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PICPA / ACPACITax Implications of New Accounting
Standards (PAS 2 and 39)*18 July 2006
*connectedthinking
Agenda
1. Introduction
2. Summary of key changes of PAS 2 and 39 from old GAAP and
related tax effects
3. Application of PAS 2 and 39 – common issues and examples
4. Question and answer
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Summary of Key Changes – PAS 2 and 39
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Summary of Key Changes – PAS 2 and 39
Changes Accounting Implications Tax Implications
LIFO no longer allowed Inventories valued at LIFO need to
be revalued using acceptable
valuation method under PFRS
LIFO also not allowed.
BIR approval for change of
inventory valuation must be
secured within 90 days from start
of taxable year
Inventory needs to be carried
at lower of cost or net
realizable value (selling price
less cost to sell/completion).
Reversal of write-down nowallowed by PAS (not allowed
by previous GAAP)
Difference between cost and net
realizable value treated as a
reconciling item for income tax
purposes
Forex loss can no longer be
capitalized as part of
inventory cost under PAS 21
PAS 2 - Inventories
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Summary of Key Changes – PAS 2 and 39
Changes Accounting Implications Tax Implications
Requires measurement and
recognition of the fair value of
derivatives, including
embedded derivatives
Mark to market/derivative gains or
losses (unrealized in nature) need
to be measured at each reporting
date
Temporary differences and fair
value adjustments are not taxable
income/deductible losses.
Financial assets/liabilities
need to be measured initially
at FV less cost of
transaction. Subsequently,
assets must be measured at
FV as follows:
Fair value adjustments of financial
assets and liabilities will be
charged/credited to operations
(except available for sale financial
assets which is part of the equity
accounts)
Gain or loss to be recognized upon
realization. Necessary to
determine whether realized gain or
loss is capital or ordinary.
Capital loss deductible only to the
extent of capital gains
PAS 39 - Financial Instruments: Recognition and Measurement
18 July 2006
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Summary of Key Changes – PAS 2 and 39
Changes Accounting Implications Tax Implications
1. Assets/liabil ities at FV
through profit and loss - at FV
(market);
2. Held to maturity
investments - at amortized
cost using the effective
interest method
3. Loans and receivables -
same as 2 above
4. Available for sale financial
assets - at FV (market)
Application of effective interest
method will create temporary
difference between actual amount
of interest received/paid and
amount reported under effective
interest method.
Fair value adjustments are timing
differences and are taxable
income/ deductible losses once
realized.
PAS 39 - Financial Instruments: Recognition and Measurement
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Application of PAS – common issues and examples
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PAS 2 - Inventories
Application of PAS –common issues and examples
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Inventory Valuation
Accounting TreatmentGeneral rule - the cost of inventories shall be determined by
using specific identification, FIFO or weighted average cost
formula.
• This cost formula shall be used for all inventories having a
similar nature and use to the entity.
• Different cost formulas may be used on inventories with
different nature or use. (PAS 2, Par. 25).
• LIFO is no longer allowed.
Application of PAS –common issues and examples
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Inventory Valuation
Tax Treatment
• LIFO is not acceptable for income tax purposes pursuant to Item
X(B)(2.1) of RAMO 1-00 dated March 17, 2000.
• In case an entity will change its inventory valuation method
pursuant to PAS 2, it should secure permission from the BIR on
the change in accounting method (Section 41 of the Tax Code
and Section 168 of RR 2).
• If an entity previously uses LIFO for accounting and a different
valuation method for tax, the effect of the change of inventory
valuation shall be a reconciling item in the income tax return in
the year of change.
Application of PAS –common issues and examples
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Inventory Valuation
Accounting Treatment
• Inventories shall be measured at the lower of cost and net
realizable value (PAS 2, Par. 9).
“Net Realizable Value” is the estimated selling price in the
ordinary course of business less the estimated costs of
completion and the estimated costs necessary to make the sale
(PAS 2, Par. 6).
Application of PAS –common issues and examples
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Inventory Valuation
Tax Treatment
Section 145 of RR 2:
The law provides two tests to which each inventory must conform:
1. It must conform as nearly as possible to the best accounting
practice in the trade or business; and
2. It must clearly reflect the income.
• Inventory practice should be consistent from year to year
• An inventory that can be used under the best accounting
practice showing the financial position of the taxpayer is, as a
general rule, regarded as clearly reflecting his income
Application of PAS –common issues and examples
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Inventory Valuation
Tax TreatmentSection 145 of RR 2 (continued):
3. Any goods in an inventory which are unsalable at normal
prices or unusable or unusable in the normal way because of
damage, imperfections, shop wear, changes of style, odd or
broken lots, or other similar causes, including second hand
goods taken in exchange, should be valued at “bona fide”
selling prices.
