How to determine the nationality of a corporation (part 2)

The July 26 post describes two tests for the determining the nationality of a corporation:  the control test and the grandfather rule.  Which one applies?  As discussed below, the control test is the primary test for determining the nationality of a corporation;  however, a recent decision of the SEC raises the question of whether the SEC is now abandoning the control test in favor of the grandfather rule.

The control test as the primary test

As a rule, the control test applies. The primacy of the control test over the grandfather rule can be traced to DOJ Opinion No. 19, s. 1989 (the “1989 DOJ Ruling”), which states:

. . . the “Grandfather Rule”, which was evolved and applied by the SEC in several cases, will not apply in cases where the 60-40 Filipino-alien equity ownership in a particular natural resource corporation is not in doubt.  (underscoring supplied)

In other words, according to the Department of Justice, the control test generally applies, with the grandfather rule applicable only when the 60-40 Filipino-alien equity ownership is in doubt.

On the basis of the 1989 DOJ Ruling, the SEC issued several opinions doing away with the grandfather rule.  For example, in a May 30, 1990 opinion, the SEC stated:

. . . the Commission En Banc, on the basis of the Opinion of the Department of Justice No. 18., S. 1989 dated January 19, 9189 voted and decided to do away with the strict application/computation of the so called “grandfather rule”. . . and instead applied the so-called “control test” method for determining corporate nationality.  (underscoring supplied)(see also SEC Opinion dated August 6, 1991;  SEC Opinion dated October 14, 1991)

Around two years after the issuance of the 1989 DOJ Ruling, Congress enacted the  Foreign Investments Act of 1991 (“FIA”), which expressly embodied the control test.   Section 3(a) of the FIA (as amended by Republic Act No. 8179) provides:

. . . the term Philippine national shall mean a citizen of the Philippines; or a domestic partnership or association wholly owned by citizens of the Philippines; or a corporation organized under the laws of the Philippines of which at least sixty percent (60%) of the capital stock outstanding and entitled to vote is owned and held by citizens of the Philippines; or a corporation organized abroad and registered as doing business in the Philippines under the Corporation Code of which one hundred percent (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 sixty percent (60%) of the fund will accrue to the benefit of Philippine nationals: Provided, That where a corporation and its non-Filipino stockholders own stocks in a Securities and Exchange Commission (SEC) registered enterprise, at least sixty percent (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 and at least sixty percent (60%) of the members of the Board of Directors, in order that the corporation shall be considered a Philippine national.”  (underscoring supplied)

Similarly, Section 1(a) of the rules and regulations implementing the FIA expressly provides for the application of the control test:

Philippine national shall mean a citizen of the Philippines or a domestic partnership or association wholly owned by the citizens of the Philippines; or a corporation organized under the laws of the Philippines of which at least sixty percent (60%) of the capital stock outstanding and entitled to vote is owned and held by citizens of the Philippines; or a corporation organized 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 sixty percent (60%) of the fund will accrue to the benefits of the Philippine nationals; Provided, that where a corporation and its non-Filipino stockholders own stocks in Securities and Exchange Commission (SEC) registered enterprise, at least sixty percent (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 and at least sixty percent (60%) of the members of the Board of Directors of each of both corporation must be citizens of the Philippines, in order that the corporation shall be considered a Philippine national. The control test shall be applied for this purpose. (underscoring supplied)

While the control test was enshrined in the FIA and its implementing rules, the SEC continues to apply the grandfather rule when the Filipino equity ownership is “in doubt” (as provided in the 1989 DOJ Ruling).  For example, in SEC-OGC Opinion No. 22-07 dated December 7, 2007, the SEC stated:

. . . when there is doubt as to the actual extent of Filipino equity in the investee corporation, the Commission is not precluded from using the Grandfather Rule.

My former professor at the UP College of Law, Prof. Raul Palabrica, makes a great summary of the SEC position in his Philippine Daily Inquirer column:

. . . this should not be taken to mean that the grandfather rule is already history.  In an inverse way, the SEC pointed out that the “grandfather rule will not apply in cases where the 60-40 Filipino equity ownership … is not in doubt.”

