Mahle Filter Systems Philippines Corporation

September 9, 2009 BIR RULING [DA-(C-202) 512-09] RR 2-40; BIR Ruling 144-85; 206-90; 004-06; DA 593-06; DA 209-06 Mahle Filter Systems Philippines Corporation Block 8 Lots 5, 6, & 7 PEZA Drive First Cavite Industrial Estate Brgy. Langkaan, Dasmarias Cavite Attention: Eleonor F. Ledesma Department Head-General Accounting and Tax Gentlemen : This refers to your letter dated July 17, 2009 requesting confirmation of your opinion that any accounting gain resulting from the derecognition of a financial liability on the part of the borrower and the corresponding extinguishment of a financial asset on the part of the lender is not subject to tax because the gain, which is merely recognized for financial accounting purposes, does not arise from a closed and completed transaction. Background The facts, as represented, are as follows: On August 19, 1996, Mahle Filter Systems Philippine Corporation (MFSP) entered into a Lease Agreement with Mahle Filter Systems Land Corporation (MFSLC), a corporation duly organized and existing under Philippine laws, for the lease of a parcel of land in Cavite. The Lease Agreement was retroacted to June 7, 1996. It has a term of 25 years and is renewable for another 25 years at the option of the parties. Pursuant to the Lease Agreement, MFSP delivered non-interest bearing refundable deposits in the amounts of Php16,000,000.00 and Php24,500,000.00 which shall be returned by MFSLC upon termination of the lease or on July 2021. The parties also entered into a Facility Agreement on August 19, 1996 wherein MFSP granted MFSLC loan facility in the amount of P8,000,000.00 to be applied exclusively by the latter for purchasing parcels of land in the First Cavite Industrial Estate in Dasmarias, Cavite. The loan is secured by a real estate mortgage and is subject to an annual interest rate of 12% until December 31, 2007. On January 1, 2008, the Facility Agreement was amended by the parties reducing the interest rate of the loan from 12% to 10% per annum to align the interest rate to the average long-term lending rate of banks. On December 1, 2005, the parties agreed to convert the refundable deposits of MFSP under the Lease Agreement into non-interest bearing long-term loan facility, with MFSLC as borrower. Consequently, the parties entered into two separate Facility Agreements covering the conversion of the refundable deposits. The Facility Agreements provide that the interest rate applicable to the transaction shall be at 10% per annum and shall take effect on January 1, 2008. The Agreements further provide that for the previous years (2006 and 2007) the loans shall be recorded as non-interest bearing. On December 29, 2008, MFSP and MFSLC consolidated the three Facility Agreements into one agreement denominated as "Consolidated Financial Agreement" making uniform the interest rates of the three loans at 10% per annum and changing the maturity date of the loans to December 31, 2032. PAS 39 Based on PAS 39- FINANCIAL INSTRUMENTS: RECOGNITION AND MEASUREMENT, the conversion of the non-interest bearing loans into interest bearing loans and the reduction of interest rate of the interest bearing loan are considered as significant revisions of the loan. According to the Standard, these revisions effectively extinguished the previous loans ( i.e ., the non-interest bearing loans and the interest bearing loan with 12% interest rate per annum). Paragraph 40 of PAS 39 provides thus: "40. An exchange between an existing borrower and lender of debt instruments with substantially different terms shall be accounted for as extinguishment of the original financial liability and the recognition of a new financial liability. Similarly, a substantial modification of the terms of an existing financial liability or a part of it (whether or not attributable to the financial difficulty of the debtor) shall be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability." As per interpretation of the above Standard adopted in 2005, MFSP and MFSLC had to reflect and record the changes in the loan agreement as follows: 1. On the P8,000,000.00 loan Although no payment is made on the loan, MFSLC had to derecognize the old loan with the interest rate of 12% per annum classified as financial liability in its books and subsequently recognize the new loan with 10% interest rate per annum. On the other hand, MFSP, as lender, had to extinguish the old loan classified as financial asset in its books and subsequently recognize the new loan with the reduced interest rate. Since it is interest bearing, the loan was measured as of December 31, 2005 by MFSP at amortized cost using the effective interest rate (EIR) method. The difference between the historical value (or the carrying value) and the fair value of the loan using the EIR was accounted for by MFSP as losses. Since there was no settlement of the loan but only reduction of the interest rate, these losses are not deductible for income tax purposes. EATCcI 2. On the non-interest bearing loans (P16,000,000.00 and P24,500,000.00 loans) Initially, MFSP had to account for the reclassification of the prepaid rent (refundable deposit) to loan receivable. Thus, for financial accounting purposes, the prepaid rent converted into non-interest bearing loan was discounted using the EIR which led to the reduction of the historical value thereby initially resulting in theoretical loss. The loss was recognized by MFSP in the profit and loss statement in 2005 but was not deducted for income tax purposes because there was no settlement of the loan. For financial accounting purposes, the balance of the loan receivables as at December 31, 2005 and subsequent years (from 2006 onwards) is carried at amortized cost which was determined using the EIR. Upon consolidation of the loans in 2008, the carrying value of the interest bearing loan was brought back to historical value while the carrying value of the non-interest bearing loans converted to interest bearing loans was brought back to the historical value of the loan, i.e ., original value of refundable deposit. Effectively, upon consolidation, there was reversal of a previously recognized theoretical loss subject to adjustments made in 2006 and 2007 computed using the EIR. As a result, MFSP recognized a gain amounting to P5,266,651.00 which is presented as "gain on extinguishment of loans receivable" in the statements of income. The gain on extinguishment of loans was computed as follows: 1 TCAHES P8,000,000.00 Loan Present value of old loan (@12% int.) 7,714,615.00 Present value, new loan (@10% int.) 8,000,000.00 Difference 285,380.67 Balance of Prepaid