BIR Ruling [DA-209-06]

April 5, 2006 BIR RULING [DA-209-06] 27; 32; 34; DA-166-2004; DA-173-2003 Punongbayan & Araullo 20th Floor, Tower I The Enterprise Center 6766 Ayala Avenue 1200 Makati City Attention: Atty. Romeo H. Duran Tax Principal Gentlemen : This refers to your letter dated January 25, 2005 requesting on behalf of your client, Hitachi Cable Philippines, Inc. ("HCP"), a PEZA-registered domestic corporation for confirmation of the following opinions: a) Gain resulting from the foreign exchange translation of the book value of foreign currency denominated loan into Philippine Peso, which was realized upon actual conversion of HCP's loan receivable from an affiliate company into equity therein is subject to regular corporate income tax rate of 32%; b) Foreign exchange loss incurred by HCP from repayment of foreign currency denominated loans is an ordinary and necessary business expenses that is deductible from ordinary income; and c) Ordinary and necessary business expenses paid or incurred in the taxable year such as foreign exchange loss incurred by HCP from the repayment of foreign currency denominated loans can be deducted from the company's ordinary income consisting of, among others, gain resulting from foreign exchange translation into Philippine Peso of the book value of foreign currency denominated loan receivable, which was realized upon debt-to-equity conversion thereof. The facts, as represented are as follows: 1) Hitachi Cable Philippines, Inc. ("HCP") is a corporation duly organized and existing under the laws of the Philippines with registered office at LIMA Technology Center "SEPZA", Lipa City, Batangas. It is engaged in the business of manufacturing wires, cables, rubber hoses for automotive use, wires and lead frames for use in semiconductor products, fiber optic cables and devices for use in telecommunications, and insulated wires and cable, power cables and accessories for infrastructure purposes. HCP is registered with the Philippine Economic Zone Authority (PEZA) as an export enterprise under PEZA Registration Certificate No. 97-087 dated December 18, 1997. As of December 1, 2002, HCP is subject to the 5% preferential tax rate granted under the Special Economic Zone Act of 1995 (the "Economic Zone Act"). 2) HCP owns 40% of the outstanding capital stock of HCP Realty Corporation ("HCP Realty"), a domestic corporation with registered office at Brgy. Bugtong na Pulo, Lipa City, Batangas, and engaged in the business of leasing its real estate property. Sometime in May 1998, HCP granted HCP Realty a US Dollar Denominated interest-bearing loan. In 2002, the amount of this loan was restated to its Japanese Yen equivalent at that time. Initially, HCP recorded its receivable from this loan in Philippine Peso based on the foreign exchange rate prevailing at the time it granted the loan to HCP Realty. Every December of each year, HCP restated its loan receivable to reflect the year end Japanese Yen to Philippine Peso exchange rate. The foreign exchange differences were recorded as unrealized foreign exchange gain or loss, as the case may be, for each year. 3) On November 17, 2004, the Securities and Exchange Commission approved the conversion of HCP's debt/loan receivable due and owing from HCP Realty into equity therein. From the time HCP granted the foreign currency denominated loan to HCP Realty up to the time said debt/loan was converted into equity in HCP Realty, the Philippine Peso equivalent of HCP's loan receivable had increased substantially by reason of the devaluation of the Philippines Peso against the foreign currency. Consequently, HCP realized a foreign currency gain when its debt/loan receivable was converted into equity. 4) HCP obtained US Dollar and Japanese Yen denominated short-term interest-bearing loans from three domestic local banks. These foreign currency denominated loans were recorded in the books of HCP in Philippine Peso using the foreign exchange rate prevailing at the time said loans were obtained. On various dates in 2004, HCP paid part of the principal and interest of these foreign currency denominated loans in US Dollars and Japanese Yen. From the time HCP obtained these loans until the time of payment thereof, the Philippine Peso equivalent of said loans increased significantly due to the continuous depreciation of the Philippine Peso vis--vis the US Dollar and Japanese Yen. Since HCP recorded the payment of these loans in Philippine Pesos using the exchange rate prevailing at the time of payment, HCP incurred foreign exchange losses during said period. In reply, please be informed as follows: a) Section 2 (nn), Rule 1 of the Implementing Rules and Regulations of the Economic Zone Act of 1995 (PEZA IRR) defines the term "gross income" for the purpose of computing the special tax due as "gross sales or gross revenues derived from business activity within the ECOZONE, net of sales discounts, sales returns 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." IDASHa The definition of "gross income" limits the application of the preferential tax rate of 5% to income derived from the registered activity by a PEZA registered-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 expressly provided under Section 1 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 1/2% stock transaction tax, as the case may be, on the sale of shares of stock." (Emphasis supplied) Fluctuation in values of foreign exchange may be recognized and recorded as income, provided such income has been realized and has arisen from a closed and completed transaction. Mere fluctuation in value of the foreign exchange vis-a-vis the Philippine peso, but short of a closed and completed transaction, does not result to recognition of a taxable income nor a deductible loss. A closed transaction is a taxable event which has been consummated as fixed by identifiable events occurring in a particular year. ( BIR Ruling No. 144-85 dated August 26, 1985, BIR Ruling No. 206-90 dated October 30, 1990, BIR VAT Ruling No. 239-89 dated September 20, 1989 ) In the instant case, HCP granted a foreign currency denominated loan to its affiliate, HCP Realty. HCP initially recorded this loan receivable in Philippine Peso based on the foreign exchange rate prevailing at the time of the grant of the loan. Every December of each year, HCP restated its loan receivable to reflect the year-end foreign currency exchange rate. Considering that the Philippine Peso devalued from the time HCP granted the foreign currency denominated loan up to the time said debt/loan was converted into equity. HCP realized a foreign exchange gain when the transaction was completed by reason of the debt-to-equity conversion. The debt-to-equity conversion set the foreign exchange gain arising from the foreign exchange translation of the book value of HCP's foreign currency denominated loan receivable (owing from HCP Realty) into Philippine