BIR Ruling [DA-050-04]

February 6, 2004 BIR RULING [DA-050-04] BIR Ruling No. 026-02 RA 8763; Secs. 27 (D) (1); 32 (B) (7) (g) Home Guaranty Corporation 335 Sen. Gil J. Puyat Avenue Makati City Attention: Mr. Gonzalo Benjamin A. Bongolan President Gentlemen : This refers to your letter dated June 6, 2003 requesting for a confirmation of your position that BIR Ruling No. 026-02 dated June 27, 2002, relative to the tax treatment with the exception of the imposition of the documentary stamp tax (DST) thereon, of the Zero coupon bonds (HGC Zeroes) issued by the Home Guaranty Corporation (HGC) to nineteen (19) or less investors on August 2002, applies to the issuance of the HGC Zeroes in Special Series (HGC Special Zeroes) that will be issued by HGC to Government Financial Institutions (GFIs) which have unpaid guaranty claims with you. Background BIR Ruling No. 026-02 has ruled on the following matters: 1. The interest or income earned from the HGC Zeroes ( i.e ., the discount to face value) up to the extent of the weighted average interest rate of 10.15% is exempt from income tax pursuant to Section 19 of the HGC Charter, as implemented by Article 44 of its Implementing Rules and Regulations; 2. Interest or income earned from the HGC Zeroes in excess of the weighted average interest rate of 10.15% is exempt from the 20% final withholding tax imposed by Section 27 (D)(1) of the Tax Code of 1997, but subject to the ordinary income tax; 3. Gains arising from the sale or transfer of the HGC Zeroes in the secondary market are exempt from income tax pursuant to Section 32(B)(7)(g) of the Tax Code of 1997; and 4. Section 32 (B)(7)(g) of the Tax Code of 1997 exempts from income tax the gain realized from the sale or exchange or retirement of bonds, debentures, or other certificate of indebtedness, with a maturity of more than five (5) years. The original issue discount does not fall within the purview of the term "gain" under the said Section. However, while HGC agrees that the sale or transfer of the HGC Zeroes in the secondary market is exempt from DST, it takes exception to the ruling that the original issuance thereof is subject to DST. In this regard, it filed a request for reconsideration with this office dated June 5, 2003, as it believes that the original issuance of the HGC Special Zeroes should not be subjected to DST for the same reasons that it set forth in its request for reconsideration of the same BIR Ruling dated June 27, 2002. Salient Features of HGC Special Zeroes TERMS AND CONDITIONS OF THE HGC ZEROES SPECIAL SERIES Issuer : Home Guaranty Instrument : Zero-Coupon Bond Form of Issue : Scripless through RoSS of the Bureau of Treasury (BTr) Registrar and Paying Agent : Bureau of Treasury (BTr) Investors : Government Financial Institutions (GFIs) who have unpaid guaranty claims with HGC Status of the Bonds : The Bonds shall constitute direct and unconditional obligations of the Issuer Amount : Up to PhP 3.0 Billion (Face/Maturity Value) Purpose : To finance the guaranty servicing requirements of HGC for socialized and low-cost housing projects Security : Unconditional ROP guaranty on principal and interest obligations as provided for in Sec. 18(a) and (b) of R.A. 8763 Borrowings of the Corporation are secured by corporate Assets Eligibility : Eligible as alternative compliance with P.D. No. 717 or the Agri-Agra Law Eligible as Reserves for Trust and other Fiduciary Duties, when the remaining maturity of the bond reaches three (3) years. Eligible as alternative form of compliance with the balanced housing provision under the Urban Development Housing Act (UDHA) of 1992 as approved by the HLURB per Board Res. No. R-739, Series of 2003, dated February 19, 2003. Qualified as Admitted Asset and Reserve Investment of Insurance Companies. (IC letter dated December 16, 2002) Issue Price : To be issued at a discount to par Mode of Issue : Negotiated, to be issued directly to GFI's upon receipt of Notice of Acceptance/Confirmation by HGC. Yield to Maturity : 90% of Bloomberg's MART 1 7-year FXTBs, which shall be determined a day before Issue Date but not to exceed 12% Tenor : Seven (7) years from Issue Date Principal Repayment : Full payment upon maturity