Isla Lipana & Co.

March 27, 2007 BIR RULING [DA-187-07] R.R. 2; BIR Ruling Nos. 144-85; 276-88; 117-89 Isla Lipana & Co . 29th Floor Philamlife Tower 8767 Paseo de Roxas Makati City Attention: Atty. Alexander B. Cabrera Managing Partner Tax Service Gentlemen : This refers to your letter dated September 14, 2006 requesting on behalf of your client, Avenue Asia Special Situations Fund III, L.P. (AASSF) , for confirmation that the unrealized foreign exchange gains of Asset Pool A (SPV-AMC), Inc. (SPV) are not considered income and should therefore be excluded in the determination of the book value of the shares of SPV for purposes of the capital gains tax on the sale by AASSF of said shares. It is represented that AASSF is a non-resident foreign limited partnership organized and existing under the laws of the State of Delaware, United States of America. It is not doing business in the Philippines and is not registered with the Philippine Securities and Exchange Commission. On the other hand, SPV is a corporation duly organized and existing under the laws of the Philippines. It was incorporated by the United Coconut Planters Bank (UCPB) in accordance with Republic Act No. 9182 or the Special Purpose Vehicle Act of 2002, with the primary purpose of investing in or acquiring non-performing assets of financial institutions. IEHTaA On April 8, 2005, with the consent of SPV, AASSF through its trustee, Lex Development Corporation, (i) purchased from UCPB all the outstanding capital stock of SPV consisting of 123,750,000 redeemable preferred shares and 1,250,000 common shares, and (ii) assumed payment of the unpaid subscription relating to such shares owing to SPV. On June 9, 2005, the legal and the beneficial title to all the shares of SPV were consolidated in AASSF. Pursuant to a Deed of Assignment dated September 30, 2005, AASSF assigned, transferred and conveyed absolutely and unconditionally to Avenue Luxembourg, LLC (ALLLC), a limited company organized under the laws of the State of Delaware, United States of America, its shareholdings in SPV. The transfer is in exchange for a controlling membership interest in ALLLC equal to the valuation of the shares. ALLLC on its part assigned, transferred and conveyed to Avenue Luxembourg SARL (ALSARL), a "societe a responsabilite limitee" organized under the laws of Luxembourg, the identical shareholding in SPV for a consideration amounting to US$20,174,959.53 and shares of ALSARL valued at US$203,787.47 or a total of US$20,378,747. Further, ALSARL assigned, transferred and conveyed to Beleggingsmaatschappij Breom BV, (BBBV), a corporation organized under the laws of the Netherlands, the same SPV shares in exchange for US$17,321,934 and shares of BBBV valued at US$3,056,813 or a total of US$20,378,747. As of December 31, 2005, SPV has retained earnings of Php89,699,020 and unrealized foreign exchange gains of Php137,760,909, each of which approximates the amount of retained earnings and unrealized foreign exchange gains, respectively, of SPV as of 30 September 2005. EcHAaS In reply, please be informed that the " realization " principle, as adopted under Revenue Regulations No. 2, provides that, for purposes of taxation, only the realized gain or loss from foreign exchange transaction will be subject to the income tax. Under this principle, income is only recognized when (i) the earning process is complete or virtually complete, and (ii) an exchange has taken place. In other words, foreign exchange gain or loss shall only be realized upon actual conversion of one currency to another currency, e.g., United States Dollar converted into Philippine Peso or vice-versa. Considering that the recognition of unrealized foreign exchange gains of Php137,760,909, which are reflected in the financial statements of SPV, is merely for financial reporting purposes pursuant to financial reporting standards under paragraphs 23 and 28 of Philippine Accounting Standards (PAS) 21, which respectively provide that: "23. At each balance sheet date: (a) foreign currency monetary items shall be translated using the closing rate ; (b) non-monetary items that are measured in terms of historical cost in a foreign currency shall be translated using the exchange rate at the date of the transaction; and (c) non-monetary items that are measured at fair value in a foreign currency shall be translated using the exchange rates at the date when the fair value was determined. " Recognition of Exchange Differences "28. Exchange differences arising on the settlement of monetary items or on translating monetary items at rates different from those at which they were translated on initial recognition during the period or in previous financial statements shall be recognised in profit or loss in the period in which they arise, except as described in paragraph 32." (Emphasis supplied) acITSD The subject foreign exchange gain was only a result of translation of foreign currency monetary items and did not arise from actual conversion or exchange transaction, which is subject to income tax. The same principle was upheld by the Court of Tax Appeals in the case of Filinvest Development Corporation vs. CIR (CTA Case No. 6182, September 10, 2002). The Tax Court held that the mere appreciation of the value of the property is not subject to income tax, thus: "The supposed gain on dilution that resulted from the exchange of FDC's interest on the project for the subscription of the equivalent shares in FAC * cannot be considered gain or income within the purview of our Tax Code. It must be pointed out that the increase in the value of shares in FAC * owned by the petitioner did not result to any economic advantage on the part of the petitioner. The P60M gain merely represents the corresponding increase in the value of the shares purchased, and such