BIR Ruling [DA-444-05]

October 27, 2005 BIR RULING [DA-444-05] Laya Mananghaya & Co. 22/F Philamlife Tower 8767 Paseo de Roxas Makati City Attention: Atty. Francisco G. Tagao Head, Tax and Corporate Services and Atty. Joseph Shelner N. Songco Assistant Manager, Tax and Corporate Services Gentlemen : This refers to your letter dated October 20, 2005 stating that your client, Global Brands Company, Inc. ("GBCI") ,is a corporation duly organized and existing under and by virtue of the laws of the Philippines with office address at 35F Penthouse Raffles Corporate Center, Emerald Avenue, Ortigas Center, Pasig City; that on the other hand, PPM Ventures Nominee Limited (PPMV),is an entity duly organized and existing under the laws of the United Kingdom and is the majority stockholder of GBCI; that On October 2, 2000, GBCI entered into a loan agreement with PPMV whereby PPMV extended a loan to GBCI; that the aggregate amount of the loan is Php402,395,000.00 broken down in three tranches, as follows: Value of Loan Notes Interest Rate Commencement Date Php 325,000,000.00 10% per annum 2 October 2000 Php 41,340,000.00 10% per annum 20 July 2001 Php 36,055,000.00 10% per annum 3 September 2001 Php 402,395,000.00 that upon the respective commencement dates of the Loan Notes and up to March 31, 2003, GBCI accrued interest in its books on the foregoing loan in the amount of Php83,138,289.00 but never remitted its interest to PPMV; that for the period covering April 1, 2003 to March 31, 2004, GBCI did not accrue the interest due in its books corresponding to the period in the amount of P38,459,130.00 and did not remit interest payment nor made any loan payments to PPMV; that from the start of its commercial operation to fiscal year ended March 31, 2004, GBCI has accumulated a total operating loss of P294,960,653 based on the audited financial statements computed as follows: 1. P212,234.00 for fiscal year ending 31 March 2001 as restated; 2. P115,721,348 for fiscal year ending 31 March 2002 3. P161,901,084.00 for fiscal year ending 31 March 2003; 4. P17,125,987.00 for fiscal year ending 31 March 2004; Total P294,960,653.00 that however, for fiscal year ended March 31, 2005, GBCI reflected taxable income in the amount of P13,572,237.00; that although the financial statements for the said fiscal year showed income, the same is not indicative of the true financial condition of GBCI because the taxable income resulted from a non-trade related activity, which is the gain from liquidation of an investee company amounting to P62,174,613.00; that GBCI still incurred substantial losses from its operations for fiscal year ended March 31, 2005 in the amount of (P44,990,242.00) if you deduct its income from non-trade related activity; that since GBCI has been continuously in an operating loss position from the time of its commencement of business operations in Year 2000, GBCI and PPMV decided to convert the accrued interest expense for the period covering October 2, 2000 to March 31, 2003 amounting to Php83,138,289.00 into equity of GBCI in the form of additional paid-in capital without issuing additional shares to PPMV; that on March 25, 2004, GBCI's Board of Directors approved the conversion of the foregoing Php83,138,289.00 accrued interest for the period covering October 2, 2000 to March 31, 2003 into additional paid in capital ("APIC");that the conversion into APIC of said accrued interest was subsequently approved by the Securities and Exchange Commission (SEC) on July 22, 2004; that furthermore, the financial difficulties encountered by GBCI as a result of its continued operating losses since Year 2000 prompted PPMV on January 14, 2004, to suspend, waive or condone all the interest from April 1, 2003 up to March 31, 2004 in order to assist the company in its operation; and that on March 25, 2004, the GBCI's Board of Directors also approved the temporary suspension of the interest on the loan for the period covering April 1, 2003 to March 31, 2004 in the total amount of P38,459,130.00. In connection therewith, you now request for confirmation of your opinion that: 1) GBCI will not realize any taxable income arising from the conversion into additional paid in capital of the accrued interest the loan from PPM Ventures Nominee Limited ("PPMV") amounting to Php83,138,289.00 for the period covering 02 October 2000 to 31 March 2003 and from the subsequent suspension or waiver or condonation of the interest due but not accrued amounting to Php38,459,130.00 corresponding to the period covering 01 April 2003 to 31 March 2004. 