BIR Ruling [DA-509-06]

August 25, 2006 BIR RULING [DA-509-06] R.A. 7916; 44; DA-135-2006; DA-077-2006 Fernandez Aguja Law Firm CPA-Lawyers Suite 5F JL Bldg., Don Jose Avila cor. Don Gil Garcia Streets Cebu City Attention: Atty. Luna Mae F. Aguja Partner Gentlemen : This refers to your letter dated August 5, 2006 requesting on behalf of your client, Lexmark Research & Development Corporation (LRDC) , for confirmation of your opinion on the following matters: 1. The rental income for the lease of land by Efficient Holdings Inc. (EHI) to LRDC shall be subject to the 5% special tax rate pursuant to Section 24 of RA 7916; 2. The offset of loans and security deposit extended by LRDC to EHI against all rental income shall constitute as the entire consideration received for the long term lease subject to the 5% special tax rate; 3. The rental income of EHI shall be taxed on the year its loans and security deposits from LRDC are offsetted against rental income based on Section 44 of the Tax Code; 4. LRDC shall not deduct creditable withholding tax (CWT) on the lease of land at the time the loans and the security deposit are offset considering that EHI is a PEZA registered enterprise enjoying the special 5% tax incentive pursuant to the exemption provided for under Section 2.57.5 of Revenue Regulations No. 2-98; 5. The lease of land by LRDC, a PEZA registered IT Enterprise, from EHI, also a PEZA registered Ecozone IT Park Developer/Operator and paid through offset of loans and the security deposit shall be exempt from the value added tax (VAT) pursuant to Section 24 of Republic Act No. 7916. 6. No documentary stamp tax is payable on the Contract of Lease since the lessor and the lessee are both PEZA registered enterprises enjoying the 5% special tax rate on gross income earned. The facts as represented, are as follows: Lexmark Research & Development Corp. (LRDC) is a corporation duly organized and existing under Philippine laws. It is engaged in the business of research and development with respect to computer printers and related IT equipment. It is registered with the Philippine Economic Zone Authority (PEZA) pursuant to the provisions of Republic Act No. 7916, as an Information Technology (IT) Enterprise engaged in the provision of engineering design and software development services. Under the said registration, the Company is enjoying the preferential tax rate of 5% on gross income in lieu of the payment of all national and local taxes for most of its products and the income tax holiday on some of its expansion activities and after the expiration thereof, to the preferential tax rate of 5%. It has been notified of its inclusion in the top 10,000 private corporations required to withhold 1% on its income payments to its supplier of goods and 2% on its income payments to its supplier of services. CIAHDT LRDC is undergoing expansion of its activities. The PEZA has already approved the registration of its new activity, particularly, engineering design and hardware development of the entire printer at the proposed Lexmark Plaza. This New Activity has been approved by PEZA as a New Project on a Pioneer Status. LRDC has opted to waive its 6 year income tax holiday incentive and go straight to the 5% special tax rate on gross income in lieu of all national and local taxes. On the other hand, Efficient Holdings, Inc. (EHI) is a corporation duly organized and existing under Philippine laws. It was registered with the PEZA on February 22, 2006 pursuant to the provisions of Republic Act No. 7916 specifically under Registration Certificate No. EZ 06-08 as the Developer/Operator of Lexmark Plaza. Said PEZA Registration only came about after the proclamation by the President of the Philippines through Proclamation No. 986 creating and designating certain parcels of land at the Cebu Business Park as an Information Technology Park. The said area declared as an Information Technology Park is the area where Lexmark Plaza will be constructed. Under Article XIII of the said registration, EHI is enjoying Income Tax Holiday (ITH) for four (4) years on income earned from locator IT enterprises and related operations and after the ITH period, the option to pay a special 5% tax on gross income earned from locator IT enterprises and related operations, in lieu of all national and local taxes, except real property taxes on land owned by the developer. EHI through a resolution of its board of directors has signified to PEZA that it will waive its 4 year ITH incentive and instead go straight to the 5% special income tax rate on gross income earned regime. EHI as Lessor and LRDC as Lessee have entered into a long term Contract of Lease over the parcels of land declared thru Presidential Proclamation No. 986 as an Information Technology Park (hereinafter to be referred to as the "Leased Premises"). The Term