Punongbayan & Araullo

August 3, 2009 BIR RULING [DA-(C-165) 432-09] Regs. No. 2; 34 (A) (1) (a) and (D) (1) 206-90; DA-592-06; DA-173-02; DA-173-02; DA-209-06 Punongbayan & Araullo 20th Floor, Tower I The Enterprise Center 6766 Ayala Avenue Makati City Attention: Atty. Raymund S. Gallardo Tax Partner Gentlemen : This refers to your letter dated January 19, 2009 stating that Sanyo Denki Philippines, Inc., (Sanyo Denki), a wholly owned subsidiary of Sanyo Denki Co., Ltd. of Japan, is a corporation duly organized and existing by virtue of Philippine laws with business address at No. 2, Blk. F-1, Subic Techno Park, Argonaut Highway, Boton Area, Subic Bay Freeport Zone; that Sanyo Denki was registered with the Securities and Exchange Commission (SEC) on January 25, 2000; that as per Sanyo Denki's Articles of Incorporation, it is primarily engaged in the business of manufacturing, processing, producing, repairing, importing, exporting, buying, selling or otherwise dealing in at wholesale electric machineries, electric appliances, electronic materials, computer wares, and all equipment, parts, accessories, materials and supplies used or employed in or related to the manufacture of such goods or products, including the planning and installation thereof; that Sanyo Denki was given a license and permit to operate within the Subic Bay Economic and Freeport Zone (SBEFZ) on February 12, 2000; that Section 43 of the Implementing Rules and Regulations of Republic Act (R.A.) No. 7227, otherwise known as "Bases Conversion and Development Act of 1992", provides that SBEFZ enterprises shall pay a final tax of 5% of their gross income earned from sources within the SBEFZ, in lieu of all national and local taxes; that Sanyo Denki subsequently became a duly registered Subic Bay Freeport Enterprise on March 23, 2008 as the Subic Bay Metropolitan Authority (SBMA) issued Certificate of Registration and Tax Exemption No. 2000-0021 in accordance with R.A. 7227, thereby entitling Sanyo Denki to certain preferred rights, privileges, and benefits indicated in its Certificate of Registration as a Freeport Enterprise; that as an establishment engaged in the export industry, Sanyo Denki inevitably utilizes and/or generates foreign currency; that as per Article I of its Certificate of Registration as a Subic Bay Freeport Enterprise Sanyo Denki's registered activities include the manufacture of electric machineries, electric appliances, computer wares, electronic materials and all parts and accessories and including the sale of scrap materials; and that ordinary fluctuations in exchange rate has the effect on Sanyo Denki's foreign exchange gain or loss, depending on the existing rate that a particular transaction is made. You now request confirmation of your opinions that: a.) whatever foreign exchange gain earned by Sanyo Denki due to fluctuations in the value thereof shall not be subject to income tax, or shall not be deductible from its gross income, in the absence of a closed and completed transaction; b.) in the event of a closed and completed transaction, any foreign exchange gains earned shall be subjected to the preferential rate of five percent (5%) in case such foreign exchange gains were derived by Sanyo Denki in connection with its registered activity, however, gains earned not in connection with its registered activities shall be subject to the regular corporate income tax of thirty percent (30%); and ESTCDA c.) the foreign exchange loss incurred in a close and completed transaction are considered as ordinary and necessary business expenses and can be deducted from Sanyo Denki's ordinary income. In reply, please be informed that in the absence of a closed and completed transaction, Sanyo Denki's unrealized foreign exchange gain is neither subject to the ordinary income tax of 30% nor to the preferential rate of 5% at gross, in the same manner that such unrealized foreign exchange loss shall not be considered as a deduction from the gross income of Sanyo Denki. TDcCIS It is common for enterprises registered with the Philippine Economic Zone Authority (PEZA) especially those involved in the export industry to make use of foreign currency, either as functional currency or supplemental currency, in financing their registered activities. As a result, these registered enterprises normally realize foreign exchange gain or incur foreign exchange loss by reason of the volatility of foreign exchange rates. In relation to the foregoing, the "realization" principle, adopted under Revenue Regulations No. 2, provides that for purposes of taxation, only the realized gain or loss from foreign exchange transaction will be subject to income tax. Under this principle, income is recognized when: (i) the earning process is complete or virtually complete, and (ii) an exchange has taken place. Fluctuations in values of foreign exchange may be recognized and recorded as income, provided such income has been realized and has arisen from a closed and completed transaction. Moreover, a closed transaction is a taxable event which has been consummated as fixed by identifiable events occurring in a particular year. As aptly explained in BIR Ruling No. 206-90 dated October 30, 1990: ". . . the annual increase in the value of an asset is not taxable income because such increase has not yet been realized. The increase in value, i.e., the gain, could only be taxed when a disposition of the property occurred which was of such a nature as to