Corporate nationality and investments in the Philippines

Author: | Published: 1 Jul 2012
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The Philippines is back in the game.

In the 1960s, the Philippine economy was considered the second biggest in Asia – next only to that of Japan. Changes in leadership and economic policies through the years, unfortunately, resulted in slower economic growth. In recent years, however, investor confidence in the Philippines has been renewed, with the Philippines being given labels such as "break-out nation", one of "the NEXT-11" and "the largest economy in South East Asia by 2050".

In the first quarter of 2012, the Philippines' $225 billion economy expanded by 6.4%, the fastest since 2010. Among Asia's currencies, the Philippine peso has fared as one of the best performing against the United States dollar in the past few years. In addition, Moody's Investor Service has announced a positive outlook on the Philippines, and Standard & Poor's has raised the Philippines' long-term foreign currency-denominated debt rating to the highest level since 2003 (see 'Philippines Targets $10 Billion of Annual Investments', Bloomberg, July 17 2012).

With a government determined to eradicate graft and corruption, investors are beginning to once again flock to the country once called the Sick Man of Asia. Last year alone, approximately $6 billion-worth of investments were pledged and other foreign companies are set to come to the Philippines to explore possible opportunities in the country. In fact, in the fast-growing business process outsourcing sector, the Philippines is now considered the world leader.

As with investing in any country, the first question that a foreign investor asks is: What areas of economic activities are open to foreign ownership? This question can easily be answered by mentioning the percentage of ownership allowed to foreign investors. The more critical issue, however, is how the nationality of a corporation is determined under Philippine law for purposes of investment.

Nationality restrictions on areas of investment


Article XII, Section 10 of the Philippine Constitution states that Congress must, upon recommendation of the economic and planning agency, when the national interest dictates, reserve to citizens of the Philippines or to corporations or associations at least 60% of whose capital is owned by such citizens, or such higher percentage as Congress may prescribe, certain areas of investments. In 1991, Congress promulgated Republic Act No. 7042, or the Foreign Investments Act (FIA), reserving certain areas of economic activities to Filipinos. These areas are referred to as fully nationalised (where no foreign ownership is permitted) or partly-nationalised (where foreign ownership is subject to a cap) activities.

Under the FIA, foreign investors may own up to 100% of domestic market enterprises unless foreign ownership is prohibited or limited by the Constitution and existing law or the Foreign Investment Negative List (Negative List) referred to under Section 8 of the FIA. Section 8 states that the Negative List must have two components: List A and List B. List A enumerates the areas of activities reserved to Philippine nationals by mandate of the Constitution and specific laws, while List B contains the areas of activities and enterprises regulated pursuant to law. Amendments to List B may be made upon the recommendation of the Secretary of National Defense or Health or Education, Culture and Sports, endorsed by the National Economic Development Agency, approved by the President, and promulgated through a Presidential proclamation. Amendments to List B can not be made by the President more often than once every two years. The latest Negative List was promulgated by former President Gloria Macapagal-Arroyo through Executive Order No. 858 on February 5 2010.

Under List A of the latest Negative List, up to 40% foreign equity is permitted in the following areas: exploration, development and use of natural resources; ownership of private lands; operation and management of public utilities; ownership and administration of educational institutions; culture, production, milling, processing, trading (excepting retailing) of rice and corn and acquiring by barter, purchase or otherwise, rice and corn and the by-products thereof; contracts for the supply of materials, goods and commodities to government-owned or controlled corporations, company, agency or municipal corporations; project proponents and facility operators of Build-Operate-Transfer projects requiring a public utilities franchise; operation of deep sea commercial fishing vessels; adjustment companies; and ownership of condominium units (where the common areas are co-owned by the owners of the separate units or owned by a corporation). Higher caps on foreign ownership are imposed on other areas of economic activities

List B allows up to 40% foreign equity in the following sectors: manufacturing, repair, storage and/or distribution products requiring clearance from the Philippine National Police or Department of National Defense; manufacture and distribution of dangerous drugs; sauna and steam bathhouses, massage clinic and other like activities; all forms of gambling (subject to certain exceptions); domestic market enterprises with paid-in capital of less than the equivalent of $200,000; and domestic market enterprises which involve advanced technology or employ at least 50 direct employees with paid-in capital of less than the equivalent of $100,000.

