Salvador & Associates

November 5, 2008 BIR RULING [DA-(C-119) 390-08] Condonation; DA-419-04; DA-593-06; 076-89 Salvador & Associates 815-816 Tower One & Exchange Plaza, Ayala Triangle, Ayala Avenue, Makati City Attention: Atty. Euney Marie J. Mata-Perez Partner Gentlemen : This refers to your letter dated July 17, 2008 requesting, on behalf of your client, Luzon Hydro Corporation ("LHC"), confirmation of your opinion that the condonation by LHC of the debt of its affiliate, Bakun Power Line Corporation ("BPLC"), is not subject to income tax and donor's tax. The facts as represented are as follows: LHC is a corporation duly organized and existing under Philippine laws. It was incorporated as an operator of a hydroelectric power plant in the Philippines. LHC is 50% owned by Philippine Hydropower Corporation ("PHC") and 50% by Pacific Hydro Bakun, Inc. ("PHBI"), both domestic corporations. BPLC, on the other hand, is a corporation duly organized and existing under Philippine laws. Among its primary purpose is "to develop, construct, own, lease, and operate a hydroelectric power plant, including associated transmission lines, to engage in build-operate-transfer arrangements with the government, its branches, agencies and instrumentalities, and non-government entities. BPLC is 50% owned by Hedcor, Inc., a domestic company, and 50% by PHBI. Under the Power Purchase Agreement ("PPA") between LHC and the National Power Corporation ("NPC") for the construction and operation of a 70 megawatt power station in Bakun River in Benguet and Ilocos Sur provinces, NPC is responsible for the construction of the Bakun AC 230 kilovolts transmission line. In 1998, LHC notified NPC of its intent to exercise its option under the PPA to finance, design, furnish and deliver, construct and commission the transmission line (the "Contract Agreement"). Accordingly, LHC entered into an Accession Undertaking, supplemental to the Contract Agreement, with BPLC and NPC. Under the Accession Undertaking, BPLC became responsible for the construction of the transmission line. As of December 31, 2000, BPLC already completed its project in relation to the construction of the Bakun AC 230 kilovolts transmission line for LHC and has not engaged in any other project. DaACIH From 1998 to 2002, LHC extended various advances to BPLC which totaled (including foreign exchange translation adjustments) P15,524,423.00 as of December 31, 2007 (the "Liabilities"). It was also represented that due to financial difficulties suffered by BPLC, it has reflected a capital deficit position beginning in 2002 and has continually sustained business downturn. Based on BLPC's unaudited financial statements as of December 31, 2007, it has current assets of P1,091,611.00 and noncurrent assets of P8,782,669.00 (or total assets of P9,874,280.00), which are not sufficient to discharge its obligations to LHC and the sub-contractors. Finally, it is represented that considering the financial position of BPLC and that the Liabilities remained unpaid, LHC believes that it can no longer fully collect its advances to BPLC. Accordingly, it has lost interest in collecting in full the Liabilities and condoned the amount of P17,103,631.00 sometime in 2005. The unaudited balance sheet of BPLC as of December 31, 2007 after the condonation will reflect the following: At Cost Basis (PhP) Total Assets 9,874,280 Total Liabilities 10,908,077 Total Capital Deficiency (1,033,797) From the foregoing, you are requesting confirmation of your opinion that: 1. The condonation by LHC of the debt of BPLC is not subject to income tax if after the condonation BPLC remains in a capital deficit position. 2. The condonation by LHC of the debt of BPLC is not subject to donor's tax. In reply, please be informed that this Office, in BIR Ruling No. 076-89 dated April 17, 1989, ruled that the condonation of indebtedness will not result to any taxable income if the debtor continues to remain insolvent after the condonation. Pertinent portion thereof state as follows: IcHTAa "Cancellation and forgiveness of indebtedness may amount to a payment of income, to a gift, or to a capital transaction, dependent upon the circumstances. If for example, an individual performs services for a creditor who, in consideration thereof cancels the debt, income to that amount is realized by the debtor as compensation for his services. If, however, a creditor merely desires to benefit a debtor and without any consideration therefor cancels the debt, the amount of the debt is a gift from the creditor to the debtor and need not be included in the latter's gross income. If a corporation to which a stockholder is indebted forgives the debt, the transaction has the effect of the payment of a dividend. (Sec. 50 Revenue Regulations No. 2) The waiver of interest by the banks on non-trade and trade related indebtedness of GMPI is not subject to income tax considering that the deduction of said interest as expense in prior years did not offset nor reduce the taxable income of GMPI since it was in a financial loss position even without the deduction. (See Barnhart-Marrow Consolidated v. Commissioner of Internal Revenue, 47 BTA 590) Moreover, when a creditor cancels a debt as part of a business transaction, the debtor is enriched or its net assets has been increased and, therefore, he realized taxable income ( Philippine Fiber Processing Co. v. CIR, CTA Case No. 1407 Dec. 29, 1966). However, a transaction whereby nothing of exchangeable value comes to or is received by a taxpayer does not give rise to or create taxable income. (See Dallas Transfer and Terminal Warehouse Co. v. Commissioner of Internal Revenue 5 Cir. 70 F 2d 95, 13AFTR 930) Accordingly, the condonation of GMPI's indebtedness by GM-US is not subject to income tax since before and after the condonation GMPI remains insolvent, i.e., in a capital deficiency position. The condonation is likewise not subject to gift tax since there is no donative interest on the part of GM-US but solely for business consideration since Isuzu will only acquire the GMPI shares from GM-US if GMPI has a "clean" balance sheet with no outstanding liabilities except those to Isuzu." ASCTac Moreover, in BIR Ruling No. DA-419-04 dated August 4, 2004, this Office ruled as follows: "Thus, the condonation of the CPI's debt to SJ shall not be subject to income tax considering that CPI is in a capital deficiency position and will remain insolvent before and after the said condonation considering that the amount to be condoned would only be P84,198,555.20. Moreover, the condonation is likewise not subject to gift tax since there is no donative intent on the part of SJ but solely for business consideration." The above principle was again reiterated in BIR Ruling No. DA-593-06 dated October 5, 2006. In your case, after the condonation by LHC of the debt of BPLC, BPLC remains in a capital deficiency position, and therefore, nothing of exchangeable value came to or was received by BPLC. Since there was no inflow of wealth into BPLC, the condonation of the debt of BPLC is not subject to income tax. In view of the foregoing, this Office confirms your opinion that the condonation by LHC of the debt of BPLC is not subject to income tax since after the condonation, BPLC remains in a capital deficit position. Moreover, this Office likewise confirms your opinion that the condonation of debt of BPLC is not subject to donor's tax there being no donative intent on the part of LHC and such condonation having been done solely for business consideration. 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. TIAEac Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service