BIR Ruling [DA-359-03]

October 10, 2003 BIR RULING [DA-359-03] S. 34 (D); 137-97/206-90, 144-85 Quasha Ancheta Pena & Nolasco 114 Amorsolo St., Makati City Attention: Attys. Alfredo Z. Pio de Roda & Daisy C. Inocentes Gentlemen : This refers to your letter dated November 26, 2002 requesting on behalf of your client, DAELIM PHILIPPINES, INC. (DPI for brevity), for a clarificatory ruling on the tax treatment of gains and losses arising from foreign exchange transactions. You seek confirmation of your opinion that foreign exchange gains and losses resulting from the increase/decrease in foreign exchange rates are taxable gains and/or deductible expenses when the: 1. Exchange rate at the time of receipt of advance payments on contracts is different from the rate at the time income is earned and debited against advance payments. 2. Exchange rate at the time of recording/recognizing accounts receivables is different from the rate at the time of actual collection of the account receivables. 3. Exchange rate at the time advance payments are made to subcontractors is different from the rate at the time expenses on the sub-contract are incurred/recorded. 4. Exchange rate at the time of recording/recognizing accounts payables is different from the rate at the time accounts payables are paid. 5. Exchange rate at the time down payments for construction materials are made is different from the rate at the time of full payment/settlement of the balance on the purchase price of these materials. The facts, as you represent, are as follows: DPI is a domestic corporation duly registered with the Securities and Exchange Commission. It is primarily engaged in the business of providing industrial procurement and construction services, including but not limited to the petro-chemical industry. DPI is likewise registered with the BIR and was issued TIN No. 004-480-780-000. In the ordinary course of its business, DPI renders services as a civil engineering, mechanical and electrical sub-contractor. DPI regularly enters into long-term construction contracts with a period ranging from three (3) to five (5) years. The consideration for the construction contracts are paid for in US dollars. During the course of the construction projects, the following transactions/events usually recur: A. Monthly progress billings by DPI contractees. Under the terms and conditions of the construction contracts, the contractee is required to make an advance payment to DPI equivalent to ten percent (10%) of the contract price. During the course of a construction project, DPI prepares monthly progress billings, based on the percentage of completion. A percentage of the monthly progress billing is applied against the advance payment, while another percentage is recognized as retention receivable from the contractee. The balance of the monthly progress billing is recorded as accounts receivables of DPI. The accounts receivable are subsequently collected from the contractee. DPI receives the advance payments in US dollars and books the same in its peso equivalent using the foreign exchange rate at the time of receipt. When DPI prepares its monthly progress billings (in US dollars), it records the deduction to advance payments, the construction income and the accounts receivables using the prevailing foreign exchange rate at the time the billing is made. Upon collection of the accounts receivables from the contractees, DPI records their payment using the exchange rate at the time of collection. There is a fluctuation in foreign exchange rates between the times of recording of the foregoing transactions, resulting in a loss or gain. B. Monthly progress billings by subcontractors to DPI In order to perform the services under the construction contract, DPI engages the services of its own sub-contractors. The consideration for the subcontract is denominated in US dollars. DPI makes an advance payment to them equivalent to ten percent (10%) of the sub-contract price. These sub-contractors bill DPI for their services through monthly progress invoices. A portion of the monthly billings is credited by DPI against its advance payment to each sub-contractor. The balance is recorded by DPI as accounts payables. DPI settles its accounts payables to sub-contractors in the following months. The advance payments are paid by DPI in US dollars and booked in pesos using the exchange rate at the time of payment. When DPI receives the monthly progress billings from its subcontractors, it records the deduction to advance payments, the subcontract expense and the accounts payables using the exchange rate at the time the invoice is received. Upon settlement of the accounts payables to the sub-contractors, DPI records peso equivalent using the exchange rate at the time of payment. The fluctuation in foreign exchange rates between the times of recording of the advance payments, the sub-contract expense and the accounts payables results in a loss or gain. acHITE C. Purchase of construction supplies from foreign suppliers. DPI also uses imported construction materials in its projects. These materials are purchased from foreign suppliers and paid for in US dollars. DPI is required to