• “Bona fide” selling price means actual offerings of goodsduring a period ending not later than 30 days after inventory
date.
Application of PAS –common issues and examples
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Inventory Valuation
Section 96, RR 2
Losses generally
• Must be evidenced by closed and completed transactions.
• The amount of loss must be reduced by the amount of any
insurance or other compensation received, and by the
salvage value, if any, of the property.
Application of PAS –common issues and examples
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Inventory Valuation
Example:Company A manufactured Product X at cost of P100,000.
Product X is usually sold to customers at P110,000 at a 5%
discount.
Delivery cost is estimated to be P10,000.
Question?
How much should be the carrying value of Product X foraccounting and tax purposes?
Application of PAS –common issues and examples
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Inventory Valuation
Example:
Carrying amount of Product X for accounting purposes:
Cost = P100,000
NRV = P94,500 (P110,000 selling price – P5,500 discount –
P10,000 delivery cost)
Carrying amount is P94,500 – lower of cost or NRV
Difference between cost and NRV = P5,500 (charged to cost of
sales)
Application of PAS –common issues and examples
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Inventory Valuation
Example (continued):• Inventory write-down of P5,500, charged to cost of sales, is not
deductible for income tax purposes. Under the tax rules, cost of
sales represents the actual cost of producing / purchasing the
inventory.
• Write-down of Cost to the Net Realizable Value charged to cost
of sales shall only be deductible once realized.
• Any recovery in the value of the inventory will also not be
recognized as a taxable income.
Application of PAS –common issues and examples
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Cost of Inventories
Application of PAS –common issues and examples
Deferred payment costs
Foreign exchange differencesSelling costs
Unrelated administrative overheadOther costs to bring inventories to
present location and condition
Storage costsCost of conversion
Abnormal wasteCost of purchase
ExcludesIncludes
Accounting Treatment
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Cost of Inventories
Tax TreatmentSection 146, RR 2
• For merchandise purchased, cost means the invoice price less
trade or other discounts, except strictly cash discounts,
approximating a fair interest rate, which may be deducted or not
at the option of the taxpayer, provided a consistent course is
followed.
• To this net invoice price should be added transportation or
other necessary charges incurred in acquiring possession of thegoods.
Application of PAS –common issues and examples
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Cost of Inventories
Accounting treatment for inventory purchases with deferred
settlement terms
• Recognize interest related to inventories purchased with
deferred settlement terms as expense over financing period.
Difference between purchase price of inventory and present
value of liability is recognized as imputed interest expense.
Tax treatment
• Inventory still valued based on actual cost
• Interest expense as reconciling item for income tax purposes
Application of PAS –common issues and examples
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Cost of Inventories
Example – Purchase of inventory under deferred settlement:
Purchase price of merchandise = P100,000
Payment terms = 5 years
Discounted at present value = P80,000
Assumed annual amortization of interest = P4,000
Application of PAS –common issues and examples
Inventory valuation:
P100,000P80,000
Tax Accounting
Reconciling item in ITR: P4,000 non-deductible interest expense
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Write-down of Inventories
Accounting Treatment
• The amount of any write-down of inventories to NRV and all losses
of inventories shall be recognized as an expense in the period when
the write-down or loss occurs. (PAS 2, Par. 34)
Tax Treatment
• Write-down of inventories to NRV is not yet deductible for income
tax purposes unless realized
• Inventory losses due to normal business operations (i.e.
