BIR Ruling [DA-696-06]

December 11, 2006 BIR RULING [DA-696-06] 34 (E) (1); DA 136-05 Agcaoili & Associates 7th Floor, Citibank Center Paseo de Roxas Makati City Attention: Atty. Ma. Carmen Agcaoili-Orena Gentlemen : This refers to your letter dated November 29, 2006 stating that your client, Surfield Development Corporation (SDC), is a domestic corporation organized and existing under the laws of the Philippines with office address at the 3rd Floor, Macondray Center, Pasong Tamo Extension, Makati City; that on the other hand, V&L Ventures (Mindanao), Inc. (V&L) is likewise a domestic corporation organized and existing under the laws of the Philippines with principal office address at Km. 13, National Highway, Pandacan, Davao City; that the shareholders of V&L and their corresponding shareholdings are as follows: Shareholder Percentage of shares Edgardo Vasquez Fifty one percent (51%) SDC Forty nine percent (49%) that Mr. Edgardo Vasquez, an inventor and owner of a patent for a system of housing construction design known as the VAZBUILT Technology, was granted by the Bureau of Internal Revenue (BIR) certain tax incentives and tax exemptions pursuant to Section 3 of Republic Act (R.A.) No. 7459, as implemented by Section 3(c) of Revenue Regulations No. 19-93; that the tax incentives and exemptions granted by the BIR extend to the companies majority-owned by Mr. Edgardo Vasquez which are also engaged in the manufacture of pre-fabricated reinforced concrete columns and, together with other house components, assemble these into modular housing units; that V&L, being a majority owned company of Mr. Edgardo Vasquez, was also extended certain tax incentives and exemptions by the BIR; that since 1998, the two (2) stockholders of V&L have made advances to V&L which amounted to P23.9 million as of October 31, 2006; that SDC made advances to enable V&L to finance the latter's day-to-day operations; that the advances are itemized as follows: Shareholder Amount of Advances SDC P16,826,290.59 Edgardo Vasquez 7,088,829.09 Total P23,915,119.68 that the advances are evidenced by checks issued by SDC that are accompanied by check payment vouchers; that several statements of account and demand letters were thereafter sent by SDC to V&L in an effort to collect the outstanding obligation of the latter; that in its audited balance sheets, V&L recorded the P23.9 million as advances from shareholders under current liabilities while SDC recorded its advances to V&L of P16.8 million as advances to affiliates under current assets; that V&L's Board of Directors has confirmed and ratified the aforesaid advances during its special meeting held on June 29, 2006; that in the meantime, the above shareholders resolved that the corporate term of V&L will be shortened as a means of dissolving the company effective December 31, 2006 in light of the continuous losses it has been sustaining since it commenced operations in 1998; that the objective is to cease operations and terminate V&L's employees by December 31, 2006; and that as of October 31, 2006, V&L's capital deficiency has reached P22,674,883.15, as follows: Capital Stock P250,000.00 Deficit (21,462,207.31) Loss for the period (1,462,675.84) Capital Deficiency P22,674,883.15 Based on the foregoing representations, you now request confirmation of your opinion that 1. SDC may write-off its advances to V&L as bad debts expense and deduct in full against its taxable income for the year ended December 31, 2006; 2. In the light of V&L's cessation of operations and impending dissolution, such write-off will not result in taxable income to V&L. 3. Finally, no documentary stamp tax shall be due on the advances extended by SDC to V&L as there is no debt instrument issued to evidence or document the loan obligation. ScaCEH In reply thereto, please be informed that your opinion is hereby confirmed as follows: 1. Section 34(E)(1) of the Tax Code of 1997 provides, as follows: "Sec. 34. Deductions from Gross Income. (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 the preceding years shall be included as part of the gross income in the year of recovery to the extent of the income tax benefit of said deduction." Corollarily, Revenue Regulations No. 25-02, amending Revenue Regulations No. 05-99, and implementing the above provision, provides the requisites for valid deduction of bad debts from gross income: "Sec. 3. Requisites for valid deduction of bad debts from gross income . The requisites for deductibility of bad debts are: (1) There must be an existing indebtedness due to the taxpayer which must be valid and legally demandable; (2) The same must be connected with the taxpayer's trade, business or practice of profession; (3) The same must not be sustained in a transaction entered into between related parties enumerated under Section 36(B) of the Tax Code of 1997; (4) The same must be actually charged off the books of accounts of the taxpayer as of the end of the taxable year; and (5) The same must be actually ascertained to be worthless and uncollectible as of the end of the taxable year." The Court of Tax Appeals (CTA) in interpreting the above requisites held that the taxpayer is not required to be an "incorrigible optimist" in enforcing collection of a debt ( Western Pacific Corporation v. Commissioner of Internal Revenue, CTA Case No. 720, 22 May 1961 citing White Dental Mfg. vs. US, 274 US 398 ). He may not postpone a bad debt deduction on the basis of a mere hope of ultimate collection but rather, should exercise sound business judgment based upon information reasonably obtainable in determining worthless debts and in the examination of all the circumstances. Thus, this Office in BIR Ruling No. UN097-95 dated March 8, 1995 , ruled that ". . . [B]ad debts are allowed as deductions in the year when ascertained to be worthless and not at the time when the taxpayer may finally 'give up' on the possibility of recovering any part of the debts and decide to charge them off. ( CCH, 60 Vol. 2, p: 21.009; (page 252, updated National Internal Revenue Code with Notations and Appendices, 1988 Edition, Jose Araas ) The taxpayer must take reasonable steps to collect the debt. He does not have to go to court if it can be shown that a judgment once obtained would be worthless because the debtor is insolvent or 'judgment proof'. If, in the exercise of sound business judgment a taxpayer believes there is no likelihood of recovery at any time in the future, the debt has been worthless. ( Western Pacific Corporation v. Collector of Internal Revenue, CTA Case No. 720 ) In applying the above principle under the circumstances, it is crystal clear that SDC need not go through the lengthy process of hiring a collection lawyer and/or filing a collection case against V&L since, in all probability, it will not result in the satisfaction of the debt or execution of the judgment. There is no likelihood of recovery at any time in the future since V&L has already ceased operations. The debt has become worthless already. Accordingly, SDC may write-off its accounts receivable due from V&L and claim it as a bad debt deduction from its gross income pursuant to Section 34(E)(1) of the Tax Code of 1997. 2. The write-off should not be considered as income of V&L subject to the regular income tax. A transaction whereby nothing of exchangeable value comes to or received by the taxpayer does not give rise to or create taxable income. Taxable income is not acquired by a transaction which does not result in the taxpayer getting or having anything the taxpayer did not have before ( BIR Ruling No. 076-89 and BIR Ruling No. DA419-04, citing Dallas Transfer, supra, BIR Ruling No. DA206-97, citing Comm. V. Rail Joint Co. [C. CA.] 61 f 2D 751; Bowers vs. Kerbough Empire Co., 271 US 170 ). Accordingly, V&L did not derive any income as a result of the write-off of the accounts receivable of P16,800,000.00 and as such, it should not be subject to income tax. 3. Finally, no documentary stamp tax is due under Section 179 of the Tax Code of 1997, as amended by Republic Act No. 9243, as implemented by Revenue Regulations No. 13-2004, as no debt instrument was issued to evidence or document the advances extended by SDC to V&L other than the check issued by SDC which was accompanied by check payment voucher of the company. 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. EcDATH Very truly yours, (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service