Aranas Consunji & Barleta Law Office

June 4, 2008 BIR RULING [DA-342-08] Sec. 27; DA-419-2004; DA-463-2007 Aranas Consunji & Barleta Law Office Unit 106 G/F Le Metropole Condominium Tordesillas Corner de la Costa Streets, Salcedo Village, Makati City Attention: Atty. Jesus Clint O. Aranas Partner Gentlemen : This refers to your letter dated 20 May 2008, on behalf of your client, Prime Orion Philippines, Inc. ("POPI"), requesting confirmation of your opinion that the condonation in favor of POPI by one of its creditors of the loan amount of P751,338,858 plus accrued interest and penalties out of the total loan obligation in the amount of P1,251,338,858.00 is not subject to income tax. It is represented that POPI is a corporation duly organized and existing under and by virtue of Philippine laws; that for taxable year ended June 30, 2007, POPI reflected a capital deficiency in the amount of P3,437,229,770; that the said capital deficiency arose from the financial difficulties suffered by POPI; that one of the primary reasons of POPI's business downturn is the continuing incurrence of interest and penalties on the substantial amount of outstanding liabilities in POPI's books; that a part of the said liabilities pertains to a loan taken from a third-party creditor with a maturity value amounting to P1,251,338,858.00 consisting of principal and capitalized interest; that POPI offered to pay, as compromise settlement with the said third-party creditor, the amount of P500,000,000.00 out of the total liability and requested the cancellation and condonation of the remaining portion of the maturity value of the loan amounting to P751,338,858 plus accrued interests; that the capitalized interest, accrued interest and penalties from the said loan were incurred by POPI way back December 2000; that during those taxable years, POPI was in a loss position, thus, it was not able to claim tax deduction benefits from said interests and penalties; that after the proposed condonation, POPI will still be in a capital deficit position as reflected in the attached Financial Statements; that the Audited Financial Statements of POPI reflect that the company continually sustained losses as follows: ECHSDc FY2006 FY2007 Net income (losses) P74,930,141 (P3,202,088,037) Capital deficiency (235,141,733) (P3,437,229,770) that the unaudited Balance Sheet of POPI as of February 29, 2008 shows the following: Total Assets P2,458,205,164 Total Liabilities 5,955,759,880 Capital Deficiency (3,497,554,717) In reply, please be informed that the cancellation of indebtedness may not give rise to taxable income. In BIR Ruling No. DA-419-04 dated August 4, 2004, this Office held that "Thus, the condonation of the CPI's debt to SJ shall not be subject to income tax considering that CPI is in a capital deficiency position and will remain insolvent before and after the said condonation considering that the amount to be condoned would only be P84,198,555.20. Moreover, the condonation is likewise not subject to gift tax since there is no donative intent on the part of SJ but solely for business consideration." The above ruling was issued by this Office on the basis of the discussions stated in BIR Ruling No. 076-89 dated April 17, 1989 which states as follows "Cancellation and forgiveness of indebtedness may amount to a payment of income, to a gift, or to a capital transaction, dependent upon the circumstances. 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 the payment of a dividend. (Sec. 50 Revenue Regulations No. 2) The waiver of interest by the banks on non-trade and trade related indebtedness of GMPI is not subject to income tax considering that the deduction of said interest as expense in prior years did not offset nor reduce the taxable income of GMPI since it was in a financial loss position even without the deduction. (See Barnhart-Marrow Consolidated v. Commissioner of Internal Revenue, 47 BTA 590) 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 (Philippine Fiber Processing Co. v. CIR, CTA Case No. 1407 Dec. 29, 1966). 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. (See Dallas Transfer and Terminal Warehouse Co. v. Commissioner of Internal Revenue, 5 Cir. 70 F 2d 95, 13AFTR 930) Accordingly, the condonation of GMPI's indebtedness by GM-US is not subject to income tax since before and after the condonation GMPI remains insolvent, i.e. , in a capital defficiency position. The condonation is likewise not subject to gift tax since there is no donative interest on the part of GM-US but solely for business consideration since Isuzu will only acquire the GMPI shares from GM-US if GMPI has a "clean" balance sheet with no outstanding liabilities except those to Isuzu." EHCaDS The same principle was reiterated in BIR Ruling No. DA-593-2006 dated October 5, 2006, where this Office likewise ruled that "It is clear from the foregoing that the condonation of POPI advances by Growluck is not subject to income tax if nothing of exchangeable value comes to or is received by POPI. This is based on the basic and generally accepted principle of taxation that taxable income is created from the inflow of wealth. xxx xxx xxx Accordingly, we hereby confirm your opinion that the condonation by Growluck of the liability of POPI is not subject to income or donor's tax if after the condonation, the same remains to be in capital deficit position. However, if after the condonation it is shown that POPI derived income from the transaction, then the said amount shall be subject to the corporate income tax accordingly." In view of the foregoing, this Office hereby confirms your opinion that the condonation by the creditors of POPI of its debt in the amount of P751,338,858.00 is not subject to income tax considering that after the condonation, the company will remain to be in a capital deficit position; and that such condonation is not subject to donor's tax since there is no donative intent on the part of the creditor but is solely for business consideration. 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 as represented 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