Consistent with Article XII, Section 11 of the Constitution, Section 3 (a) of the FIA defines the term "Philippine national" as (a) a citizen of the Philippines; (b) a domestic partnership or association wholly owned by citizens of the Philippines; (c) a corporation organised under the laws of the Philippines of which at least 60% of the capital stock outstanding and entitled to vote is owned and held by citizens of the Philippines; or (d) a corporation organised abroad and registered as doing business in the Philippines under the Corporation Code of which 100% of the capital stock outstanding and entitled to vote is wholly owned by Filipinos or a trustee of funds for pension or other employee retirement or separation benefits, where the trustee is a Philippine national and at least 60% of the fund will accrue to the benefit of Philippine nationals. Nonetheless, where a corporation and its non-Filipino stockholders own stocks in a Securities and Exchange Commission (SEC)-registered enterprise, at least 60% of the capital stock outstanding and entitled to vote of each of both corporations must be owned and held by citizens of the Philippines, in order for the corporation to be considered a Philippine national.

The question of nationality is easily answered when the stockholders are individuals. The rule is not as straightforward where the investee corporation has corporate stockholders, however.

In the recent case of Gamboa v Teves  (G.R. 176579, June 28 2011, 652 SCRA 690), the Supreme Court took the opportunity to define the term "capital" in Article XII, Section 11 of the Constitution in relation to determining the nationality of a corporation engaged in the operation of a public utility. The issue was mainly whether all of a corporation's outstanding capital stock should be considered in determining the corporation's nationality for purposes of participating in fully nationalised or partly nationalised activities. The petitioner in that case argued that only those shares that entitle the shareholder to vote for members of the company's board of directors were relevant for determining nationality. In its decision dated June 29 2011, the Supreme Court agreed and ruled that, in light of the intention behind the Constitution's granting effective control of enterprises in fully or partly nationalised activities to Filipinos, the term "capital" in Section 11, Article XII of the Constitution refers only to shares of stock that entitle their stockholders to vote in the election of directors, and not to the total outstanding capital stock comprising both common and non-voting preferred shares. This ruling would have validated the current practice of structuring foreign investments in nationalised activities in the Philippines through the issuance of non-voting preferred shares.

In its resolution (G.R. No. 176579, October 9 2011) of the motion for reconsideration filed by the respondents in Teves, however, the Supreme Court – while denying such motion – appeared to have modified its earlier decision. It held that the 60-40 ownership requirement in favour of Filipino citizens must apply separately to each class of shares, whether common, preferred non-voting, preferred voting or any other class of shares. The highest court reasoned that since the constitutional requirement of at least 60% Filipino ownership applies not only to voting control of the corporation but also to the beneficial ownership of the corporation, it is therefore imperative that such requirement apply uniformly and across the board to all classes of shares, regardless of nomenclature and category, comprising the capital of a corporation. According to the court, this is because, under the Corporation Code, capital stock consists of all classes of shares issued to stockholders – that is, common shares as well as preferred shares, which may have different rights, privileges or restrictions as stated in the articles of incorporation. The court noted that preferred shares, even if denied the right to vote in the election of directors, are in fact entitled to vote on the certain corporate matters. Accordingly, the court held that "since a specific class of shares may have rights and privileges or restrictions different from the rest of the shares in a corporation, the 60-40 ownership requirement in favour of Filipino citizens in Section 11, Article XII of the Constitution must apply not only to shares with voting rights but also to shares without voting rights."

Methods of determining nationality

In determining the nationality of a corporation, three methods have been recognised in the Philippine legal system: the place of incorporation test, the control test, and the grandfather rule (SEC-Office of the General Counsel (OGC) Opinion No. 02-12, February 2 2012).

Based on the Corporation Code of the Philippines, the principal test in determining the nationality of a corporation is the Place of Incorporation Test. Simply put, Section 123 of the Code states that a corporation will be deemed a foreign corporation if it was "formed, organised or existing under any laws other than those of the Philippines." For the purpose of determining compliance with nationality restrictions on fully or partly nationalised activities, however, the place of incorporation test is not the only test applicable. For such purpose, the control test has also been adopted by the SEC (SEC Opinion dated November 23 1993).

Under the control test, the nationality of a corporation is determined by the nationality of its stockholders (see SEC Opinion No. 04-40 dated August 10 2004, where the SEC stated that in applying the control test, all of the corporation's capital stock must be considered; this should now be read in light of the Teves decision). To determine the nationality of a corporation under the control test, the formula is quite simple: a corporation is automatically considered a Filipino national if at least 60% of its capital is owned by Filipino citizens.

