Puno & Puno Law Offices

May 27, 2009 BIR RULING [DA-(C-074) 256-09] Sec. 32 (B) (6) (b); 34; DA 046-03 Puno & Puno Law Offices 12th Floor East Tower Philippine Stock Exchange Center Exchange Road, Ortigas Center Attention: Attys. Ma. Elizabeth E. Peralta-Loriega Christina E. Reside and Mercedita L. Ona This refers to your letter dated May 25, 2009 requesting, on behalf of your client, AP Renewables, Inc. ("APRI"), confirmation of your opinion that payments of APRI to former employees of National Power Corporation ("NPC"), as discussed below, are exempt from tax and are deductible from APRI's gross income. EaDATc It is represented that APRI and Power Sector Assets and Liabilities Management Corporation ("PSALM") entered into an Asset Purchase Agreement dated August 22, 2008 ("APA"), which sets forth the terms and conditions of the purchase by APRI of the Tiwi-MakBan Geothermal Complex (the "Tiwi-MakBan Complex"). Under the APA, all of NPC's employees, regardless of the status of their employment, who are rendering work or services at the Tiwi-MakBan Complex on or before the closing date shall cease to work on closing date. The APA further provides that APRI must hire as contractual employees all of the separated regular employees of NPC for a period of five (5) months under terms and conditions as may be agreed upon with APRI. During its due diligence of the Tiwi-MakBan Complex prior to the public bidding, and as part of the preparations for its takeover of the plants after it was declared as the winning bidder, APRI conducted an extensive study on the existing workforce operating and managing the Tiwi-MakBan Complex. The study showed that the Tiwi-MakBan Complex is overmanned and several positions in the existing workforce are redundant and unnecessary for efficient and profitable operations. To address this concern, APRI developed an improved organizational structure for the management of the Tiwi-MakBan Complex composed only of those positions that are necessary and desirable for the business. The implementation of an improved organizational structure will entail consolidation and elimination of certain positions and functions in order to right-size and streamline the operations of the plants (the "Reorganization Plan"). The Reorganization Plan will be implemented in at least three phases. Phase 1 will commence on or before the take-over of APRI of the Tiwi-MakBan Complex. Phase 2 will commence anytime during the period of employment of the separated regular employees of NPC. Finally, Phase 3 will commence upon the expiration of the period of employment of the separated regular employees of NPC. To fully implement the Reorganization Plan, APRI plans to enter into settlement agreements with certain regular employees of NPC working in the Tiwi-MakBan Complex. Under the proposed settlement agreements, these regular employees of NPC will waive their right to be hired by APRI as contractual employees ("Non Hired NPC Employees") and will release APRI, its stockholders, directors, officers, and agents, from any and all causes of action, sums of money, damages, claims and demands whatsoever for which said regular employee may be entitled under APA and the law. In exchange for this mutual waiver and release, the Non Hired NPC Employees will receive an amount equivalent to their five months salary in NPC (the "Settlement Sum"). Furthermore, as part of the Reorganization Plan, the regular employees of NPC who meet the 60 year old retirement age of APRI will likewise be offered compromise not to accept employment and will be paid the Settlement Sum. APRI anticipates that not all separated NPC employees who will be affected by the Reorganization Plan will accept its offer of compromise as explained above, and APRI will be constrained to hire them as contractual employees for five months pursuant to the APA. However, in order to implement the Reorganization Plan, these contractual employees will have to be terminated on the ground of redundancy shortly after APRI's takeover of the plants ("Redundant Former NPC Employees"). APRI plans to pay these Redundant Former NPC Employees a redundancy separation pay equivalent to their salaries for the unexpired term of their contractual employment with APRI (the "Redundancy Separation Pay"). TAaEIc On the basis of the foregoing representations, you now request for confirmation of the following: 1. the proposed payments by APRI of the Settlement Sum to the Non Hired NPC Employees are not subject to donor's tax; 2. the proposed payments by APRI of the Redundancy Separation Pay to the Redundant Former NPC Employees are exempt from income tax; and 3. the proposed payments by APRI of the Settlement Sum and the Redundancy Separation Pay are deductible against its gross income. In reply, please be informed that this Office hereby confirms your opinion as follows: 1. The proposed payments by APRI of the Settlement Sum to the Non Hired NPC Employees are not considered as a donation; hence, they are not subject to donor's tax. A donation contemplates an act of liberality whereby a person disposes gratuitously a thing or a right in favor of another, who accepts it (Article 725, Civil Code). Donative intent or the intention to do an act of liberality is an essential element of donation. Thus, transfers made for purely business reasons, although without consideration, are not considered donations (BIR Ruling No. DA-537-06 dated September 5, 2006; BIR Ruling No. DA-398-06 dated June 26, 2006; BIR Ruling No. DA-136-05 dated April 7, 2005; BIR Ruling No. DA-576-06 dated September 22, 2006; and BIR Ruling DA-224-07 dated April 13, 2007) . In this case, the proposed execution of the compromise agreement and the consequent payment of the Settlement Sum to the Non-Hired NPC Employees are necessary measures to avoid litigation that may arise from the termination of the services of NPC employees, and to fully implement the improved organizational structure of the workforce of the Tiwi-MakBan Complex. The implementation of the improved organizational structure for Tiwi-Makban is essential to enhance effectivity, streamline its operations and reduce operating costs. In short, the payment by APRI of the Settlement Sum to the Non-Hired NPC Employees will be made for purely business reasons. The payment of the Settlement Sum must not therefore be construed as a donation, hence, not subject to donor's tax. CaHcET 2. The proposed payments by APRI of the Redundancy Separation Pay to the Redundant Former NPC Employees are exempt from income tax. Under Section 32 of the Tax