obsolescence) are deductible for income tax purposes
• Write-off of inventories must be accompanied by BIR Certification
of Inventory Destruction
Application of PAS –common issues and examples
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PAS 39 – Financial Instruments: Recognition andMeasurement
Application of PAS –common issues and examples
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Financial Instrument Defined
A financial instrument is any contract that gives rise to a
financial asset of one entity and a financial liability or
equity instrument of another entity. (PAS 32, Par. 11)
Application of PAS –common issues and examples
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Categories of Financial Instruments
A. Financial asset or financial liability at fair value throughprofit
or loss
Classified as held for trading if it is:
• Acquired or incurred principally for the purpose of selling or
repurchasing it in the near term;
• Part of a portfolio of identified financial instrument; or
• A derivative (except for a derivative that is a designated and
effective hedging instrument)
Application of PAS –common issues and examples
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Categories of Financial Instruments
B. Held-to-maturity investments – a non-derivative financial
assets with fixed or determinable payments and fixed maturity
that an entity has the positive intention and ability to hold to
maturity other than:
• those that the entity upon initial recognition designates as at fair
value through profit or loss• those that the entity designates as available for sale; and
• those that meet the definition of loans and receivables
Application of PAS –common issues and examples
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Categories of Financial Instruments
C. Loans and Receivables – a non-derivative financial assets with
fixed or determinable payments that are not quoted in an active
market, other than:
• those that the entity intends to sell immediately or in near term
classified as held for trading, and those that the entity upon initial
recognition designates as at fair value through profit or loss;
• those that the entity upon initial recognition designates as
available for sale; or
• those for which the holder may not recover substantially all ofits
initial investment, other than because of credit deterioration
classified as available for sale.
Application of PAS –common issues and examples
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Categories of Financial Instruments
D. Available-for-sale financial assets – non-derivative financial
assets that are designated as available for sale or are not
classified as (a) loans and receivables, (b) held-to-maturity
investments or (c) financial assets at fair value through profit or
loss.
Application of PAS –common issues and examples
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Initial Measurement
Application of PAS –common issues and examples
Imputed interest is not a taxable
income or deductible expense.
Difference between actual amount of
loan and PV is recognized as interest
income or expense.
Financial assets or liabilities with no
provision for payment of interest shall
be recognized at inception date of the
loan at present value (PV) – effective
interest rate method.
Recognized at contract amount or
transaction value.
Financial assets or liabilities are
recognized at fair market values
(FMV). Transaction costs are
included in the case of financial asset
or liability not at fair value through
profit or loss.
Tax TreatmentAccounting Treatment
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Financial Instrument
Example:
A non-interest bearing notes receivable of P60,000 due in 3 yearly
installments of P20,000. Imputed interest rate of 10%. Present value of the
loan at Year 1 is P49,737.04.
Application of PAS –common issues and examples
49,737.0410,262.9660,000.00
18,181.821,818.1820,000.0018,181.823
16,528.933,471.0720,000.0034,710.742
15,026.304,973.7020,000.0049,737.041
PrincipalInterestAmortizationBalance Year
PaymentOutstanding
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Financial Instrument
Example (continued):
1. Entry to record notes receivable
Dr. Notes receivable 49,737.04
Dr. Interest expense 10,262.96
Cr. Cash 60,000.00
2. Entry to record installment payment on Year 1
Dr. Cash 20,000.00
Cr. Notes receivable 20,000.00
Ann ual accret ion of interest income usin g ef fect ive interest method
Dr. Notes receivable 4,973.70
Cr. Interest income 4,973.70
Application of PAS –common issues and examples
Recon itemin ITR
Recon item
in ITR
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Financial Instrument
Example (continued):
3. Entry to record installment payment on Year 2
Dr. Cash 20,000.00
Cr. Notes receivable 20,000.00
Dr. Notes receivable 3,471.07
Cr. Interest income 3,471.07
4. Entry to record installment payment on Year 3
Dr. Cash 20,000.00
Cr. Notes receivable 20,000.00
Dr. Notes receivable 1,818.18
Cr. Interest income 1,818.18
Application of PAS –common issues and examples
Recon itemin ITR
Recon item
in ITR
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Imputation of Interest Income
Filinvest Development Corporation vs CIR [CA-GR SP No. 72992
dated December 16, 2003
Issue:
Imputation of interest income on Filinvest Development
Corporation’s (FDC) non-interest bearing cash advances based onSection 43 (now Section 50) of the Tax Code
Facts:
• FDC extended several cash advances to its affiliates with nostipulation on interest.
• The CIR imputed interest income on the said advances.
• The CTA upheld the imputation of interest made by the CIR.
Application of PAS –common issues and examples
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Imputation of Interest Income
Filinvest Development Corporation vs CIR [CA-GR SP No. 72992
dated December 16, 2003
CA held:
• Section 43 (now Section 50) of the Tax Code is not applicable in thecase of FDC.
• There is no showing that FDC’s advances to its affiliates are
designed to evade payment of taxes or that FDC deliberatelydevised a scheme to avoid the payment thereof.
