BIR Ruling [DA-196-03]

June 20, 2003 BIR RULING [DA-196-03] 34 (B); UN251-95 SGV & Co. 6760 Ayala Avenue Makati City Attention: J. A. Osana Gentlemen : This refers to your letter dated February 5, 2003 requesting on behalf of your client, Caltex (Philippines), Inc. (CPI), for a ruling that interest on refinancing loans to be extended by Pleasanton 2A ApS (Pleasanton) to CPI may be claimed as deduction by CPI against its corporate income for income tax purposes. It is represented that CPI is a domestic corporation organized and existing under the laws of the Philippines; that CPI is a wholly-owned subsidiary of Chevron Texaco Global Energy, Inc. (CTGEI) [formerly Caltex Corporation], a non-resident corporation organized and existing under US laws; that Pleasanton is a non-resident foreign corporation organized and existing under the laws of Denmark: that Pleasanton is 100% owned by San Ramon 1A ApS, also a non-resident foreign corporation organized and existing under Denmark laws; that San Ramon 1A ApS is also a wholly-owned subsidiary of CTGEI; that Pleasanton, being indirectly owned by CTGEI, is an affiliate of CPI; that on the other hand, CTGEI is 100% owned by Chevron Texaco Corporation (CTC), another non-resident foreign corporation based in the US; that CTC is a publicly-held/listed corporation; that presently, CPI has interest bearing US dollar-denominated loans from international financial institutions, the proceeds of which were used to finance the operations, maintenance and repairs of CPI's refineries and other downstream petroleum activities; that these US dollar-denominated loans shall be refinanced with loans to be extended by Pleasanton under a credit agreement (the Agreement) to be executed by CPI and Pleasanton; that under the Agreement, Pleasanton undertakes to extend loans to CPI, which shall not exceed an aggregate amount of US$400,000,000 outstanding at any one time; that the interest at market rate shall be paid by CPI to Pleasanton on any unpaid amount of the loan principal; that CPI shall pay Pleasanton a commitment fee on the daily average unused amount of Pleasanton's commitment at the rate of 0.05% per annum; that this loan will be submitted to the Bangko Sentral ng Pilipinas (BSP) for approval by the Monetary Board prior to its execution; and that upon drawdown, the loan and other required documentation will be submitted to the BSP for registration. In reply thereto, please be informed that Section 34(B)(1) of the Tax Code of 1997, as implemented by Revenue Regulations No. 13-2000, provides that the amount of interest paid or incurred within a taxable year on indebtedness in connection with the taxpayer's profession, trade or business shall be allowed as deduction from gross income. For interest to be deductible from gross income, the following are the requisites, viz. : (1) There must be an indebtedness; (2) There should be an interest expense paid or incurred upon such indebtedness; (3) The indebtedness must be that of the taxpayer; (4) The indebtedness must be connected with the taxpayer's trade, business or exercise of profession; (5) The interest expense must have been paid or incurred during the taxable year; (6) The interest must have been stipulated in writing; (7) The interest must be legally due; (8) The interest payment arrangement must not be between related taxpayers as mandated in Section 34(B)(2), in relation to Section 36(B), both of the Tax Code of 1997; (9) The interest must not be incurred to finance petroleum operations; and (10) In case of interest incurred to acquire property used in trade, business or exercise of profession, the same was not treated as a capital expenditure. ( Sec. 3, Revenue Regulations No. 13-2000 ) In general, the amount of interest expense paid or incurred within a taxable year on indebtedness in connection with the CPI's trade or business shall be allowed as deduction from its gross income. The term "interest" shall refer to the payment for the use or forbearance or detention of money, regardless of the name it is called or denominated. However, for the interest to be deductible, said interest payments are not among the exceptions to deductibility under Section 34(B)(2)(b) and (c) of the Tax Code, which provide (a) . . . (b) If both the taxpayer and the person to whom the payment has been made or is to be made are persons specified under Section 36(B); or (c) If the indebtedness is incurred to finance petroleum exploration. Section 36(B) of the Tax Code of 1997 provides for the instances of related taxpayers who are not allowed to claim deductions for losses from sales or exchanges of property incurred by and between them. This provision on related taxpayer is also made applicable to deductions for interest and bad debts as provided in the same Code. Section 36(B) states that: "(B) Losses from Sales or Exchanges of Property. In computing net income, no deduction shall in any case be allowed in respect of losses from sales or exchanges of property directly or indirectly "(1) Between members of a family. For purposes of this paragraph, the family of an individual shall include only his brothers and sisters (whether by the whole or half-blood), spouse, ancestors, and lineal descendants; or "(2) Except in the case of distributions in liquidation, between an individual and a corporation more than fifty percent (50%) in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual; or "(3) Except in the case of distributions in liquidation, between two corporations more than fifty percent (50%) in value of