Taxes : Interest or income earned from the HGC-Zero Coupon Bonds to the extent of 10.15% is tax exempt. All costs representing the documentary stamp tax on the original issuance of the HGC Zeroes at the rate of P0.30 for every P200.00 of the face value thereof, if any is due, shall be for the account of the HGC. The transfer, however, of the HGC-Zeroes bearer form in the secondary market by way of simple delivery to the buyer is not subject to documentary stamp tax. Trading shall be exempt from taxation. Ownership of the Bond : Title to the HGC Bonds passes by transfer and registration in the Registry of Scripless Securities (RoSS) maintained by the BTr. Proposed Issue date : _________ 2003 Proposed Maturity Date : _________ 2010 BIR Reply We reply as follows: 1. Section 19 of Republic Act 8763 (the HGC Charter) provides that "SEC. 19. Tax Exemption . Interests and yields earned or accumulated on mortgage, debentures, notes, mortgage and asset-backed securities, interest under a lease, and other credit instruments, whether issued by the Corporation or covered by its guaranty in favor of natural or juridical person, in cash or in bonds, shall be exempt from all taxation to the same extent provided in Section 15(a) hereof: Provided, however , That the Corporation shall have the authority to increase the limit of such exemption in such varying amounts as shall be reflective of the social concerns of the State: Provided, further , That the exercise of said authority shall be subject to the approval of the President of the Philippines upon the recommendation of the Monetary Board of the Bangko Sentral ng Pilipinas : Provided, finally, That the corporation shall not exercise such authority more often than once every five (5) years." Section 44(b) of the Rules and Regulations implementing the HGC Charter sets the limit of the exemption of corporate borrowings, to wit: "ART. 44. Tax Exemption on Corporate Borrowings . Corporate obligations on mortgage, debentures, bonds, notes and other credit instruments issued by the Corporation shall be exempt from all taxation, as to principal and interest, except estate, inheritance and gift taxes. The utilization of corporate Borrowings shall determine the extent of tax exemption, as follows: "(a) . . . "(b) For Corporate Borrowings to be utilized for capital formation purposes, the extent of tax exemption on the interest or yield earned shall be the extent of the weighted average of the tax exempt rate provided in the preceding Article: This will be computed as follows: Type of Housing Package Guaranty Allocation Tax Exemption Weighted Average Socialized 40.0% 11.0% 4.40% Low-Cost 30.0% 10.0% 3.00% Medium-Cost 20.0% 9.5% 1.90% Open Housing 10.0% 8.5% 0.85% Total 100.0 10.15% In case the rate of interest on the funds borrowed or on the credit instrument issued by the Corporation I is lower than the weighted average tax exemption rate, the applicable tax exempt rate shall be the interest or nominal yield as indicated in the credit instrument. Any upward revision in the limit of tax exemption in such varying amounts as shall be reflective of the social concerns of the state authorized by the Board of Directors is subject to the final approval of the President of the Philippines, upon the recommendation of the Monetary Board of the Bangko Sentral ng Pilipinas . The Corporation shall not exercise this authority more often than once every five (5) years." On the above basis we ruled that interest or income earned from the HGC Bonds ( i.e. , the discount to face value) up to the extent of the weighted average interest rate of 10.15% is exempt from income tax. 1 Thus, irrespective of whether HGC Special Zeroes will be issued to twenty (20) or more or less than nineteen (19) GFIs which have unpaid guaranty claims with HGC, the interest or income earned therefrom up to the extent of the weighted average interest rate of 10.15% shall be exempt from the 20% final tax imposed under Section 27(D)(1) or to corporate income tax of 32% or 2% minimum corporate income tax imposed under Sections 27(A) and 27(E) all of the Tax Code, as the case may be. 2. Considering that HGC failed to disclose the number of GFIs that will subscribe