2) The conversion into additional paid in capital of the accrued interest on the loan from PPMV amounting to Php83,138,289.00 for the period covering 02 October 2000 to 31 March 2003 and the suspension or waiver or condonation of the interest due but not accrued amounting to Php38,459,130.00 corresponding to the period covering 01 April 2003 to 31 March 2004 are not subject to withholding tax 3) The conversion into additional paid in capital of the accrued interest on loan to PPMV amounting to Php83,138,289.00 for the period covering 02 October 2000 to 31 March 2003 and the suspension or waiver or condonation of the interest due but not accrued on the loan from PPMV amounting to Php38,459,130.00 for the period covering 01 April 2003 to 31 March 2004 are not subject to donor's tax. HICSaD In reply thereto, please be informed that your opinion is hereby confirmed as follows I. Accrued Interest Converted into Additional Paid in Capital Not Subject To Income Tax and Donor's Tax GBCI will not realize any taxable income arising from the conversion into APIC of the accrued interest for the period covering October 2, 2000 to. March 31, 2003 amounting to Php83,138,289.00. The contribution of paid-in surplus in the form of money or property without the issuance of additional shares by GBCI's major stockholders is not subject to any income tax. Capital contribution generally does not give rise to a taxable event pursuant to Section 56 of Revenue Regulations No. 2, otherwise known as the Income Tax Regulations, which provides that Section 56. Contributions by shareholders . Where a corporation requires additional funds for conducting its business and obtains such needed money through voluntary process payments by its shareholders, the amounts so received being credited to its surplus account or to a special capital account, will not be considered income ,although there is no increase in the outstanding shares of stock of the corporation. The payments in such circumstances are in the nature of voluntary assessments upon, and represent an additional price paid for, in shares of stock held by the individual shareholders, and will be treated as an addition to and as part of the operating capital of the company. Thus, in BIR Ruling Nos. DA-117-03 dated 14 April 2003 and DA-221-02 dated 25 November 2002 citing earlier rulings, as follows: BIR Ruling No. 586-88 dated 19 December 1988 additional contribution in the form of donated surplus without the necessity of issuing additional shares of stock is deemed capital investment which is not within the purview of the term "taxable income" and is not subject to income tax. BIR Ruling Nos. 270-87 dated 8 September 1987 and 127-89 dated 13 June 1989 additional capital contribution without necessarily issuing additional shares of stock, which merely increase the basis of the stockholders' stock but not their proportionate equity in the corporation, is a transaction not subject to income or gift taxes. Moreover, in BIR Ruling No. DA-465-03 dated 5 December 2003, this Office ruled that the conversion into paid-in capital of a loan obtained from its non resident parent company, which constitutes additional capital contribution on the part of the latter, is a capital investment not within the purview of the term taxable income as defined in Section 32 in relation to Section 34 of the Tax Code of 1997. The debt-to-equity conversion was deemed not subject to income tax. Furthermore, the conversion into APIC of the accrued interest for the period covering October 2, 2000 to March 31, 2003 amounting to Php83,138,289.00 will not give rise to donor's tax on the part of PPMV considering that there is no donative intent on the part of PPMV. Likewise, the conversion into paid-in capital or surplus of a company's payables to its stockholder is a capital investment not subject to the donor's tax because there is no donative intent in a debt-to-equity conversion transaction. ( BIR Ruling No. UN221-94 dated July 25, 1994 ) Such being the case, this Office holds that GBCI is not subject to income tax on the Php83,138,289.00 accrued interest converted into additional paid in capital as it is a capital investment which will not constitute as taxable income. The additional capital investment is likewise not subject to donor's tax because there is no donative intent in a debt-to-equity conversion transaction. II. Suspension or Waiver or Condonation of Interest not subject to income tax and donor's tax With regard to PPMV's subsequent suspension of interest due but not accrued on the loan notes from April 1, 2003 to March 31, 2004 amounting to Php38,459,130.00, it is the opinion of this Office that it is in the nature of a waiver or condonation of interest. As such, GBCI will not realize any taxable income nor will PPMV be subjected to donor's tax. HTCSDE It is to be emphasized, that the suspension of the interest on the loan notes may be considered as waiver or condonation of a portion of the indebtedness. Thus, Section 50 of the Income Tax Regulations, provides "Section 50. Forgiveness of indebtedness . The 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 service. 