BIR Ruling [DA-545-04]

November 5, 2004 BIR RULING [DA-545-04] Sec. 27 (D) (5) BIR Ruling No. 123-86; DA-459-88 & DA-049-00 Atty. Miguel Romualdo T. Sanidad Phinma Plaza, Level 11, 39 Plaza Drive Rockwell Center, Makati City 1200 S i r : This refers to your letter dated September 9, 2004 requesting on behalf of United Industrial Bag Company, Inc. ("UIBC") for a ruling on the tax consequence/s of the reversal of interest accrued on UIBC's loan in case it decides to pay such loan by way of a dacion en pago of its equipment and machineries with condonation of interest. It is represented that UIBC is in the business of making paper bags for cement companies; that through borrowed funds from Solidbank Corp. (now Metropolitan Bank and Trust Company) and Rizal Commercial Banking Corporation, it was able to double its capacity; and that unfortunately, for failure to service its loan of P95,072,941 from Metrobank since 1999 and at present, UIBC has interest in arrears of P46,745,252. It is further represented that UIBC has been incurring losses since 1997 and in October 2001 it has ceased operations, retiring all its personnel and paying its loan by way of dacion en pago of its land and building; that to settle its loan and arrears with Metrobank, UIBC proposes to pay by way of dacion en pago its two lines of paper bag converting equipment, machineries and related parts (UIBC's only remaining assets of value); that when the dacion en pago transaction is completed, UIBC intends to dissolve by shortening its corporate term; that Metrobank has expressed its willingness to condone P43,237,717 in interest and penalties; that Metrobank booked P3,507,535 only as interest receivables since banks are not allowed to book interest receivables from non-performing loans (NPLs) pursuant to BSP Circular No. 202 dated May 27, 1999; that UIBC will then reverse the same amount of interest it has accrued since 1999 up to 2002; that for years 1999 to 2001, for tax purposes it deducted from its gross income the accrued interest as interest expense; that for year 2002, for tax purposes it no longer deducted accrued interest from its gross income; that as shown in the simulated schedule of Annual Income (Losses) and Interest Expenses from year 1998 to 2003 submitted by UIBC, the reversal of corresponding accrued interest for the pertinent year would still result in loss, to wit: Year Income/(Loss) Int. Expense Metro Income (Loss) Before Loan Interest 1998 (26,526,678) 13,205,896 (13,320,782) 1999 (30,166,335) 13,205,896 (16,960,439) 2000 (20,341,457) 13,242,076 (7,099,381) 2001 (33,950,819) 9,877,276 (24,073,543) 2002 (31,045,320) (31,045,320) 16,281,241 on deductible (13,434,204) (13,434,204) and that the reversal of the accrued interest through condonation of the said loan should not be considered as income on the part of UIBC since it did not derive any tax benefit during the years that it deducted the interest expense from its income for tax purposes as it was in tax loss position before and after the interest deduction. ITSaHC In reply please be informed that pursuant to Section 27(D)(5) of the Tax Code of 1997, acquisition of real property treated as capital asset and acquired by way of "dation in payment" is subject to capital gains tax on the gains presumed to have been realized from said transfer taking into consideration the outstanding balance of the loans as the selling price. 1 If the property transferred by way of "dation in payment" is an ordinary asset, it shall be subject to income tax imposed under Section 27(A) of the same Code. The outstanding balance of the loan shall be taken into consideration in determining the selling price of the real property or chattel acquired by way of dacion en pago . In the instant case, the properties proposed to be transferred by way of dacion en pago are paper bag converting equipment, machineries and related parts which are UIBC's only remaining assets of value. Thus, for purposes of income tax, the taxable income shall be net taxable gains derived from dacion en pago and determined pursuant to Section 39 of the Tax Code. In short, the original acquisition cost of the real property, or the net book value of the chattel, as the case may be, shall be allowed as deduction from the selling price (outstanding balance of the loan inclusive of the interest) to arrive at the net taxable gain (loss) subject to income tax imposed under Section 27(A) of the Tax Code of 1997. The issue presented before us for consideration is the tax consequence/s of the proposed condonation by Metrobank of the amount booked and accrued as interest expense in the books of UIBC for years 1999 up to 2001, and the reversal of that accrued interest expense account by UIBC. This Office has noted your representation that the amount booked as interest on the non-performing loans by parties UIBC and Metrobank are different. UIBC has booked and accrued the total amount of P46,745,252 as interest expense and on the part of Metrobank, the amount booked as interest receivables was only P3,507,535 in consideration of the fact that banks are not allowed to book interest receivables from non-performing loans (NPLs) pursuant to BSP Circular No. 202 dated May 27, 1999. We however, noted that as per UIBC's simulated schedule of Annual Income (Losses) and Interest Expenses, the accrual of the amounts in arrears as interest expense for taxable years 1998 up to 2003 did not change UIBC financial position considering that for the aforementioned years it consistently incurred operating losses. Even assuming that no such interest expenses have been accrued, UIBC's financial position will still remain in negative position as shown in the above schedule. The reversal of amounts booked and accrued as interest expenses will call for the application of the " tax benefit doctrine " which is a theory which provides for the inclusion in gross income of amounts deducted in earlier taxable years and recovered in later years, but only to the extent that the earlier deductions resulted in income tax liability of the earlier year . 2 On the basis of the above facts as represented, this Office opines that since UIBC did not and will not derive any tax benefit whether the said accrued expenses are allowed or not, the subsequent reversal/write off of the amount booked will not result in any taxable income subject to tax. Hence, the amounts reverted or written off shall not be considered as part of the outstanding loan which is proposed to be settled by way of dation in payment. This Office also took note of your representation on the express willingness of Metrobank to condone the amount of P43,237,717 in interest and penalties which UIBC had booked and accrued in prior years. The condonation will not include the amount of P3,507,535 actually booked by Metrobank. aTcSID Pursuant to the provision of Art. 1270 of the Civil Code, condonation or remission is essentially gratuitous, and requires acceptance by the obligor (debtor/mortgagor). It may be made expressly or impliedly. In this case, the object of condonation or remission is a demandable debt which is the supposed interest receivables amounting to P43,237,717 but which creditor Metrobank did not record/recognize in its books as such because pursuant to BSP Circular No. 202, banks are not authorized to book an interest receivables on non-performing loans (NPL) under BSP Circular No. 202. Such being the case, it is hereby opined that the since the proposed condonation of P43,237,717 was not recognized by Metrobank as a demandable debt/receivables, then Metrobank is condoning nothing. Hence, there is no condonation to speak of. On the other hand, since the amount has been booked and accrued by UIBC, the entry calls for reversal the taxability of which has been discussed above. 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 Nos. DA-459-88 dated September 19, 1988 and DA-049-00 dated January 21, 2000, both citing BIR Ruling No. 123-86 dated July 23, 1986. 2. Barron's Law Dictionary, 3rd edition citing I.R.C. 111.