BIR Ruling [DA-166-04]

April 5, 2004 BIR RULING [DA-166-04] RR 20-02; DA-023-03; 144-85; 206-90; 137-97 117-99; 175-03 SGV & Co. 6760 Ayala Avenue 1226 Makati City Attention: Atty. Luis Jose P. Ferrer Partner, Tax Services Gentlemen : This refers to your letter dated February 27, 2004 stating that your client, ASE Holding Electronics (Philippines), Incorporated (ASE), is a domestic corporation duly organized and existing under Philippine laws with principal place of business at Lots 3, 4 & 5, Block 7, First Cavite Industrial Estate, Bo. Langkaan, Dasmarias, Cavite, Philippines; that ASE is registered with the PEZA as an Ecozone Export Enterprise engaged in the assembly of semiconductor devices in plastic packages (integrated circuits); that as Ecozone Export Enterprise, ASE was granted income tax holiday (ITH) for four years up to July 1, 2000; that after the ITH, ASE availed of the preferential tax rate of 5% based on the modified gross income earned, as defined under Republic Act No. 7916, in lieu of all local and national taxes. It is further represented that ASE purchased machineries and equipments needed for its business in US Dollars; that the costs of acquisition of the machineries and equipments were recorded in its books in Philippine Peso using the foreign exchange rate prevailing at the time the assets were obtained; that ASE also obtained foreign currency denominated loans and the same were recorded in Philippine Peso using the foreign exchange rate prevailing at the time said loans were obtained; that after several years of operation, ASE decided to close its business in the Philippines and it sold its machineries and equipments to its affiliated companies abroad at a price equivalent to the US Dollar book value of the said machineries and equipments; that ASE recorded the sale of these machineries and equipments in Philippine Peso using the exchange rate prevailing at the time of such sale; that the US Dollar denominated financial statements of ASE would not show any gain or loss in the above sale but the company would appear to have realized gains from the transactions based on its Philippine peso denominated financial statements due to the foreign exchange translation; that the foreign exchange rate of the Philippine peso against the US dollar at the time of the acquisition of the machineries and equipments were much lower than the foreign exchange rate at the time of their sale; that ASE also paid the principal and interest of its foreign currency denominated loans in US Dollars; that the peso equivalent of the loans went up tremendously due to continuous depreciation of the Philippine peso vis--vis the US Dollar from the time of ASE's receipt of the loan until the time of payment thereof; that since ASE recorded the repayment of said loans in pesos using the exchange rate prevailing at the time of payment, the company incurred foreign exchange losses in said period and suffered net operating loss. In connection therewith, you now request confirmation of your opinion that: 1. Gain derived by ASE from the sale of machineries and equipments resulting from the foreign exchange translation of the US Dollar denominated book value in pesos is subject to the regular corporate income tax rate of 32% based on the net taxable income pursuant to Section 27(A) in relation to Section 32(A) of the Tax Code; 2. Foreign exchange loss incurred by ASE from the repayment of foreign currency denominated loans as well as net operating loss of the past taxable year are ordinary and necessary business expense that are deductible from ordinary income pursuant to Section 34(A)(1)(a) and (D) of the Tax Code; and, 3. Ordinary and necessary business expenses paid or incurred in the taxable year such as foreign exchange loss incurred by ASE from the repayment of foreign currency denominated loans as well as net operating loss carried over from past taxable year can be deducted from the company's ordinary income comprising of the gain from the sale of machineries and equipments resulting from the foreign exchange translation of their US Dollar denominated book value in pesos. aSIATD In reply thereto, please be informed as follows: 1. ASE is registered with PEZA as an Ecozone Export Enterprise and primarily engaged in the assembly of semiconductor devices in plastic packages (integrated circuits). Such registered activity was granted by PEZA income tax holiday (ITH) for four years up to July 1, 2000. After the ITH, ASE availed of the preferential tax rate of 5% based on the modified gross income earned, as provided under Section 24 of Republic Act (RA) No. 7916, in lieu of all local and national taxes. Section 2(nn), Rule I of the Implementing Rules of RA No. 7916 defines the term "gross income" as follows: "(nn) "Gross Income "for purposes of computing the special tax due under Section 24 of the Act refers to gross sales or gross revenues derived from business activity within the ECOZONE, net of sales discounts, sales return and allowances and minus costs of sales or direct costs but before any deduction is made for administrative expenses or incidental losses during a given taxable period. The allowable deductions from "gross income " are specifically enumerated under Section 2, Rule XX of these Rules." The definition of "gross income" limits the application of the preferential tax rate of 5% to income derived from the registered