Regulatory Compliance on Excessive Retained Earnings

One indicator that a business is in good financial standing is it has excessive retained earnings or accumulated profits. With this, users of the financial statements, for example, investors can decide whether to put up additional funds to expand business operations or banks may approve loan applications. The question is, when do you consider retained earnings excessive and what is the regulatory compliance associated with it?

Retained Earnings; definition and classification

Retained earnings in simplest words, is the excess profit accumulated and generated from business operations net of dividend payment to shareholders. It represents a portion of your business equity that may be used for investment in Research and Development, equipment, or business expansion for example. Retained Earnings may be classified further into two: Unrestricted and Restricted. Restricted retained earnings are those that a business may not distribute as dividends such as appropriation of retained earnings for a loan (as required by loan covenant) while unrestricted retained earnings are those that are available for dividend distribution.

When Retained Earnings Is Excessive and Its Exemption?

Retained Earnings are considered excessive if unrestricted retained earnings are more than the 100% paid-up capital of your company.

If your Philippine Company has excess retained earnings, the financial statements must include the following information in accordance with Section 42 of the Revised Corporation Code (RA 11232):

“Stock corporations are prohibited from retaining surplus profits in excess of one hundred (100%) percent of their paid-in capital stock, except:

Regulatory Compliance Requirement So, unless covered by the limitations listed above, the Securities and Exchange Commission (SEC) in the Philippines requires that the Audited Financial Statements include a Statement of Reconciliation of Retained Earnings Available for Dividend Declaration. The template for such a statement provided by SEC MC No.11-2008 is attached to this article for reference.

It is a key takeaway that the amount of retained earnings of the Company for the reconciliation statement should be based on Retained Earnings of “stand-alone” or Separate Financial Statements. So, if your Company is a Philippines Subsidiary of a Parent Corporation, the amount of retained earnings for such reconciliation is of the PH Subsidiary Company. This is because retained earnings based on consolidated financial statements include a surplus of subsidiaries, which are not yet actual earnings of the parent unless distributed in the form of dividends by the subsidiaries. However, in accordance with Revised SRC Rule 68, the Parent company’s retained earnings reconciliation must be submitted along with the consolidated financial statements.

In reference with PAS 1, the notes to financial statements of Corporations shall disclose information that is relevant to an understanding of the financial statements which includes any provisions indicating retention for expansion projects must be definite and approved by the Board of Directors. The following disclosures are relevant pursuant to PAS 1 to provide an understanding on the impact of the retention of earnings on the financial statements:

(i) Details of the expansion (e.g., description of the project, timeline) to render the project definite;

(ii) The date of the approval of the project by the Board of Directors

Noncompliance of such regulatory requirements will be subjected to appropriate sanction of the SEC upon review of the audited financial statements as per SEC MC 6-2005: “Failure to Comply with any of the requirements of SRC Rule 68 or Incomplete Disclosures in the Financial Statements”

• First Offense: P 25,000.00 + P 500.00 per day of violation
• Second Offense: P 50,000.00 + P 1,000.00 per day of violation
• Third Offense: P 100,000.00 + P 1,000.00 per day of violation

Tax Implications Prior to CREATE LAW, improper accumulated earnings tax (IAET) is at 10%. IAET was imposed on the excessive accumulated taxable income of a corporation founded for the intention of avoiding income tax on its shareholders by allowing the corporation’s revenues and profits to accrue rather than distributing them to the shareholders as dividends. Its implementation was intended to discourage or penalize firms for improperly accumulated earnings in order to avoid paying dividend taxes that would have been required had the earnings been distributed as dividends to shareholders.

The 10% IAET has been REPEALED with the implementation of CREATE LAW, and there is no retroactivity clause for 10% IAET. According to RR No. 5-2021, the repeal of IAET applies to the entire tax year for all fiscal years/taxable years ending after the effective date of CREATE LAW. Because CREATE LAW went into effect on April 11, 2021, your financial statements of prior to 2021 that contain improperly accumulated earnings over the “reasonable needs” of the business may still be subject to IAET evaluation during tax audit.

At the end of the day, knowing that your firm is in conformity with local regulations in the Philippines can help you save money on penalties and avoid having to deal with future tax or regulatory evaluations. So, if you’re an accountant, you should check your retained earnings before year-end reporting to see if there’s any reporting or disclosure required.