BIR Ruling [DA-403-03]

November 10, 2003 BIR RULING [DA-403-03] BIR Ruling DA-023-03 Section 34 (D) (1) Aranas Consunji Barleta & Co . Unit 106 G/F Le Metropole Building 326 Tordesillas cor. De la Costa Sts. Salcedo Village, Makati City Attention: Atty . Casey M . Barleta Gentlemen : This refers to your letter dated June 20, 2003 requesting confirmation of your opinion that an impairment loss (based on prompt sale value of assets as determined by an independent firm of appraisers and an auction firm commissioned by the company) will not affect the computation of gain or loss on the disposal of such assets because the loss is not yet a closed and completed transaction. FACTUAL BACKGROUND Rex Technologies Philippines, Inc. ("Rex Technologies") is a PEZA-registered company located at Lima Technology Center, Malvar, Batangas. It is primarily engaged in the manufacture, exporting, buying, selling or otherwise dealing in, at wholesale, of multi-layer printed wiring board and other related goods of the same nature. Due, however, to the worldwide decrease in the demand for these products, the company's management has found it unprofitable to continue operations. Rex Technologies is therefore contemplating on selling its machinery and equipment to a domestic buyer. The machinery has an adjusted book value ( i.e. , net of depreciation) of P289,936,000.00. An adjustment for impairment loss, however, would result in a restated book value of P14,133,000.00. OPINION/DISCUSSION It is your opinion that an impairment loss, being only an estimated loss based on prompt sale value of assets as determined by an independent firm of appraisers and an auction firm commissioned by the company, will not affect the computation of gain or loss on the disposal of such assets because such loss is not yet a closed and completed transaction. Consequently, for purposes of computing gain, all that would have to be determined is whether there is an excess of the selling price over the book value, i . e ., original acquisition cost less depreciation and related costs of such sale: In other words, Rex Technologies would only have to determine whether there is any excess between the selling price and the adjusted book value of P289,936,000.00, without taking into consideration the impairment loss attributable to the asset being sold. For purposes of determining gain, all that would have to be considered is whether there is an excess of the selling price over the acquisition cost or adjusted basis of the asset being sold. The adjusted basis of the asset would only take into account its depreciated value, i . e ., book value and related costs in the sale of the asset. For tax purposes, the impairment loss of an asset would not be considered, as it applies only for financial reporting purposes and the loss itself has not actually been realized. While recognizing an impairment loss would result in a presentation in the financial statements of the fair or real value of an asset, it would not be material for purposes of computing the tax due, if any, on the sale of that asset. Impairment Loss To better appreciate the role of an "impairment loss" in the valuation of an asset, it would be helpful to understand the concept of "impairment of assets." The impairment of assets rule prescribes how an enterprise should test its assets to reflect their true value for financial reporting purposes. The standard that is being followed is International Accounting Standard No. 36 ("IAS 36") issued by the International Accounting Standards Committee. This was adopted in the Philippines by the Accounting Standards Council in August, 2001 as Statement of Financial Accounting Standards 36 ("SFAS 36"). SFAS 36, referred interchangeably as IAS 36, became effective in the Philippines for financial statements covering periods beginning on or after January 1, 2002. EATcHD SFAS 36/IAS 36 The objective of this accounting standard is to ensure that an asset is carried in the books at no more than its recoverable amount. An asset is carried at more than recoverable amount if its carrying value ( i . e ., book value) exceeds the amount to be recovered through use or sale of the asset. If this is the case, the asset is described as impaired. SFAS 36/IAS 36 then requires the enterprise to recognize an impairment loss. Looking at it from the opposite point of view, if the recoverable value of an asset is less than its book value, an impairment loss should be recognized. Thus, recognition of an impairment loss, from an accounting outlook, will bring down the value of an asset to its fair or real value, and a company's balance sheet would thereby not appear to be overstated. It is worth noting that SFAS 36/IAS 36 also has specific definitions for certain terms. Thus, as used therein: Recoverable amount is the higher of an asset's fair market value 1 and its value in use. Value in use is the present value of estimated future cash flows expected to arise from the continuing use of an asset and from its disposal at the end of its useful life. Net selling price is the amount obtainable from the sale of an asset in an arm's length transaction between knowledgeable, willing parties, less the costs of disposal. An impairment loss is the amount by which the carrying amount of an asset exceeds its recoverable amount. Carrying amount is the amount at which an asset is recognized in the balance sheet after deducting any accumulated depreciation (amortization) and accumulated impairment losses thereon. Determination of Gain In determining whether a sale of an ordinary asset results in a taxable gain, all that would have to be computed is the excess of the selling price over the acquisition cost or adjusted basis of that asset. Thus, the formula would be: Selling price less acquisition cost/adjusted cost basis = Gain/Loss An impairment loss, being in the nature of an accounting standard whose purpose is to reflect in the financial statements the true condition of an asset, would not be relevant for tax purposes, inasmuch as such impairment loss is only an estimate of what is prudently believed to be an unrecoverable value in a subsequent sale of the asset, or minimal estimated future cash flows arising from the continued use of the asset. Thus, as it applies to a sale of an asset, the premise of an impairment loss is "if the asset will be sold or otherwise disposed of," its value will only be so much and that is the value that should