activity by an Ecozone enterprise. Thus, any income derived by a registered enterprise that is not related to its registered activity is not entitled to the preferential tax rate of 5%. Instead, such income derived from an unregistered activity shall be subject to regular internal revenue tax as provided under Section 1 (1st par.) of Revenue Regulations No. 20-02, to wit: "SEC. 1. Tax Treatment . Income derived by an enterprise registered with the Subic Bay Metropolitan Authority (SBMA), the Clark Development Authority (CDA), or the Philippine Economic Zone Authority (PEZA) from its registered activity/ies shall be subject to such tax treatment as may be specified in its terms of registration ( i . e ., the 5% preferential tax rate, the income tax holiday, or the regular income tax rate, as the case may be). Nonetheless, whatever the tax treatment of said enterprise with respect to its registered activity/ies, income realized by such registered enterprise that is not related to its registered activity/ies shall be subject to the regular internal revenue taxes, such as the 20%, final income tax on interest from Philippine Currency bank deposits and yield or any other monetary benefit from deposit substitutes, and from trust funds and similar arrangements, the 7.5% tax on foreign currency deposits and the 5%/10% capital gains tax or % stock transaction tax, as the case may be, on the sale of shares of stock." ASE, being a domestic corporation, is subject to the regular income tax rate of 32% based on the net taxable income ( i . e . , gross income less allowable deductions) derived from non-registered activities as provided under Section 27(A) in relation to Section 32(A), both of the 1997 Tax Code. This position finds basis in BIR Ruling No. DA-023-03 dated January 28, 2003, where this Office ruled that the sale by a PEZA-registered enterprise enjoying ITH and subsequently, the preferential tax rate of 5%, of its manufacturing plant and equipment such as generator sets and others is subject to an ordinary income tax at the rate of 33% or 32%, as the case may be, based on its net taxable income ( i . e ., gross income less allowable deductions). The registered enterprise was engaged in the sale of disk drives and the sale of said plant and equipment was not among the activities duly approved and registered with PEZA. Such being the case and considering that ASE realized a gain from the sale of machineries and equipments resulting from the foreign exchange translation of their US Dollar denominated book value in pesos, the gain derived therefrom is subject to regular income tax rate of 32% based on the net taxable income as provided in Section 27(A), in relation to Section 32(A) of the Tax Code. 2. As regards the issue on foreign exchange loss and net operating loss, Section 4, Rule XX of the implementing rules of RA No. 7916 enumerates all the allowable deductions for the purpose of computing the 5% based on the modified gross income of PEZA registered enterprises, to wit: "SEC. 4. Gross Income Earned, Allowable Deductions For purposes of these Rules, Gross Income earned shall be, as defined in Section 2(nn), Rule I of these Rules, subject to the following allowable deductions for specific types of enterprises: 1. Ecozone Export Enterprises, Free Trade Enterprises and Domestic Market Enterprises Direct salaries, wages or labor expenses Production supervision salaries Raw materials used in the manufacture of products Goods in process (intermediate goods) Finished goods Supplies and fuels used in production Depreciation of machinery and equipment used in production and buildings owned or constructed by an ECOZONE Enterprise Rent and utility charges associated with building, equipment and warehouses, or handling goods Financing charges associated with fixed assets . . ." From the foregoing, it is clear that foreign exchange loss and net operating loss are not allowed as deductions for purposes of computing the gross income from the registered activity of a PEZA-registered enterprise subject to the preferential tax rate of 5%. Instead, such losses ( i . e ., foreign exchange loss and net operating loss) shall be allowed as deductions from the gross income pursuant to Section 34(A)(1)(a) and (D) of the 1997 Tax Code. In this regard, Section 34(A)(1)(a) and (D) of the 1997 Tax Code provides as follows: "SEC. 34. Deductions from Gross Income . . . . there shall be allowed the following deductions from gross income: (A) Expenses. (1) Ordinary and Necessary Trade, Business or Professional Expenses. (a) In General. There shall be allowed as deduction from gross income all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on or which are directly attributable to, the development, management, operation and/or conduct of the trade, business . . . . (D) Losses. (1) In General. Losses actually sustained during the taxable year and not compensated for by insurance or other forms of indemnity shall be allowed as deductions: . . ." In the case of The Coca-Cola Export Corporation vs. CIR (CTA Case No. 5238, December 19, 1997), the Court of Tax Appeals held that: SACEca "We find nothing ambiguous nor obscure in the language of Section 29 (d)(2) [now Section 34(A)(1)(a) and (D)] of the Tax Code, insofar as the same is brought to bear upon the circumstances of the petitioner in the case at bar. The provision itself furnishes the best means