BIR Ruling [DA-222-04]

April 28, 2004 BIR RULING [DA-222-04] Sections 27; 34 BIR Ruling 003-2000 SGV & Co. 6760 Ayala Avenue 1226 Makati City Attention: Atty. Luis Jose P. Ferrer Partner, Tax Services Gentlemen : This refers to your letter dated March 24, 2004 requesting for a confirmation of your opinion regarding the tax implications of the following issues: (1) The off-setting by Union Cement Corporation ("Union") of its advances to Alsons Cement Corporation ("Alsons") and the assumption by Union of Alsons' liabilities with creditors which have various terms and conditions shall constitute the entire consideration received for the three year lease and shall be included in the gross income of Alsons in the taxable year the advances are offset and the liabilities are assumed and shall be subject to income tax based on the taxable income in said period pursuant to Section 27 in relation to Section 34 of the Tax Code of 1997; (2) Union shall deduct the corresponding creditable withholding tax (CWT) on the lease of property, plant and equipment at the time the advances are offset and the liabilities are assumed based on the entire consideration received for the lease and thereafter remit the tax withheld to the BIR; (3) Alsons shall be subject to value added tax (VAT) on the lease of its property, plant and equipment pursuant to Section 108 of the Tax Code, at the time the advances are offset and the liabilities are assumed based on the entire consideration received for the lease. It is represented that Union is a domestic corporation duly organized and existing under Philippine laws; that Union is engaged in the manufacture and distribution of cement products nationwide; that Alsons is a domestic corporation duly organized and existing under Philippine laws and also engaged in the manufacture and distribution of cement products nationwide; that Alsons is a subsidiary of Union; that in a move to enhance synergies, gain economies of scale, improve market access and better channel management, Union will lease the property, plant and equipment (PPE) of Alsons for a period of three (3) years; that as consideration for the lease, Union will offset its advances to Alsons as well as assume Alsons' liabilities with creditors which have various terms and conditions; and that the amount equivalent to the entire consideration for the three (3) year lease will be offset/assumed by Union in the first year of the lease period. In reply, please be informed as follows: 1. The term "gross income" means all income derived from whatever source including gains derived from dealings in property as well as rentals of properties. Section 32(A) of the Tax Code of 1997 (Tax Code) explicitly defines gross income as follows: "SEC 32. Gross income . (A) General definition. Except as otherwise provided in this Title, gross income means all income derived from whatever source, including (but not limited to) the following items: xxx xxx xxx (3) Gains derived from dealings in property; xxx xxx xxx (5) Rents; . . ." On the other hand, Section 40 (C)(5)(a) of the Tax Code speaks of the assumption of liabilities as a consideration in a transaction. Relevant portion of said section states that: ". . . That if as part of the consideration to the transferor, the transferee of the property assumes a liability of the transferor or acquires from the latter property subject to a liability, such assumption or acquisition (in the amount of the liability) shall, for purposes of this paragraph, be treated as money received by the transferor on the exchange; . . . " Based on the foregoing, the amount of advances offset plus the liabilities assumed by Union shall constitute the entire consideration received for the lease of the PPE of Alsons for three years and shall be included in the gross income of Alsons. In BIR Ruling No. 020-02 dated May 13, 2002, this office had an occasion to rule that an assumption of liability could be a part of a consideration of a sale. Said ruling provides as follows: "Consideration is defined as the inducement to a contract. It is the reason or material cause of a contract. It is some right, interest, profit, or benefit accruing to one party. (Black's Law Dictionary, 6th Edition) EIaDHS In the case of PSALM, its assumption of NPC's liabilities is mandated by law. Normally, the transfer of property by a person (transferor) to another person (transferee) in exchange for the assumption by said person of the transferor's liability will be considered a sale, where the assumption of liability constitutes a consideration for the assets. The gain, if any, from the transfer is the difference between the higher of the consideration received or zonal value, if applicable, and the value of the assets given up. The amount of the liabilities transferred is treated as part of the consideration. Moreover, in Revenue Ruling 68-364 (U.S. IRS Ruling) which has a persuasive effect in Philippine jurisdiction, the U.S. Internal Revenue Service ruled that a small business corporation (seller) could include in its gross receipts the amount of debt that was assumed by the purchaser who bought its encumbered property. The Internal Revenue Service held that: "The amount received or accrued from