BIR Ruling [DA-257-03]

August 8, 2003 BIR RULING [DA-257-03] 37; 035-98 SGV & Co. 6760 Ayala Avenue 1226 Makati City Attention: J.A. Osana Tax Division Gentlemen : This refers to your letter dated June 26, 2003 stating that your client, Shell Philippines Exploration B.V., (SPEX), is a company formed and organized under the laws of the Netherlands; that it operates in the Philippines through a branch that is duly licensed by the Securities and Exchange Commission (SEC); that SPEX is a petroleum service contractor of the Government of the Philippines under Presidential Decree No. 87, as amended, otherwise known as the Oil Exploration and Development Act and under Service Contract No. 38 (SC 38); that in its capacity as petroleum service contractor to the Government, SPEX and its co-venturers have entered into Gas Sales and Purchase Agreement (GSPA) with various Buyers such as, among others, First Gas Power Corporation and the National Power Corporation; that the conditions under which the sale of Natural Gas shall be made are on a "Take or Pay" (TOP) basis; that under the GSPA, SPEX and its co-venturers (collectively referred to as the (Seller) are obliged to make available for sale to the Buyer a specified amount of natural gas for each contract year (referred to as the Annual Contract Quantity or ACQ) from which the Buyer shall make its daily nominations for delivery. Pursuant to the TOP provisions, the Buyer shall likewise pay the amount by which the ACQ exceeds the aggregate daily nominations (compute and invoiced during or at the end of each contract year); that such payment shall entitle the Buyer to receive in the subsequent contract years(s) the quantity paid for but not yet taken in the past contract year(s), with no additional charge from the Seller; that in any event, the title and risk of loss of or damage to the natural gas pass to the Buyer only upon delivery of the natural gas by the Seller at the delivery point; and that in this case, the Seller uses the accrual method of accounting in accordance with the Generally Accepted Accounting Principles (GAAP), wherein under the accrual method, income is included in gross income when earned, whether received or not, and expenses area allowed as deductions when incurred although not paid. In connection therewith, you now request confirmation of your opinion that the amount of the TOP represents an advance payment for the sale of natural gas to be delivered in the future and is reportable as revenue for tax purposes by the seller in the year of receipt of such payment or conversely, prior to the receipt, actual or constructive, of the TOP payment, no revenue shall be reported for tax purposes by the Seller. In reply, please be advised as follows: Section 43 of the Tax Code of 1997 provides that 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 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 relation thereto, Section 38 of Revenue Regulations No. 2, otherwise known as the Income Tax Regulations reads "Section 38. Bases of Computation. Approved standard methods of accounting will be ordinarily regarded as clearly reflecting income. A method of accounting will not, however, be regarded as clearly reflecting income unless all items of gross income and all deductions are treated with reasonable consistency. All items of gross income shall be included in the gross income for the taxable year in which they are received by the taxpayer and deductions taken accordingly, unless in order clearly to reflect income such amounts are to be properly accounted for as of a different period. For instance, in any case in which it is necessary to use an inventory, no accounting in regard to purchases and sales will correctly reflect income except an accrual method. 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." Revenue is recognized when it is probable that future economic benefits will flow to the enterprise and these benefits can be measured reliably. Thus two conditions must be present for the recognition of revenue, namely: a) it is probable that future economic benefits will flow to the enterprise and b) the economic benefits can be measured reliably. Undoubtedly, both conditions are present at the point of sale. Accordingly, the point of sale is the point of revenue recognition. The reason is that it is at the point of sale that the enterprise has transferred to the buyer the significant risks and rewards of ownership of the goods. Stated differently, legal title to the goods passes to the buyer at the point of sale. The point of sale is usually the point of delivery which may be actual or constructive. Legally, it is delivery that transfers ownership from the seller to the buyer. Thus, the general rule is that a taxpayer is allowed to report income and expenses in accordance with the method of accounting employed, provided such method conforms with generally accepted accounting principle. An accrual basis taxpayer is required to accrue income in a taxable year when all events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable certainty. (BIR Ruling No. 035-98 dated April 18, 1998) Inasmuch as no accounting in regard to purchases and sales will correctly reflect income except an accrual method, which the seller herein employs, advance payments for the sale of natural gas to be delivered in the future is included in gross income only when earned, whether received or not and not in the year of receipt of such payments. 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