BIR Ruling [DA-483-04]

September 10, 2004 BIR RULING [DA-483-04] Atty. Maria Lourdes R. Reyes 131 F. Manalo Street San Juan, Metro Manila M a d a m : This refers to your letter dated August 3, 2004 stating that your client, Tanglaw Realty. Inc. (Tanglaw), is a corporation duly organized and existing under the laws of the Philippines: that it is organized with the following primary purpose: "To acquire by purchase or lease, or otherwise, subdivide lands and interest in lands and to own, hold, improve, develop and manage any real estate so acquired and to erect or cause to be erected on any lands, owned, held or occupied by they corporation, buildings, or other structures with their appurtenances and to rebuild, enlarge, alter or improve any buildings or, structures now or hereafter erected on any lands so owned, held, occupied and to mortgage, sell, lease or otherwise dispose of any lands or interests in lands and in buildings or other structures, and any stores, shops, suites, rooms, or parts of any buildings or other structures at anytime owned or held by the corporation." that Tanglaw is the absolute owner of two (2) parcels of land covered by TCT Nos. 9277 and 10366 issued by the Registry of Deeds for Rizal with an aggregate area of 4,994 square meters located at the corner of Shaw Boulevard and Torres Street, Mandaluyong City: that on June 17, 1978. Tanglaw entered into a lease agreement with Motown Vehicle, Inc. (Motown), a duly registered domestic corporation engaged in the business of selling cars, for the lease of portions of the above-described properties totaling 4,811.75 square meters; that the said Lease Agreement provided among others, that the term of the lease shall be for a period of 25 years or until November 14, 2003; that on the basis of the June 17, 1978 Lease Agreement, Motown constructed a building on the aforementioned leased portions of the properties; that sometime, thereafter during the term of the lease, due to the subsequent turn of events, Motown failed to deliver peaceful and continued possession of the aforesaid leased premises and committed violations of its obligations under the aforementioned Lease Agreement; that due to the violation of Motown of its commitments and obligations under the lease, Tanglaw notified Motown of its decision to cancel its lease under the then existing June 17, 1978 Lease Agreement; that in full reliance of the representation of Mr. Francisco Gonzales, the owner of outstanding shares in Motown, that the said lease agreement is valid and subsisting, Mr. Severino Lim, one of the principal stockholders of Toyota Shaw, Inc., for and on behalf of Toyota Shaw, Inc., purchased all the outstanding shares of stock in Motown and made improvements on the properties and consequently, Toyota Shaw, Inc., having acquired the controlling stocks of Motown became the new lessee and agreed in writing to the cancellation of the June 17, 1978 Lease Agreement between Motown and Tanglaw; that on October 10, 1989. Tanglaw, as Lessor, and Toyota Shaw, Inc., as the new Lessee, entered into a New Lease Agreement wherein the latter agreed to lease the subject properties; that the salient features of the New Lease Agreement provides that "1. TERM This lease shall have a term of fifteen (15) years commencing on June 1, 1989 and ending on May 31, 2004. xxx xxx xxx that upon expiration of the New Lease Agreement on May 31, 2004, the buildings and improvements were turned over by Toyota Shaw, Inc., as successor in interest of Motown, to Tanglaw; that the building has an estimated life span of twenty-five (25) years while the estimated life span of the improvements is ten (10) years; that the building and improvements were introduced by Motown, the previous lessee in 1978, which is more than 25 years ago from the termination of the lease agreement; that at the time of turn over of the subject properties or 26 years from the construction of the said properties, the same have been fully depreciated; that the condition of said properties is such that necessary renovations and extraordinary repairs have to be undertaken to make the same in useful condition; and that the book value has diminished to zero, which is tantamount to having the improvements removed by the new lessee. Based on the foregoing representations, you now request confirmation of your opinion that upon termination of its lease agreement, Tanglaw, as the Lessor, shall not realize any taxable gain arising from the improvements made by the Lessee on its leased properties. In reply thereto, please be informed that Section 49 of Revenue Regulations No. 2, otherwise known as the Income Tax Regulations provides "Section 49. IMPROVEMENTS BY LESSEES. When buildings are erected or improvements made by a lessee in pursuance of an agreement with the lessor, and such buildings or improvements are not subject to removal by the lessee, the lessor may at his option report the income therefrom upon either the following bases: "(a) The lessor may report as income at the time when such buildings or improvements are completed the fair market value of such buildings or improvements subject to the lease. "(b) The lessor may spread over the life of the lease the estimated depreciated value of such buildings or improvements at the termination of the lease and report as income for each year of the lease an aliquot part thereof. "If for any other reason than a bona fide purchase from the lessee by the lessor the lease is terminated, so that the lessor comes into possession or control of the property prior to the time originally fixed for the termination of the lease, the lessor receives additional income for the year in which the lease is so terminated to the extent that the value of such buildings or improvements when he became entitled to such possession exceeds the amount already reported as income on account of the erection of such buildings or improvements. No appreciation in value due to causes other than the premature termination of the lease shall be included. Conversely, if the building or improvements are destroyed prior to the expiration of the lease, the lessor is entitled to deduct as a loss for the year when such destruction takes place the amount previously reported as income because of the erection of such buildings or improvements, less any salvage value subject to the lease to the extent that such loss was not compensated for by insurance. If the buildings or improvements destroyed were acquired prior to March 1, 1913, the deduction shall be based on the cost or the value subject to the lease to the extent that such loss was not compensated for by insurance." Prescinding from the above-cited section, the buildings erected or improvements made by the lessee on the leased premises are taxable only if the same are made pursuant to an agreement with the lessor and the buildings erected or improvements made are not subject to removal by the lessee. The lessor has the option to report as income, at the time when such buildings or improvements are completed, the fair market value of such buildings or improvements, subject to the lease, or to spread over the life of the lease the estimated depreciated value of such buildings or improvements at the termination of the lease and to report as income for each year the lease an aliquot part thereof. Accordingly, in applying the said Regulations, this Office holds that Section 49 of Revenue Regulations No. 2 does not apply to the instant case because the improvements made by the new lessee, Toyota Shaw, Inc., under the new Lease Agreement with Tanglaw were not made in pursuance of the agreement with the latter. Moreover, there is no explicit provision in the New Lease Agreement that the building and improvements are subject to removal by the new lessee. The said improvements at the termination of the new Lease Contract last May 31, 2004, have been fully depreciated. Thus, Tanglaw may not realize any taxable gain therefrom. IN VIEW OF THE FOREGOING, this Office holds that since the improvements, at the time of the termination of the Lease Agreement between Tanglaw and Toyota Shaw, Inc., have been fully depreciated and rendered its book value to zero. Tanglaw, as the lessor, may not realize any taxable gain therefrom. CcaDHT 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 Deputy Commissioner Legal & Inspection Group