SGV & Co.

December 2, 2009 BIR RULING [DA-(C-295) 723-09] Art. 39, EO 226; DA-(IL-011) 107-08; DA 375-2008; DA-195-2008 SGV & Co. 6760 Ayala Avenue 1226 Makati City Attention: W. U. Villanueva Principal Gentlemen : This refers to your letter dated July 1, 2009 requesting confirmation of your opinion that the foreign exchange gains realized by Maynilad Water Services, Inc. ("MWSI" or "Maynilad") on the settlement of the U.S. Dollar denominated loans obtained mainly for the payment of concession fees to the Metropolitan Waterworks and Sewerage System ("MWSS") and other related expenses are generated from its registered activity and are thus covered by the Company's income tax holiday ("ITH") incentive. It is represented that MWSI, with Tax Identification Number 005-393-442, was incorporated in January 1997 for the operation of privatized system of waterworks and sewerage services of the MWSS for Metropolitan Manila; that the Company is registered with the Board of Investments ("BOI") as an operator of water supply and sewerage system for the Metro Manila west zone service area, under BOI Registration Certificate No. 97-201 dated January 13, 1998; that MWSI was initially granted ITH of six years beginning August 1, 2001 up to July 31, 2007; that in the Certificate of Entitlement 2008-00304 issued on April 25, 2008, MWSI's start of commercial operations was amended to January 1, 2003 from August 1, 2001; that its ITH entitlement was extended by one year or up December 31, 2008; that on January 8, 2009, the BOI granted another ITH extension to Maynilad of up to December 31, 2009; that as the assignee of the rights of MWSS under its Concession Agreement dated February 21, 1997, MWSI is obligated, among others, to: 1) pay MWSS the concession fees and that to guarantee the payment of the concession fees, MWSI was required to post a performance bond guaranteed by standby letters of credit ("SBLC") with international commercial banks amounting to $120 million; and DTIaHE 2) meet certain targets in water supply and sewerage and sanitation serviwwwwwwces and to finance capital expenditures to meet these targets; that the short-term and bridge loans secured to finance these capital expenditures are called "Concessionaire Loans"; that likewise under the Concession Agreement, MWSI is entitled to a water tariff adjustment; that a Rate Rebasing Adjustment ("RRA") mechanism allows rates to be adjusted every five years to enable the Company to recover expenditures efficiently and prudently incurred, payments corresponding to debt service on concession fees, and Company loans incurred to finance such expenditures; that on October 5, 2001, the MWSS Board issued Resolution No. 487-2001 ("Amendment No. 1") which allowed Maynilad to implement a special rate adjustment mechanism that accounts for future foreign exchange gains and losses; that the MWSS Board said this extraordinary remedy is "being granted to enable the Concessionaire to continue with its investment programs as committed in the Concession Agreement, and to ensure the efficient and viable delivery of water and sewerage services which are to the best interest of the public" (last Whereas clause, MWSS Board Resolution No. 487-2001 dated October 5, 2001); that in January 2005, MWSS drew the $120-million performance bond of MWSI after it failed to pay MWSS the concession fees as these fell due and this resulted in MWSI's indebtedness to its guarantor-banks; that in January 2007, after a competitive bidding and the required approvals from regulatory agencies, DMCI-MPIC Water Company, Inc. (DMCI-MPIC) became the owner of approximately 84% of MWSI's outstanding capital stock; that to lessen the enormous exposure to foreign exchange risk, MWSI entered into a Prepayment and Settlement Agreement ("PSA") with its bank creditors and shareholders, including MWSS and DMCI-MPIC, whereby DMCI-MPIC obligated itself to make a cash contribution to MWSI; that said cash contribution was used to settle MWSI's outstanding foreign currency denominated loans, including the $120-million performance bond secured by its guarantor-banks; that MWSI realized foreign exchange gains on the prepayment in January 2008; that on December 12, 2008, the MWSS-Regulatory Office (RO), which oversees MWSI's operations, approved a one-time, average all-in tariff adjustment of P37.82 per cubic meter effective May 1, 2009; and that in the resolution, the RO recognized that foreign exchange gains and losses realized by MWSI are related to concession fees and other loans incurred to finance its operations enjoying ITH. In reply, please be informed as follows: Article 39, Title III of the Omnibus Investments Code of 1987 states, thus: "ART. 39. Incentives to Registered Enterprises. . . . (a) Income Tax