January 1, 1959, pursuant to the Deed of Assignment, and not on January 25,
1959, its original expiry date.  As the properties of the Old Corporation were
transferred to the New Corporation before that expiry date, there could not have
been any distribution of liquidating dividends by the Old Corporation for which
the private respondents should be held liable in taxes.

We sustain the
Court of Tax Appeals.  We hold that it did not err in finding that no taxable
gain was derived by the private respondents from the questioned
transaction.

Contrary to the claim of the petitioner, there was a valid
merger although the actual transfer of the properties subject of the Deed of
Assignment was not made on the date of the merger.  In the nature of things,
this was not possible.  Obviously, it was necessary for the Old Corporation to
surrender its net assets first to the New Corporation before the latter could
issue its own stock to the shareholders of the Old Corporation because the New
Corporation had to increase its capitalization for this purpose.  This required
the adoption of the resolution to this effect at the special stockholders
meeting of the New Corporation on January 12, 1959, the registration of such
issuance with the SEC on March 5, 1959, and its approval by that body on August
20, 1959.  All these took place after the date of the merger but they were
deemed part and parcel of, and indispensable to the validity and enforceability
of, the Deed of Assignment.

The Court finds no impediment to the exchange
of property for stock between the two corporations being considered to have been
effected on the date of the merger.  That, in fact, was the intention, and the
reason why the Deed of Assignment was made retroactive to January 1, 1959.  Such
retroaction provided in effect that all transactions set forth in the merger
agreement shall be deemed to be taking place simultaneously on January 1, 1959,
when the Deed of Assignment became operative.

The certificates of stock
subsequently delivered by the New Corporation to the private respondents were
only evidence of the ownership of such stocks.  Although these certificates
could be issued to them only after the approval by the SEC of the increase in
capitalization of the New Corporation, the title thereto, legally speaking, was
transferred to them on the date the merger took effect, in accordance with the
Deed of Assignment.

The basic consideration, of course, is the purpose of
the merger, as this would determine whether the exchange of properties involved
therein shall be subject or not to the capital gains tax.  The criterion laid
down by the law is that the merger “must be undertaken for a bona fide
business purpose and not solely for the purpose of escaping the burden of
taxation.” We must therefore seek and ascertain the intention of the parties in
the light of their conduct contemporaneously with, and especially after, the
questioned merger pursuant to the Deed of Assignment of January 9,
1959.

It has been suggested that one certain indication of a scheme to
evade the capital gains tax is the subsequent dissolution of the new corporation
after the transfer to it of the properties of the old corporation and the
liquidation of the former soon thereafter.  This highly suspect development is
likely to be a mere subterfuge aimed at circumventing the requirements of
Section 35 of the Tax Code while seeming to be a valid corporate combination. 
Speaking of such a device, Justice Sutherland declared for the United States
Supreme Court in Helvering v. Gregory:

“When subdivision (b) speaks of a transfer of assets by one
corporation to another, it means a transfer made ‘in pursuance of a plan of
reorganization’ (Section 112[g]) of corporate business; and not a transfer of
assets by one corporation to another in pursuance of a plan having no relation
to the business of either, as plainly is the case here.  Putting aside, then,
the question of motive in respect of taxation altogether, and fixing the
character of proceeding by what actually occurred, what do we find?  Simply an
operation having no business or corporate purpose — a mere devise which put on
the form of a corporate reorganization as a disguise for concealing its real
character, and the sole object and accomplishment of which was the consummation
of a preconceived plan, not to reorganize a business or any part of a business,
but to transfer a parcel of corporate shares to the petitioner.  No doubt, a new
and valid corporation was created.  But that corporation was nothing more than a
contrivance to the end last described.  It was brought into existence for no
other purpose; it performed, as it was intended from the beginning it should
perform no other function.  When that limited function had been exercised, it
immediately was put to death.

“In these circumstances, the facts speak
for themselves and are susceptible of but one interpretation.  The whole
undertaking, though conducted according to the terms of subdivision (b), was in
fact an elaborate and devious form of conveyance masquerading as a corporate
reorganization and nothing else.  The rule which excludes from consideration the
motive of tax avoidance is not pertinent to the situation, because the
transaction upon its face lies outside the plain intent of the statute.  To hold
otherwise would be to exalt artifice above reality and to deprive the statutory
provision in question of all serious purpose.”^[2]

We see no such furtive intention in the instant case.  It is
clear, in fact, that the purpose of the merger was to continue the business of
the Old Corporation, whose corporate life was about to expire, through the New
Corporation to which all the assets and obligations of the former had been
transferred.  What argues strongly, indeed, for the New Corporation is that it
was not dissolved after the merger agreement in 1959.  On the contrary, it
continued to operate the places of amusement originally owned by the Old
Corporation and transferred to the New Corporation, particularly the Capitol and
Lyric Theaters, in accordance with the Deed of Assignment.  The New Corporation,
in fact, continues to do so today after taking over the business of the Old
Corporation twenty-seven years ago.

