Punongbayan & Araullo

September 26, 2008 BIR RULING [DA-(FIT-009) 260-08] RR 2; BIR Ruling No. 206-90; Sec. 179; DA-340-06 Punongbayan & Araullo 20th Floor, Tower 1, The Enterprise Center 6766 Ayala Avenue, Makati City Attention: Atty. Fluvio D. Dawilan Tax Partner Gentlemen : This refers to your letter dated May 30, 2008 requesting, on behalf of your clients, Koyo Manufacturing (Philippines) Corp. and KBP Real Estate Corporation, confirmation of your opinion relative to the tax consequences of the amendment of the applicable currency in the loan agreement and the lease contract between the two companies. It is represented that Koyo Manufacturing (Philippines) Corp. ("KMC") is a domestic corporation duly organized and existing under the laws of the Republic of the Philippines with principal office address at Lima Technology Center, Malvar, Batangas; that KBP Real Estate Corporation ("KRC") is also a domestic corporation duly organized and existing under the laws of the Republic of the Philippines with principal office address at Suite 504 Comfoods Bldg., Sen. Gil Puyat Ave., Makati City; that in 1998 KMC and KRC entered into a loan agreement whereby KMC contracted to loan KRC the amount of US$7,600,000 but only US$7,360,000 was actually availed by KRC; that this loan transaction has not yet been settled to date; that in the same year 1998, KMC and KRC entered into a lease agreement whereby KRC leased to KMC its property located in Lima Technology Center, Malvar, Batangas for a 50-year term; that the rental fee for the lease was denominated in Philippine currency; that the documentary stamp taxes on both agreements were paid; that following the development in the accounting rules, both KMC and KRC adopted the Japanese Yen as the functional currency for financial recording and reporting purposes; that accordingly, the financial statements of both companies are now being presented in Japanese Yen; that to avoid making translations from one currency to another, KMC and KRC decided to amend the currency denomination in the loan agreement and lease agreement; that on March 3, 2008, the lease agreement was amended by changing the currency denomination from Philippine Peso to Japanese Yen; that on the same date, the loan agreement was also amended by changing the currency denomination from U.S. Dollar to Japanese Yen; that the interest rate thereon was likewise reduced from 3% to 2.5% per annum; that per Amendment to Loan Agreement, the parties agreed to convert the US Dollar loan amount into its Japanese Yen equivalent at the time the loan was availed effective January 1, 2007; that at the time the said amendment was effected, the Japanese Yen equivalent to the US Dollar loan of US$7,360,000 was 875,361,600; that the amended loan agreement provides that effective January 1, 2007, the total amount loaned by KMC to KRC (then set in US Dollars) shall be converted to the Japanese Yen equivalent at the time the loan was availed ( i.e., in 1998) which is 988,878,475; that the same principal amount is reflected in the records of KMC as receivable and KRC as payable; and that the difference was reflected in the financial statements of both KMC and KRC as adjustment of carrying cost of loans receivable/payable to agreed value relative to the change in currency denomination. SEIDAC You now request for confirmation of your following opinions: 1. The amendment of the loan agreement between KMC and KRC did not result in the realization of the accumulated foreign exchange losses and accumulated exchange gains incurred by KMC and KRC, respectively. Thus, the amendment of the loan would not result to the deductibility of the accumulated foreign exchange losses on the part of KMC and to the taxability of the accumulated foreign exchange gain on the part of KRC. 2. Neither would the adjustment in the carrying cost of the loan to the agreed value relative to the change in currency denomination as a result of the reversion of the principal amount to the Japanese Yen equivalent at the time (1998) the US Dollar loan was contracted, be treated as taxable income on the part of KMC nor deductible loss on the part of KRC. 3. There is no documentary stamp tax on the amendment of the loan agreement by changing the currency denomination of the principal amount from US Dollar to Japanese Yen. 4. There is no documentary stamp tax on the amendment of the lease agreement by changing the currency denomination from Philippine Peso to Japanese Yen. In reply, please be informed as follows: 1. Amendment of the loan agreement did not result in realization of accumulated foreign exchange loss/gain The "realization" principle, as 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 the income tax. Under this principle, income is only recognized when (i) the earning process is complete or virtually complete, and (ii) an exchange has taken place. In other words, foreign exchange gain or loss shall only be realized upon actual conversion of one currency to another currency, e.g., United States Dollar converted into Philippine Peso or vice-versa. (BIR Ruling No. DA-187-07 dated March 27, 2007) In BIR Ruling No. 206-90 dated October 30, 1990, Porcelana Mariwasa, Inc. (PMI) had existing US Dollar loans from Noritake Company, Limited (Noritake) and Toyota Tsusho Corporation (Toyota) and in a