BIR Ruling [DA-136-05]

April 7, 2005 BIR RULING [DA-136-05] Sec. 50, RR 2 076-89 KPMG Laya Mananghaya & Co . 22F Philamlife Tower 8767 Paseo de Roxas Makati City Attention: Francisco G. Tagao Head, Tax & Corporate Services and Floripe B. Garcia Assistant Manager, Tax & Corporate Services Gentlemen : This refers to your request stating that in 2001, PHPI, a domestic corporation and the operator of the Cebu Plaza Hotel (hotel), obtained several loans (loan) from Metropolitan Bank and Trust Company (Metrobank); that said loan was secured by the hotel and its improvements (hotel), the furniture, furnishings, and equipments (FFE) therein and the land on which the hotel stands (aggregately called "security" or "mortgaged properties"); that the hotel is owned by PHPI but the land is owned by Trellis Properties Corporation (TPC) acting as the accommodation mortgagor of PHPI; that PHPI and TPC are not related parties; that On 18 April 2002, Metrobank assigned the loan to Asia Recovery Corporation (ARC); that because of financial difficulties, PHPI defaulted on its loan obligation and the loan became past due and demandable; that to avoid incurring operational expenses and continuing losses, PHPI ceased its hotel operations on 15 March 2003 and terminated its lease agreement with TPC; that ARC was left with no option but to go against the security or the mortgaged properties to be able to recoup its loan investment; that to avoid cost, expense, publicity and other adverse effects of the foreclosure of the properties, on 3 December 2004, ARC, PHPI and TPC entered into a dacion en pago agreement whereby after PHPI and TPC shall have transferred and ceded the mortgaged properties to ARC, the latter shall have no further claims of any nature against PHPI in accordance with the following arrangements: partial extinguishment of the loan obligation to the extent of the fair market value of the land and the building in accordance with section 6(E) of the Tax Code and the negotiated price of the building equipment which is higher than the book value thereof; and condonation as to the remaining loan obligation. CEDED PROPERTIES FAIR MARKET VALUE/ LOAN OBLIGATION BOOK VALUE Php735,198,712.00 Hotel Php 283,599,842.40 FFE 100,000,000.00 Land 198,547,740.00 Total (582,147,582.40) AMOUNT CONDONED Php153,051,129.60 ============== that a comparison of the financial position of PHPI prior and after the dacion en pago shows that the condonation did not result in the increase of the assets of PHPI: that PHPI remains insolvent (the liabilities exceed the assets) and is in a capital deficiency position; that as a result of the dacion en pago arrangement, TPC is subrogated to the rights which ARC previously had against PHPI corresponding to the value of the land that was ceded pursuant to Article 2067 of the New Civil Code; that TPC has an accounts receivable Php198,547,740.00 from PHPI; that Since PHPI has no more sufficient assets in its books and has ceased operation since 15 March 2003, TPC has no more reasonable prospect of collecting the entire amount from PHPI; and that accordingly, it would like to write-off its accounts receivable of Php 198,547,740.00 net of any remaining assets of PHPI and claim it as a bad debt deduction from its gross income. Based on the foregoing representations, you now request confirmation of your opinion that: "1) PHPI will not realize any taxable income arising from the condonation by ARC of the amount of Php153,051,129.60, which is the difference between the loan obligation of Php735,198,712.00 by PHPI to ARC and the aggregate value of Php582,147,582.40 of the ceded (dationed) properties; "2) The condonation of the amount of Php153,051,129.60 by ARC is not subject to donor's tax; "3) TPC may write-off its accounts receivable of Php 198,547,740.00, less any remaining assets of PHPI, and claim such item as a bad debt deduction from its gross income in 2004; "4) The write-off by TPIC should not be treated as donation subject to donor's tax; and "5) The write-off of the above accounts receivable is not considered as income of PHPI subject to the regular income tax. In reply thereto, please be informed that your opinion is hereby confirmed, as follows: 1 & 2. Section 50 of Revenue Regulations No. (RR) 2, otherwise known as the Income Tax Regulations provides, as follows: "Section 50. Forgiveness of indebtedness . Cancellation and forgiveness of indebtedness may amount to a payment of income, to a gift, or to a capital transaction, dependent upon the circumstances. If for example, an individual performs