‘Peace bonds’: market integrity as social good

The Supreme Court has not only ruled on—with an order to release P5 billion in improperly withheld taxes—but also documented the convoluted “Peace bonds” saga in painful detail. The experience should never be repeated except as a cautionary tale in securities and tax law classes.

Where we all enjoy passionate debate on political philosophy and human rights, we must leave securities and tax law as boring as possible. The late senator Raul Roco once stressed that a concept of social justice must underlie our Securities Regulation Code, that it must give access to investment opportunities to poor farmers and fishermen, and help them build more stable financial futures. The overriding values in managing our capital markets must be clarity, predictability and stability—boring values that let the investing public sleep soundly.

Our Bureau of Treasury (BTr) issued the Peace bonds, P35 billion of zero coupon bonds, in 2001. A bond is a debt security that typically makes interest payments at regular intervals, then repays the principal to the investor when it matures after a set period. A zero does not make interest payments, and instead pays all interest along with the principal in a single huge payment at maturity. Thus, the Peace bonds were sold in 2001 for P10.17 billion and were to pay P35 billion to investors in 2011. The mathematics is fair given that the investors receive nothing for 10 years.

Different instruments cater to investors with different needs. A typical bond may suit a retiree who needs a stream of fixed payments during the bond’s lifetime. A zero may suit the parents of a toddler who do not need any returns from the bond until many years later when the child is ready to go to college. The zero’s placing all interest payouts at the very end of the bond’s life spares the parents the problem of reinvesting periodic interest payments—a real problem if interest rates drop and there are no investment opportunities comparable to the original bond. In technical parlance, zeros have no “reinvestment risk.”

Prior to the Peace bonds’ issue, the Bureau of Internal Revenue issued three rulings in 2001 reiterating that they would be tax-free. A 20-percent “deposit substitutes” tax is imposed on the interest paid when an entity borrows from “twenty (20) or more individual or corporate lenders at any one time.” The Peace bonds were intended to be initially sold to one bank only. The BIR ruled that the number of borrowers is determined at the time of the bonds’ initial issuance, and would count only one borrower in the case of the Peace bonds.

The Peace bonds were issued and sold to the bank RCBC. It then sold them to Code-NGO (or Caucus of Development NGO Networks), which could not buy them directly as it was not a licensed securities dealer. Code-NGO sold them at a markup of P1.4 billion to RCBC Capital, and used the markup to fund NGO projects nationwide. RCBC Capital then sold the bonds to various investors.

The confusion began three years later. In response to the BTr’s queries, the BIR issued four new rulings in 2004 and 2005 declaring that the Peace bonds were subject to tax after all. Our largest conglomerates may not change such terms without investor consent, so why should the government be different when it enters the financial market as an ordinary borrower?

Picture a young couple in 2001 whose eldest child just entered Grade 1. They decide to invest in Peace bonds through RCBC, confident that each P120,000 invested will become P350,000 in 2011, in time for the eldest’s high school graduation. They have no worries because there is no reinvestment risk or any risk of the government going bankrupt (as it can always print more money). How would they feel when, in 2004, they hear that a substantial tax might be imposed on the child’s college fund? Clearly, the substantial cost of any policy change will be borne by such investors and the market’s very integrity, not the initial purchasers.

On Oct. 7, 2011, 11 days before the Peace bonds were to mature, the BIR issued a ruling ordering the BTr to withhold deposit substitutes tax from the Peace bonds’ large final payment. Banks, which also represent bondholders, sued, but the BTr withheld the taxes despite a restraining order from the high court. Imagine the shock of a parent who held the bonds since 2001 as his child grew up!

The high court gave a clever and admirably jargon-free resolution. It ruled that the government is not held to the BIR’s 2001 interpretation because it may change mistaken rulings and the BTr has no control over the BIR, a technically correct but rather hollow argument. However, the bonds were in fact initially issued to just one bank and not initially subject to deposit substitutes tax. The BIR must thus first establish when exactly they became held by 20 investors and subject to that tax. Hopefully, future rulings will more explicitly pronounce market integrity as a modern social good.

Still, there are a few technical points to clarify. First, the ruling seems to imply that an investor who sold his bonds may be made responsible for collecting the tax from the next investor. Such an unusual requirement would discourage investment, and no money from the BTr even passes through a preceding investor. Second, the ruling raised the exemption in Section 24 of the Tax Code, where individual persons who hold investments for five years are not taxed on interest earned. However, this has been applied only to bank-issued products, not bonds. Third, the ruling cited RCBC’s term sheet together with its underwriting agreement. I hope nonbinding transaction summaries are not being given undue weight beside formal contracts.

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