of its own exposition that all losses actually sustained during the taxable year not compensated by insurance or otherwise are deductible from gross income. It does not specify that the loss must be the result of transactions in the taxable year only. What the law requires is that the loss must be actually sustained in the taxable year and not compensated by insurance or otherwise. In other words, what is needed to be entitled to a loss deduction, is for the taxpayer to prove that a closed and completed transaction sets the loss in the taxable year or in the year claimed and it is not compensated by insurance or otherwise. A closed and completed transaction is one in which the facts indicate the transaction sufficiently final to ascertain that a loss has occurred (Mertens, Law of Federal Income Taxation, Chapter 28, Page 3). Thus, applying the latin maxim " Ubi lex non distinguit nec nos distinguere debemos ", where the law does not distinguish, we should not distinguish, the loss which is the result of a foreign exchange fluctuation ascertained and realized during the taxable period and not compensated by insurance or otherwise, . . . , is deductible from gross income of said taxable period, albeit it may relate to transactions of prior years." As ruled in BIR Ruling Nos. 144-85, 206-90 and 137-97, a foreign exchange loss arises from foreign currency denominated liability when the transaction was closed and terminated by the payments of said liability. Accordingly, foreign exchange losses sustained as a result of devaluation of the Philippine peso vis--vis the foreign currency ( e.g . US dollar) are deductible from gross income for income tax purposes when the remittance of scheduled amortization consisting of principal and interest on the foreign loan has actually been made. Again, in BIR Ruling No. DA-175-2003, it was reiterated that any realized foreign exchange losses arising from the decrease in the value of the Philippine Peso could be treated as an ordinary and necessary business expense. Based on all the foregoing and considering that ASE incurred foreign exchange loss from the repayment of foreign currency denominated loans as well as net operating loss of the past taxable year, such losses, i . e. , foreign exchange loss and net operating loss, are ordinary and necessary business expenses that are deductible from ordinary income pursuant to Section 34(A)(1)(a) and (D) of the Tax Code. 3. The tenor "taxable income" as mentioned in Section 27(A) of the 1997 Tax Code is defined in Section 31 of the same Code as follows: "SEC. 31. Taxable Income defined . The term 'taxable income' means the pertinent items of gross income specified in this Code, less the deductions and/or personal and additional exemptions, if any, authorized for such types of income by this Code or other special laws." On the other hand, Section 34 of the Tax Code provides the rules on the allowable deductions for purposes of computing the "taxable income" in a given taxable year. Said section states that ordinary and necessary expenses paid or incurred during the taxable year in carrying on or which are directly attributable to, the development, management, operation and/or conduct of the trade or business are allowed as deductions from the gross income. Moreover, losses actually sustained during a taxable year and not compensated for by insurance or other forms of indemnity are allowed as deductions from the gross income. As mentioned above, such losses include, among others, foreign exchange loss incurred from the repayment of foreign currency denominated loans. Applying the definition of "taxable income" in Section 31 of the Tax Code, it is clear that foreign exchange losses incurred by ASE from the repayment of foreign currency denominated loans can be deducted from the company's ordinary income in the taxable year when payment was made. In BIR Ruling No. 117-99, this Office had the occasion to rule that the income derived by a PEZA-registered enterprise from the unregistered activity ( i . e ., sale of electricity to customs territory enterprises) was considered as ordinary income subject to the regular corporate income tax under Section 27 of the Tax Code and the allowable deductions provided under Section 34 of the Tax Code may be deducted from such income. It was further represented that ASE sustained net operating losses from its unregistered activity in the past taxable years on account of its foreign exchange losses. These net operating losses may be carried over as deductions from the ordinary gross income for the next three (3) consecutive taxable years immediately following the year when such losses were incurred pursuant to Section 34(D)(3) of the Tax Code as implemented by Section 4 of Revenue Regulations No. 14-2001. In view of the foregoing, this Office is of the opinion as it hereby holds that foreign exchange loss incurred by ASE from the repayment of foreign currency denominated loans as well as net operating loss carried over from past taxable year can be deducted from the company's ordinary income comprising of the gain from the sale of machineries and equipments resulting from the foreign exchange translation of their US Dollar denominated book value in pesos. 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, Commissioner of Internal Revenue By: (SGD.) JOSE MARIO C. BUAG Deputy Commissioner Legal and Inspection Group