• No interest shall be due unless it has been stipulated in writing.
• There is no implementing revenue regulation authorizing the CIR toimpute a theoretical or imaginary interest income.
Application of PAS –common issues and examples
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Imputation of Interest Income
Section 50 of Tax Code
Allocation of Income and Deductions:
In the case of two or more entities, the BIR is authorized to distribute,
apportion, or allocate gross income or deductions between or amongsuch entities if it determines that such distribution, apportionment or
allocation is necessary in order to prevent evasion of taxes or clearly to
reflect the income of said entities.
Application of PAS –common issues and examples
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Requisites for Deductibility of Interest Expense (RR 13-00)
1. An indebtedness exists.*
2. The interest has been paid or incurred.*
3. The indebtedness must be that of that of the taxpayer.*
4. The indebtedness is connected with the taxpayer’s trade, business or
exercise of profession.*
5. The interest was paid or incurred during the taxable year.*
6. The interest is stipulated in writing and must be legally due. [Filinvest
Development Corporation vs CIR (CA-G.R. SP No. 72992 dated December 16,2003) and Article 1956 of the Civil Code]
7. The indebtedness is not between related taxpayers.*
8. The interest was not incurred to finance petroleum exploration.*
9. If incurred on an indebtedness to acquire property, the interest was nottreated as a capital expenditure. (Sec 79 of RR 2)
Application of PAS –common issues and examples
*[Sec 34(B)(1)of the Tax Code]
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Subsequent Measurement
Application of PAS –common issues and examples
Amortization of interest income or
interest expense are non-taxable or
not deductible for income taxpurposes.
Financial assets or liabilities on
amortized cost (loans and receivables
and assets held to maturity)
Gain or loss arising from changes in
fair values of the financial asset are
non-taxable or not deductible for
income tax purposes. Said gain or
loss is recognized for tax purposes
when actually realized or incurred on a
closed and completed transaction
(e.g. upon sale or exchange).
Financial assets at fair value through
profit and loss are charged to P&L
Tax TreatmentAccounting Treatment
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Impairment loss
Application of PAS –common issues and examples
If securities become worthless during
the taxable year and are capital
assets, the loss resulting therefrom
shall be considered as a loss from the
sale or exchange of the capital assets
(Section 34(D)(4) of the Tax Code).
Impairment loss is recognized for a
financial asset measured other than at
fair value. Such impairment is
recognized in the P&L.
Tax TreatmentAccounting Treatment
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Sale or disposition of financial asset
Application of PAS –common issues and examples
Gain or loss on the sale or disposition
of a financial asset is the difference
between the consideration received
and the unadjusted carrying value of
the financial asset (based on
transaction value).
Gain or loss from the sale or
disposition of a financial asset is the
difference between the consideration
received and the carrying value of the
financial asset.
Tax TreatmentAccounting Treatment
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Derivatives and hedging instruments
Application of PAS –common issues and examples
Income/losses from derivatives and
hedging instruments shall be
recognized only when the transaction
covered by the instrument has already
been closed and completed.
The difference between the
transaction and fair values of the
derivatives and hedging instruments is
not taxable.
Derivatives/hedging instruments are
measure at fair values.
Gains or losses on re-measurement to
fair values are included in P&L unless
the derivatives will qualify as cash
flow hedges or hedge of net
investment in a foreign operation
which is recognized as part of equity.
Tax TreatmentAccounting Treatment
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Illustrative Interest rate swap transaction
Counterparty A Bank
Fixed interest rate
(actual loan)
Transaction with interest
Counterparty B
Floating interest
rate
Fixed interest rate
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Derivatives and hedging Instruments
Accounting entries – Swap transaction:
Example: A bank enters into an interest rate swap transaction by paying a
fixed interest rate per annum and receives floating interest rate per quarter
1. At transaction date - Memorandum entry only (“off-books”); reference
asset of the swap transaction (i.e. loan) is only notional.
• There is no interest accrual for the trading book. The interest rate element
is addressed via the daily marking-to-market
2. Mark-to-market valuation at cut-off date
In case the bank recognizes a positive mark -to-market fair value on the
swap, it will recognize a gain in the income statement.