Rent Current Non-current Gain on Extinguishment of Loan 285,380.67 ========= P16,000,000.00 Loan Present value, old loan (non-interest bearing) 1,698,198.00 Present value, new loan (interest bearing) 16,000,000.00 Difference 14,301,801.64 Balance of Prepaid Rent Prepaid Rent-Current (880,690.59) Prepaid Rent-Non-Current (11,448,977.69) Gain on Extinguishment of Loan 1,972,133.36 =========== P24,500,000.00 Loan Present value, old loan (non-interest bearing) 2,690,341 Present value, new loan (interest bearing) 24,500,000.00 Difference 21,809,659.36 Balance of Prepaid Rent Prepaid Rent-Current (1,342,894.39) Prepaid Rent-Non-Current (17,457,627.02) Gain on Extinguishment of Loan 3,009,137.95 =========== As at December 31, 2008, the details of the loan receivable from MFSLC are as follows: CDISAc Based on the foregoing, you now seek an opinion that the gain arising from the extinguishment of the old loans as a consequence of determining the proper accounting treatment of the changes in the terms of MFSP's loan agreements with MFSLC is not taxable gain because it did not arise from a closed and completed transaction. In reply, please be informed that for taxation purposes, gain is recognized only if it is realized and arises from a closed and completed transaction. A closed and completed transaction, as referred to in Revenue Regulations 2-40, is one in which the facts indicate that the transaction is sufficiently final to ascertain that a gain (or loss) occurred. In other words, a closed transaction is a taxable event which has been consummated as fixed by identifiable events occurring in a particular year. (BIR Ruling No. 144-85 dated August 26, 1985, BIR Ruling No. 206-90 dated October 30, 1990, BIR VAT Ruling No. 239-89 dated September 20, 1989) . ESCacI It appears that the issue in the instant case arose from the differences between the accounting and tax treatments of gains on extinguishment of loans or loan receivables. On one hand, taxation rules provide that a gain, in order to be taxable, must be realized and must arise from a closed and completed transaction. With respect to financial liabilities, it has been held that the taxable event that consummates and completes the transaction is the full payment of the loan for it is only from that point that one can ascertain the actual gains realized by the creditor. On the other hand, accounting rules provide that a financial liability is removed from the balance sheet when, and only when, it is extinguished. A liability is extinguished when the obligation specified in the contract is discharged, cancelled or expires normally by paying the creditor with cash or assets like goods or services. Under PAS 39, a financial liability may also be considered as extinguished where there is a substantial modification of the terms of a financial liability. This means therefore that even if no actual payment is made on a loan, a financial liability is extinguished when the terms of the loan are significantly revised or modified. DSTCIa In the instant case, the extinguishment of the loan resulted from the application of an accounting rule and not from the occurrence of a taxable event. It is not by virtue of payment that a debtor has been discharged of its liability but by the application of PAS 39 which requires that substantial modifications in a loan agreement be accounted for as extinguishment of the old loan and the recognition of a new liability. From the perspective of the lender or the creditor, the change requires a corresponding derecognition of a financial asset (loan receivable) in its accounting books. As represented, the changes in the loan agreement found to be substantial are as follows: 1) reduction in the interest rate of the P8,000,000.00 loan from 12% to 10%; and 2) the conversion of the non-interest bearing to interest-bearing loans. Because of this substantial modification, the old loans to MFSLC had to be derecognized or considered extinguished for financial accounting purposes. Inasmuch as fair value accounting is used in recording the transaction, there is a difference in the present values of the old non-interest bearing loans and the new interest bearing loans. It is this difference (also called Day 1 difference) which is accounted for as gain on the extinguishment of the old loans. However, it must be emphasized that for tax purposes, there is yet no taxable event inasmuch as the derecognition of loans by MFSP and MFSLC is driven by the changes in the loan agreement, and not the settlement of the loan, which is the event that consummates and completes the transaction. Based on MFSP's financial statements as of December 31, 2008, the amount of loan receivables from MFSLC is in fact recorded at P48,500,000.00 (See note 21). This means that the loans remain unpaid or unsettled. Based on the foregoing, it is clear, therefore, that the gain on the extinguishment of the non-interest bearing loans is unrealized and considered merely as accounting or "paper" gain intended only to reflect the changes of the terms of the loan facility. It has been consistently ruled that gains from changes in fair value, reversal or reclassification of assets or liabilities are not taxable. Thus, in BIR Ruling No. 144-85 dated August 26, 1985, it was held that: ". . . Annual increase in 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." cEATSI Relative to the above discussion, this Office finds it relevant to pass upon the tax treatment of the interest component of the non-interest bearing loans. For tax purposes, interest income and expense on a loan agreement are taxable and deductible, respectively, when the covering agreement provides for the payment of such interest. Revenue Regulations 13-00 requires that interest be legally due and stipulated in writing. Accordingly, the imputed interest of the non-interest bearing loans, which is determined for accounting purposes as the difference between the face value and present value at the date of the inception of the loan, is not recognized as income or expense for tax purposes. In view of the foregoing, this Office confirms your opinion as it hereby holds that the gain resulting from the derecognition of a financial liability in the books of MFSLC (borrower) and the corresponding extinguishment of a financial asset in the books of MFSP (lender) is not subject to tax because the gain, which is merely recognized for financial accounting purposes, does not arise from a closed and completed transaction. 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. Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service Footnotes 1. Based on 2007 Financial Statements of MFSP.