BIR Ruling [DA-419-04]

August 4, 2004 BIR RULING [DA-419-04] S.27 045-92/2-13-92; 076-89/4-17-89 Comsys Phils, Inc. 5th Floor RFM Corporate Center, Pioneer cor. Sheridan Sts., Mandaluyong City Attention: Emmanuel C. Fernandez Division Manager Finance and Administration Gentlemen : This refers to your letter dated July 2, 2004 requesting, on behalf of COMSYS PHILS, INC. (CPI for brevity), for a clarificatory ruling on the following: 1. What will be the tax consequence on the debt to equity conversion between CPI and Nippon COMSYS Corporation (NCC for brevity)? 2. What will be the tax consequences on the condonation of Sumitomo Japan (SJ for brevity) of the obligation of CPI? The facts, as you represent, are as follows: CPI is a corporation duly organized and existing under and by virtue of the laws of the Philippines with office address at 5th Floor RFM Corporate Center, Pioneer cor. Sheridan Sts., Mandaluyong City. It is engaged in the telecommunications construction business and is owned by 60% Filipino and 40% foreign stockholders. As of the end of May 2004, the shareholding and the percentage ownership are as follows: Stockholders No. of Shares Subscribed % Ownership Peter Rodriguez 8 .0064% Asea One 8,328 6.6624% Valeriano Del Rosario 29,168 23.3344% Daikyo Internet 37,492 29.9936% Teresita Hizon (Daikyo) 4 .0032% Koi Otsu (NCC) 4 .0032% Tsuneo Ando (NCC) 4 .0032% Tetsuya Inami (NCC) 4 .0032% NCC 49,988 39.9904% Total 125,000 100.00% ======= ======= All shares are subscribed and paid up. IECcaA In the course of conducting your business, CPI has a cumulative loan from the following banks as of June 30, 2002: Mizuho/Fuji Bank US$8,000,000.00 Bank of Tokyo US$2,801,000.00 Total US$10,801,000.00 ============== Due to financial difficulties, CPI defaulted on its payments of the said loans in June 2002. As a result thereof SJ and NCC paid the total loans of US$10,824,415.47 (including interest), as guarantors 25% (US$2,705,527.65) and 75% (US$8,118,887.82), respectively. For the last two years (as per attached audited financial statements Annexes A and B), CPI continually sustained the following business downturn summarized as follows: 2002 2003 Net losses P45.60M P229.50M Capital deficiency 305.60M 535.10M The unaudited Balance Sheet (as per attached Annex C) of CPI as of May 31, 2004 is as follows: Total Assets P279,175,153.04 Total Liabilities 862,461,066.35 Accounts Payable & Accrued Expenses P149,845,046.91 (see annex E) Accounts Payable Others (see annex E1) P84,198,555.20 (of which P72,497,636.22 CPI owes SJ) Accounts Payable P65,646,491.71 Due to Stockholders (to NCC) P712,616,019.44 Total Stockholders' Equity (P583,285,913.31) ============= NCC contemplates of converting its debt into equity without the necessity of issuing additional number of shares of stocks but will only form part of the Additional Paid-In Capital structure. Moreover, the debt converted to equity will only increase its book value but not its proportionate equity in the corporation. As to the debt of CPI to SJ, the latter party is showing no interest in collecting its loan from the former. In reply, please be informed that in BIR Ruling No. 045-92 dated February 13, 1992, this Office had the occasion to rule that: "Section 55 of the Income Tax Regulations implementing then Section 29(a) [now Section 28(a)] of the Tax Code, as amended, pertinent portion of which provides: 'Sec 55. Acquisition or Disposition by a Corporation of its Own Capital Stock . Whether the acquisition or disposition by a corporation of share of its own capital stock gives rise to taxable gain or deductible loss depends upon the real nature of the transaction, which is to be ascertained from all its facts and circumstances. The receipt by a corporation of the subscription price of shares of its capital stock upon their original issuance gives rise to neither taxable gain nor deductible loss, whether the subscription or issue price be in excess of, or less than, the par or stated value of such stock.' (Emphasis supplied) Nonoc shall not be subject to income tax on the difference between the receivables of P15,063,178,815.00 and the total par value of the converted shares of P7,586,032,760.00 because the receipt by Nonoc of the receivables constituting the subscription price for said shares (converted shares) upon the original issuance thereof did not give rise to taxable income or gain on the part of Nonoc even if the subscription or issue price consisting of the receivables is in excess of the total par value of the converted common and preferred shares. Moreover, the stockholder's equity is the sum of the paid-in capital and retained earnings. The conversion of APT's receivables in the amount of P15,063,178,815.00 into shares of stock with par value of P7,586,032,760 only, is indicative of the fact that the difference of P7,477,146,055 (15,063,178,815 less 7,586,032,760 = 7,477,146,055) is applied to increase Nonoc's retained earnings and equity from a negative total of P5,954,932,484.00 to a positive total of P7,611,032,760. The difference of P7,477,146,055 is not taxable income to Nonoc because they are not earnings from the use of capital; neither are they earnings from the exertion of physical or mental effort. On the other, such receivables would constitute additional capital investment of APT in Nonoc which is not included within the purview of the term "taxable income" as defined in Section 28 of the Tax Code, as amended. Likewise, such additional capital investment shall not be subject to the donor's tax because there is no donative intent in a debt-to-equity conversion transaction . . . ." (Emphasis ours.) Accordingly, the conversion of CPI's loan to NCC into equity including interest and royalty fees without the necessity of issuing additional number of shares of stocks shall not give rise to a taxable income and shall only be considered as an additional capital investment on the part of NCC. By the same token, such additional capital investment shall not be subject to donor's tax since there is no donative intent in this scenario. Anent the second query, BIR Ruling No. 076-89 dated April 17, 1989 ruled that: DcaECT 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 efficiency 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. xxx xxx xxx" (Emphasis ours.) 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 interest on the part of SJ 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 ascertained that the facts are different, then this ruling shall be considered void. cTSHaE Very truly yours, Commissioner of Internal Revenue By: (SGD.) JOSE MARIO C. BUAG Deputy Commissioner Legal and Inspection Group