services for a creditor, who, in consideration thereof cancels the debt, income to that amount is realized by the debtor as compensation for his services. If, however, a creditor merely desires to benefit a debtor and without any consideration therefor cancels the debt, the amount of the debt is a gift from the creditor to the debtor and need not be included in the latter's gross income. If a corporation to which a stockholder is indebted forgives the debt, the transaction has the effect of the payment of a dividend." TADaCH Applying the foregoing provision, this Office in BIR Ruling No. 076-89 dated/April 17, 1989 ruled that before the condonation or forgiveness of indebtedness will give rise to a taxable income, there must be an increase in the assets of the debtor thereby enriching the latter. A transaction whereby nothing of exchangeable value comes to or is received by a taxpayer; does not give rise to or create a taxable income. Gain or profit is essential to the existence of taxable income. The same was recently reiterated by this Office in BIR Ruling [DA-419-04] dated, August 4, 2004 holding that: ". . . the condonation..of the CPI's debt to SJ shall not be subject to income tax considering that CPI is in a capital deficiency position and will remain insolvent before and after the said condonation considering that the amount to be condoned would only be P84,198,555.20. Moreover, the condonation is likewise not subject to gift tax since there is no donative intent on the part of SJ but it solely for business consideration." To strengthen the above position, the US Supreme Court in Dallas Transfer and Terminal Warehouse v. Commissioner of Internal Revenue, 70 F.2d 95 in holding that Dallas Transfer did not realize taxable income explained that: ". . . The transaction was not in form or substance a sale for US$107,880.77 of property which has an appraised value of US$17,507.20. In effect the transaction was similar to what occurs in an insolvency or bankruptcy proceeding when, upon a debtor surrendering, for the benefit of his creditors, property insufficient in value to pay his debts, he is discharged from liability for his debts. This does not result in the debtor acquiring something of exchangeable value in addition to what he had before. There is a reduction or extinguishment of liabilities without . any increase in assets. There is an absence of such a gain or profit as is required to come within the accepted definition of income that the increase in clear assets so brought about constituted taxable income is not applicable to the factors of the instant case, as the cancellation of Dallas' past due debt to its lessor did not have the effect of making the Dallas' assets greater than they were before that transaction occurred. Taxable income is not acquired by a transaction which does not result in the taxpayer getting or having anything he did not have before. Gain or profit is essential to the existence of taxable income." The above is on all fours with the case of PHPI wherein the mortgaged properties insufficient in value were transferred to ARC and in exchange thereof, PHPI's liability was discharged. However, the extinguishment of PHPI's liability did not increase its assets. The condonation did not have the effect of making PHPI's assets greater than they were before. Its liabilities still exceed its assets. Moreover, PHPI remains in a capital deficiency position and as such, did not realize any taxable income as a result of the condonation. SUCH BEING THE CASE, this Office holds that PHPI is not subject to income tax on the amount of Php153,051,129.60 condoned by ARC. Furthermore, the condonation is not subject to donor's tax since there is no donative intent on the part of ARC but solely for business consideration. 3, 4 & 5. Section 34(E)(1) of the Tax Code of 1997 provides, as follows: "Sec. 34. Deductions from Gross Income. . . . (E) Bad Debts . (1) In General . Debts due to the taxpayer actually ascertained to be worthless and charged off within the taxable year except those not connected with profession, trade or business and those sustained in a transaction entered into between parties mentioned under Section 36(B) of this Code: Provided, That recovery of bad debts previously allowed as deduction, in the preceding years shall be included as part of the gross income in the year of recovery to the extent of the income tax benefit of said deduction." RR 25-02, amending RR 05-99 and implementing the above provision, provides the requisites for valid deduction of bad debts from