to the HGC Special Zeroes, we hereby reiterate our previous ruling on the matter. As a rule, under Section 24(B)(1), 27(D)(1), 28(A)(7) in relation to Section 22(Y), all of the Tax Code of 1997, a final tax at the rate of twenty percent (20%) is imposed on "interest on any currency bank deposit and yield or any other monetary benefit from deposit substitutes and from trust funds and similar arrangements." In connection therewith, Section 2(h)(iii)(b) of Revenue Regulations No. 17-84 considers all borrowings of the national and local government and its instrumentalities including the Central Bank of the Philippines (now Bangko Sentral ng Pilipinas), evidenced by debt instruments denoted as treasury bonds, bills, notes, certificate of indebtedness and similar instruments as "deposit substitutes" subject to the provision of Section 22(Y) of the Tax Code which defines the term as follows: "The term "deposit substitutes" refers to alternative form of obtaining funds from the public (the term public means borrowing from 20 or more individuals or corporate lenders at any one time), other than deposits, through the issuance, endorsement, or acceptance of debt instruments for the borrower's own account for the purpose of relending or purchasing of receivables and other obligations, or financing their own needs or the needs of their agent or dealer. . . . " In the light of the aforecited Section 22(Y) of the Tax Code, this Office, however, has consistently opined that to be considered as "deposit substitutes" subject to twenty percent (20%) final withholding tax, the borrowing of funds must be obtained from twenty (20) or more individuals or corporate lenders at any one time. 2 Therefore, if there will be twenty (20) or more GFIs that will be issued the HGC Special Zeroes, the interest or income earned from the HGC Bonds in excess of the weighted average interest rate of 10.15% shall be subject to the 20% final withholding tax imposed by Section 27(D)(1) of the Tax Code of 1997. Otherwise, if HGC Special Zeroes will be issued to nineteen (19) or less investors/GFIs the same shall not be considered as deposit substitutes falling within the purview of the above definition. Therefore, the withholding tax on deposit substitutes will not apply. In such case and since the interest or income earned from the HGC Zeroes up to the weighted average interest rate of 10.15% is exempt from income tax pursuant to Section 19 of the HGC Charter as implemented by Article 44 of the Implementing Rules and Regulations, only the excess thereof shall be subject to corporate income tax of 32% or 2% minimum corporate income tax imposed under Section 27(A) and 27(E) of the Tax Code of 1997 since the GFIs are domestic corporations. 3. On the matter of whether gains realized from the sale or transfer of bonds in the secondary market are exempt from income tax, this Office has consistently ruled that "gains from the sale, exchange, or retirement of bonds with maturity of more than five (5) years, shall be exempt from income tax as provided for under Section 32(B)(7)(g) of the Tax Code of 1997," 3 the pertinent portion which reads as follows: "SEC. 32. Gross Income . (A) . . . (B) Exclusions from Gross Income . The following items shall not be included in gross income and shall be exempt from taxation under this Title [on Income]: xxx xxx xxx (7) Miscellaneous Items . xxx xxx xxx (g) Gains from the sale of bonds, debentures or other certificates of indebtedness . Gains realized from the sale or exchange or retirement of bonds, debentures or other certificate of indebtedness of more than five (5) years." Since HGC Special Zeroes have a tenor of 7 years, any gain realized from their sale or exchange or retirement is excluded from gross income; hence, exempt from income tax pursuant to the above-cited Section 32(B)(7)(g) of the Tax Code of 1997. For this purpose, the term "gain" shall refer to the gain, if any, from secondary trading which is the difference between the selling price of the bonds in the secondary market and the price at which the bonds were purchased by the seller. The term "gain" shall also include the gain (that is, the difference between the proceeds from the retirement of the bonds and the price at which such last holder acquired the bonds) realized by the last holder of the bonds when such bonds are surrendered for retirement upon their maturity. 