SGV & Co

July 17, 2007 BIR RULING [DA-390-07] DA 112-04 SGV & Co 6760 Ayala Avenue Makati City Attention: R.C. Vinzon Tax Services Gentlemen : This refers to your letter dated February 15, 2007 stating that your client, Radio Communications of the Philippines, Inc. (RCPI), is a corporation duly organized and existing under and by virtue of the laws of the Philippines; that RCPI is the holder of a legislative franchise to provide telecommunications services of all types; that the National Telecommunications Commission (NTC) has authorized RCPI to provide and operate the following major services: local exchange carrier, international gateway facility, leased line service, and cellular mobile telephone systems; that during the years ended December 31, 2005 and 2006, respectively, RCPI continued to be in a capital deficit position; that the company's financial position is such that its auditors have expressed the existence of a material uncertainty which may cast doubt on RCPI's ability to continue operations normally; that in order to address this problem, RCPI requested its creditors for the restructuring of its bank loans and bonds payable; that the debt restructuring plan includes, among others, the extension of the repayment of terms of RCPI's outstanding loans and bonds, reduction in interest rates and conversion of certain debt into equity; that pursuant to a rehabilitation plan duly approved by RCPI's creditors, there will be a change in the payment scheme which does not include the reduction of the principal liability but only the reclassification of the debt into sustainable (68.933% of the total debt) and unsustainable debt (31.067% of the total debt), recalculation of interest expense based on lower interest rates provided by the court, which also form part of the unsustainable debt, and the waiver of penalties; and that pursuant to the rehabilitation plan, RCPI shall continue to pay interest on the portion of its debt classified as sustainable debt. Based on the foregoing representations, you now request confirmation of your opinion that the interest expense to be paid by the company on its debt payments pursuant to a debt restructuring plan is an allowable expense for income tax purposes. In reply thereto, please be informed that Section 3 of Revenue Regulations No. 13-2000 provides that for interest to be deductible from gross income, the following are the requisites, to wit: (1) There must be an indebtedness; (2) There should be an interest expense paid or incurred upon such indebtedness; (3) The indebtedness must be that of the taxpayer; (4) The indebtedness must be connected with the taxpayer's trade, business or exercise of profession; (5) The interest expense must have been paid or incurred during the taxable year; (6) The interest must have been stipulated in writing; (7) The interest must be legally due; (8) The interest payment arrangement must not be between related taxpayers as mandated in Section 34 (B) (2), in relation to Section 36 (B), both of the Tax Code of 1997; (9) The interest must not be incurred to finance petroleum operations; and (10) In case of interest incurred to acquire property used in trade, business or exercise of profession, the same was not treated as a capital expenditure. cSATEH In stressing the principle of the above-mentioned section, this Office elucidated the matter in BIR Ruling No. DA112-04 dated March 11, 2004 , as follows: "In general, the amount of interest expense paid or incurred within a taxable year on indebtedness in connection with the CPI's trade or business shall be allowed as deduction from its gross income. The term 'interest' shall refer to the payment for the use or forbearance or detention of money, regardless of the name it is called or denominated. However, for the interest to be deductible, said interest payments should not be among the exceptions to deductibility under Section 34(B)(2)(b) and (c) of the Tax Code, which provide (a) . . . (b) If both the taxpayer and the person to whom the payment has been made or is to be made are persons specified under Section 36(B); or (c) If the indebtedness is incurred to finance petroleum exploration. Prescinding from the above-cited provision, it is apparent that for the interest to be deductible, the ownership of both corporations (CTFBV and CPI) must be traced to the level of the individual shareholder. (Sec. 36(B), Tax Code of 1997) Considering that both CPI and CTFBV are 100% owned by CTGEI which in turn is wholly-owned by CTC, which are ultimately owned by a publicly-held or listed US corporation, hence, no individual owns directly or indirectly more than 50% of the outstanding capital stock of both CPI and CTFBV. Accordingly, the interest payments by CPI to CTFBV on the refinancing loan are deductible from its gross income for income tax purposes. aDcTHE Likewise, in BIR Ruling No. UN251-95 dated July 7, 1995 , this Office ruled that the disallowance of interest expense arising from indebtedness incurred by Philodrill, a corporation engaged in the exploration of all kinds of petroleum and petroleum products, to fund the payment of various obligations arising from its investment activities, such as acquisition of shares of stock and subscription payments to companies in which it holds equity, has no legal and factual basis. It was also ruled that interest incurred from indebtedness used to finance petroleum operations are not deductible from gross income. Corollarily, under Section 3(d) of P.D. No. 87, the term 'petroleum operations' is defined as searching for and obtaining petroleum within the Philippines through drilling and pressure or suction or the like, and all other operations incidental thereto. It includes the transportation, storage, handling and sale (whether for export or for domestic consumption) of petroleum so obtained but does not include any: (1) transportation of petroleum outside the Philippines; (2) processing or refining at a refinery; or (3) any transactions in the products so refined. It is clear from the aforesaid definition that petroleum operations refers only to upstream activities (i.e., search and obtaining of petroleum) and not to downstream activities (i.e., importing, exporting, shipping, transporting, processing, refining, storing, distributing, marketing, selling). Hence, interest on loans used to finance upstream activities is non-deductible while interest relating to loans used for downstream activities is deductible. Accordingly, since the proceeds of the original US dollar-denominated loans subject of refinancing were used for the repair and maintenance of CPI's refineries and in general, for CPI's operations, which are clearly not upstream activities, the interest paid thereon may be claimed as a tax deduction by CPI in the year the interest is paid or incurred. In fine, the interest to be paid by CPI on the loans to be extended by CTFBV for purposes of refinancing CPI's US dollar denominated loans shall be deductible from its gross income pursuant to Section 34(B) of the Tax Code of 1997." ( BIR Ruling No. DA196-03 dated June 26, 2003 ) EScAID IN VIEW OF THE FOREGOING, this Office hereby confirms your opinion that the interest expense to be paid by the company on its debt payments as mandated by a court-approved debt restructuring plan is an allowable expense for income tax purposes subject to the limitation prescribed under Section 34 (B) (2) of the Tax Code of 1997, as amended. 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, (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service