Peso. With the conversion into equity, HCP Realty's obligation to repay the loan as well as HCP's right to collect payment has been extinguished. The income derived by a PEZA-registered enterprise from unregistered activity is considered as ordinary income subject to regular corporate income tax ( BIR Ruling No. DA-023-03 dated January 28, 2003, BIR Ruling No. 117-99 dated August 10, 1999 ). In BIR Ruling No. DA-166-04 dated April 5, 2004, this Office ruled that in the case of a PEZA-registered enterprise engaged in the sale of integrated circuits, "gain realized from the sale of machineries and equipment resulting from the foreign exchange translation of their US Dollar denominated book value in pesos, is subject to regular income tax rate of 32% based on the net taxable income." In the present case, the grant by HCP of a foreign currency denominated loan to its affiliate, HCP Realty, is evidently not related to HCP's registered activity. Thus, the foreign exchange gain due to foreign exchange translation of the book value of foreign currency denominated loan receivable into Philippine Peso, granted by HCP to its affiliate, which gain was realized when the transaction was closed and completed by reason of conversion into equity, is income derived from unregistered activity, and as such, is subject to regular corporate income tax rate of 32% based on net taxable income as provided in Section 27(A), in relation to Section 32(A) of the 1997 Tax Code. b) The realized foreign exchange loss of HCP arising from foreign currency denominated loans payable, when the transaction was closed and completed by reason of repayment thereof, is not among the allowable deductions and hence, shall be treated as an ordinary and necessary business expenses deductible from ordinary income. In connection with the foregoing, Section 2, Rule XX of the PEZA IRR enumerates all the allowable deductions for the purpose of computing the preferential tax rate of 5% on gross income of a PEZA-registered enterprise as follows: "SEC. 2. Gross Income Earned; Allowable Deductions . For purposes of these Rule, 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 - Supplied 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 of goods - Financing charges associated with fixed assets" In BIR Ruling No. DA-166-04 dated April 5, 2004, this Office ruled that "[F]rom the foregoing, it is clear that foreign exchange loss . . . is not allowed as deduction 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 foreign exchange loss . . . shall be allowed as deduction from the gross income pursuant to Section 34(A)(1)(a) and (D) of the 1997 Tax Code 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 . . ." The Court of Tax Appeals case of The Coca-Cola Export Corporation vs. CIR (CTA Case No. 5238 dated December 19, 1997) explained the requirements for a loss to be deductible from gross income, to wit, "[W]hat the law requires is that the loss must be actually sustained in the taxable year and not compensated by insurance or otherwise. . . . 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. Thus, . . . 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." In several rulings, this Office has consistently held that 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 pesos vis--vis the foreign currency are deductible from gross income for income tax purposes when the remittance of amortization consisting of principal and interest on the foreign loan has actually been made ( BIR Ruling No. 144-85 dated August 26, 1985, BIR Ruling No. 137-97 dated December 11, 1997 ). This was reiterated in BIR Ruling No. DA-175-2003 dated May 4, 2003 to the effect 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. Applying the foregoing, HCP incurred a foreign exchange loss on its loans payable to creditor banks resulting from the devaluation of the Philippine Peso as against the foreign currency in which the loans were denominated, from the time HCP obtained the loans until payment thereof. HCP actually sustained this foreign exchange loss when the transaction was closed and completed by the repayment thereof on various dates in 2004. As such, HCP's realized foreign exchange loss from the repayment of its foreign currency denominated loans is an ordinary and necessary business expense that is deductible from ordinary income pursuant to Section 34(A)(1)(a) and (D) of the 1997 Tax Code ( BIR Ruling No. DA-359-03 dated October 10, 2003). c) The foreign exchange loss incurred by HCP from the repayment of foreign currency denominated loans is an ordinary and necessary business expense deductible from its ordinary income consisting of, among others, gain due to foreign exchange translation of the book value of foreign currency denominated loan receivable into Philippine Peso which was realized upon the conversion of said loan into equity. In this regard, the term "taxable income" 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." As aforementioned, foreign exchange gain due to foreign exchange translation into Philippine peso of the book value of foreign currency denominated loan of a PEZA-registered enterprise which was realized when the debt was converted into equity, is income derived from unregistered activity. Accordingly, such gain is subject to regular corporate income tax rate of 32% (now 35%) based on net taxable income. Section 34 of the 1997 Tax Code, as amended, in turn, 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. In this regard, 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. Applying the definition of "taxable income," it is clear that foreign exchange loss incurred by HCP from the repayment of foreign currency denominated loans can be deducted from its ordinary income in the taxable year when payment was made. In BIR Ruling No. 117-99 dated August 10, 1999, it was held that "the income derived by a PEZA-registered enterprise from the unregistered activity (i.e. sale of electricity to customers from the customs territory) 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." In applying the foregoing principle, it is clear that foreign exchange loss incurred by a PEZA-registered enterprise, from the repayment of foreign currency denominated loans 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 the US Dollar denominated book value in pesos. ( BIR Ruling No. DA-166-04 dated April 5, 2004 ) Thus, the foreign exchange loss incurred by HCP from the repayment of foreign currency denominated loans is an ordinary and necessary business expense which can be deducted from the company's ordinary income consisting of, among others, gain resulting from foreign exchange translation of the book value of foreign currency denominated loan receivable into Philippine Peso which was realized upon conversion of the debt into equity. 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.) PABLO M. BASTES, JR. OIC, Head Revenue Executive Assistant