BIR Ruling [DA-537-06]

September 5, 2006 BIR RULING [DA-537-06] 34; 39; R.R. 05-99 & 25-02; DA-353-03; DA-136-05 Salvador Guevara & Associates 815-816 Tower One & Exchange Plaza, Ayala Triangle, Ayala Avenue, Makati City Attention: Atty. Edmundo P. Guevara Atty. Ma. Rosario L. Bernardo & Atty. Nympha D. Bundoc Gentlemen : This refers to your letter dated April 26, 2006 requesting a ruling on the tax implications to Nestl Philippines, Inc. ("Nestl") of the sale and termination of business of Goya, Inc. ("Goya"). It is represented that Nestle is a domestic corporation owning 99.8% of the shares of Goya, maker of popular confectionery products sold under the Goya brand. The Goya shares were bought by Nestle for a total consideration of Php365 Million. Upon Nestl's acquisition of Goya, the latter continued manufacturing and distributing chocolate and sugar confectionary products under both the Goya and Nestle brands under license from Nestl, S.A. In 1998, Goya entered into an Independent Distributorship Agreement with Nestl for the distribution and marketing of Goya products under a 7% distributor's margin to Nestl on all Goya products sold under the agreement. For greater efficiency and economy, Nestl and its subsidiaries and affiliates, including Goya, centralized the procurement of raw materials through Nestl. The costs of raw materials used in the business of each affiliate were charged to each affiliate as advances and were evidenced by debit notes. In addition to the charges for raw materials to Goya, Nestl made additional advances to Goya, evidenced by debit notes, for Goya's operational expenses. Goya has periodically paid for the advances out of cash generated from its operations, as well as from the sale of some of its assets. As of December 31, 2005, Goya is already in a deficit position. Thus, its shares have a negative book value. As of January 11, 2006, the total amount of advances given by Nestl to Goya ("Advances") stood at Php932,241,133.38 Million. This was booked by both Goya and Nestl in their Balance Sheets as "Advances from Parent Company" and "Advances to Affiliates or Subsidiaries", respectively. aHCSTD On January 11, 2006, a resolution was approved and ratified by the Stockholders of Goya to: (a) sell all its net tangible fixed assets, cease its business operations and terminate all its existing agreements effective upon the close of business hours on March 1, 2006, and (b) amend Goya's Articles of Incorporation to shorten its corporate life to June 30, 2006. This resolution was ratified by the stockholders of Goya representing 99.8% of its outstanding capital stock. Consequently, on January 23, 2006, Petra Foods Limited ("Petra") agreed to purchase, and Goya agreed to sell, Goya's confectionary business on March 1, 2006. Upon the liquidation of Goya, all of the outstanding shares of Goya shall be surrendered by its stockholders and cancelled. The stockholders of Goya shall not receive any assets from Goya, consisting of the cash proceeds from the sale of its business to Petra, net of expenses and pay-outs, as such net amount shall be retained to fund Goya's expenses until its liquidation and to pay for outstanding obligations. Based on the foregoing representations, you now request confirmation of your opinion on the following matters: 1. The liquidating loss suffered by Goya's shareholders from the liquidation of their investment in Goya is a capital loss, which may be deducted only to the extent of capital gains, if any. 2. Nestl may deduct the Advances as a bad debts deduction in the year of the sale of Goya's business and its cessation of operations. Moreover, the amount of Advances that are deductible may be determined as of December 31, 2006. 3. The write off by Nestl of the Advances in its books is not a donation subject to donor's tax as it does not constitute a condonation of the debt, which remains in the books of Goya. In reply thereto, please be informed that your opinion is hereby confirmed as follows: 1. As represented, as of December 31, 2005, Goya is in a deficit position. Thus, its shares have a negative book value. Accordingly, Goya's shareholders will suffer a liquidating loss, measured by their respective costs of investment in Goya shares. This liquidating loss is in the nature of a capital loss and therefore shall be treated in the manner stated in Section 39 of the 1997 Tax Code, as amended, which provides that capital losses are deductible only to the extent of capital gains from the sale of capital assets, if any: "Sec. 39. Capital gains and losses . (A) Definitions. As used in this Title (1) Capital assets. The term "capital assets" means property held by the taxpayer (whether or not connected with his trade or business) but does not include stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade of business, or property used in the trade or business, of a character which is subject to the allowance for depreciation provided in subsection (F) of Section 34; or real property used in the trade or business of the taxpayer. xxx xxx xxx (C) Limitation on capital losses. Losses from sales or exchanges of capital assets shall be allowed only to the extent of the gains from such sales or exchanges. . . ." Applying the foregoing provision, this Office in BIR Ruling No. 146-81 dated August 4, 1981, 1 ruled that: ". . . losses suffered by a stockholder from liquidation of a corporation are capital losses which may be offset against gains derived from the sale or exchange of capital assets which may or may not be shares of stock." as well as in BIR Ruling No. DA-353-03 dated October 10, 2003, which provides in part, viz.: ". . . shareholders of the corporation may realize gain or loss on their receipt of liquidating dividends from the dissolving corporation. The gain or loss is measured by the difference between the fair market value of the liquidating dividends and the adjusted cost to the stockholders of their respective shareholdings in the said corporation." However, since the Goya shareholders will not receive any liquidating dividends, their respective liquidating loss is the cost of their investment in Goya. In the case of Nestl, this liquidating loss is PhP365 Million, which is its acquisition cost in Goya. 2. Nestle may likewise deduct the Advances as bad debts in the year of the sale of Goya's business and its cessation of operations. The amount of Advances that are deductible is to be determined as of