constitute a realization of such gain, that is, a severance of the gain from the original capital invested in the property. The same conclusion obtains as to losses. The annual decline in the value of property is not normally allowable as a deduction. Hence to be allowable, the loss must be realized." cIADaC It was further emphasized in BIR Ruling No. DA-592-06, dated October 5, 2006 that: ". . . Mere fluctuation in value of foreign exchange vis--vis the Philippine peso, but short of a closed and completed transaction, does not result to recognition of deductible loss." Evidently, whatever gains derived from the fluctuation of foreign currency denominated transactions shall be recognized as income only if the same has been realized. The same apply as to the losses. To be deductible, losses must likewise be realized. Without realization, there can neither be taxable gain nor deductible loss. Prior to realization, the unrealized foreign exchange gain may not be treated as taxable income, in the same vein that the unrealized foreign exchange loss may only be booked for accounting purposes but cannot be allowed as an item of deduction. Corollarily, BIR Ruling No. DA-173-02, dated September 20, 2002 citing U.S. vs. Supplee-Biddle Hardware Co., 265 U.S. 189, L. Ed. 970, 44 S. Ct. 546 (1924) Mertens Chap. 5.04, Vol. 1, p. 165 provides: ". . . income consists of realized appreciation of capital or investment and realized returns, either in the form of receipts or benefits, flowing from the use of capital, services, activities or acts of the taxpayer, or which come to the taxpayer other than as a return of capital or investment, or as a substitution of money value for something permanently lost." HCaEAT Moreover, the realized foreign exchange gain derived by Sanyo Denki from its registered activities shall be subject to the preferential rate of 5%, while the realized foreign exchange gain obtained by them from its unregistered activities shall be subject to the regular corporate income tax. Through the issuance of PEZA Memorandum Circular No. 2005-032 dated September 15, 2005, the aforesaid agency has already clarified the tax treatment of foreign exchange gain and/or loss incurred by PEZA-registered enterprises. Accordingly, the tax treatment of foreign exchange gains shall depend on the activities from which the aforementioned gains arise. Thus, if the foreign exchange gain is attributed to an activity with income tax incentive (Income Tax Holiday or 5% Gross Income Tax), said foreign exchange gain shall be covered by the same income tax incentive. On the other hand, if the foreign exchange gain is attributed to an activity without income tax incentive, said gain shall likewise be without income tax incentive, i.e., therefore, subject to normal corporate income tax. 1 The same principle may be applied to companies registered with the SBEFZ which are enjoying an income tax incentive. Hence, in consonance with the above-stated discussion that realized foreign exchange gain shall be subject to income tax, it is imperative to make a distinction between the income derived by Sanyo Denki by reason of its registered activities and income earned because of its unregistered activities. In view thereof, the income derived by Sanyo Denki from the fluctuations of foreign exchange arising from transactions connected with its registered activity shall be included in the computation of its gross income subject to preferential rate of 5% instead of the regular corporate income tax rate of 30%. HIaSDc Finally, Sanyo Denki's realized foreign exchange loss is considered as ordinary and necessary business expenses which can be consequently deducted from its ordinary income and is subject to the regular corporate income tax of 30%. In BIR Ruling No. DA-166-04 dated April 5, 2004, this Office opines that: ". . . any realized foreign exchange losses arising from the decrease in the value of the Philippine Peso could be treated as an ordinary and necessary business expense." Also in BIR Ruling No. DA-209-06 dated April 5, 2006, citing DA-166-04 dated April 5, 2004, this Office ruled that: "[F]rom the foregoing, it is clear that foreign exchange loss . . . is not allowed as deduction for purposes of computing the gross income from the registered activity of a PEZA-registered enterprise subject to the preferential tax rate of 5%. Instead, such foreign exchange loss . . . shall be allowed as deduction from the gross income pursuant to Section 34(A)(1)(a) and (D) of the 1997 Tax Code as follows: SEC. 34. Deductions from Gross Income. . . . there shall be allowed the following deductions from gross income: (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 . . . HIaSDc (D) Losses. (1) In General. Losses actually sustained during the taxable year and not compensated for by insurance or other forms of indemnity shall be allowed as deductions . . ." Though the above-cited opinions refer to PEZA registered companies, the same principle may likewise be applied with SBEFZ-registered enterprises. Thus, any foreign exchange loss incurred by Sanyo Denki shall be allowed as a deduction from its ordinary income subject to the income tax rate of 30%, the same being considered as its ordinary and necessary business expense. 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 as null and void. Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service Footnotes 1. PEZA Memorandum Circular No. 2005-032 dated September 15, 2005.