Improperly Accumulated Earnings

A corporation’s profits and losses are accumulated to the Company’s Retained earnings. The stockholders receive their profit share through dividends that are being declared at the discretion of the Company’s Board of Directors (BOD) provided that the Retained earnings account has a positive balance.

As the declaration of dividends are upon the will of the BOD, it may not be a regular activity of the Company especially when it comes with a price, a ten percent (10%) final tax based on the amount of dividends declared. With this in consideration, corporations do not normally distribute dividends on a regular basis, hence there are oversights on the excessive retention of its profits.

As a general rule, Section 42 of the Revised Corporation Code of the Philippines prohibits stock corporations from retaining or accumulating surplus profits in excess of its paid-in capital (capital stock and additional paid in capital combined). It shall be noted that if the accumulation of profit is justifiable and within the reasonable business needs of the Company, which shall be properly supported and documented, it shall not be referred to as an improper accumulation.

On the perspective of the Bureau of Internal Revenue (BIR), however, non-distribution of company profits may be perceived as avoidance of the 10% final tax imposed on dividends which may have led to the concept of the Improperly Accumulated Earnings Tax (IAET).

Section 29 of the National Internal Revenue Code (NIRC) imposes an IAET equal to 10% on the improperly accumulated taxable income of each corporation for each taxable year. Be it noted that this is applicable to all corporations except publicly-held corporations, banks and other nonbank financial intermediaries, insurance companies, taxable partnerships, general professional partnerships, non-taxable joint ventures, enterprises duly registered with the Philippine Economic Zone Authority (PEZA) and under R.A. 7227, and enterprises registered under special economic zones enjoying special tax rate.

For purposes of computation of the IAET, please refer to the illustration below (based on the provisions of NIRC, Sec. 29):

Taxable incomeXXX
Add:  Income exempt from taxXXX
Income excluded from gross incomeXXX
Income subject to final taxXXX
Less:Dividends paid (actual or constructive)XXX
Income tax paid for the yearXXX(XXX)
Improperly accumulated taxable incomeXXX
Tax rate10%
Improperly accumulated income taxXXX

Accumulation of surplus profits may be avoided by declaring dividends. Likewise, appropriating a part of the Company’s retained earnings for reasonable needs like material business plan of the Company such as future business expansion, expected material purchase of equipment, etc., will not be considered as improper accumulation of the Company’s earnings. As mentioned earlier, these should be properly supported and documented to qualify as a reasonable business need of the Company.

Aside from the imposition of IAET by the BIR, penalties are also being imposed by the Securities and Exchange Commission (SEC) to the aforementioned corporations. This is why companies are encouraged to regularly monitor its retained earnings to prevent incurrence of unnecessary costs.

It is very evident that whether to distribute or to accumulate surplus profits without justifiable reason will have a cost either way. It is still in the Company’s advantage on how it will plan the effective and timely utilization of its funds in accomplishing its set goals without defying the regulations of the government authorities and regulators.