of the said Contract of Lease is for fifty (50) years (the Original Term), at the expiration of which, Lessee shall have the option to renew the Contract for another period of twenty five (25) years (Renewal Period) as provided for under Republic Act No. 7652, otherwise known as the Investors' Lease Act. Under the terms of the Contract of Lease, LRDC as Lessee shall use the Leased Premises to put up an office building and testing center in connection with its research and development activities. In consideration for the above Contract of Lease, Lessee shall give to Lessor the following: 1. Security deposit which shall be non-interest bearing and shall serve as guarantee to secure the faithful compliance by the Lessee of all the covenants and conditions of the Contract of Lease and shall be refunded by the Lessor to the Lessee upon complete payment to the Lessor of the Up-front Rent; 2. Upfront Rent Payment equivalent to three (3) years rental payments to be payable upon fulfillment of certain conditions among them the consolidation of the lot titles into one lot and the re-titling of the newly consolidated lot with the subject Contract of Lease registered on the title. This Upfront Rent has not been paid yet as the condition for the payment has not yet been fulfilled; 3. Upfront Payment to be paid by the Lessee on or before the fifth (5th) anniversary of the commencement of subject Contract of Lease. Subsequent to the signing of the Contract of Lease, the Lessee extended to the Lessor a non-interest bearing loan covered by a Promissory Note. Upon further negotiation it was proposed by the Lessor to the Lessee that the non-interest bearing loan, together with the Security Deposit given by the latter to the former be considered as the entire rental for the term of the lease (the Original Term and the Renewal Period, if any) and that the same be offset against all the rental payments due under the subject Contract of Lease. In reply, please be informed as follows: 1. On the Special Tax of 5% on Gross Income Earned Section 24 of Republic Act (RA) No. 7916, as amended by R.A. No. 8748 provides: "SEC. 4. Chapter III, Section 24 of Republic ActNo.7916 is hereby amended to read as follows: SEC. 24. Exemption from National and Local Taxes. Except for real property taxes on land owned by developers, no taxes, local and national, shall be imposed on business establishments operating within the ECOZONE. In lieu thereof, five percent (5%) of the gross income earned by all business enterprises within the ECOZONE shall be paid and remitted as follows: (a) Three percent (3%) to the National Government; (b) Two percent (2%) which shall be directly remitted by the business establishments to the treasurer's office of the municipality or city where the enterprise is located." Section 1(A) of Rule XIV of the Rules and Regulations Implementing Republic Act No. 7916 provides, viz: "Rule XIV. Incentives to Ecozone Developers/Operators Section 1. Incentives to Ecozone Developers/Operators. Ecozone Developers/Operators shall be entitled to the following incentives: A. Exemption from National and Local Taxes and Licenses. Except for real property taxes on land, an Ecozone Developer/Operator shall be exempt from payment of all real and local taxes. In lieu thereof, the Ecozone Developer/Operator shall pay a five percent (5%) final tax on gross income in accordance with the provisions of Rule XX of these Rules." Thus, PEZA registered enterprises are granted specific income tax exemption such that no taxes, local and national shall be imposed on business establishments operating within the Ecozone in lieu of the five percent (5%) preferential tax rate on the gross income earned by all businesses and enterprises within the Ecozone. ( BIR Ruling DA-277-06 dated April 24, 2006 ). In relation thereto, Section 2 (nn), Rule I of the Rules and Regulations implementing Republic Act No. 7916 "gross income" refers to gross sales or gross revenue derived from business activity within the Ecozone, net of sales discounts, sales returns and allowances minus cost of sales or direct costs but before deduction is made for administrative expenses or incidental losses during a given taxable period. In addition, Section 3 of Revenue Regulations No. 2-2005, as amended by Revenue Regulations No. 11-2005, defines "gross income earned" to implement the tax incentive provision in Section 24 of RA 7916, as follows: "Section 3. Gross Income Earned . For purposes of implementing the tax incentive of registered Special Ecozone enterprises in Section 24 of Republic ActNo.7916, the term "gross income earned" shall refer to gross sales or gross revenues derived from business activity within the Ecozone, net of sales discounts, sales returns and allowances and minus costs of sales or direct costs but before any deduction is made