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." In view of the foregoing, this Office holds that the suspension or waiver or condonation by PPMV of the interest is treated as a capital transaction. Accordingly, to fortify this opinion, this Office likewise invoke a US jurisprudence, which has persuasive effect in this jurisdiction, which read as follows: "Section 26:31 of Mertens, The Law of Federal Taxation provides that even though a valid debtor-creditor relationship may originally have been intended, insolvency or continuous losses of a debtor-subsidiary over a long period of time has been held to change the relationship when it becomes apparent to the creditor parent that it can have no reasonable expectation of payments in the near future. Moreover, in the case of Hoguel Real Estate Corp. v. Commissioner, 30 TC 580 (199958) ,the U.S. Court said that were the provision for payment of "interest" semi-annually was treated by the taxpayer's Board of Directors as one which obliged it to make payments only when it has sufficient earnings from which the "interest" could be paid, the provision is not a characteristic of interest obligation but is characteristic of the duty to pay dividends under the premise that the advances made by the creditor-parent are in substance, a capital contribution or equity investment. ( reiterated in Sherwood Memorial Gardens, Inc. v. Commissioner, 42 TC 211 ." Based on the audited financial statements of GBCI for the taxable years ending March 31, 2001, March 31, 2002, March 31, 2003 and March 31, 2004, GBCI has incurred operating losses of P294,960,165 computed as follows:, 1. P212,234.00 for fiscal year ending 31 March 2001 as restated; 2. P115,721,348 for fiscal year ending 31 March 2002; 3. P161,901,084.00 for fiscal year ending 31 March 2003; 4. P17,125,987.00 for fiscal year ending 31 March 2004; Total P294,960,653.00 However, for fiscal year ended March 31, 2005, GBCI reflected taxable income in the amount of P13,572,237.00. Although the financial statements for the said fiscal year showed income, the same is not indicative of the true financial condition of GBCI because the taxable income resulted from a non-trade related activity, which is the gain from liquidation of an investee company amounting to P62,174,613.00. GBCI still incurred substantial losses from its operations for fiscal year ended 31 March 2005 in the amount of (P44,990,242.00) if you deduct its income from non-trade related activity. Although its assets are more than its liabilities, a review of its other assets would reveal that this is substantially in the nature of goodwill which GBCI, cannot use to pay off its liabilities. If on the other hand, you deduct the goodwill from its assets, this will result in its total liabilities exceeding its total assets. TDcHCa Similarly situated is BIR Ruling No. 076-89, 17 April 1989, where this Office ruled that "before the condonation or forgiveness of indebtedness will give rise to a taxable income, there must be an increase in the assets of the debtor thereby enriching the latter .A transaction whereby nothing of exchangeable value comes to or is received by a taxpayer does not give rise to or create a taxable income. Gain or profit is essential to the existence of taxable income." This Office, in setting forth the above pre-condition for imposing income tax on the condonation of indebtedness, adopted the principle laid down by the US Supreme Court in Dallas Transfer & Terminal Warehouse v. Commissioner of Internal Revenue, 70 F.2d 95 ,which held that there must be an increase in assets for there to be income realized from the reduction or extinguishment of liability. In this case, Dallas was renting an office building from its lessor. Due to the lease, Dallas incurred a debt of US$107,880.77 rendering it insolvent. In order to enable Dallas to remain in business and to have a chance to pay the reduced future rental agreed upon, and also to keep its building from being vacant and unprofitable, the lessor accepted as partial payment Dallas' Alamo street property with the appraised value of US$17,507.20 and cancelled the balance of that debt, charging it off as worthless. The US Supreme Court in ruling that Dallas did not realize taxable income explained that: "The transaction was not in form or substance a sale for US$107,880.77 of property which has an appraised value of US$17,507.20. In effect the transaction was similar to what occurs in an insolvency or bankruptcy proceeding when, upon a debtor surrendering, for the benefit of his creditors, property insufficient in value to pay his debts, he is discharged from liability for his debts. This does not result in the debtor acquiring something of exchangeable value in addition to what he had before. There is a reduction or extinguishment of liabilities without any increase in assets. There is an absence of such a gain or profit as is required to come within the accepted definition of income that the increase in clear assets so brought about constituted