make a down payment equivalent to thirty percent (30%) of the cost of materials upon placing the purchase order. Full payment is made by DPI upon delivery and receipt of the construction materials. DPI makes the down payments in US dollars but records the same in pesos using the exchange rate at the time of payment. When the construction materials are delivered to DPI, it makes full payment of the purchase price in US dollars but books the cost using the exchange rate at the time of delivery. The fluctuation in foreign exchange rates between the times of recording the down payment and full payment results in a loss or gain. In reply, please be informed of the following: There is an actual foreign exchange gain or loss realized by DPI depending on the appreciation/depreciation of the Philippine Peso to the US dollar between the time income/expense or the asset/liability is recorded in its books and the time the same is collected/paid. What DPI has reflected in its books as a liability or expense ( i.e. , accounts payables, advance payments from contractees, purchase of construction materials) was the amount before the foreign exchange fluctuated, thus, since the payment of said liability was done when the peso depreciated, it suffered a foreign exchange loss when it used more pesos to pay its foreign currency obligations ( The Coca-cola Export Corporation vs. Commissioner of Internal Revenue , C.T.A. Case No. 5238, December 19, 1997.) Alternatively, if DPI has reflected in its books as an asset or income ( i.e ., accounts receivables, advance payments to sub-contractors, construction income) an amount before the foreign exchange fluctuated, it will realize a gain when the peso depreciated at the time of collection. Section 34(D) of the 1997 Tax Code provides that losses actually sustained during the taxable year and not compensated by insurance or other forms of indemnity shall be allowed as deductions from gross income. Thus, foreign exchange losses may be allowed as a deduction if the losses have actually been incurred in the course of trade or business during the taxable year. In several BIR Rulings, this Office opined that: " . . . the annual increase in value of an asset is not taxable income because such increase has not yet been realized. The increase in value, i.e ., the gain, could only be taxed when a disposition of the property occurred which was of such a nature as to constitute a realization of such gain, that is, a severance of the gain from the original capital invested in the property. The same conclusion obtains as to losses. The annual decrease in the value of property is not normally allowable as a loss. Hence, to be allowable, the loss must be realized. (Surre Warren, Federal Income Taxation (1950, pp. 422-4)" (BIR Ruling No. 144-85 dated August 26, 1985; BIR Ruling No. 206-90 dated October 30, 1990.) caHCSD "When a foreign currency acquired in connection with a transaction in the regular course of business is disposed of ordinary gain or loss results from the fluctuations. The loss is deductible only for the year it is actually sustained. It is sustained during the year in which the loss occurs as evidenced by the completed transaction and as fixed by identifiable events occurring in that year. A closed transaction is a taxable event which has been consummated." (BIR Ruling No. 144-85 dated August 26, 1985; BIR Ruling No. 206-90 dated October 30, 1990; BIR Ruling No. 137-97 dated December 11, 1997) The Court of Tax Appeals has likewise ruled that: ". . . , the loss which is the result of a foreign exchange fluctuation ascertained and realized during the taxable period and not compensated by insurance or otherwise, except those provided in Sec. 30(b) of the Tax Code, is deductible from gross income of the said taxable period, albeit it may relate to transaction of prior years." (The Coca-Cola Export Corporation vs. Commissioner of Internal Revenue, Ibid.) In view of the foregoing, this Office confirms your opinion that foreign exchange rates are taxable gains and/or deductible expenses when the: 1. Exchange rate at the time of receipt of advance payments on contracts is different from the rate at the time income is earned and debited against advance payments. 2. Exchange rate at the time of recording/recognizing accounts receivables in different from the rate at the time of actual collection of the account receivables. 3. Exchange rate at the time advance payments are made to subcontractors is different from the rate at the time expenses on the sub-contract are incurred/recorded. 4. Exchange rate at the time of recording/recognizing accounts payables is different from the rate at the time accounts payables are paid. 5. Exchange rate at the time down payments for construction materials are made is different from the rate at the time of full payment/settlement of the balance on the purchase price of these materials. This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it will be ascertained that the facts are different, then this ruling shall be considered void. Very truly yours, Commissioner of Internal Revenue By: (SGD.) JOSE MARIO C. BUAG Deputy Commissioner Legal & Inspection Group