gross income: "Sec. 3. Requisites for valid deduction of bad debts from gross income . The requisites for deductibility of bad debts are: (1) There must be an existing indebtedness due to the taxpayer which must be valid and legally demandable; (2) The same must be connected with the taxpayer's trade, business or practice of profession; (3) The same must not be sustained in a transaction entered into between related parties enumerated under Sec. 36(B) of the Tax Code of 1997; (4) The same must be actually charged off the books of accounts of the taxpayer as of the end of the taxable year; and (5) The same must be actually ascertained to be worthless and uncollectible as of the end of the taxable year." The Court of Tax Appeals (CTA) in interpreting the above requisites held that the taxpayer is not required to be an "incorrigible optimist" in enforcing collection of a debt ( Western Pacific Corporation v. Commissioner of Internal Revenue, CTA Case No. 720, 22 May 1961 citing White Dental Mfg. vs. US, 274 US. 398 ). He may not postpone a bad debt deduction on the basis of a mere hope of ultimate collection but rather, should exercise sound business judgment based upon information reasonably obtainable in determining worthless debts and in the examination of all the circumstances. Thus, this Office in BIR Ruling [UN097-951 dated March 8, 1995 ruled that: ". . . [B]ad debts are allowed as deductions in the year when ascertained to be worthless and not at the time when the taxpayer may finally "give up" on the possibility of recovering any part of the debts and decide to charge them off. (CCH, 60 Vol. 2, p: 21.009; ( page 252, updated National Internal Revenue Code with Notations and Appendices, 1988 Edition, Jose Araas ) The taxpayer must take reasonable steps to collect the debt. He does not have to go to court if it can be shown that a judgment once obtained would be worthless because the debtor is insolvent or "judgment proof". If, in the exercise of sound business judgment a taxpayer believes there is no likelihood of recovery at any time in the future, the debt has been worthless, ( Western Pacific Corporation vs, Collector of Internal Revenue, CTA Case No. 720 )" Based on the foregoing, sound business judgment warrants that TPC should write off its accounts receivable from PHPI in 2004 arising from the dacion en pago of TPC land to ARC to pay for PHPI's liabilities. It need not go through the lengthy process of hiring a collection lawyer and/or filing a collection case against PHPI since, in all probability, it will not result in the satisfaction of the debt or execution of the judgment. At that time the dacion en pago was entered into by PHPI and TPC with ARC on the mortgaged properties in settlement of PHPI's indebtedness to ARC, TPC has no more prospects of collecting the said accounts receivable. The fact that TPC's land was used to pay off PHPI's loan to ARC shows that PHPI has no more sufficient assets to pay its liability to TPC. There is no likelihood of recovery at any time in the future since PHPI has already ceased operations. The debt has become worthless already. Accordingly, TPC may write-off its accounts receivable of Php198,547,740.00 net of any remaining assets of PHPI after the dacion and claim it as a bad deduction from is gross income pursuant to Section 34(E)(1) of the Tax Code. ICHDca Furthermore, the write-off of the accounts receivable should not be considered as donation subject to donor's tax since there is no donative intent on the part of TPC. The write-off is purely for business consideration since PHPI has no more sufficient assets to cover its payables to TPC. ( BIR Ruling Nos. 076-89 and DA-419-04 ). Finally, the write-off should be not considered as income of PHPI subject to the regular income tax. A transaction whereby nothing of exchangeable value comes to or received by the taxpayer does not give rise to or create taxable income.. Taxable income is not acquired by a transaction which does not result in the taxpayer getting or having anything the taxpayer did not have before ( BIR Ruling No. 076-89 and BIR Ruling FDA-419-04J, citing Dallas Transfer, supra, BIR Ruling DA-206-97, citing Comm. V. Rail Joint Co. [C. CA.] 61 f 2D 751; Bowers vs. Kerbough Empire Co., 271 US 170 ). Accordingly, PHPI did not derive any income as a result of the write-off of the accounts receivable of Php 198,547,740.00 and as such, it should not be subject to income tax. This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it will 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