In addition to the above tests, a third test has been applied by the SEC in determining the nationality of a corporation for purposes of meeting the nationality requirements in certain activities. Known as the grandfather rule, this method applies when a corporation is owned by another corporation with foreign stockholdings (SEC Opinion No. 31-10 dated December 9 2010; see also SEC-OGC Opinion No. 19-07 dated November 28 2007). Under this rule, nationality is determined by breaking down the equity structure of the component corporation(s). If the percentage of Filipino ownership in the corporation is less than 60%, only the number of shares corresponding to such percentage will be counted as of Philippine nationality. This is done by multiplying the number of shares in the corporate shareholder owned by Filipinos by the number of shares of that corporate shareholder in the investee company, and then adding the numbers of shares owned by Filipinos in the investee company. One must not stop until the citizenships of the individual or natural stockholders of layer after layer of investing corporations have been established, the very essence of the grandfather rule (see SEC En Banc Case No. 09-09-177 dated March 25 2010; some commentators have also stated, relying on the early case of Palting v San Jose Petroleum (18 SCRA 924 (1966)), that the application of the grandfather rule cannot go beyond what is reasonable – for instance, the SEC has suggested in the past that the grandfather rule be applied up to three levels in relation to shares not traded in the stock exchange (Cesar Villanueva, Philippine Corporate Law 66 (2010))).

Take for example Corporation Y, whose voting stock is owned 60% by Corporation Z, with the remaining 40% in Corporation Y being owned by foreigners. Corporation Z, in turn, is 60% owned by Filipino individuals and 40% owned by foreign individuals. Under the grandfather rule, Corporation Y is not necessarily considered a Filipino national because Corporation Z's investment of 60% will have to be broken down to determine the respective actual, indirect interests in Corporation Y of Corporation Z's Filipino and foreign shareholders. The respective resulting indirect interests in Corporation Y of Corporation Z's Filipino and foreign shareholders will then be added to the existing direct Filipino and/or foreign interests in Corporation Y. To illustrate, Corporation Z's shareholding in Corporation Y (60%) multiplied by Corporation Z's shares of stock actually owned by Filipinos (60%) results in 36% Filipino ownership. This means that, under the grandfather rule, Corporation Y is not a Filipino national because the percentage of shareholding actually held by Filipino citizens is less 60%.

Nevertheless, in both the control test and the grandfather rule, Section 3 (a) of the FIA requires a second element: where a corporation and its non-Filipino stockholders own stocks in an SEC-registered enterprise, at least 60% of the capital stocks outstanding and entitled to vote of both corporations must be owned and held by citizens of the Philippines and at least 60% of the members of the board of directors of both corporations must be citizens of the Philippines, in order for the corporations to be considered a Philippine national.

Control test v grandfather rule

As both tests have been applied in determining the nationality of a corporation for purposes of investment, the question of which of these two tests should be applied is a recurrent issue. It would be well to note that the control test and the grandfather rule are in fact two parts of one rule (DOJ Opinion No. 20 dated May 5 2005). In the 1967 SEC Rules implementing the requirements of the Constitution and other laws imposing nationality restrictions for the exploitation of natural resources, the nationality of a corporation with foreign equity was to be determined as follows: "shares belonging to corporations or partnerships at least 60% of the capital of which is owned by Filipino citizens will be considered as of Philippine Nationality, but if the percentage of Filipino ownership in the corporation or partnership is less than 60%, only the number of shares corresponding to such percentage will be counted as of Philippine nationality." The Department of Justice (DOJ) has explained that the first part of the rule is what is now essentially known as the control test. It is the more liberal rule because there will be no need to look into the equity or ownership of an investing corporation as long as at least 60% of the investee-company is Filipino-owned. Meanwhile, the second part of the rule corresponds to what is now termed as the grandfather rule. In contrast, it is the more stringent of the two rules, since the equity or ownership of both the investing and investee-company must be broken down and ownership traced and thereafter combined (grandfathered, in other words) in order to determine the actual percentage of Filipino ownership.

But when should each test apply?

Both these tests appear to be relevant when fully or partly nationalised activities are involved. According to the DOJ and the SEC, however, the grandfather rule should be applied when the shareholders of a corporation are also corporations and the voting stock owned by Filipinos in the former is less than 60% of the voting stock or the 60-40 Filipino-foreign equity ownership is in doubt: in cases where a joint venture corporation with less than 60% Filipino stockholdings invests in another joint venture corporation which is either 60% or less than 60% Filipino (SEC-OGC Opinion No. 26-11 dated April 19 2011). Otherwise, where 60% Filipino ownership is well established, the grandfather rule will not apply and the control test will be applicable (DOJ Opinion No. 20 dated May 5 2005). Thus, if say only 50% of the capital stock or capital of the corporation or partnership belongs to Filipino citizens, the grandfather rule will apply (SEC Opinion dated November 23 1993, citing DOJ Opinion dated January 19 1989).