December 31, 2006. Please note that Section 34(E) of the 1997 Tax Code, as amended, states that: "SEC. 34. Deductions from gross income . . . ., in computing taxable income subject to tax . . ., there shall be allowed the following deductions from the gross income: xxx xxx xxx (E) Bad Debts . (1) In general . Debts due to the taxpayer actually ascertained to be worthless and charged off within the taxable year except those not connected with profession, trade or business and those sustained in a transaction entered into between parties mentioned under Section 36(B) of this Code; provided , that recovery of bad debts previously allowed as deduction in preceding years shall be allowed as part of the gross income in the year of recovery to the extent of the income tax benefit of said deduction. . . . ." Revenue Regulations (RR) No. 05-99, as amended by RR No. 25-02, implementing the above provision, provides that bad debts refer to those debts resulting from the worthlessness or uncollectibility, in whole or in part, of amounts due the taxpayer by others, arising from money lent or from uncollectible amounts of income from goods sold or services rendered . 2 Hence, in accordance with the provisions of the Tax Code and the above regulations, the following are the requirements for a bad debt deduction: 3 a. There must be an existing indebtedness due to the taxpayer which must be valid and legally demandable; b. The same must be connected with the taxpayer's trade, business or practice of profession; c. The same must not be sustained in a transaction entered into between related parties enumerated under Sec. 36(B) of the Tax Code of 1997; d. The same must be actually charged off the books of accounts of the taxpayer as of the end of the taxable year; and e. The same must be actually ascertained to be worthless and uncollectible as of the end of the taxable year. In determining whether a debt can be considered worthless and uncollectible, Section 2, RR No. 05-99, as amended by RR No. 25-02, provides the following guidelines: "The determination of worthlessness in a given case must depend upon the particular facts and the circumstances of the case. A taxpayer may not postpone a bad debt deduction on the basis of a mere hope of ultimate collection or because of a continuance of attempts to collect notes which have long become overdue. While a mere hope probably will not justify postponement of the deduction, a reasonable possibility of recovery will permit the account to be carried along notwithstanding that the probabilities are that the debt may not be collected at all. The creditor may offer evidence to show some expectation that the debt would have been paid in the intervening years, and that subsequently, the hope was shattered or appeared to have been unfounded. Good faith does not require that the taxpayer be an "incorrigible optimist" but on the other hand, he may not be unduly pessimistic. Creditors do not have to wait until some turn of the wheel of fortune may bring their debtors into affluence. The taxpayer may strike a middle course between pessimism and optimism and determine debts to be worthless in the exercise of sound business judgment based upon as complete information as is reasonably ascertainable. The taxpayer need not have perfect discernment . The Commissioner of Internal Revenue will consider all pertinent evidence, including the value of the collateral, if any, securing the debt and the financial condition of the debtor in determining whether a debt is worthless, or the assigning of the case for collection to an independent collection lawyer who is not under the employ of the taxpayer and who shall report on the legal obstacle and the virtual impossibility of collecting the same from the debtor and who shall issue a statement under oath showing the propriety of the deductions thereon made for alleged bad debts. Thus, where the surrounding circumstances indicate that a debt is worthless and uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment, a showing of those facts will be sufficient evidence of the worthlessness of the debt for the purpose of deduction." (Emphasis supplied) CSHDTE Without any assets and any prospect of future revenues both on the long and the short term, owing to the cessation of Goya's business operations, the sale thereof effective upon the close of business on March 1, 2006 and the cessation of its corporate existence as of June 30, 2006, there is no prospect left for Nestl to recover the Advances from Goya. Accordingly, it would be appropriate for Nestl to determine the worthlessness of such debt and deduct the same as bad debts in its gross income for the taxable year 2006. The ascertainment of worthlessness should be pegged as of December 31, 2006, the end of the taxable year when Goya has actually ceased its business operations (effective, March 1, 2006), or when its corporate life has ceased to exist (that is, June 30, 2006). This is so regardless of when the Securities and Exchange Commission actually approves the shortening of its corporate life. As of December 31, 2006, the amount of Advances that are deductible as bad debts should be the outstanding amount of Advances as of January 11, 2006, the date when the Stockholders approved and ratified the sale of Goya's business less any amounts paid thereafter by Goya to Nestl as a result of the sale of Goya's assets. If, after December 31, 2006, Nestle should receive additional amounts from Goya as payment for the Advances, Nestle should recognize the same as income in the year the payment was received. 3. The write off of the Advances cannot be considered a donation subject to donor's tax since there is no donative intent on the part of Nestl. The write off is purely for business consideration since Goya has no more sufficient assets to pay the Advances. Such is our ruling in BIR Ruling No. DA-136-05 dated April 7, 2005. Moreover by charging off Goya's indebtedness in its books, Nestl is not condoning the Advances. In accordance with Section 4, RR No. 05-99, if Nestle realized a reduction of the income tax due from it on account of the bad debts deduction, its subsequent recovery of the debt from Goya shall be treated as a receipt of realized taxable income. 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 Footnotes 1. This was reiterated in BIR Ruling UN-453-95 dated December 27, 1995. 2. Section 2(a), RR No. 05-99, as amended. 3. Section 3, RR No. 25-02.