TeaM (Philippines) Energy Corporation

April 11, 2008 BIR RULING [DA-233-08] RR 25-02; UN-1-30-97 TeaM (Philippines) Energy Corporation CTC Building Roxas Boulevard Pasay City Attention: Kazunobu Takijima Vice President/Controller Gentlemen : This refers to your letter dated March 25, 2008 requesting confirmation of your opinion that Mirant (Philippines) Energy Corporation (hereinafter referred to as "Mirant") [now TeaM (Philippines) Energy Corporation (hereinafter referred to as "TPEC")] may validly deduct the uncollectible portion of its trade receivables, arising from its sale of electricity to Bataan Polyethylene Corporation (hereinafter referred to as "BPC"), as a bad debt deduction from gross income pursuant to Section 34 (E) of the 1997 Tax Code, as amended. It is represented that Mirant is a corporation duly organized and existing under Philippine laws. It is registered with the Board of Investments (BOI) under Executive Order No. 226 (otherwise known as the Omnibus Investments Code) as a pioneer enterprise and was issued a BOI Certificate of Registration relating to Mirant's project with Bataan Polyethylene Corporation. As such enterprise, Mirant was entitled to various incentives, including the Income Tax Holiday (ITH). Under its BOI Certificate of Registration, Mirant's ITH was for six (6) years, reckoned from August 2000 or from actual start of commercial operation whichever came first. On the other hand, Bataan Polyethylene Corporation (hereinafter referred to as "BPC") is a corporation duly organized and existing under Philippine laws. BPC was granted the authority to construct a polyethylene plant (hereinafter referred to as "Plant") by the Philippine National Oil Company Petrochemical Development Corporation (hereinafter referred to as "PNOC-PDC") pursuant to a Locator Agreement dated January 29, 1996 executed between BPC and PNOC-PDC. Under the Locator Agreement, BPC was fully and solely responsible for obtaining all its electric power and other utility requirements from third parties for the operation of the Plant. On December 24, 1999, BPC entered into an Electric Power Purchase Agreement (hereinafter referred to as "EPPA") with Mirant. Under the EPPA, Mirant agreed to design, finance, construct, test, operate and maintain a substation, including other facilities required for the continuous supply of electric power to the Plant. From the period beginning July 25, 2000 to January 20, 2003, Mirant started to supply BPC's electricity requirements. Sometime in 2001, BPC ceased operations due to lack of raw materials and rising production cost. BPC defaulted and incurred late payment charges for the unpaid electricity fees from the middle of 2001 to the early part of 2003. Thus, Mirant terminated the EPPA with BPC on November 13, 2002 and demanded from BPC payment of its outstanding obligations including the termination fees. cAaTED In 2003, Mirant filed a Complaint against BPC for Sum of Money for the recovery of the unpaid electricity fees, penalties and surcharges. Because of the financial situation of BPC, the parties were forced to agree to enter into a Settlement Agreement on December 11, 2007. Among others, it was agreed that BPC shall pay TPEC (formerly "Mirant") a settlement fee in the amount of Two Million US Dollar (US$2mil) as full and final settlement of all claims, liabilities, causes of action, suits, damages and expenses against BPC. Although the amount is far less than the total obligation of BPC, TPEC has no other recourse than to accept the offer inasmuch as BPC has already been insolvent and its total obligation can no longer be collected since BPC has no known property which can be garnished or levied upon. It was further agreed that all existing cases between the parties shall be jointly dismissed with prejudice. It is understood, however, that the right of TPEC to claim the remaining unpaid portion of BPC's obligation as bad debt is not affected by the agreement. Based on the foregoing representations, you now request for confirmation of your opinion that the uncollectible portion of accounts receivables from Mirant's sale of electricity to BPC shall be allowed as a deduction in the current year. In reply thereto, please be informed that your opinion is hereby confirmed as follows: Section 45 of the Tax Code, as amended provides for expense recognition, to wit: Section 45. Period for which Deductions and Credits Taken. The deductions provided for in this Title shall be taken for the taxable year in which 'paid or accrued' or 'paid or incurred', dependent upon the method of accounting upon the basis of which the net income is computed, unless in order to clearly reflect the income, the deductions should be taken as of a different period. (emphasis ours) Thus, the recognition of expense shall be taken for the taxable year in which it is "paid or accrued" or "paid or incurred", dependent upon the method of accounting upon the basis of which the net income is computed, unless in order to clearly reflect the income, the deductions should be taken as of a different period. In this case, Mirant incurred the bad debt expense related to uncollectible portion of the receivables during the current year, the year when the parties signed the Settlement Agreement dated December 11, 2007 which represents the full and final settlement of BPC's debt obligation. Furthermore, the 1997 Tax Code, as amended, provides for requisites for deductibility of bad debts as follows: Section 34 (E) of the Tax Code, as amended, states that: "Section 34. Deductions from gross income. . . . in computing taxable income subject to tax, there shall be allowed the following deductions from the gross income: xxx xxx xxx (E) Bad Debts. (1) In general. Debts due to the taxpayer actually ascertained to be worthless and charged off within the taxable year except those not connected with profession, trade or business and those sustained in a transaction entered into between parties mentioned under Section 36(B) of this Code; provided, that recovery of bad debts previously allowed as deduction in preceding years shall be allowed as part of the gross income in the year of recovery to the extent of the income tax benefit of said deduction. . . ." It is clear from the foregoing that bad debt expense is incurred in the year when the liability therefore becomes fixed, such as when debts are ascertained to be worthless and uncollectible. Likewise, Revenue Regulations (RR) No. 05-99, as amended by RR No. 25-02, implementing the above provision, provides