the outstanding stock of each of which is owned, directly or indirectly, by or for the same individual, if either one of such corporations, with respect to the taxable year of the corporation preceding the date of the sale or exchange was, under the law applicable to such taxable year, a personal holding company or a foreign personal holding company; "(4) Between the grantor and a fiduciary of any trust; or "(5) Between the fiduciary of a trust and the fiduciary of another trust if the same person is a grantor with respect to each trust; or "(6) Between a fiduciary of a trust and a beneficiary of such trust. The word "individual" in Section 36(B)(3) of the Tax Code above, which is applicable to this case, refers to natural persons only, excluding therefrom estates, trusts or corporations. Relevant to this section is the provision on personal holding company found in the Tax Code of 1939. To determine whether a corporation is a personal holding company, the attribution rule prescribed in Section 66 of the Tax Code of 1939, as implemented by Section 224 of Revenue Regulations No. 2 should be followed, to wit: CSIDTc "SEC. 66. Stock ownership . For the purpose of determining whether a corporation is a personal holding company, insofar as such determination is based on stock ownership, the following rules shall be observed: (a) Stock not owned by individual. Stock owned, directly or indirectly, by or for a corporation, estate, or trust shall be considered as being owned proportionately by its shareholders, partners, or beneficiaries. xxx xxx xxx" "SEC. 224. Stock not owned by individual . In determining the ownership of stock for any of the purposes set forth in the preceding section, stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by its shareholders, partners, or beneficiaries. . ." Therefore, in the case of multi-tiered corporation, the attribution rule must be allowed to run continuously along the chain of ownership until it finally reaches the individual stockholders. [ BIR Ruling No. 072-97 dated July 2, 1997 ]. Such being the case, it may be said that the term "individual" pertains to a natural person as distinguished from a corporate or juridical person. Prescinding from the above-cited provisions, it is apparent that to determine whether the prohibition against the deductibility of interest between related taxpayer provided under Section 36(B)(3) of the Tax Code of 1997 applies, the ownership of both corporations (CPI and Pleasanton) must be traced to the level of the individual shareholder. Considering that both CPI and Pleasanton are 100% owned by CTGEI which in turn is wholly owned by CTC, which are ultimately owned by a publicly held-listed US corporation, no individual owns directly or indirectly more than 50% of the outstanding capital stock of both CPI and Pleasanton. In other words, while CPI and Pleasanton are affiliated corporations, the same are not considered related taxpayers within the contemplation of Section 36(B)(3) of the Tax Code of 1997. Consequently, the prohibition does not apply and the interest payments by CPI to Pleasanton on the refinancing loan are deductible from its gross income for income tax purposes. As to the other requirement that the indebtedness must not be incurred to finance petroleum operations, this Office in BIR Ruling No. UN-251-95 dated July 3, 1995 ruled that the disallowance of interest arising from indebtedness incurred by Philodrill, a corporation engaged in the exploration of all kinds of petroleum and petroleum products, to fund the payment of various obligations arising from its investment activities, such as acquisition of shares of stock and subscription payments to companies in which it holds equity, has no legal and factual basis. The same Office ruled that interest incurred from indebtedness used to finance petroleum operations are not deductible from gross income." Corollarily, under Section 3(d) of PD No. 87, the term "petroleum operations" is defined as searching for and obtaining petroleum within the Philippines through drilling and pressure or suction or the like, and all other operations incidental thereto. It includes the transportation, storage, handling and sale (whether for export or for domestic consumption) of petroleum so obtained but does not include any: (1) transportation of petroleum outside the Philippines; (2) processing or refining at a refinery; or (3) any transactions in the products so refined. It is clear from the aforesaid definition that petroleum operations refers only to upstream activities ( i.e. , search and obtaining of petroleum) but not to downstream activities ( i.e. , importing, exporting, shipping, transporting, processing, refining, storing, distributing, marketing, selling). Hence, interest on loans used to finance upstream activities is non-deductible while interest relating to loans used for downstream activities is deductible. Accordingly, since the proceeds of the original US dollar-denominated loans subject of refinancing were used for the repair and maintenance of CPI's refineries and in general, for CPI's operations, which are clearly not upstream activities, the interest paid thereon may be claimed as a tax deduction by CPI in the year the interest is paid or incurred. In fine, the interest to be paid by CPI on the loans to be extended by Pleasanton for purposes of refinancing CPI's US dollar denominated loans shall be deductible from its gross income pursuant to Section 34(B) of the Tax Code of 1997. 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