BIR Ruling [DA-522-03]

December 16, 2003 BIR RULING [DA-522-03] Secs. 24 (B) (1), 27 (D) (1), 28 (A) (7) (a); DOF Order No. 141-95, S of 1995 BIR Ruling 03-03 Bureau of the Treasury Intramuros, Manila Attention: Hon. Sergio G. Edeza Treasurer of the Philippines Gentlemen : This refers to your letters dated October 21 and December 11, 2003 requesting for confirmation of the applicability of the principles laid down in BIR Ruling No. 003-03 dated March 27, 2003, on your proposed issuance of Peso Denominated Zero Coupon. Bonds, to wit: "1. The discount earned from FCDU T-Notes is income on FCDUs of banks from a foreign currency transaction with resident and thus falls within the purview of Sec. 28(A)(7)(b) of the Tax Code of 1997. As such, BTr shall withhold upfront the 10% final tax on the discount at the time of the issuance of the FCDU T-Notes; and "2. The calculation of the 10% tax on said interest income shall be valued at its present value since the interest is earned over the life of the security and not upfront." Further, you request for clarification or confirmation of the applicability of Revenue Regulations No. 20-2003 dated June 02, 2003 on the Value Added Tax (VAT), and request a ruling on how the payment should be effected considering that the proposed issuance is a zero coupon bonds. The Bureau of the Treasury (BTr) posits that it should acknowledge liability of the incremental portion of the VAT passed on to it by the financial institution-lender/investor only after payment by the latter of the equivalent GRT portion. FACTS It is represented that the National Government (NG) plans to issue Peso Denominated Zero Coupon Bond with tenors of 2, 3, 4, 5, 7 and 10 year maturities through public auction, over-the-counter and tap facility window before the year ends to finance its budgetary requirements. The planned issue although longer-dated will operate structurally in the same manner as Treasury Bills and shall be priced at a discount. The BTr has scheduled an auction relative to this issuance on 16 December 2003. The scheduled auction is for the issuance of a PhP 3.5 Billion zero coupon bonds with maturity of 7 years. It is BTr's position that the above-mentioned BIR Ruling or the tax treatment stated therein is likewise applicable on the 20% withholding tax imposable on the interest income from the 7-year zero coupon bond issuance scheduled on 16 December 2003. SALIENT FEATURES OF THE P300B 2, 3, 4, 5, 7, 10 YEAR ZERO COUPON TREASURY BONDS Term Sheet Rationale of the Issue Deepening of the capital market by offering a new bonds structure Establish Medium to Long Term Yield Curve Provide an outlet for investor's long term investment requirements Lengthen the maturity profile of the Republic's liabilities Issuer Republic of the Philippines Issue Amount Up to P300.0B to be issued in several tranches and with maturities as follows: 2-year P50.0B 3-year P50.0B 4-year P50.0B 5-year P50.0B 7-year P50.0B 10-year P50.0B Issue Price At a discount Term 2, 3, 4, 5, 7 and 10 years Redemption In one lump sum at maturity date per tranche/issue size Yield rate Market determined Form Uncertificated, to be registered with Registry of Scripless Securities Manner of Offering Through auction, over-the-counter, tap, firm underwriting, combined bookbuilding and public offering or as may be determined by the Secretary of Finance Taxation Prevailing final withholding tax at the time of issue of the discount; documentary stamp tax (DST) on original issue shall be for the account of the issuer Eligibilities Eligible as insurance reserves, performance and judicial bonds, reserves for trust duties and as liquidity floor requirement for government funds held (subject to existing Bangko Sentral ng Pilipinas rules and regulations thereon) Security Issue Direct, unconditional and general obligations of the National Government Firms Eligible Government Securities Eligible Dealers (GSEDs) and any financial institutions as provided under Section 28 of the Department of Finance Order No. 114, as amended, Series of 1995. Sinking Fund A sinking fund shall be established. Other Feature Tradeable and transferable BIR REPLY We reply as follows: 1. Under Sections 24(B)(1), 27(D)(1), 28(A)(7)(a) in relation with Section 22(Y), all of the Tax Code of 1997 (Tax Code), a final tax at the rate of twenty percent (20%) is imposed on "interest on any currency bank deposit and yield or any other monetary benefit from deposit substitutes and from trust funds and similar arrangements." Section 2(h)(iii)(b) of Revenue Regulations No. 17-84 considers all borrowings of the national and local government and its instrumentalities including the Central Bank of the Philippines (now Bangko Sentral ng Pilipinas), evidenced by debt instruments denoted as treasury bonds, bills, notes, certificate of indebtedness and similar instruments as "deposit substitutes" subject to the provision of Section 22(Y) of the Tax Code which defines the term as follows: "The term "deposit substitutes" refers to alternative form of obtaining funds from the public (the term public means borrowing from 20 or more individuals or corporate lenders at any one time), other than deposits, through the issuance, endorsement, or acceptance of debt instruments for the borrower's own account for the purpose of relending or purchasing of receivables and other obligations, or financing their own needs or the needs of their agent or dealer. . . ." In this light, this Office has consistently opined that to be considered as "deposit substitutes" subject to twenty percent (20%) final