taxable income is not applicable to the factors of the instant case, as the cancellation of Dallas' past due debt to its lessor did not have the effect of making the Dallas' assets greater than they were before that transaction occurred .Taxable income is not acquired by a transaction which does not result in the taxpayer getting or having anything he did not have before. Gain or profit is essential to the existence of taxable income." The above situation may be applied to the case of GBCI. The extinguishment of GBCI's liability as a result of the suspension or waiver or condonation of the interest on the loan did not increase GBCI's assets. It did not have the effect of making GBCI's assets greater than they were before. Its liabilities still exceed its assets. Moreover, GBCI did not realize any taxable income as a result of the suspension or waiver or condonation. Based on the foregoing, this Office holds that GBCI is not subject to income tax on the amount of Php38,459,130.00 suspended or waived or condoned by PPMV. Furthermore, the suspension, waiver or condonation is not subject to donor's tax since there is no donative intent on the part of PPMV, but was made solely for business consideration to assist GBCI to continue with its operations. (BIR Ruling Nos. 076-89 and DA-419-04) III. No Withholding Tax on Accrued Interest and Interest due but not Accrued which was Suspended, Waived or Condoned No withholding tax should be due on the accrued interest and on the interest due but was not accrued in the books of GBCI because no interest was remitted. In Commissioner of Internal Revenue v. Mar Fishing Co., Inc. CA-G.R. No. 29838 dated 31 January 1994 ,the Court of Appeals affirmed the ruling of the Court of Tax Appeals saying that in a situation where technical fees were accrued in the books but no actual payment was made to the foreign corporation, no withholding tax can be imposed thereon since there was no income realized by the foreign corporation subject to Philippine taxation. In this case, Mar Fishing Co.,Inc.,a domestic corporation, accrued in its books the technical service fees supposedly to be paid to British Columbia Packers, Ltd. ("BCPL"),a non-resident foreign corporation. Thereafter, the foreign corporation condoned or waived the payment thereof due to substantial financial losses of the domestic corporation. Since there was no payment remitted abroad, the domestic corporation did not withhold taxes thereon. Hence, the assessment. The Court of Appeals, in saying that there was no withholding tax on the transaction, explained that: " ...in the instant case, the technical service fee in the amount of P413,196.00 for 1982 was never remitted to the foreign corporation (BCPL),hence, there is no income realized by the foreign corporation from sources within the Philippines from which the withholding tax could have been based. Considering that the technical service fee was condoned/waived by the foreign corporation, private respondent cannot be held liable for the payment of the withholding tax deficiency assessed by the petitioner. DaHISE Based on the foregoing jurisprudence, it is the opinion of this Office that the accrued interest on loan payment to PPMV amounting to Php83,138,289.00 for the period covering October 2, 2000 to March 31, 2003 as well as the interest due but not accrued amounting to Php38,459,130.00 for the period covering April 1, 2003 to March 31, 2004 are not subject to withholding tax WHEREFORE, your opinion is hereby confirmed as follows: 1. GBCI will not realize any taxable income arising from the conversion into additional paid in capital of the accrued interest from PPM Ventures Nominee Limited ("PPMV") amounting to Php83,138,289.00 for the period covering October 2, 2000 to March 31, 2003 and from the subsequent suspension, waiver or condonation of the interest due but not accrued in the books of GBCI amounting to Php38,459,130.00 for the period covering April 1, 2003 to March 31, 2004. 2. The conversion into additional paid in capital of the accrued interest on loan from PPMV amounting to Php83,138,289.00 for the period covering October 2, 2000 to March 31, 2003 and the suspension, waiver or condonation of the interest due but not accrued in the books of GBCI amounting to Php38,459,130.00 for the period covering April 1, 2003 to March 31, 2004 are not subject to withholding tax. 3. The conversion into additional paid in capital of the interest due on the loan from PPMV amounting to Php83,138,289.00 for the period covering October 2, 2000 to March 31, 2003 and the suspension, waiver or condonation of the interest due but not accrued in the books of GBCI on the loan from PPMV amounting to Php38,459,130.00 for the period covering April 1, 2003 to March 31, 2004 are not subject to donor's tax. 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.) JOSE MARIO C. BUAG OIC, Commissioner of Internal Revenue