The rule therefore is: While the control test shall be used as standard to determine the nationality of corporations, the grandfather rule will be applied if there are questions about compliance with Filipino ownership requirements. (see Raul Palabrica, Nationality Ownership Rule, Philippine Daily Inquirer, October 19, 2007)

Based on the FIA and its implementing rules and regulations (which embody the control test), my personal view is that the control test should be the test used in determining the nationality of a corporation.   While the 1989 DOJ opinion made reference to the application of the grandfather rule when the 60-40 equity ownership interest is in doubt, the 1989 DOJ opinion was issued prior to the enactment of the FIA.  Also, I believe that if there is doubt as to the 60-40 Filipino-alien equity ownership interest in the investing corporation that has a 60% equity in a corporation engaged in a partly nationalized activity, what should be applied is the Anti-Dummy Law (in conjunction with the control test), not the grandfather rule.  Thus, if 60% of the shares of the investing corporation is held by Filipinos as dummies for foreigners, that 60% equity in the investing corporation will not be deemed held by Philippine nationals.  Applying the control test, the investee corporation will not also be a Philippine national.

A return to the grandfather rule?

It is noteworthy that a recent SEC case raises the issue of whether the SEC is now going back to the grandfather rule as the primary test for determining the nationality of a corporation.  In Redmont Consolidated Mines Corporation vs.  McArthur Mining Corporation, SEC En Banc Case No. 09-09-177 dated March 25, 2010, the SEC applied the grandfather rule because the foreign investor provided “practically all the funds” of the Philippine mining companies;  as such, the SEC concluded that the 60-40 Filipino alien equity ownership was in doubt and therefore the grandfather rule should be applied.   However, the SEC did not stop there – the SEC made statements that seem to indicate a return to the grandfather rule.  The SEC said:

The avowed purpose of the Constitution is to place in the hands of Filipinos the exploitation of our natural resources. Necessarily, therefore, the Rule interpreting the constitutional provision should not diminish that right through the legal fiction of corporate ownership and control. But the constitutional provision, as interpreted and practiced via the 1967 SEC Rules, has favored foreigners contrary to the command of the Constitution. Hence, the Grandfather Rule must be applied to accurately determine the actual participation, both direct and indirect, of foreigners in a corporation engaged in a nationalized activity or business.

Compliance with the constitutional limitation(s) on engaging in nationalized activities must be determined by ascertaining if 60% of the investing corporation’s outstanding capital stock is owned by “Filipino citizens”, or as interpreted, by natural or individual Filipino citizens. If such investing corporation is in turn owned to some extent by another investing corporation, the same process must be observed. 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.

Lastly, it was the intent of the framers of the 1987 Constitution to adopt the Grandfather Rule.

While the constitutional deliberations certainly made reference to the grandfather rule, there is nothing in the Constitution that ultimately embodied the grandfather rule.  In the absence of any provision in the Constitution embodying the grandfather rule, I believe that Congress can adopt a law (in this case the FIA) embodying the control test.

Hopefully, the statements made by the SEC in Redmont do not signal a return to the grandfather rule.  A change in the rules of the game will have a tremendous adverse impact on investor confidence in the Philippines.

One final note. Redmont involved mining companies that require 60% Filipino ownership because these mining companies apparently applied for a Mineral Production Sharing Agreement (which can be granted to Philippine nationals only).  In Redmont, the SEC appears to have reached the conclusion that the 60-40 Filipino-alien equity ownership was in doubt because the foreign investor provided “practically all the funds” of the Philippine mining companies.  My own view is that the fact that the foreign investor may have contributed a big chunk of the corporate funds should not, by itself, put the 60-40 Filipino-alien equity ownership in doubt.  The important consideration is whether the Filipino stockholders legally and beneficially own and control 60% of the shares in the relevant company (and do not otherwise act as dummies for the foreigners).  If the foreigner wishes to provide greater financial support for the mining project, that should be fine for as long as Filipinos remain the legal and beneficial owner of 60% of the shares in the mining company (or in a layered structure, the investing company).  We should not deprive Filipinos of the ability to enter into contracts with foreigners whereby foreigners provide greater funding to projects that remain under Filipino control.

(Note: This is part of a series of “How To” articles. These articles intend to give the reader a general overview of the legal aspects of doing certain things and they will not contain all details regarding the proposed action. There may be changes to applicable laws and regulations after the article is posted. You should consult your lawyer if you wish to take a particular action. See Disclaimer page for additional disclaimers.)

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