increase is not taxable under our tax laws . In an old case entitled Nelly Lopez Magallanes vs. The Commissioner of Internal Revenue, CTA Case No. 2607, April 21, 1982, this Court had the occasion to pass upon a similar issue: "In other words, the mere increase in value from their original net book value . . . to their asserted fair market value . . . is not income but merely unrealized increased in value through the conversion of property which is not fundamentally taxable." (Mertens, Law of Federal Income Taxation, Vol. I, par 5.05 . . . )" "True enough, only upon sale or disposition of the subject shares could the gain be realized as income by FDC. A mere increase in the value of property is not income but merely an unrealized increase in capital . In the case of Fisher vs. Trinidad , G.R. No. 17518, October 30, 1922, the Supreme Court, citing the case of Gray vs. Darlington (82 US. 63) held that mere advance in value in no sense constitutes the "income" specified in the revenue law as "income" of the owner for the year in which the sale of the property was made. Such advance constitutes and can be treated merely as an increase of capital." (Emphasis supplied) THacES Likewise, in BIR Ruling No. 144-85 dated August 26, 1985, the Commissioner of Internal Revenue (CIR) confirmed that the increase in the value of property without actually realizing the same is not subject to tax, thus: "In reply thereto, I have the honor to inform you that annual increase in value of an asset is not taxable income because such increase has not yet been realized. The increase in value, i.e., the gain, could only be taxed when a disposition of the property occurred which was of such a nature as to constitute a realization of such gain, that is, a severance of the gain from the original capital invested in the property . The same conclusion obtains as to losses. The annual decrease in the value of property is not normally allowable as a loss. Hence, to be allowable the loss must be realized. (Surrey and Warren, Federal Income Taxation (1950), pp. 422-4) " When foreign currency acquired in connection with a transaction in the regular course of business is disposed of ordinary gain or loss results from the fluctuations . (Prentice-Hall Federal Taxes, Vol. 1, par. 6261) The loss is deductible only for the year it is actually sustained . (Emphasis supplied) Further, in BIR Ruling No. 276-88 dated June 28, 1988, it was reiterated that appraisal surplus is not subject to income tax, thus: "In reply, please be informed that appraisal surplus is defined as the excess of estimated depreciated replacement cost, or other basis of measurement, of fixed or other assets over their cost or book value. It is given expression as a credit on books of accounts when appraisal values are recorded and thus may find its way into financial statements. It is sometimes referred to as an unrealized profit . Under the laws of most states in the United States, appraisal surplus is generally not available for cash or property dividends to stockholders; at the time of its creation it is essentially a valuation account rather than retained income. (A Dictionary for Accountants, Eric L. Kahler, fifth edition, p. 31). "Moreover, a taxpayer is deemed to have received items of gross income which have been credited to or set apart for him without restriction. On the other hand, appreciation in value of property is not even an accrual of income to a taxpayer prior to the realization of such appreciation through sale or conversion of the property . (Sec. 38, Revenue Regulations No. 2). " Such being the case, "appraisal surplus" account which is being reported as a separate item in the stockholders equity portion of audited balance sheet is not subject to income tax ." (Emphasis supplied) aSTcCE Moreover, in BIR Ruling No. 117-89 dated June 5, 1989, the Commissioner of Internal Revenue specifically ruled that the appraisal surplus or the revaluation increment should not be considered in computing the book value per share of a corporation for purposes of computing the capital gains tax, thus: In reply thereto, I have the honor to inform you that appreciation in value of property is not even an accrual of income to a taxpayer prior to the realization of such appreciation through sale or conversion of the property (Sec. 38, Revenue Regulations No. 2). Such being the case, the "accumulated and current equity in the investee's net earnings" i.e., the imputation but without dividend declaration of the earnings of the subsidiary or sister corporation to the parent or stockholder corporation in the amount of P117,562,844.00 and the "share in revaluation increment" i.e., increase in value of property because of reappraisal thereof at current value without sale or exchange in the amount of P114,004,128.00 are not considered as income and should not therefore be included in the determination of the book value of the PHINMA shares for purposes of the capital gains tax on the sale of said shares . Furthermore, AASSF, ALLLC, ALSARL and BBBV (transferees and transferors of SPV shares) in determining the price of SPV shares excluded the subject unrealized foreign exchange gains. In light of all the foregoing, we confirm that the unrealized foreign exchange gains, similar to the appreciation in value of property, do not yet constitute taxable income unless the same have been realized. Necessarily, in computing the book value of the SPV shares for purposes of establishing the prima facie market value of the shares, the unrealized foreign exchange gains should be excluded. This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation it will be ascertained that the facts are different, then this ruling shall be considered as null and void. DHITSc Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service