Holiday (1) For six (6) years from commercial operation for pioneer firms and four (4) years for non-pioneer firms, new registered firms shall be fully exempt from income taxes levied by the National Government . . . Relative thereto, Section 1 (t), Rule I, Part I of the Rules and Regulations implementing the Code provides that the 'income' of the registered firm entitled to income tax holiday shall be confined to income directly derived from registered operations." The tax treatment of foreign exchange gains of BOI-registered enterprises such as MWSI shall depend on the activities from which they arise. Thus, as clarified in Philippine Economic Zone Authority (PEZA) Memorandum Circular No. 2005-032 dated September 15, 2005, if the foreign exchange gain is derived from an activity with an income tax holiday incentive, the foreign exchange gain shall be covered by the same incentive. On the other hand, if the foreign exchange gain is derived from an activity without income tax incentive, said foreign exchange gain shall likewise be without income tax incentive, therefore, subject to normal corporate income tax. IcDHaT In BIR Ruling DA-(IL-011) 107-08 dated August 5, 2008, the BIR confirmed that the foreign exchange gains realized by Manila North Tollways Corporation on the repayment and prepayment of its U.S. Dollar denominated loans obtained exclusively for the upgrading, expansion and operation of Phase I of an expressway, its BOI-registered activity, are considered income generated from its registered activity and are thus covered by its ITH. Likewise in BIR Ruling DA-375-08 dated June 20, 2008, it was held that realized gains by Samsung Electronic Philippines Manufacturing Corporation arising from transactions directly attributed to its registered activity should be covered by the tax incentive granted by PEZA. Also in BIR Ruling DA-195-08 dated March 25, 2008, the BIR confirmed that the difference in the foreign currency translation of costs directly attributable to eTelecare Global Solutions, Inc.'s registered activity should be covered by the tax incentives granted by PEZA to eTelecare. In the case of MWSI, its realized foreign exchange gains mainly arose from the prepayment of its Concessions Fees and Concessionaire Loans, which are directly attributable to the Company's registered activity, i.e., "the operation of water supply and sewerage system for the west zone service area." The Company could not have stepped into the shoes of MWSS as west zone operator without the Concession Fees paid to MWSS. Due to MWSI's cash flow difficulties in 2001, it failed to pay these fees on time, resulting in the drawing of the performance bond, which loan was in turn settled by MWSI's new majority shareholder, DMCI-MPIC. Article 6.4 of the Concession Agreement clearly provides that part of MWSI's responsibilities as concessionaire is to pay and/or guarantee payment of the Concession Fees to MWSS. As there would be no operation to speak of on the part of MWSI without payment of the concession fees, it is clear that the structuring and management of MWSI's loans to pay the Concession Fee and other loan-related expenses and charges are intimately related to, if not an essential element of, MWSI's business of operating as water supply and sewerage system operator. Consequently, the prepayment of the Concession Fee and other loan-related expenses and charges is a necessary and indispensable part of MWSI's BOI-registered activity. Hence, any gain arising therefrom is covered by the ITH incentive granted by BOI to MWSI. The foregoing position is consistent with pronouncements of the BIR that realized foreign exchange gains arising from transactions directly attributable to the registered activity of PEZA-registered companies are covered by the applicable tax incentive, i.e., 5% GIT/ITH. This should equally apply to BOI-registered companies, such as MWSI. ScCDET Moreover, under Article 2.5 of Amendment No. 1, in determining the forex losses/gains to be recovered by Maynilad under the Rate Rebasing process, "the RO shall ensure that the Concessionaire's loans finance only concession fees and capex expenditures which have been prudently and efficiently incurred." Thus, the proceeds of the prepaid loans could not have been paid for expenses other than those related to the registered activity as there is a strict requirement under Amendment No. 1. We thus confirm your opinion that the foreign exchange gains realized by MWSI on the settlement of the U.S. Dollar denominated loans obtained mainly for the payment of concession fees to the MWSS and other related expenses are generated from its registered activity and are thus covered by the Company's ITH incentive. 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