for administrative, marketing, selling and/or operating expenses or incidental losses during a given taxable period." ScaATD In BIR Ruling No. DA-135-06 dated March 17, 2006, the BIR opined that "from the foregoing, it is clear that the 5% preferential tax rate applies to gross sales or gross revenues derived from business activity within the Ecozone, but the direct costs (costs of sales) are deductible from gross sales/revenues for purposes of computing a PEZA firm's taxable gross income subject to the 5% final tax. Based on the above, the offsetting of the loans and the security deposit against the entire rental for the term of the lease constitutes income from registered activity of EHI since it came from rental payments made by its sole locator enterprise, LRDC. Such being the case, the same is subject to 5% special tax rate on gross income earned in lieu of all national and local (except real property tax) taxes. 2. Offset of Loans and Security Deposit Constitutes as Entire Consideration In BIR Ruling No. 020-02 dated May 13, 2002, the BIR had the occasion to rule that an assumption of liability could be a part of a consideration of a sale. Said ruling provides as follows: "Consideration is defined as the inducement to a contract. It is the reason or material cause of a contract. It is some right, interest, profit or benefit accruing to one party. (Black's Law Dictionary, 6th Edition) In the case of PSALM, its assumption of NPC's liabilities is mandated by law. Normally, the transfer of property by a person (transferor) to another person (transferee) in exchange for the assumption by said person of the transferor's liability will be considered a sale, where the assumption of liability constitutes a consideration for the assets. The gain, if any, from the transfer is the difference between the higher of the consideration received or zonal value, if applicable, and the value of the assets given up. The amount of the liabilities transferred is treated as part of the consideration." Also, in RevenueRuling68-364 (a US IRS ruling) which has a persuasive effect in Philippine jurisdiction, the US Internal Revenue Service ruled that a small business corporation (seller) could include in its gross receipts the amount of debt that was assumed by the purchaser who bought its encumbered property. The US Revenue Ruling emphasized that any liabilities of the seller assumed by the purchase could be included in the receipts/sales realized by the seller. Moreover, on the part of the loans being applied as rental payments, Section 40 (C) (5) (a) of the Tax Code speaks of assumption of liabilities as a consideration in a transaction. Relevant portion of said section states that: ". . . if as part of the consideration to the transferor, the transferee of the property assumes a liability of the transferor or acquires from the latter property subject to a liability, such assumption or acquisition (in the amount of the liability) shall, for purposes of this paragraph, be treated as money receive by the transferor on the exchange; . . ." In another BIR ruling (BIR Ruling No. DA 222-2004 dated April 28, 2004), the BIR opined that the amount of advances offset plus the liabilities assumed by Union shall constitute the entire consideration received for the lease of the PPE of Alsons for three years and shall be included in the gross income of Alsons. Further, the consideration received, consisting of advances offset and liabilities assumed by Union shall be included in the gross income of Alsons in the first year of the lease period and shall be subject to income tax based on the taxable income in said pursuant to Section 27 in relation to Section 34 of the Tax Code. As a rule, all items of gross income shall be included in the gross income for the taxable year in which they were received by the taxpayer. Thus, the consideration to be received, consisting of loans payable and security deposit applied against rental payments under the Contract of Lease shall be included in the gross income of EHI in the year when actually offset and shall be subject to income tax at the 5% special tax rate. 3. Rental Income Taxed At Time of Receipt of Consideration or Offset of Loans and Security Deposit As a rule, all items of gross income shall be included in the gross income for the taxable year in which received by the taxpayer. Section 44 of the Tax Code provides that: "The amount of all items of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under methods of accounting permitted under Section 43, any such amount are to be properly accounted for as of a different period . . . ." In relation thereto, Section 43 of the Tax Code provides, as follows: "The taxable income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such methods as in the opinion of the Commissioner clearly reflects the income . . . ." In BIR Ruling No. 003-00 dated January 5, 2000, the BIR has reiterated the rule that advance payments for rental shall be included in the taxable income of the taxpayer in the year when received, as follows: "The general rule is that the taxpayer is allowed to report income and expenses in accordance with the method of accounting employed, provided such method conforms to the generally accepted accounting principles. However, for income arising from rentals of property, a taxpayer must report as part of the gross income "advance rentals received" during the taxable year, including "rentals actually earned" but uncollected as of the end of such period. In the instant case, the accounting method being implemented by KSA in reporting its lease income in its books of accounts in accordance with the rules set forth under the International Accounting Standard (IAS) No. 17 will be higher in the initial months of the lease than the actual income earned during the relevant taxable period had it been determined based on the regular accrual method of accounting. In other words, under IAS No. 17, the sum of the expected rental for the lease term is computed and divided equally over the total number of months covered by the lease. This Office interposes no objection over such treatment, with the understanding that, for income tax reporting purposes, no advance rental received for the first year is aggregated and spread over the duration of the lease periods covered by such advances. Such being the case and considering the existing practice of the industry, KSA, as lessor of the abovementioned condominium project may report as gross income, by using the accrual method of accounting, only those rental income actually earned as well as advance payments which constitute the taxable income of KSA in the year when received. This is true even though the lessor is on the accrual or the cash method of accounting. (BIR Ruling No. 259-91) ( Hyde Park Realty, Inc. v. Commissioner , 211 F. 2d 462 Cf. Evansville Courier v. Commissioner 62 F .2d 232)". THcaDA In BIR Ruling No. 144-88 dated April 18, 1988, the BIR held that if part of the security deposits is applied as rental of office space building, said payment shall be considered as income to the lessor and shall be subject to 5% CWT. Thus, upon the actual conversion of the security deposit which was given to insure faithful compliance to the terms and conditions of the Contract, as part of the consideration of the Contract of Lease, the same becomes the income of EHI. Inasmuch as the offset of the loans extended to as well as the security deposit given to EHI by LRDC shall constitute the entire consideration received for the term of the lease (the Original Term and the Renewal Period, if any), such consideration shall be included in the gross income of EHI in the year when the offsetting will take place and shall be subject to the 5% special tax rate on gross income earned in said period pursuant to Section 24 of RA 7916. 4. On Creditable Withholding Tax Section 2.57.5 of Revenue Regulations No. 2-98 implementing Republic Act No. 8424 "An Act Amending the National Internal Revenue Code, as amended" relative to the withholding on income subject to the expanded withholding tax and final withholding tax, withholding of income tax on compensation, withholding of creditable value-added tax and other percentage, taxes provides to wit: "Section 2.57.5. Exemption from withholding . The withholding of creditable withholding tax prescribed in these Regulations shall not apply to income payments made to the following: (A) . . .; (B) Persons enjoying exemption from payment of income taxes pursuant to the provisions of any law, general or special, such as but not limited to the following: (1) . . . (2) Corporations registered with the Board of Investments and enjoying exemption from the income tax provided by Republic ActNo.7916 and the OmnibusInvestmentsCodeof 1987; (3) . . . ." Based on the above, the aforequoted Section is explicit in its provision that the withholding tax does not apply to income payments to persons enjoying exemption from payment of income taxes pursuant to the provisions of any law, general or special. Furthermore, the said Section specifically mentions those corporations registered and enjoying exemption from the income tax provided by Republic Act No. 7916 otherwise known as the PEZA Law as among those exempted from the coverage of the withholding taxes. Considering that EHI is a corporation duly registered with PEZA and enjoying the 5% special tax rate on its gross income as one of its incentives as a PEZA registered enterprise, then it falls squarely under the above-cited exemptions. Hence rental payments in the form of offsetting the loans and the security deposit made to EHI by LRDC under the subject Contract of Lease shall