BIR Ruling [DA-592-06]

October 5, 2006 BIR RULING [DA-592-06] Section 34 (D) (1); DA-166-04 Aranas Consunji Barleta Unit 106 Le Metropole Bldg. Dela Costa cor. Tordesillas St. Salcedo Village, Makati City Attention: Atty. C.M. Barleta Tax Services Gentlemen : This refers to your letter dated April 24, 2006 requesting on behalf of your client, Bauer Foundation Phils., Inc . (BFPI), confirmation of your opinion that the unrealized foreign exchange loss booked by BFPI in prior years, but which were realized only in 2005, are deductible for tax purposes for taxable year 2005. It is represented that BFPI is a corporation duly organized and existing under Philippine laws. It is primarily engaged in the business of sale of heavy equipment used for construction. In the ordinary course of its business, BFPI regularly enters into long-term loan agreements with other companies to finance its acquisition of heavy equipment. In 1999, BFPI obtained a loan in the amount of 1,122,000 from DEG-Deutsche Investitions-Und Entwicklungsgesellschaft MBH (DEG) to finance the acquisition of certain drilling equipment accessories. The principal of the loan is to be amortized at 93,500 semi-annually beginning January 31, 2002 until July 31, 2007. The interest for the loan, which is stated at 7.25% per annum, is likewise payable within the same period. BFPI received the loaned amount in Euros () and recorded the same in its books in their peso equivalent using the foreign exchange rate at the time of receipt. On January 31, 2002, BFPI partially paid its first semi-annual amortization in the amount of 93,500 and booked the same using the prevailing foreign exchange rate. The same amount was paid and booked using the prevailing exchange rates on July 31, 2002, January 31, 2003, July 31, 2003, January 31, 2004, July 31, 2004, January 31, 2005 and July 31, 2005 representing partial payments for the semi-annual amortizations. From January 31, 2002 up to July 31, 2005, BFPI sustained unrealized foreign exchange losses from the unpaid portion of its semi-annual amortizations, as reflected on its books, due to exchange rate fluctuations between the Euro and Philippine peso, but the said loss was not deducted from its gross income for tax purposes. On December 31, 2005, BFPI paid in full the remaining balance of the loan in the amount of 374,000 and recorded the same using the prevailing exchange rate. Upon the completion of the transaction, BFPI's books reflected a realized loss from the loan transaction due to foreign exchange fluctuations in the amount of P109,126,392.61 which includes unrealized foreign exchange loss booked in prior years from January 31, 2002 up to July 31, 2005. BFPI deducted the said loss from its gross income for taxable year 2005. acAESC In reply, please be informed that this Office has already recognized the taxability/deductibility of gain or loss arising from the fluctuation in foreign exchange rates. Thus, when a foreign currency acquired in connection with a loan agreement is paid, ordinary gain or loss results from the fluctuations in foreign exchange rates. In BIR Ruling DA-359-03 dated October 10, 2003, the reason for the deductibility of foreign exchange loss was explained: "What DPI has reflected in its books as a liability or expense (i.e. accounts payables, advance payments from contractees, purchase of construction materials) was the amount before the foreign exchange fluctuated, thus, since the payment of said liability was done when the peso depreciated, it suffered a foreign exchange loss when it used more pesos to pay its foreign currency obligations ( The Coca-cola Export Corporation vs. Commissioner of Internal Revenue , C.T.A. Case No. 5238, December 19, 1997.) Alternatively, if DPI has reflected in its books as an asset or income ( i.e ., accounts receivables, advance payments to subcontractors, construction income) an amount before the foreign exchange fluctuated, it will realize a gain when the peso depreciated at the time of collection." However, foreign exchange loss is deductible only if the same has been realized. Without realization, there can be no loss. There is realization of loss in the year it is actually sustained. ( BIR Ruling No. 206-90 dated October 30, 1990) It is sustained during the year in which the loss occurs as evidenced by a closed and completed transaction and as fixed by identifiable events occurring in that year. ( BIR Ruling No. DA-359-03 dated October 10, 2003). A closed transaction is a taxable event which has been consummated. (p. 231 Black's Law Dictionary, Fifth Edition) Mere fluctuation in value of the foreign exchange vis-a-vis the Philippine peso, but short of a closed and completed transaction, does not result to recognition of deductible loss. ( VAT Ruling No. 239-89 dated September 20, 1989) In the subject loan agreement, the taxable event that consummates the transaction is the remittance of the scheduled amortizations and full payment of the loan. The full payment of the loan completes the transaction and it is from that point that one can ascertain the actual foreign exchange loss sustained. Deduction from the unrealized foreign exchange loss sustained from prior years can only be made in the taxable year that the loan was fully paid. Prior to realization, the unrealized foreign exchange loss may only be booked for accounting purposes but cannot be allowed as an item of deduction. In the case of BFPI, the foreign exchange loss it sustained arising from the unpaid portion of the semi-annual amortizations from January 31, 2002 to July 31, 2005 was merely booked as unrealized loss because the same is not subject to deduction as the loan was not yet fully paid. It was only on December 31, 2005 when the loan was fully paid that the loan transaction was closed and completed. At that time, BFPI's books reflected a realized foreign exchange loss in the amount of P109,126,392.61 which included the unrealized loss arising from the unpaid portion of the eight (8) semi-annual amortizations it had paid. BFPI deducted the said loss from its gross income for taxable year 2005. In view of the foregoing, this Office confirms your opinion that BFPI properly deducted the unrealized loss it sustained from prior years for taxable year 2005, the year the said loan transaction was closed and completed. This view is also consistent with the ruling of the Court of Tax Appeals in the case of The Coca-cola Export Corporation vs. Commissioner of Internal Revenue , C.T.A. Case No. 5238 December 19, 1997, where it was held that loss arising from foreign exchange fluctuation, ascertained and realized during the taxable period and not compensated by insurance or otherwise, is deductible from gross income albeit it may relate to transaction of prior years. Otherwise stated, a realized foreign exchange loss sustained in a loan transaction may include unrealized foreign exchange loss from prior years. This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it will be ascertained that the facts are different, then this ruling shall be considered void. SETaHC Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service