withholding tax, the borrowing of funds must be obtained from twenty (20) or more individuals or corporate lenders at any one time. (BIR Ruling No. 020-2001 dated May 31, 2001) Further, for purposes of determining whether the borrowing is from the "public," the number of investors shall be counted at the time of origination or original issuance, regardless of whether the bonds are thereafter traded or sold in the secondary market, i . e ., the individual or corporate investor must be twenty (20) or more. Since the first tranche, i.e. , the 7-year Peso Denominated Zero Coupon Bonds shall be offered through auction and therefore, there will be more than twenty (20) or more subscribers at the time of its origination, the discount earned therefrom is income of the investors/lenders subject to the twenty percent (20%) final tax imposed under the aforementioned Sections 24(B)(1), 27(D)(1), 28(A)(7)(a) of the Tax Code. Such being the case, the Republic through the Bureau of the Treasury, shall withhold upfront from the amount of discount the twenty percent (20%) final tax imposed on deposit substitutes under the aforementioned sections 1 depending on the kind of the lender-taxpayer. 2. With respect to the calculation of the 20% tax on such interest income, please be informed that pursuant to Section 7 in relation to Section 5 of Department of Finance Order No. 141-95, Series of 1995 (Revised Rules and Regulations for the Issuance, Placement, Sale, Service and Redemption of Treasury Bills and Bonds under R.A. No. 245, as amended), which read as follows: "Section 7. Taxation . The income derived from Treasury Bills and Bonds, and instruments with recourse as authorized by Bangko Sentral ng Pilipinas (BSP), shall be subject to the 20% final income tax to be withheld on discounts valued at the time of issue on every original sale which shall be deducted by the buyer from the discounts of the T-bills/bonds and included in the remittance of the purchase price. "In the case of Treasury Bonds, the 20% final income tax shall be withheld on discounts valued at present value on every original sale . Periodic coupon payments on Treasury Bonds shall be subject to the 20% final income tax to be withheld at the time the coupon payments are made. "The documentary stamp tax on the original issue shall be for the account of the issuer. "No other taxes shall be collected on subsequent trading of the securities which have been subjected to tax under the first two paragraphs herein." (Emphasis supplied) Section 5 of DOF No. 141-95 reads as follows: "Section 5. Treasury Bonds . Treasury Bonds shall be issued at a discount basis, at a premium, or at par and payable on maturity of not earlier than one (1) year but not later than twenty-five (25) years. They may be offered for sale through competitive or non-competitive auction or any other method as determined appropriate by the Bureau of Treasury. The foregoing provision is consistent with the previous ruling of this Office " that the total discount of coupon bearing government securities and other similar instruments with maturities of more than one (1) year shall be considered earned in the year of sales based on the current values " such that the issuing agency shall remit " the corresponding final income tax withheld on discount valued at present value on every original sales [sic] in the primary market within the period " 2 so then specified under Revenue Regulations No. 17-84. caEIDA It is noted though that the zero coupon instrument is different from a coupon bearing instrument subject of BIR Ruling No. 177-95, supra , and to which the aforequoted provision is applicable, as there are no semi-annual cash payments made to security holders. Zero coupons are therefore issued at a discount to yield par at maturity. The difference between par and discount is the imputed interest earned on the security. As you stated, all things being constant, the price of a zero coupon instrument accordingly would increase with time to account for the accreted interest. Moreover, since payment is made at maturity, the interest earned is the accreted interest on the security, but because it is a zero coupon instrument there is no cash outflow. Applying the above Section 7 of DOF Order No. 141-95 in the instant case, this Office opines that the 20% should be present valued by the net yield on the security to ensure that the interest is taxed at 20%. Accordingly, since the interest is earned over the life of the security and not upfront, your opinion that the 20% final income tax withheld on such discounts should be valued at its present value is hereby confirmed. 3 Consequently, as first ruled, the Bureau of the Treasury shall withhold and remit the corresponding 20% final income tax withheld on discounts valued at present value upon original issue of the subject 7-year Peso Denominated Zero Coupon. 