not be subject to the expanded withholding tax prescribed in Revenue Regulations No. 2-98 and 17-2003. In BIR Ruling Nos. DA 101-2006 dated March 9, 2006 and DA-070-2006 dated March 1, 2006, this Office confirmed that payments made to PEZA registered enterprises enjoying the 5% special tax rate on gross income earned in lieu of all taxes shall not be subject to the creditable withholding tax. 5. On Value Added Tax Section 24 of Republic Act No. 7916 provides: "Section 24. Exemption from Taxes Under the National Internal Revenue Code . Any provision of existing laws, rules and regulations to the contrary notwithstanding, no taxes, local and national, shall be imposed on business establishments operating within the Ecozone. In lieu of paying taxes, five percent (5%) of the gross income earned by all businesses and enterprises within the Ecozone shall be remitted to the national government." Based on the aforequoted provision, the lease of the land by LRDC, a PEZA registered enterprise subject to the 5% special tax rate in lieu of all national and local taxes, shall be exempt from the value added tax. In the case of Commissioner of Internal Revenue vs. Seagate Technology (Philippines), Inc . (G.R. No. 153866, February 11, 2005), the Supreme Court held, viz: "Applying the special laws we have earlier discussed, respondent as an entity is exempt from internal revenue laws and regulations. This exemption covers both direct and indirect taxes, stemming from the very nature of the VAT as a tax on consumption, for which the direct liability is imposed on one person but the indirect burden is passed on to another. Respondent, as an exempt entity, can neither be directly charged for the VAT on its sales nor indirectly made to bear, as added cost to such sales, the equivalent VAT on its purchases. Ubi lex non distinguit, nec nos distinguere debemus . Where the law does not distinguish, we ought not to distinguish. Moreover, the exemption is both express and pervasive for the following reasons: . . . RA7916 states that "no taxes, local and national, shall be imposed on business establishments operating within the ecozone". Since this law does not exclude the VAT from the prohibition, it is deemed included. Exceptio firmat regulam in casibus non exceptis . An exception confirms the rule in cases not excepted; that is, a thing not being excepted must be regarded as coming within the purview of the general rule. Moreover, even though the VAT is not imposed on the entity but on the transaction, it may still be passed on and, therefore, indirectly imposed on the same entity a patent circumvention of the law. That no VAT shall be imposed directly upon business establishments operating within the ecozone under RA7916 also means that no VAT may be passed on and imposed indirectly. Quando aliquid prohibetur ex directo prohibetur et per obliquum . When anything is prohibited directly, it is also prohibited indirectly. HCSAIa xxx xxx xxx." Thus based on the foregoing, the Contract of Lease between EHI, a PEZA registered IT Park Developer/Operator enjoying the 5% special tax rate on one hand and LRDC, also a PEZA registered IT Enterprise enjoying the 5% special tax rate in lieu of all national and local taxes shall be exempt from the VAT. 6. On Documentary Stamp Tax Section 24 of RA No. 7916, as amended by RA No. 8748, provides that no taxes, local and national, except real property taxes, shall be imposed on business establishments operating within the Ecozone. In lieu thereof, 5% of the gross income earned by all businesses and enterprises within the Ecozone shall be remitted to the national government (3%) and to the municipality or city where the enterprise is located (2%). Since both parties to the Contract of Lease are both duly registered PEZA enterprises enjoying the 5% special tax rate on gross income earned, then the Contract of Lease over the "Leased Premises" shall not be subject to the Documentary Stamp Tax imposed under Section 194 of Republic Act No. 9243 by virtue of the exemption provided by Section 24 of RA 7916 and Section 173 of RA 9243 which provides that whenever one party to the taxable document enjoys exemption from the tax herein imposed, the other party thereto who is not exempt shall be the one directly liable for the tax. Since both EHI and LRDC are exempt from all national and local taxes in lieu of the 5% special tax rate on gross income earned, then the Contract of Lease between them is exempt from the DST. BIR Ruling No. DA-010-06 dated January 17, 2006 reiterating BIR Ruling No. 008-99 dated January 1, 1999 held that since the buyer of the said assets is likewise a PEZA registered company, no documentary stamp tax is payable on such sale transaction. 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, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service