TAXATION OF REPURCHASE AGREEMENTS

By Russell Stanley Q. Geronimo

I. Definition of repurchase agreement

Through a repurchase agreement (“repo”), a bank sells units of a given security to

another party, in exchange for cash. After a certain pre-agreed period, the selling bank
buys back the same number of units of the same security from the buying party, at an
amount higher than the original price of the security. The first part of the transaction (i.e.
sale from bank to buyer) is called the “opening leg”, and the second part (i.e. buyback) is
called the “closing leg”. The repo allows the bank to have liquidity during the period
between the opening and closing legs. The buying party earns from the spread between
the original price of the opening leg and the repurchase price of the closing leg. In the
Philippine money market, the object of a repo is usually a debt instrument, although
technically it can be any security.

II. Repurchase agreements as deposit substitutes

One may structure a repo transaction in such a way that it has substantially the
same financial returns as a certificate of deposit. For instance, a one-year certificate of
deposit with a principal amount of P10 million and an interest of 1% p.a. results in an
interest income of P100 thousand at year-end. A repo may be structured to replicate the
1% interest by having the bank sell units of a debt instrument with total price of P10
million, and buying back the debt instrument at a repurchase price of P10.1 million. The
spread between the original price and the repurchase price, called the “repo rate”, is the
same as the 1% interest on the certificate of deposit. It is in this manner that a repurchase
agreement functions as a deposit substitute.

III. Legal nature of repurchase agreements

While a repo may replicate the economic effects of a certificate of deposit, a repo
is not legally and technically a bank deposit. It is a sale subject to a suspensive condition,
with the condition being the undertaking to repurchase the object of the sale. The transfer
of title over the security subject of the repo, first from seller to buyer, and then from buyer
to seller, is analogous to a collateral arrangement in a secured debt, which exists in order
to enhance the quality of credit. Note that while a certificate of deposit is an insurable
deposit, a repo transaction is not. Therefore, when the bank becomes insolvent, the
Philippine Deposit Insurance Corporation (PDIC) indemnifies the depositors to the extent
of the insured portion of the deposit, but the same protection is not extended to a holder
of a repo. This is the reason why an additional security feature is necessary. In case of
bank insolvency, the repo holder may satisfy the bank’s debt obligation from the proceeds
of the sale of the security subject of the repo while the holder has legal title.
IV. Tax treatment of repurchase agreements

While a repo consists of two transfers of securities, it is treated as a single

transaction for tax purposes. Section 6, RMC No. 95-2017 dated November 10, 2017
(Providing Guidelines on the Tax Treatment of the Government Securities Repurchase
Transactions Governed by the Global Master Repurchase Agreement) provides:

The Repo rate, which is the difference between the original price and the
repurchase price, and other interest income including interest accruing from the
‘cash margin’, shall be subject to 20% final withholding tax (FWT) pursuant to
Sections 27(D)(1) and 28(A)(7) of the 1997 Tax Code, as amended, as well as to
the applicable gross receipts tax (GRT) imposed under Section 127 or 122 of the
same Code. However, any [marked-to-market] gain or loss, and any other realized
gain, arising from subsequent sale of Repo Securities within the Repo period, shall
be subject to Thirty Percent (30%) Corporate Income Tax under Sections 27(A)
and 28(A) and GRT under Section 121 or 122 of the 1997 Tax Code, as amended.

A. Repo gain of domestic corporation

For repo holders which are domestic corporations, the gain from the repo is a
passive income subject to 20% FWT. The applicable income tax provision is Section
27(D)(1) of the Tax Code, which states:

(D) Rates of Tax on Certain Passive Incomes. —

(1) Interest from Deposits and Yield or Any Other Monetary Benefit from
Deposit Substitutes and from Trust Funds and Similar Arrangements, and
Royalties. — A final tax at the rate of twenty percent (20%) is hereby imposed upon
the amount of interest on currency bank deposit and yield or any other monetary
benefit from deposit substitutes and from trust funds and similar arrangements
received by domestic corporations, and royalties, derived from sources within the
Philippines: Provided, however, That interest income derived by a domestic
corporation from a depository bank under the expanded foreign currency deposit
system shall be subject to a final income tax at the rate of fifteen percent (15%) of
such interest income.

B. Repo gain of resident foreign corporation

For repo holders which are resident foreign corporations, the gain from the repo is
a passive income also subject to 20% FWT. The applicable income tax provision is
Section 28(A)(7)(a) of the Tax Code, which states:

(7) Tax on Certain Incomes Received by a Resident Foreign Corporation.

—

(a) Interest from Deposits and Yield or any other Monetary Benefit from
Deposit Substitutes, Trust Funds and Similar Arrangements and Royalties. —
Interest from any currency bank deposit and yield or any other monetary benefit
from deposit substitutes and from trust funds and similar arrangements and
royalties derived from sources within the Philippines shall be subject to a final
income tax at the rate of twenty percent (20%) of such interest: Provided, however,
That interest income derived by a resident foreign corporation from a depository
 bank under the expanded foreign currency deposit system shall be subject to a
final income tax at the rate of seven and one-half percent (7 1/2%) of such interest
income.