the sale or exchange of property is not confined to cash items, but includes other items that enter into the amount realized by the taxpayer. Thus, the amount received or accrued from the sale or exchange of property includes any property in kind received by the seller, and any liabilities of the seller, including encumbrances on the property sold, taken over by another party. Citing Beulah B. Crane v. Commissioner, 331 U.S. 1 (1947), Ct. D. 1684, C.B. 1947-1, 97. This is true regardless of the taxpayer's method of accounting for the sale. The US Revenue Ruling emphasized that any liabilities of the seller assumed by the purchaser could be included in the receipts/sales realized by the seller. Similarly, the advances offset and liabilities assumed by Union constitute consideration received for the lease of PPE and shall be included in gross income of Alsons. The consideration received, consisting of advances offset and liabilities assumed by Union, shall be included in the gross income of Alsons in first year of the lease period and shall be subject to income tax based on the taxable income in said period pursuant to Section 27 in relation to Section 34 of the Tax Code. As a rule, all items of gross income shall be included in the gross income for the taxable year in which received by the taxpayer. Section 44 of the Tax Code provides that: "The amount of all items of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under methods of accounting permitted under Section 43, any such amount are to be properly accounted for as of a different period. . . ." In relation thereto, Section 43 of the Tax Code states as follows: "The taxable income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner clearly reflects the income. . . ." In BIR Ruling No. 003-00 dated January 5, 2000, this office reiterated the rule that advance payments for rental shall be included in the taxable income of the taxpayer in the year when received, as follows: "The general rule is that the taxpayer is allowed to report income and expenses in accordance with the method of accounting employed, provided such method conforms with generally accepted accounting principles. However, for income arising from rentals of property, a taxpayer must report as part of the gross income 'advance rentals received' during the taxable year, including 'rentals actually earned' but uncollected as of the end of such period. In the instant case, the accounting method being implemented by KSA in reporting its lease income in its books of accounts in accordance with the rules set forth under the International Accounting Standard (IAS) No. 17 will be higher in the initial months of the lease than the actual income earned during the relevant taxable period had it been determined based on the regular accrual method of accounting. In other words, under the IAS No. 17, the sum of the expected rental for the lease term is computed and divided equally over the total number of months covered by the lease. This Office interposes no objection over such treatment, with the understanding that, for income tax reporting purposes, no advance rental received for the first year is aggregated and spread over the duration of the lease periods covered by such advances. Such being the case and considering the existing practice of such industry, KSA, as lessor of the above-mentioned condominium project may report as gross income, by using the accrual method of accounting, only those rental income actually earned as well as advance payments which constitute the taxable income of KSA in the year when received. This is true even though the lessor is on the accrual or the cash method of accounting. ( BIR Ruling No. 259-91 ) ( Hyde Park Realty, Inc. v. Commissioner , 211 F. 2d 462, Cf. Evansville Courier v. Commissioner 62 F.2d 232)" Inasmuch as the advances offset and the liabilities assumed by Union shall constitute the entire consideration received for the three year lease of Alsons' PPE, such consideration shall be included in the gross income of Alsons in first year of the lease period and shall subject to income tax based on the taxable income in said period pursuant to Section 27 in relation to Section 34 of the Tax Code. 2. The entire consideration received for the lease is subject to 5% CWT based on Revenue Regulations No. 2-98, as amended by Revenue Regulations Nos. 14-02 and 17-2003, which provide as follows: "Except as herein otherwise provided, there shall be withheld a creditable income tax at the rates herein specified for each class of payee for the following items of income payments to persons residing in the Philippines: xxx xxx xxx (C) Rentals (1) Real properties. On gross rental for the continued use or possession of real property used in business which the payor or obligor has not taken or is taking title, or in which he has no equity Five percent (5%); (2) Personal properties. On gross rentals or lease in excess of ten thousand pesos (P10,000) annually for which the continued use or possession of personal property used in business which the payor or obligor has not taken title, or in which he has no equity, except those under financial lease arrangements with leasing and finance companies authorized to