Rescission of a contract to buy and sell: Uncovering tax implications

RELATIONSHIPS and agreements may at times end on a sour note. And more often, when nothing more can be done, parties have no better option but to release each other from their obligations, pick up the pieces, and look forward to move on with anticipation at restoring the status quo.

Legally, the right to rescind or to nullify the agreement is an available remedy to the injured party. The wronged party is entitled to apply with the court for a decree of rescission. However, the right proceeds from a judicial pronouncement, and not from the parties’ prerogative to walk-away from the obligation. To enforce the rescission against the whole world, a binding court decision must be secured.

Such is the case of two corporations that entered into a contract to buy and sell real properties. For failure of one of the parties to comply with its undertakings, a judicial decree to declare the contract void (or rescission of contract) was secured by the wronged party. Both parties were directed by the court to return whatever they had received from each other, with one party returning the purchase price, and the other party reconveying the titles over the real properties.

Ordinarily, restoration would have meant a mere handing over of wares. In a twist, title and ownership over the disputed lands had already been transferred to the buyer. And consequently, to return the disputed lands to the seller, a Certificate Authorizing Registration (CAR) must be obtained from the Bureau of Internal Revenue for the cancellation of titles over the lands and retransfer of the registration to the seller. For the CAR to be issued, the corresponding taxes, i.e. capital gains tax and documentary stamp tax, must be paid or a tax exemption ruling must be obtained.

The gnawing question is whether the reconveyance of the parcels of land should be exempt from the payment of capital gains tax (CGT) and documentary stamp tax (DST).

In the affirmative, the BIR favorably granted exemption from payment of CGT and DST over the reconveyance of the real properties in favor of the seller. The BIR’s position is underpinned by the principle that rescission of a contract is tantamount to declaring a contract void from its inception, as if no contract existed between the parties. In effect, rescission of a contract would not give rise to a taxable event. This principle is supported by the argument that first, no income is realized from a sale or exchange that has been declared void, and second, the return of the property is not for monetary consideration, but merely an acknowledgment of the title or ownership of the original owner of the property.

However, the BIR went a step further to clarify the issue on payment of DST, and this is where the fine line of distinction is drawn. DST is levied on the exercise of certain privileges, regardless of the legal status of the transactions that gave rise to it -- that is, irrespective of whether the contract was declared void or unenforceable. The operative impact of the DST is that it is levied upon the issuance of the specific instrument or document, and not on the legal transaction or agreement evidenced by the document. Thus, DST previously paid on the initial transfer of title is no longer refundable by the BIR, a judicial rescission of the Contract to Buy and Sell notwithstanding.

Perhaps a good lesson that can be culled from this common tale of relations gone wrong would be for the aggrieved party not to forget to seek the recovery of whatever taxes and costs that it had to pay to the BIR in carrying out the original transfer of the property to the defaulting buyer. This way the aggrieved party is fully restored to its former status.

After all, life is full of uncertainties. The least that we can do is to plan ahead, strategize our backup plans, and identify our exit mechanisms to avoid falling into economic traps and to cushion potential detrimental effects.

The author is a director at the tax services department of Isla Lipana & Co., the Philippine member firm of the PricewaterhouseCoopers global network. Readers may send feedback to ma.teresa.t.ledesma@ph.pwc.com.