C. Repo gain of non-resident foreign corporation

For repo holders which are non-resident foreign corporations, the gain from the
repo is a passive income which forms part of the corporation’s gross income, which is
subject to 32% income tax rate. The applicable tax provision is Section 28(B)(1) of the
Tax Code, which provides:

(1) In General. - Except as otherwise provided in this Code, a foreign

corporation not engaged in trade or business in the Philippines shall pay a tax
equal to thirty-five percent (35%) of the gross income received during each taxable
year from all sources within the Philippines, such as interests, dividends, rents,
royalties, salaries, premiums (except reinsurance premiums), annuities,
emoluments or other fixed or determinable annual, periodic or casual gains, profits
and income, and capital gains, except capital gains subject to tax under
subparagraphs (C) and (D): Provided, That effective 1, 1998, the rate of income
tax shall be thirty-four percent (34%); effective January 1, 1999, the rate shall be
thirty-three percent (33%); and, effective January 1, 2000 and thereafter, the rate
shall be thirty-two percent (32%).

D. Sample computation of income tax on repo gain

To illustrate the foregoing tax provisions, assume that Bank A possesses corporate
bonds issued by XYZ, Inc. To increase its loanable funds, Bank A executes a repo with
Bank B, whereby Bank A sells the XYZ bonds to Bank B, subject to a buyback after one
year and a repo rate of 2%, for an original price of P5 million. At the end of one year, Bank
A repurchases the XYZ bonds from Bank B. Assuming that Bank B is a domestic
corporation, the computation of its taxable gain and final withholding tax is as follows:

Original price P5,000,000

Multiply by: repo rate 2%
Repo gain 100,000
Multiply by: FWT 20%
FWT on repo gain P20,000

The same FWT of P20,000 on the repo is due if Bank B is a resident foreign
corporation. This is because a resident foreign corporation is treated similarly as a
domestic corporation for the purpose of final withholding tax on passive income. If
Bank B is a non-resident foreign corporation, the repo gain of P100,000 is included
in its gross income for the taxable year, which is then subject to 32% income tax.

V. Exemption from documentary stamp tax

A repo is exempt from DST, pursuant to Section 199(h) of the Tax Code, which
provides:
 Section 199. Documents and Papers Not Subject to Stamp Tax. — The
provisions of Section 173 to the contrary notwithstanding, the following
instruments, documents and papers shall be exempt from the documentary stamp
tax:

[...]

(h) Derivatives: Provided, That for purposes of this exemption, repurchase

agreements and reverse repurchase agreements shall be treated similarly as
derivatives.

VI. Trading gain from sale of repo prior to buyback date

A repo holder which sells the repo to a third party prior to the buyback date is
subject to the regular income tax rate, and not FWT on passive income. This is because
the gain from the sale of repo during the interim period does not constitute passive
income, but trading income.

A. Trading gain of domestic corporation

For a domestic corporation selling the repo prior to buyback date, the gain from
the sale forms part of the gross income, subject to 30% of the taxable income. The
applicable provision is Section 27(A) of the Tax Code, which states:
Section 27. Rates of Income Tax on Domestic Corporations.—

(A) In General. — Except as otherwise provided in this Code, an income

tax of thirty-five percent (35%) is hereby imposed upon the taxable income derived
during each taxable year from all sources within and without the Philippines by
every corporation, as defined in Section 22(B) of this Code and taxable under this
Title as a corporation, organized in, or existing under the laws of the Philippines:
Provided, That effective January 1, 2009, the rate of income tax shall be thirty
percent (30%).

B. Trading gain of resident foreign corporation

For a resident foreign corporation selling the repo prior to buyback date, the gain
from the sale also forms part of the gross income, subject to 30% of the taxable income.
The applicable provision is Section 28(A) of the Tax Code, which states:
Section 28. Rates of Income Tax on Foreign Corporations. —

(A) Tax on Resident Foreign Corporations. —

(1) In General. — Except as otherwise provided in this Code, a corporation

organized, authorized, or existing under the laws of any foreign country, engaged
in trade or business within the Philippines, shall be subject to an income tax
equivalent to thirty-five percent (35%) of the taxable income derived in the
preceding taxable year from all sources within the Philippines: Provided, That
effective January 1, 2009, the rate of income tax shall be thirty percent (30%).
C. Trading gain of non-resident foreign corporation

For a non-resident foreign corporation selling the repo prior to buyback date, the
gain from the sale forms part of the gross income, which is subject to the 32% income tax
rate. Section 28(B)(1) of the Tax Code applies whether the corporation earns passive
income or trading income on the repo. Financially, it does not matter whether the non-
resident foreign corporation will wait until the repo’s buyback date, or whether it will sell
the repo prior to buyback date.

D. Sample computation of income tax on repo trading gain

To illustrate, assume that the repo issued by Bank A to Bank B has a term of one
year, but Bank B sold the repo to Bank C after six months. The repo’s original price is P5
million. The repo rate is 2%. The selling price paid by Bank C is P5.05 million. Bank B’s
taxable trading income is P50,000, which forms part of its gross income for the taxable
year, obtained as follows:

Selling price during the interim period P5,050,000.00

Less: original price 5,000,000.00
Repo trading gain P50,000.00