Code of 1997, as amended ("Tax Code"), amounts received by an employee from the employer as a consequence of his separation from service due to any cause beyond the control of said employee is excluded from gross income, and thus exempt from income tax. Section 32 provides in part: SEC. 32. Gross Income . (A) General Definition . Except when otherwise provided in this Title, gross income means all income derived from whatever source, including (but not limited to) the following items: . . . (B) Exclusions from Gross Income . The following items shall not be included in gross income and shall be exempt from taxation under this title: (6) Retirement Benefits, Pensions, Gratuities, etc . xxx xxx xxx (b) Any amount received by an official or employee or by his heirs from the employer as a consequence of separation of such official or employee from the service of the employer because of death sickness or other physical disability or for any cause beyond the control of the said official or employee. (Emphasis supplied.) Section (32) (B) (6) (b) of the Tax Code requires the presence of two conditions in order that the employee benefits may be granted tax exemption, namely: (a) the employee is separated from the service of the employer due to death, sickness or other physical disability or for any cause beyond the control of the said official or employee; and (b) the employer pays benefits to the official or employee or his heirs as a consequence of such separation. Where the separation of an employee is due to redundancy, said separation is beyond the control of the employee. Hence, any and all amounts received by the employee as a result thereof are exempt from income tax and consequently from the withholding tax pursuant to Section (32) (B) (6) (b) of the Tax Code (BIR Ruling No. DA-046-03 dated February 20, 2003; BIR Ruling DA-100-00 dated February 15, 2000; BIR Ruling No. DA-320-00 dated August 22, 2000; BIR Ruling No. DA-065-00 dated February 1, 2000; BIR Ruling No. DA-499-99 dated September 3, 1999; and BIR Ruling No. 105-96 dated October 15, 1996) . As such, APRI's proposed payments of the Redundancy Separation Pay to the Redundant Former NPC Employees are exempt from income tax and withholding tax. 3. The proposed payments by APRI of the Settlement Sum and the Redundancy Separation Pay are deductible against its gross income. Section 34 of the Tax Code provides for the requirements for deductibility of expenses for income tax purposes. Section 34 provides in part: SEC. 34. Deductions from Gross Income . Except for taxpayers earning compensation income arising from personal services rendered under an employer-employee relationship where no deductions shall be allowed under this Section other than under subsection (M) hereof, in computing taxable income subject to income tax under Sections 24 (A); 25 (A); 26; 27 (A), (B) and (C); and 28 (A) (1), there shall be allowed the following deductions from gross income: ACcHIa (A) Expenses . (1) Ordinary and Necessary Trade, Business or Professional Expenses . (a) In General. There shall be allowed as deduction from gross income all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on or which are directly attributable to, the development, management, operation and/or conduct of the trade, business or exercise of profession . . . (b) Substantiation Requirements . No deduction from gross income shall be allowed under Subsection (A) hereof unless the taxpayer shall substantiate with sufficient evidence, such as official receipts or other adequate records: (i) the amount of the expense being deducted, and (ii) the direct connection or relation of the expense being deducted to the development, management, operation and/or conduct of the trade, business or profession of the taxpayer. . . . Pursuant to the foregoing statutory provision, three conditions are imposed for the deductibility of an expense, namely: (1) the expense must be ordinary and necessary; (2) it must be paid or incurred within the taxable year; (3) it must be in carrying on, or directly attributable to the development, management, operation and or conduct of the trade, business or exercise of profession; and (4) it must be substantiated by official receipts or adequate records (BIR Ruling No. DA-298-05 dated July 1, 2005; BIR Ruling No. DA-698-07 dated December 28, 2007; BIR Ruling No. DA-718-06 dated December 15, 2006; BIR Ruling No. DA-007-07 dated January 8, 2007; and BIR Ruling No. DA-697-07 dated December 28, 2007) . In Collector of Internal Revenue vs. Philippine Education Company, Inc. (G.R. No. L-8505, May 30, 1956), the Supreme Court defined the terms "ordinary" and "necessary" for purpose of deductibility of expenses as follows: [T]he term, "ordinary" as used in the statutes, does not require that the payments be habitual or normal in the sense that the same taxpayer will have to make them often; the payment may be unique or non-recurring to the particular taxpayer affected. Furthermore, an expense will be considered "necessary" where the expenditure is appropriate and helpful in the development of the taxpayer's business. It is sufficient that the expense was incurred for purposes proper to the conduct of the corporate affairs or for the purpose of realizing a profit or for minimizing a loss. Applying the foregoing definition, the proposed payments of APRI of the Settlement Sum to the Non Hired NPC Employees and of the Redundancy Separation Pay to the Redundant Former NPC Employees are ordinary and necessary in APRI's conduct of business of Tiwi-MakBan Complex. aCcSDT The implementation of the revised organizational structure which removed unnecessary positions in the workforce of Tiwi-MakBan Complex necessarily resulted in APRI's proposed payments of the Settlement Sum and the Redundancy Separation Pay. To reiterate, the implementation of the revised organizational structure for Tiwi-MakBan Complex is essential to streamline the operations, reduce operating costs and thereby improve the profitability of the Tiwi-MakBan Complex. Thus, the proposed payments of the Settlement Sum and the Redundancy Separation Pay constitute an ordinary and necessary expense. Provided that the proposed payments of Settlement Sum and the Redundancy Separation Pay are fully substantiated by supporting documents, these payments are deductible against APRI's gross income. This ruling is being issued in the basis of the foregoing facts as represented. However, if upon investigation, it will be disclosed that the facts as represented 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