that bad debts refer to those debts resulting from the worthlessness or uncollectibility, in whole or in part, of amounts due the taxpayer by others, arising from money lent or from uncollectible amounts of income from goods sold or services rendered. Hence, in accordance with the provisions of the Tax Code and the above regulations, the following are the requirements for a bad debt deduction: a. There must be an existing indebtedness due to the taxpayer which must be valid and legally demandable; b. The same must be connected with the taxpayer's trade, business or practice of profession; c. The same must not be sustained in a transaction entered into between related parties enumerated under Sec. 36 (B) of the Tax Code of 1997; d. The same must be actually charged off the books of accounts of the taxpayer as of the end of the taxable year; and e. The same must be actually ascertained to be worthless and uncollectible as of the end of the taxable year. In determining whether a debt can be considered worthless and uncollectible, Section 2, RR No. 05-99, as amended by RR No. 25-02, provides the following guidelines: "The determination of worthlessness in a given case must depend upon the particular facts and the circumstances of the case. A taxpayer may not postpone a bad debt deduction on the basis of a mere hope of ultimate collection or because of a continuance of attempts to collect notes which have long become overdue. While a mere hope probably will not justify postponement of the deduction, a reasonable possibility of recovery will permit the account to be carried along notwithstanding that the probabilities are that the debt may not be collected at all. The creditor may offer evidence to show some expectation that the debt would have been paid in the intervening years, and that subsequently, the hope was shattered or appeared to have been unfounded. Good faith does not require that the taxpayer be an "incorrigible optimist" but on the other hand, he may not be unduly pessimistic. Creditors do not have to wait until some turn of the wheel of fortune may bring their debtors into affluence. The taxpayer may strike a middle course between pessimism and optimism and determine debts to be worthless in the exercise of sound business judgment based upon as complete information as is reasonably ascertainable. The taxpayer need not have perfect discernment. The Commissioner of Internal Revenue will consider all pertinent evidence, including the value of the collateral, if any, securing the debt and the financial condition of the debtor in determining whether a debt is worthless, or the assigning of the case for collection to an independent collection lawyer who is not under the employ of the taxpayer and who shall report on the legal obstacle and the virtual impossibility of collecting the same from the debtor and who shall issue a statement under oath showing the propriety of the deductions thereon made for alleged bad debts. Thus, where the surrounding circumstances indicate that a debt is worthless and uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment, a showing of those facts will be sufficient evidence of the worthlessness of the debt for the purpose of deduction. " (Emphasis supplied) In a coterie of cases, the Supreme Court has been consistent in its judicial interpretation of the aforecited Tax Code provision that for debts to be considered as "worthless" and thereby qualify as "bad debts" making them deductible, the taxpayer should show that: 1. There is a valid and subsisting debt; 2. The debt must be actually ascertained to be worthless and uncollectible during the taxable year; 3. The debt must be charged off during the taxable year; and 4. The debt must arise from the business or trade of the taxpayer; 5. The taxpayer has exerted diligent efforts to collect the debts, viz. : a. sending of statement of accounts; b. sending collection letters; c. giving the account to a lawyer for collection; and d. filing a collection in court. Applying the above principles in the present case, it is clear that Mirant has sufficiently complied with all the requisites of bad debts deductibility. Mirant's legal action to enforce payment was futile and did not result in the full settlement of the outstanding receivables. In fact, upon signing of the Settlement Agreement in 2007, portion of the debt is now actually ascertained to be worthless in the current year (2007). The same can no longer be collected since BPC has already been insolvent and left no visible assets which could satisfy the debt. These circumstances are sufficient evidence of the worthlessness and uncollectibility of the debt for the purpose of deduction. (BIR Ruling UN-1-30-97, dated January 30, 1997) DaIAcC The said bad debt deduction is allowed in the year when such debt is ascertained to be worthless and uncollectible, regardless where such debt was created out of income previously taxed or exempted. United States (U.S.) jurisprudence allows the deduction of a bad debt from gross income even if the debt was created out of income previously taxed or exempted. A bad debt deduction is denied if funds used to create the debt have improperly escaped liability for income tax. It went on to elaborate that a taxpayer's basis in a debt obligation is: 1. in the case of money, the amount of money advanced; or 2. in the case of other property, ( i.e. , notes or accounts receivable) the taxpayer's adjusted basis in the property for purposes of determining the loss from the sale or other disposition of it. Applying the above discussion, a bad debt deduction is allowed even if such debt was created out of income previously taxed or exempted. In the case of Mirant, its sale to BPC (out of which the debt was created) was previously reported as income during the year when it is still enjoying ITH. It can be argued that during this period, Mirant's income was taxed at 0% rate or exempt. It did not improperly escape liability for income tax considering that Mirant was granted by BOI various incentives, one of which is the ITH. Thus, Mirant's basis in a debt obligation is the adjusted basis of the trade receivables, which is the uncollectible portion, for purposes of determining the loss from the sale of electricity to BPC. HIETAc This ruling is being issued on the basis of the foregoing facts as represented. If upon investigation, however, it is disclosed that the facts are different, then this ruling shall be considered null and void. Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service