BIR Ruling [DA-257-05]

June 16, 2005 BIR RULING [DA-257-05] Cancellation of Interest 076-89 Diaz Murillo Dalupan & Co. 5/F, Don Jacinto Building Dela Rosa cor. Salcedo Streets Legaspi Village, Makati City Attention: Mr. Juanito O. Cubos Gentlemen : This refers to your letter dated May 28, 2005 requesting on behalf of your client, Plantation Bay Holdings Corporation (PBHC) , a ruling/confirmation on the tax treatment of interest on bank loan that was subsequently cancelled/condoned by the bank. It is represented that PBHC is a registered taxpayer with the Large Taxpayer District Office No. 123, City of Cebu; that it is a Board of Investments (BOI)-registered company enjoying income tax holiday (ITH) until year 2004; that as an entity enjoying ITH, it is exempt from income tax during the ITH period and the expenses recognized during the ITH years which are deductions to gross income to arrive at supposed taxable income do not result in any tax benefit since PBHC is exempt from income tax; that Section 1(t), Rule I, Part I of the Rules and Regulations implementing E.O. No. 226 reads: "The 'income' of the registered firm entitled to income tax holiday shall be confined to income directly derived from registered operations"; that the company's BOI registered activity is the operation of tourist accommodation facility (resort); that accordingly, income other than the incidents of resort operation is not entitled to ITH; that in 1996, the company secured a bank loan with the Philippine National Bank (PNB); that in subsequent years, the interest rate thereof was not resolved between the parties, hence, the company recognized provisional interest in the books and recorded it as expense and accrued interest (liability); that accrual of interest was done annually until 2001 only; that the loan had become a "non-performing loan" and, as such, banks were restricted from recognizing interest income on non-performing loans as expressly provided for in Section 4 of BSP Circular No. 202; that in 2004, the loan was restructured wherein, as part of the conditions, a portion of the accrued interest up to 2001 would be converted as part of the principal loan, and since banks were restricted from recognizing interest income from non-performing loans, the balance of said accrued interest would be, in effect, totally cancelled/condoned by PNB; that in accounting, recognized liability that will no longer be paid is treated as other income or a change in accounting estimate that will be an adjustment to beginning Retained Earnings as stated in the Statement of Financial Accounting Standard (SFAS) No. 13 or International Accounting Standard (IAS) No. 8; that it is your position that this cancelled/condoned interest is not taxable on the basis that there was no tax benefit realized for the previous years thereby no actual income will be realized in 2004; that the restructuring of the loan, which will in effect result in the cancellation/condonation of a portion of the accrued interest, will not result in any loss on the part of the bank because no interest income was recognized in the previous years, beginning in the year 2001; and that this will be a matter of accounting entry and presentation in the financial statements in accordance with generally accepted accounting principles. DSATCI In support of your request, you now submit the following documents 1) BIR Certificate of Registration 2) BOI Certificate of Registration and Agreement 3) BOI Approval for Extension of ITH 4) Bank Loan Agreement 5) Restructured Bank Loan Agreement 6) BSP Circular No. 202 Non-Performing Loans In reply, please be informed that cancellation and forgiveness of indebtedness may amount to a payment of income, to a gift, or to a capital transaction, dependent upon the circumstances prevailing. 1 If for example, an individual performs services for a creditor who, in consideration thereof cancels the debt, income to that amount is realized by the debtor as compensation for his services. If, however, a creditor merely desires to benefit a debtor and without any consideration therefor cancels the debt, the amount of the debt is a gift from the creditor to the debtor and need not be included in the latter's gross income. If a corporation to which a stockholder is indebted forgives the debt, the transaction has the effect of payment of a dividend. 2 Moreover, when a creditor cancels a debt as part of a business transaction, the debtor is enriched or its net assets has been increased and, therefore, he realized taxable income. 3 However, a transaction whereby nothing of exchangeable value comes to or is received by a taxpayer does not give rise to or create taxable income. 4 Accordingly, since the cancellation of the portion of the accrued interest on the loan granted by PNB to PBHC was due to the fact that the loan has become a non-performing loan and, as such, PNB is restricted from recognizing interest income on the same as expressly provided for in Section 4 of BSP Circular No. 202, the cancellation of the balance of the interest of the indebtedness of PBHC by PNB, therefore, is not subject to income tax. Further, the cancellation of the portion of the accrued interest by the bank on the indebtedness of PBHC does not create or give rise to a taxable income on its part considering that the deduction of said interest as expense in prior years in its books did not result to a tax benefit in its favor thereby no actual income materialized in the taxable year 2004. 5 Likewise, the cancellation of the portion of the accrued interest is not subject to donor's tax since there is no donative intent on the part of PNB. 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 as null and void. Very truly yours, (SGD.) JOSE MARIO C. BUAG Deputy Commissioner Legal & Inspection Group Footnotes 1. BIR Ruling No. 076-89 dated April 17, 1989. 2. Sec. 50 Revenue Regulations No. 2. 3. Philippine Fiber Processing Co. v. CIR , CTA Case No. 1407 Dec. 29, 1966. 4. See Dallas Transfer and Terminal Warehouse Co. v. Commissioner of Internal Revenue 5 Cir: 70 F 2d 95, 13AFTR 930. 5. See Barnhart-Marrow Consolidated v. Commissioner of Internal Revenue , 47 BTS 590.