Dr. Unrealised MTM Gain on Trading (B/S) xxx
Cr. Profit and loss account – IRS (P/L) xxx
Application of PAS –common issues and examples
Recon item
in ITR
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Derivatives and hedging Instruments
Accounting entries – Swap transaction:
In case the bank recognizes a negative mark-to-market fair value on the
swap, it will recognize a loss in the income statement.
Dr. Profit and loss account – IRS (P/L) xxx
Cr. Unrealized MTM Loss on Trading (B/S) xxx
Note: The entries to record the swap transaction at fair/market value are
normally reversed in the next business day.
3. At settlement/payment date of the swap, the actual gain or loss on the
swap transaction is recognized.
Application of PAS –common issues and examples
Recon item
in ITR
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Derivatives and hedging Instruments
Accounting entries – Swap transaction:
a. If the swap has a positive fair value
Dr. Cash (B/S) xxx
Cr. Gain on swap transaction (P/L) xxx
b. If the swap has a negative fair value
Dr. Loss on swap transaction (P/L) xxx
Cr. Cash (B/S) xxx
Application of PAS –common issues and examples
Taxable item
in ITR
Deductible
item in ITR
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Derivatives and hedging Instruments
Accounting entries – Option transaction:
Example: A bank (buyer of the option) enters into a currency option
transaction.
1. At trade/contract date - Memorandum entry only (“off-books”)
2. Recording of option premium (Bank has buy option)
Dr. Profit and loss account – Option (P/L) xxx
Cr. Option Premium Payable (B/S) xxx
Application of PAS –common issues and examples
Recon itemIn ITR; not yet
realized
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Derivatives and hedging Instruments
Accounting entries – Option transaction:
3. Mark-to-market valuation at cut-off date
In case the bank recognizes a positive mark -to-market fair value on the
option, it will recognize a gain in the income statement.
Dr. Option Premium Asset (B/S) xxx
Cr. Profit and loss account – Option (P/L) xxx
In case the bank recognizes a negative mark-to-market fair value on the
swap, it will recognize a loss in the income statement.
Dr. Profit and loss account – Option (P/L) xxx
Cr. Option Premium Liability (B/S) xxx
Note: The entries to record the option transaction at fair/market value are
normally reversed in the next business day.
Application of PAS –common issues and examples
Recon itemin ITR
Recon item
in ITR
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Page 49Tax Implications of New Accounting Standards
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Derivatives and hedging Instruments
Accounting entries – Option transaction:
4. On exercise date of the options, the memorandum entry at the date of
transaction will be reversed.
• The actual gain or loss on the transaction is a taxable/deductible item on
exercise date.
Application of PAS –common issues and examples
18 July 2006
Page 50Tax Implications of New Accounting Standards
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Derivatives and hedging Instruments
Taxation of derivatives and hedging instruments
BIR Rulings on swap transactions (BIR Ruling Nos. 137-97;146-95; DA9-01; DA 381-98)
• gains or losses on swap transactions are recognized on a realized
basis for tax purposes
• only net swap receipts/payments are subject to income tax/GRT
• not subject to DST as the reference asset/principal is not an actual
loan agreement but merely notional; also derivatives are not subject toDST pursuant to Section 199(h) of the Tax Code (as amended by RA
9243 or the amended DST law)
Application of PAS –common issues and examples
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Page 51Tax Implications of New Accounting Standards
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Derivatives and hedging Instruments
Taxation on sale of stock options
• Sale of stock options is subject to capital gains tax
• Section 22 (Definitions on “Tax on Income”) of the Tax Code defines“shares of stock” to include warrants and/or options to purchase shares
of stock
• Sale of stock options is not subject to documentary stamp tax
Application of PAS –common issues and examples
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Page 52Tax Implications of New Accounting Standards
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Derivatives and hedging Instruments
Taxation on exercise of stock options (employer-employee transaction)
• Exercise of stock option at an exercise price lower than market value
of the stock gives rise to a taxable event for the person (e.g. employee)exercising the option
• Employer is required to withhold tax (WT on compensation) on thebenefit derived by its employee upon exercise of the stock option.
• DST on original issuance of shares of stock (P1.00 for every P200 of
the par value of shares)
Application of PAS –common issues and examples
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Page 53Tax Implications of New Accounting Standards
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Reclassification
Application of PAS –common issues and examples
Gains or losses arising from
reclassification of financial assets and
liabilities shall have no tax effect.
Reclassification of financial assets
and liabilities.
Tax TreatmentAccounting Treatment
Question and Answer
art4
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Thank you.
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