operate under Republic Act No. 8556 (Financing Company Act of 1998). Five percent (5%); . . ." It must be emphasized that the obligation of the payor to withhold arises at the time an income is paid or payable, whichever comes first. Such rule is provided in Section 2.57.4 of Revenue Regulations No. 2-98 as amended by Section 4 of Revenue Regulations No. 12-2001, which reads as follows: "Section 4. Time of Withholding . Section 2.57.4 of RR 2-98, is hereby amended to read as follows: "Sec. 2.57.4. Time of Withholding . The obligations of the payor to deduct and withhold the tax under Section 2.57 of these regulations arises at the time an income payment is paid or payable, or the income payment is accrued or recorded as an expense or asset, whichever is applicable in the payer's books, whichever comes first. The term 'payable' refers to the date the obligation become due, demandable or legally enforceable. cSATDC Provided, however, that where income is not yet paid or payable but the same has been recorded as an expense or asset, whichever is applicable, in the payor's books, the obligation to withhold, shall arise in the last month of the return period in which the same is claimed as an expense or amortized for tax purposes." In BIR Ruling No. 144-88 dated April 18, 1988, this office had an occasion to rule that if part of the security deposits is applied as rental of office space building, said payment shall be considered as income to the lessor and shall be subject to 5% CWT. In the instant case, the entire consideration for the three-year lease of the PPE shall be received in the first year of the lease period. It follows that Union's obligation to offset its advances and assume liabilities of Alsons becomes due, demandable and legally enforceable at the inception of the lease. Such being the case, Union is required to withhold the corresponding 5% CWT upon the offsetting of advances and assumption of liabilities based on the entire consideration of the lease and thereafter, remit to the BIR the CWT withheld. 3. The lease of property, plant and equipment by Alsons to Union is subject to 10% VAT. The transaction is covered by Section 108 of the Tax Code which states that: "There shall be levied, assessed and collected, a value-added tax equivalent to ten percent (10%) of the gross receipts derived from the sale or exchange of services, including the use or lease of properties." "The phrase "sale or exchange of services" means the performance of all kinds of services in the Philippines for others for a fee, remuneration or consideration, including . . .; lessors of property, whether personal or real; . . ." "Lease of properties shall be subject to the tax herein imposed irrespective of the place where the contract of lease or licensing agreement was executed if the property is leased or used in the Philippines." Said section of the Tax Code further defines the term "gross receipts", as follows: "The term " gross receipts " means the total amount of money or its equivalent representing the contract price, compensation, service fee, rental or royalty, including amount charged for materials supplied with the services and deposits and advance payments actually or constructively received during the taxable quarter for services performed or to be performed for another person, excluding value-added tax." Inasmuch as the term "gross receipts" refers to the total amount of money or its equivalent representing the contract price, it follows that the entire consideration of the lease which consists of advances offset and liabilities assumed is subject to 10% VAT. In VAT Ruling No. 071-97 dated December 4, 1997, this office upheld the position that the basis of the VAT shall be the gross receipts/collections. Moreover, Section 4.102-1 (c) of Revenue Regulations 7-95, Consolidated Value-Added Tax Regulations, explicitly provides as follows: "In a lease contract, the advance payment by the lessee may be: (1) a loan to the lessor from the lessee, or (ii) an option money for the property, or (iii) a security deposit to insure the faithful performance of certain obligations of the lessee to lessor, or (iv) pre-paid rental. If the advance payment is actually a loan to the lessor, or an option money for the property, or a security deposit for the faithful performance of certain obligations of the lessee, such advance payment is not subject to VAT. However, a security deposit that is applied to rental shall be subject to VAT. If the advance payment is, in fact a pre-paid rental, then such payment is taxable to the lessor in the month or quarter when received regardless of the accounting methods used." Such being the case, it is clear that Alsons being a VAT registered taxpayer, is subject to VAT on its lease of property, plant and equipment to Union based on the entire consideration received for the three year lease which is at the time the advances are offset and the liabilities are assumed. However, since VAT is an indirect tax, it may be passed on by Alsons to Union which the latter may use as a credit against its output VAT provided the said payment is evidenced by a duly registered VAT invoice or official receipt. 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