It may be recalled at this point that
under the original provisions of the old Corporation Law, which was in effect
when the merger agreement was concluded in 1959, it was not possible for a
corporation, by mere amendment of its charter, to extend its life beyond the
time fixed in the original articles; in fact, this was specifically prohibited
by Section 18, which provided that “any corporation may amend its articles of
incorporation by a majority vote of its board of directors or trustees and the
vote or written assent of two-thirds of its members, if it be a non-stock
corporation, or if it be a stock corporation, by the vote or written assent of
the stockholders representing at least two-thirds of the subscribed capital
stock of the corporation x x x:  Provided, however, That the life of
said corporation shall not be extended by said amendment beyond the time fixed
in the original articles x x x.”

This prohibition, which incidentally has
since been deleted, made it necessary for the Old and New Corporations to enter
into the questioned merger, to enable the former to continue its unfinished
business through the latter.

The procedure for such merger was prescribed
in Section 28-1/2 of the old Corporation Law which, although not expressly
authorizing a merger by name (as the new Corporation Code now does in its
Section 77), provided that “a corporation may, by action taken at any meeting of
its board of directors, sell, lease, exchange, or otherwise dispose of all or
substantially all of its property and assets, including its goodwill, upon such
terms and conditions and for such considerations, which may be money, stocks,
bonds, or other instruments for the payment of money or other property or other
considerations, as its board of directors deem expedient.” The transaction
contemplated in the old law covered the second type of merger defined by Section
35 of the Tax Code as “the acquisition by one corporation of all or
substantially all of the properties of another corporation solely for stock,”
which is precisely what happened in the present case.

What is also worth
noting is that, as in the case of the Old Corporation when it was dissolved on
December 31, 1958, there has been no distribution of the assets of the New
Corporation since then and up to now, as far as the record discloses.  To date,
the private respondents have not derived any benefit from the merger of the Old
Corporation and the New Corporation almost three decades earlier that will make
them subject to the capital gains tax under Section 35.  They are no more liable
now than they were when the merger took effect in 1959, as the merger, being
genuine, exempted them under the law from such tax.

By this decision, the
government is, of course, not left entirely without recourse, at least in the
future.  The fact is that the merger had merely deferred the claim for taxes,
which may be asserted by the government later, when gains are realized and
benefits are distributed among the stockholders as a result of the merger.  In
other words, the corresponding taxes are not forever foreclosed or forfeited but
may at the proper time and without prejudice to the government still be imposed
upon the private respondents, in accordance with Section 35(c)(4) of the Tax
Code.  Then, in assessing the tax, “the basis of the property transferred in the
hands of the transferee shall be the same as it would be in the hands of the
transferor, increased by the amount of gain recognized to the transferor on the
transfer.” The only inhibition now is that that time has not yet
come.

The reason for this conclusion is traceable to the purpose of the
legislature in adopting the provision of law in question.  The basic idea was to
correct the Tax Code which, by imposing taxes on corporate combinations and
expansions, discouraged the same to the detriment of economic progress,
particularly the promotion of local industry.  Speaking of this problem, H.B.
No. 7233, which was subsequently enacted into R.A. No. 1921 embodying Section 35
as now worded, declared in the Explanatory Note:

“The exemption from the tax of the gain derived from exchanges
of stock solely for stock of another corporation resulting from corporate
mergers or consolidations under the above provisions, as amended, was intended
to encourage corporations in pooling, combining or expanding their resources
conducive to the economic development of the country.”^[3]

Our ruling then is that the merger in question involved a
pooling of resources aimed at the continuation and expansion of business and so
came under the letter and intendment of the National Internal Revenue Code, as
amended by the above-cited law, exempting from the capital gains tax exchanges
of property effected under lawful corporate
combinations.

WHEREFORE, the decision of the Court of
Tax Appeals is affirmed in full, without any pronouncement as to
costs.

SO ORDERED.

Yap, (Chairman), Narvasa, Melencio-Herrera, Feliciano,
Gancayco, and Sarmiento, JJ., concur.

^[2] 293 U.S. 465, 79 L. ed. 596.

^[3] Rollo, p. 44.