3. Section 32(B)(7)(g) of the Tax Code, which reads as follows: "(g) Gains from the sale of bonds, debentures or other certificates of indebtedness . Gains realized from the sale or exchange or retirement of bonds, debentures or other certificate of indebtedness with a maturity of more than five (5) years shall not be included in gross income and shall be exempt from taxation." does not limit the exclusion of gain or income derived from the sale or exchange or retirement of the bond only to those derived by a subsequent holder. Absent such qualification, no distinction should be read into the law. Where the law provides no qualification for the grant of tax exemption, the court, much less the BIR, is not at liberty to supply one. 4 It should be understood, therefore, that the term "gain" shall refer to the gain, if any, from secondary trading which is the difference between the selling price of the bonds in the secondary market and the price at which the bonds were purchased by the seller. The term "gain' shall also include the gain (that is, the difference between the proceeds from the retirement of the bonds and the price at which such last holder acquired the bonds) realized by the last holder of the bonds when such bonds are surrendered for retirement upon their maturity. (BIR Ruling No. 035-2001 dated August 16, 2001) It is emphasized, however, that the term "gain" does not include "interest" ( Nippon Life Insurance Company of the Philippines, Inc. vs. Commissioner of Internal Revenue , CTA Case No. 6142, promulgated February 4, 2002), which, as stated, is subject to income tax as described above. 5 Such being the case, since the first tranche, i.e. , 7-year Peso Denominated Zero Coupon Bonds has a maturity of seven (7) years from issue date, any gain realized from the sale or exchange or retirement thereof is excluded from the gross income as provided for under the aforecited Section 32(B)(7)(g) of the Tax Code; hence, exempt from income tax. 4. The proviso of Section 3 of Revenue Regulations No. 20-2003 implementing Section 5 of Republic Act (RA) No. 8424, otherwise known as the "Tax Reform Act of 1997 and other pertinent provisions of the Tax Code of 1997 imposing VAT on the services of the banks, non-bank financial intermediaries and finance companies beginning January 1, 2003 pursuant to RA No. 9010, provides that " with respect to income, including net trading gains, or government securities where the financial institution-lender/investor primarily liable for paying the VAT thereon does not pass-on or shift to the government-borrower part or whole of the output tax (output VAT) due, the recognizable income of the said financial institution-lender/investor shall be net of the output tax (output VAT) assumed or not shifted to the customer/client which will be remitted by the financial institution- lender/investor to the Bureau of Internal Revenue (BIR). On the other hand, any output VAT passed-on or shifted to the government-borrower shall be remitted directly by the government-borrower to the BIR in the form of or as a withholding tax creditable against the value-added tax liability of the financial institution-lender/investor, as provided under Section 114 and Section 245 of the Tax Code of 1997. The creditable amount shall, nonetheless, be evidenced by a Certificate of Creditable Tax Withheld and Paid/Payable (BIR Form No. 2307) issued by the government-borrower . Provided, the payment by the financial institution-lender/investor of the assumed part of the output tax (output VAT) shall be deemed payment by said financial-lender/investor of the VAT due from it on its interest income and net trading gains on government securities, it being understood that it is the government-borrower/withholding agent which shall be liable to pay and remit to the BIR the output VAT passed- on/shifted to and duly acknowledged by it, as evidenced by duly issued Certificate of Creditable Tax Withheld at Source, on said interest income and net trading gains ." Based on the foregoing, the government-borrower shall withhold and remit the output VAT passed-on/shifted to and duly acknowledged by it. Considering that gross receipts of the financial lender may be properly determined only upon receipt of the interest or trading gains earned in the course of its investment in or sale of such securities, this Office is of the opinion that the corresponding amount of output VAT due and passed on to the Bureau of the Treasury may be acknowledged by it only after payment by said financial institution-lender/investor of the equivalent GRT portion but within the period so provided for in Section 114 of the Tax Code, as implemented by Rev. Regs. No. 2-98, as amended by Rev. Regs. No. 6-2001. 4. The original issuance of the first tranche of Peso Denominated Zero Coupon Bonds shall be subject to DST at the rate of P0.30 for every Two hundred Pesos (P200.00) or fractional part thereof of their face value pursuant to Section 180 of the Tax Code. Finally, pursuant to Section 6 of Revenue Regulations No. 26, the DST Regulations, which provides: "Section 6. Transfer of bonds, debentures, etc . No documentary stamp tax accrues on mere transfers of bonds, debentures, or certificates of indebtedness issued by any association, company or corporation, but where the transfer of the bonds carries with it the issuance of new bonds in the name of the transferee to replace the old ones, the tax imposed on the issuance of the bonds should be paid." the transfer of 7-year Peso Denominated Zero Coupon Bonds in bearer form in the secondary market by way of simple delivery to the buyer is not subject to the DST unless the transfer of the instruments carries with it a renewal or issuance of new instruments in the name of the transferee to replace the old ones. (BIR Ruling No. 050-2001 dated October 29, 2001) This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it shall 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 Footnotes 1. BIR Ruling No. 050-01 dated October 29, 2001. 2. BIR Ruling No. 177-95 dated November 9, 1995. 3. BIR Ruling No. 03-03 dated March 27, 2003. 4. Republic Flour Mills, Inc. vs. Commissioner of Internal Revenue, 31 SCRA 520. 5. BIR Ruling Nos. 035-2001 dated August 16, 2001 and 017-2002 dated April 29, 2002.