4 For a discounted instrument, it is worthy to note that trading gains arise only when the instrument is sold above par. Otherwise stated, "trading gains" shall be the excess of the selling price over the par value or book value of the instrument. For this purpose, the par value of the HGC Special Zeroes is the adjusted value which consists of the original purchase price plus the accumulated discount from the time of purchase up to the time of sale. 5 Accordingly, the gains arising from the sale or transfer of the HGC Special Zeroes in the secondary market are exempt from income tax pursuant to Section 32(B)(7)(g) of the Tax Code of 1997. 4. On the matter whether the amount discounted may be considered gain in the absence of any secondary trading on the part of the original investor, such that it shall be excluded from the computation of the taxable gross income: It is noted that HGC Zeroes shall be issued at a discount. Being zero coupon bonds, it is expected that no periodic interest payments shall be made thereon. Rather, the discount granted to the investor shall be amortized over the term of the bond. Section 32(B)(7)(g) of the Tax Code of 1997 exempts from income tax the gains derived from sale, exchange or retirement of bonds, debentures and other certificate of indebtedness with maturity of more than 5 years. Thus, while it is clear that any gain from redemption or retirement of bonds will not be subject to income tax, there must, however, be a clear definition of what such gain would constitute. AcHEaS As earlier stated, the term "gain" shall include the gain (that is, the difference between the proceeds from the retirement of the bonds and the price at which such last holder acquired the bonds) realized by the last holder of the bonds when such bonds are surrendered for retirement upon their maturity. 6 For a discounted instrument, it is worthy to note that trading gains arise only when the instrument is sold above par. Otherwise stated, "trading gains" shall be the excess of the selling price over the par value or book value of the instrument. For this purpose, the par value of the HGC Special Zeroes is the adjusted value which consists of the original purchase price plus the accumulated discount from the time of purchase up to the time of sale. 7 Therefore, the amount discounted from the face value of the HGC Special Zeroes that has been enjoyed by the original investor ( i.e. , GFIs) upfront and amortized over the term of such bonds shall not be understood to come within the meaning of the term "gain" as stated in Section 32(B)(7)(g) of the Tax Code of 1997. 8 5. Finally, the original issuance of the HGC Zeroes shall be subject to documentary stamp tax (DST) at the rate of P0.30 for every Two Hundred Pesos (P200.00) or fractional part thereof of their face value pursuant to Section 180 of the Tax Code of 1997. 9 On the other hand, the transfer of HGC Zeroes in bearer form in the secondary market by way of simple delivery to the buyer is not subject to the DST, unless the transfer of the instruments carries with it a renewal or issuance of new instruments in the name of the transferee to replace the old ones. 10 This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it shall be disclosed that the facts are different, then this ruling shall be considered null and void. Very truly yours, (SGD.) JOSE MARIO C. BUAG Deputy Commissioner Legal & Inspection Group Footnotes 1. BIR Ruling No. 026-02 dated June 27, 2002. 2. BIR Ruling No. 020-2001 dated May 31, 2001. 3. BIR Ruling Nos. 017-2002 dated April 29, 2002 and BIR Ruling No. 035-2001 dated August 16, 2001 . 4. BIR Ruling No. 035-2001 dated August 16, 2001. 5. BIR Ruling No. 050-2001 dated October 29, 2001. 6. BIR Ruling No. 035-2001 dated August 16, 2001. 7. BIR Ruling No. 050-2001 dated October 29, 2001. 8. BIR Ruling No. 026-02 dated June 27, 2002, supra . 9. BIR Ruling No. 050-2001 dated October 29, 2001 and BIR Ruling No. 020-2001 dated May 31, 2001. 10. BIR Ruling No. 050-2001 dated October 29, 2001 .