BIR Ruling [DA-489-05]

December 6, 2005 BIR RULING [DA-489-05] Section 32 (B) (6) (a); BIR Rulings Nos. 219-93; 417-93; & DA-527-04 Mr. Emmanuel D. Arriola, Jr . 37 East 3rd St.,Angela Village Las Pias City 1749 S i r : You stated in your letter dated June 15, 2005 that you were employed by The Studio Communication Arts Corporation (the "Company") from February 1974 until your retirement on December 31, 2003, or for a period of almost 30 years. You were also a shareholder of the Company to the extent of 80,000 shares with a par value of P10.00 per share or a total par value of PhP800,000.00. The Company has a Profit-Sharing Plan and Trust Agreement for the exclusive benefit of its qualified officers and employees which was executed on December 20, 1974 and made effective as of February 1, 1974 (the "Retirement Plan"),under the terms of which a participating employee of the Company shall be entitled to stated benefits upon his or her retirement. On December 31, 2003, you retired from the Company at the age of sixty-five (65) years old. On June 21, 2004, you instituted a civil case for "Injunction, Breach of Contract, Sum of Money, Quasi-Delict, and Damages with a Prayer for the Issuance of a Writ of Preliminary Injunction and Temporary Restraining Order and a Writ of Preliminary Mandatory Injunction and the Appointment of a Receiver or Management Committee" with Branch 138 of the Regional Trial Court of Makati City docketed as Civil Case No. 04-711 against, among others, the Company and WPP Marketing Communications, Inc. ("WPP").Your complaint alleged that WPP's breach of a long-standing contract between it and the Company ran the Company to the ground and, consequently, prejudiced you as it depleted and exhausted the value of your shareholdings in the Company such that you lost your entire investment in the Company. Your prayer included payment of your retirement benefits under the Company's Retirement Plan which had remained unpaid as of the filing of the complaint, moral and exemplary damages, attorney's fees and costs of suit. The complaint also sought payment of actual damages from WPP equivalent to the value of your shares in the Company. While the aforesaid case was being heard on your prayer for injunction, on September 17, 2004, a Settlement Agreement (the "Settlement Agreement") was instituted between the parties to the suit. Under the Settlement Agreement, the defendants agreed to pay you actual damages in an amount equivalent to the par value or acquisition cost of your investment or shares in the Company, your retirement benefits under the Company's Retirement Plan as well as moral and exemplary damages, attorney's fees and costs. On October 17, 2004, the Regional Trial Court of Makati City, Branch 138, through the Honorable Judge Sixto C. Marella, Jr.,approved the Settlement Agreement among the parties and ordered the parties to comply with the terms thereof. The judgment of the Court in Civil Case No. 04-711 has become final and executory. ITaESD We proceed to rule on the particular issues raised for our consideration: 1) On the issue of whether or not the award of actual damages constitutes a return of capital or investment, hence, not subject to income tax and, consequently, to withholding tax, please be informed that the term "income" for purposes of the imposition of income tax, consists of realized appreciation of capital or investment and realized returns, either in the form of receipts or benefits, flowing from the use of capital, services, activities or acts of the taxpayer, or which come to the taxpayer other than as a return of capital or investment, or as a substitution of money value for something permanently lost. Thus, damages from a breach of contract constitute taxable income to the recipient thereof in the year received only to the extent that such damages constitute a loss of anticipated profits and non-taxable to the extent the same represent a return of capital or investment (BIR Ruling dated May 28, 1953). In view of the foregoing, this Office is of the opinion as it hereby holds that the award of actual damages to you in Civil Case No. 04-711 in an amount equivalent to the par value or acquisition cost of your shares in the capital stock of the Company as reparation for the depletion or exhaustion of the value of your shares (or the loss of your investment in the Company) due to a breach of contract, constitutes a return of capital or investment, hence, not subject to income tax and, consequently, to withholding tax, as the same constitutes a "return of capital or investment" or a "substitution of money value for something permanently lost." 2) This Office holds that the award to you of attorney's fees and costs to the extent of actual expenses only, pursuant to Civil Case No. 04-711 is not subject to income tax and consequently, to the withholding tax since the same are merely a reimbursement of your expenses/advances in the course of the hearing of your case. Such being the case, any amount in excess of actual expenses shall be taxable. In respect to the award to you of moral and exemplary damages, Section 32(B)(4) of the Tax Code of 1997 provides "SEC. 32. Gross Income . xxx xxx xxx (B) Exclusions from Gross Income . The following items shall not be included in gross income and shall be exempt from taxation under this Title: xxx xxx xxx (4) Compensation for Injuries or Sickness . Amounts received, through Accident or Health Insurance or under Workmen's Compensation Acts, as compensation for personal injuries or sickness, plus the amounts of any damages received, whether by suit or agreement, on account of such injuries or sickness." The Federal Income Tax of the U.S.A. to which our tax laws are patterned contains a similar provision which provides that amounts received as damages (other than punitive damages) on account of personal physical injuries or physical sickness are excludable from income (Sec. 104(a)(2), U.S. Tax Code). However, nowhere in either the. U.S Tax Code or the Philippine Tax Code is there a provision exempting from income tax moral and exemplary damages arising from a breach of contract. Accordingly, award to you of moral and exemplary damages arising from breach of contract is subject to income tax and consequently, to the withholding tax. 3) Anent your retirement benefits, please be informed that Section 32(B)(6)(a) of the Tax Code of 1997 provides as follows: "SEC. 32. Gross Income . (A) ... (B) Exclusions from Gross Income . The following items shall not be included in gross income and shall be exempt from taxation under this Title: ... (6) Retirement Benefits, Pensions, Gratuities, etc . (a) Retirement benefits received under Republic Act No. 7641 and those received by officials and employees of private firms, whether individual or corporate, in accordance with a reasonable private benefit plan maintained by the employer: Provided, That the retiring official or employee has been in the service of the same employer for at least ten (10) years and is not less than fifty (50) years of age at the time of his retirement: Provided, further, That the benefits granted under this subparagraph shall be availed of by an official or employee only once . . ." It will be observed that under the afore-quoted provisions, retirement benefits may be received either under Republic Act (R.A.) No. 7641 and in accordance with a reasonable private benefit plan maintained by the employer under then R.A. No. 4917 (now Section 32(B)(6)(a) of the Tax Code of 1997). If there is a retirement plan duly approved by the BIR, collective bargaining agreement or other applicable employment contract providing for retirement benefits, the same shall be followed and R.A. No. 7641 shall not apply. In view thereof, this Office confirms your opinion that the retirement benefits you received pursuant to the BIR-approved Company's Retirement Plan are exempt from income tax and consequently, the withholding tax prescribed by Section 79, Chapter XIII, Title II of the Tax Code of 1997 pursuant to Section 32(B)(6)(a) of the Tax Code of 1997. 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 as null and void. Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service