be reflected in the balance sheet. That is why if an asset is carried in the books at an amount higher than its recoverable amount, SFAS/IAS 36 requires that an impairment loss be recorded so that that asset's value may be brought down to the level of its recoverable amount (and not any higher). It should be noted, however, that there is as yet no actual sale or disposal to speak of. The issue has been squarely passed upon previously by this office in BIR Ruling DA-023-03, dated January 2, 2003 . In said ruling, the BIR opined that: "Section 34(D)(1) of the Tax Code of 1997 provides in part that losses actually sustained during the taxable year and not compensated for by insurance or other forms of indemnity shall be allowed as deductions. "It is well-established that a mere decline, diminution or shrinkage of the value of property does not constitute a deductible loss. In other words, fluctuations in market value are never to be accounted for in the computation of income until the gain or loss becomes an accomplished fact. [ Reggio v . U . S . , 151 Supp 740 (Ct Cl, 1957 )] Hence, the decline in the fair market value of Seagate's properties as appraised by an independent accredited appraiser and which was classified in its financial statements as ' loss or write down of real estate held for resale' will not affect the computation of gain or loss on subsequent sale of its assets . Accordingly, the book value (i . e . , original acquisition cost less any depreciation allowance) instead, should be deducted from the selling price in computing the gain or loss of the property sold ." (Emphasis ours) And this is as it should be, since losses are, as a rule, not recognized unless evidenced by a closed and completed transaction. ( Section 96, Rev. Regs. No. 2 ). Since an impairment loss is only an estimated loss resorted to only approximate the real value of an asset for financial accounting purposes, there being no actual loss just yet, it need not be considered in computing for taxable gain in a sale of such asset. For tax purposes, what would be relevant is the adjusted book value and the excess of the selling price over such adjusted book value in determining gain. BIR REPLY In reply, your opinion is hereby confirmed as follows: Section 34(D)(1) of the Tax Code of 1997 provides in part that losses actually sustained during the taxable year and not compensated for by insurance or other forms of indemnity shall be allowed as deductions. In several BIR Rulings, this Office opined that: "It is well-established that a mere decline, diminution or shrinkage of the value of property does not constitute a deductible loss. In other words, fluctuations in market value are never to be accounted for in the computation of income until the gain or loss becomes an accomplished fact. [ Reggio v . U . S . , 151 Supp 740 (Ct C1, 1957 )] Hence, the decline in the fair market value of Seagate's properties as appraised by an independent accredited appraiser and which was classified in its financial statements as ' loss or write down of real estate held for resale' will not affect the computation of gain or loss on subsequent sale of its assets . Accordingly, the book value (i . e . , original acquisition cost less any depreciation allowance) instead, should be deducted from the selling price in computing the gain or loss of the property sold ." 2 (Emphasis supplied) AaHTIE ". . . the annual increase in value of an asset is not a 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 the 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])" 3 As noted, the concept of "impairment loss" is to ensure that the true value of the asset is carried in the books of the company at no more than its recoverable amount. Accounting wise, the impairment loss is recognized immediately by reducing the assets carrying amount to its recoverable value. It is adjusted through the accumulated depreciation account and therefore, classified as other operating expenses and is not to be treated as an extraordinary item. This is consistent with IAS 36 which provides that "impairment loss recognized for an asset in prior years should be recovered if there has been a change in the estimate used to determine the asset's recoverable amount since the last impairment loss was recognized." In other words, if the recoverable amount of an asset that has been impaired turns out to be higher than the asset's current carrying value, the carrying amount of the asset should be increased to its new recoverable amount. The reversal of the impairment loss should be recognized immediately as income in the income statement. Thus, while under the above SFAS/IAS 36 an impairment loss account is set up at the time of the recognition of impairment loss, and which account is ultimately reversed when the asset carrying an impairment loss is disposed or sold, the Tax Code does not allow the recognition of an impairment loss as deduction for tax purposes if such loss is not actually sustained during the taxable year. Henceforth, even if impairment loss of an asset is reflected in the financial statements for financial accounting purposes, the same will not result in any tax benefit since no actual loss is sustained that may be allowed as deduction in the corporation's taxable income. Considering the foregoing, this Office is of the opinion that since the recognition of impairment loss in the company's financial statements for financial accounting purposes does not result to any taxable income or deductible loss, the amount to be considered for taxation purposes in the subsequent disposal or sale of the asset carrying such impairment loss would be the excess of the selling price of the asset vis-a-vis its book value, i . e ., acquisition cost less accumulated depreciation. This ruling is being issued on the basis of the foregoing fact as represented. However, if upon investigation, it shall be disclosed that the facts are different, then this ruling shall be considered null and void. Very truly yours, (SGD.) JOSE MARIO C. BUAG Deputy Commissioner Legal & Inspection Group Footnotes 1. Fair value is the net selling price of the asset in an active market. If there is no active market for the asset, the fair value is the best estimate of knowledgeable, willing parties in an arm's length transaction. 2. BIR Ruling DA-023-03 dated 28, 2003. 3. BIR Ruling No. 144-85 dated August 26, 1985; BIR Ruling No. 206-90 dated October 30 1990.