Structuring investments

Without labouring the point, the rules on determining nationality must be taken seriously as any violation of nationality restrictions will not only result in the imposition of heavy fines but may, depending on the circumstances, trigger penal liability (under the Anti-dummy Law, for example).

With the resurgence of foreign investment in the Philippines, caution must be taken by foreign investors in setting up wholly or majority foreign-owned vehicles that will, in turn, own companies in the Philippines that will engage in partly-nationalised activities. Previously, foreign investors have resorted to the issuance of non-voting preferred shares to avoid breaching nationality restrictions. Following the Supreme Court's resolution of the motion for reconsideration in Teves, foreign investors may have to rethink their investment strategies by veering away from equity options and instead exploring the debt side of the investment equation.

Aris L Gulapa
  Aris L Gulapa

Aris L Gulapa is a partner at Caguioa & Gatmaytan, specialising in corporate and commercial transactions, particularly mergers and acquisitions, banking, corporate finance, and corporate restructuring. He has advised and assisted leading banks and financial institutions, multinational corporations and other clients in the course of his diverse practice in Manila, Singapore, Vietnam and Tokyo.

Gulapa recently advised a publicly-listed French company and an Indonesian pharmaceutical company in restructuring their Philippine subsidiaries. He is assisting one of the leading IT companies based in the US in a potential share acquisition in the Philippines, a Thai investor in setting up a manufacturing plant in Luzon, and a Philippine manufacturing company in a potential joint venture with a foreign metalloid supplier.

Gulapa graduated with honours from the Ateneo de Manila University School of Law in 2003 (ranking fifth in his class) and was admitted to the Philippine Bar in 2004. He obtained his Masters of Law (LLM) in Trade Regulation in 2011 from the New York University, where he was a recipient of the Arthur T Vanderbilt scholarship. He passed the New York bar in 2011 and is awaiting admission.

Before joining Caguioa & Gatmaytan, Gulapa worked at SyCip Salazar Hernandez & Gatmaitan (December 2003 to June 2006); Kelvin Chia Partnership (Singapore and Vietnam offices, July 2006 to June 2008); and Anderson Mori & Tomotsune (Tokyo office, July 2008 to June 2010). He is also a member of the faculty of Ateneo de Manila University College of Law, where he teaches trade regulation subjects, including Asean Economic Law and Relations.

Pamela Joy L Alquisada
  Pamela Joy L Alquisada

Pamela Joy L Alquisada is an associate at Caguioa & Gatmaytan, specialising in corporate and commercial transactions, particularly mergers and acquisitions and general corporate housekeeping. She advises multinational companies in relation to incorporation, structuring, and regulatory compliance. She provides corporate housekeeping and general corporate advisory services to several foreign-invested Philippine companies.

Recently, Alquisada led a team in closing an acquisition by a major manufacturing company based in the US (Central) of the assets of one of the pioneer equipment manufacturing enterprises in the Philippines. She is assisting a global lighting company in setting up a subsidiary in the Philippines.

Alquisada graduated with honours from the Ateneo de Manila University School of Law in 2009. She was admitted to the Philippine bar in 2010. 

Ben Dominic R Yap

Ben Dominic R Yap
Caguioa & Gatmaytan

30/F 88 Corporate Center
Sedeño cor. Valero Streets
Salcedo Village, Makati City 1227
Philippines

T: (632) 894-0377 to 79; (632) 894-4931 to 32; (632) 552-1977
F:
(632) 552-1978
E:
bdryap@cagatlaw.com

Ben Dominic R Yap is a partner of Caguioa & Gatmaytan. He specialises in litigation and arbitration and has handled a broad range of cases before various Philippine courts and quasi-judicial bodies. He recently acted as counsel in an ICC arbitration involving a Philippine power generation company and two multinational oil companies, and is currently acting as counsel in another ICC arbitration involving a Philippine solar wafer slicing company and a Korean wafer company.

Yap's practice recently expanded to include work in the energy sector. He is assisting a leading Philippine generation conglomerate on the financing and construction of a 300-MW coal-fired plant and with the fuel supply requirements of another 600-MW coal-fired plant.

Yap co-authored several articles on doing business and dispute resolution published by the American Bar Association in 2005, 2006 and 2010. He was cited as a leading Philippine lawyer in the corporate/commercial field by a leading legal directory in its 2012 publication.

He obtained his degree in Legal Management from Ateneo de Manila University in 1993. He graduated with honours from its College of Law in 1997, ranked second. He was also the recipient of the school's Evelio Javier Leadership Award. Yap was admitted to the Philippine Bar in 1998.