Sycip Gorres Velayo & Co.

February 14, 2007 BIR RULING [DA-091-07] 27; 34; No. 429-88 Sycip Gorres Velayo & Co. 6760 Ayala Avenue 1226 Makati City Attention: Atty. E.C. Alcantara Co-Head, Tax Services Gentlemen : This refers to your letter dated December 18, 2006 requesting for a ruling on the tax implications of the insurance proceeds received by Mindanao 1 Geothermal Partnership (M1GP) for replacement of the Turbine Rotor Assembly Unit owned by M1GP which was heavily damaged upon unloading from the vessel. It is represented that M1GP is a duly registered Philippine partnership duly organized and existing under and by virtue of the laws of the Philippines, with registered office and principal place of business at Level 36, Tower 1, The Enterprise Center, 6766 Ayala Avenue, Makati City; that M1GP owns, operates and maintains the Mindanao 1 Geothermal Power Plant located in Mount Apo, North Cotabato, Mindanao; that M1GP sent to Germany for repair one (1) unit rotor assembly with an original acquisition cost of US$2,200,000 and net book value of US$146,667; that the rotor assembly is the rotating component of the steam turbine that drives the electric generator rotor to generate electricity; that on January 6, 2006, upon unloading of the cargo/metal tank containing the repaired rotor assembly unit owned by M1GP which was scheduled for delivery to the Davao City Port on the same day, the said metal tank was discharged and accidentally fell, causing damage to the rotor assembly. It is further represented that the said rotor assembly unit is covered by a Marine Cargo Insurance Policy from Tokio Marine & Nichido Fire Insurance Co. Ltd.; that the insured value of the repaired rotor assembly unit is US$2,700,423.00; that M1GP filed an insurance claim for the said amount to cover replacement and or repair/restoration of the rotor assembly unit which was severely damaged because of the accident; that M1GP was able to claim as insurance proceeds the full value of the insured amount; that in the course of investigation of the accident and the resulting damage to the rotor assembly unit, it was determined through an engineering inspection report provided by a specialized contractor for repair works that the rotor assembly unit suffered several damages and needs very extensive repair; that the report also showed that the cost of repairing the damaged rotor assembly unit will be much higher than the cost of purchasing a new rotor assembly unit; that, hence, it was recommended to M1GP that a new rotor assembly unit be purchased in replacement of the damaged rotor assembly unit; that based on these findings and recommendation, M1GP purchased and imported from a Japanese supplier one new rotor assembly unit with a total cost of around US$3,309,090.91 inclusive of taxes and duties using the insurance proceeds; and that in support of your request, you submitted to this Office the following documents: IcSADC 1. Copy of the Marine Cargo Insurance Policy issued by Tokio Marine & Nichido Fire Insurance Co., Ltd.; 2. Copy of the Remittance of Cargo Insurance Claim Money evidencing the remittance of the insured amount; 3. Copy of the premium invoice evidencing the payment of premium by M1GP; 4. Copy of the Marine Protest filed by Davao Integrated Port & Stevedoring Services Corp. detailing the incident during the unloading of the cargo containing the rotor assembly; 5. Copy of the engineering inspection report provided by the specialized contractor for repair works; 6. Copy of the Purchase Order for a new rotor assembly. In this regard, you are requesting confirmation of your opinion as follows: 1. The excess of the total cost for the replacement of the rotor assembly unit over the total acquisition cost shall be considered as additional capital for which depreciation may be claimed; and 2. The excess of the amount of the insurance proceeds over the net book value of the insured rotor assembly unit is not taxable income on the part of M1GP since the said proceeds were used to replace the insured asset. HcSDIE In reply, please be informed that the above situation partakes of the nature of an involuntary conversion of property not considered as realized income, hence, not subject to income tax, as explained in BIR Ruling No. 373-87 dated November 23, 1987 and BIR Ruling No. 429-88 dated September 2, 1998 and reiterated in BIR Ruling No. 329-92 dated November 18, 1992. The Involuntary Conversion of Property Doctrine, as explained in BIR Ruling No. 329-92, is quoted, to wit: "xxx xxx xxx "In reply, please be informed that the aforementioned expropriation of MJC's real property is embraced under the involuntary conversion of property doctrine which this Office relied upon in BIR RULING NO. 373-87, dated November 23, 1987, in the case of the MERCURY GROUP OF COMPANIES. This ruling was reiterated in BIR RULING NO. 429-88, dated September 2, 1988: "The excess of the amount of the insurance proceeds over the net book value of the insured assets is not taxable income to the corporation, it having been used in restoring the burned assets. The rule is, where insurance proceeds are actually reinvested in similar property, no gain is recognized. (Herder V. Helvering, 23 AFTR, p. 322)" "The aforesaid Herder V. Helvering case is a discussion of the Involuntary Conversion of Property Doctrine in determining whether or not a gain from the involuntary conversion of a property may be recognized as realized income subject to income tax to the recipient, theft or seizure, its expropriation or condemnation, or the threat or imminence thereof. ScaHDT "Involuntary Conversion if property (as a result of its destruction, in whole or in part, theft or seizure, or an exercise of the power of requisition or condemnation or the threat or imminence thereof) is compulsorily or involuntarily converted into property similar or related in service or use to the property so converted, or into money which is forthwith in good faith . . . expended in the acquisition of other property, or in the acquisition of a control of a corporation owning such other property, or in the establishment of a replacement fund, no gain or loss shall be recognized. If any part of the money is not so expended the gain, if any, shall be recognized, but in an amount not in excess of the money so expended. (MERTENS, Chap. 20, 121, Vol. 3, pp. 337-338) "The facts in the Herder v. Helvering case were: On January 15, 1934 fire destroyed the milling property owned by the partnership of George Herder and R.L. Williams. For this loss, the partnership received $50,000 as fire insurance proceeds. This amount was immediately distributed to the partners, being pro-rated in accordance with their respective interest in the partnership, namely, two-thirds to George Herder, and one-third to R.L. Williams. George Herder received $33,333.67 under such distribution and that $19,199.50 thereof represented his portion of the total amount received by the partnership in excess of the adjusted cost basis of the property at the time of its destruction. HCTaAS "The court held the said gain ($19,199.50) is not a realized income, hence, not subject to income tax, ( supra ) pursuant to the rule that no realized income may be recognized from a compulsory or involuntary conversion of a property. This doctrine is one of the several doctrines enunciated by the Courts in the U.S.A. that explain the meaning of the term "income" and "realization of income". xxx xxx xxx" Thus, this Office confirms your opinion that the excess of the total replacement cost of the insured rotor assembly unit which was destroyed and damaged over its total acquisition cost is not a deductible loss. However, such excess shall be considered as additional capital expenditure for which depreciation may be claimed by M1GP. ( BIR Ruling No. 373-87 dated November 23, 1987, BIR Ruling No. 429-88 dated September 2, 1998 ) HDAECI With regard to the excess of the amount of the insurance proceeds received by M1GP over the net book value of the insured rotor assembly unit, this Office likewise confirms that the same is not a taxable income on the part of M1GP, it having been used in restoring the damaged asset. The rule is where insurance proceeds are actually reinvested in similar property, no gain is recognized. ( Herder V. Helverling, 23 AFTR, p. 322 ) However, for purposes of depreciation, M1GP can claim depreciation of the insured property plus any additional capital outlay incurred in restoring the property, if any. ( BIR Ruling No. 373-87 dated November 23, 1987 and BIR Ruling No. 429-88 dated September 2, 1958 ) This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation it shall be disclosed or discovered that the facts are different, then this ruling shall be considered as null and void. Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service