subsequent year, the parties agreed to convert the said dollar denominated loans into pesos and PMI was of the opinion that it sustained losses in the conversion of US dollar denominated loans to peso is more than a shrinkage in value of money. The BIR ruled that aDSAEI "When foreign currency acquired in connection with a transaction in the regular course of business is disposed ordinary gain or loss results from the fluctuations. (Pr Hall Federal Taxes, Vol. 1, par. 6261) The loss is deductible only for the year it is actually sustained. It is sustained during the year in which the loss occurs as evidenced by the completed transaction and as fixed by identifiable events occurring in that year. (par, 6570, 34 Am. Jur. 2d, 1976) A closed transaction is a taxable event which has been consummated. (p. 231 Black's Law Dictionary, Fifth Edition) No taxation event has as yet been consummated prior to the remittance of the scheduled amortization. Accordingly, your request for confirmation of your aforesaid opinion is hereby denied considering that foreign exchange losses sustained as a result of conversion or devaluation of the peso vis-a-vis the foreign currency or US dollar and vice versa but which remittance of scheduled amortization consisting of principal and interests payment on a foreign loan has not actually been made are not deductible from gross income for income tax purposes. Furthermore, in BIR Ruling No. DA-592-06 dated October 5, 2006, this Office was of the opinion, viz. : "However, foreign exchange loss is deductible only if the same has been realized. Without realization, there can be no loss. There is realization of loss in the year it is actually sustained. (BIR Ruling No. 2 0 6-90 dated October 30, 1990) It is sustained during the year in which the loss occurs as evidenced by a closed and completed transaction and as fixed by identifiable events occurring in that year. (BIR Ruling No. DA-359-03 dated October 10, 2003). A closed transaction is a taxable event which has been consummated. (p. 231 Black's Law Dictionary, Fifth Edition) Mere fluctuation in value of the foreign exchange vis-a-vis the Philippine peso, but short of a closed and completed transaction, does not result to recognition of deductible loss. (VAT Ruling No. 239-89 dated September 20, 1989) In the subject loan agreement, the taxable event that consummates the transaction is the remittance of the scheduled amortizations and full payment of the loan. The full payment of the loan completes the transaction and it is from that point that one can ascertain the actual foreign exchange loss sustained." In the case of KMC and KRC, the loan remains unsettled at the time the currency denomination in the loan agreement was amended from US Dollar to Japanese Yen. The loan transaction between them cannot be said to be a closed and completed transaction yet and therefore, the foreign exchange loss or gain is still unrealized. Thus, this Office confirms your opinion that the amendment of the loan agreement did not result in the realization of accumulated foreign exchange losses and accumulated exchange gains incurred by KMC and KRC, respectively and that the amendment of the loan would not result to the deductibility of the accumulated foreign exchange losses on the part of KMC and to the taxability of the accumulated foreign exchange gain on the part of KRC. EADSIa This view is also consistent with the ruling of the Court of Tax Appeals in the case of The Coca-cola Export Corporation vs. Commissioner of Internal Revenue, (C.T.A. Case No. 5238, December 19, 1997) where it was held that loss arising from foreign exchange fluctuation, ascertained and realized during the taxable period and not compensated by insurance or otherwise, is deductible from gross income albeit it may relate to transaction of prior years. Otherwise stated, a realized foreign exchange loss sustained in a loan transaction may include unrealized foreign exchange loss from prior years. 2. The adjustment in the carrying cost of the loan to the agreed value relative to the change in currency denomination neither taxable income nor deductible loss At the time the loan was contracted, the US Dollar loan extended by KMC to KRC was recorded in the former's books in its Japanese Yen equivalent which was 988,878,475. When the loan agreement was amended in 2008, the Japanese Yen equivalent of the loan was now carried at 875,361,600. However, the amended loan agreement provided that effective January 1, 2007, the loan shall be converted from US Dollars to the Japanese Yen equivalent at the time the loan (1998) which is 988,878,475. Thus, there was a need to adjust the carrying cost of loans receivable/payable to the agreed value relative to the change in currency denomination. By reverting to the original value of the loan in Japanese Yen, the adjustment is merely a recovery of accumulated foreign exchange losses on the part of KMC and accumulated foreign exchange gains. However, both are still unrealized although reflected in the parties' books as income and loss respectively for accounting purposes. Hence, the adjustment in the carrying cost of the loan to the agreed value relative to the change in currency denomination shall neither be treated as taxable income on the part of KMC nor deductible loss on the part of KRC. 3. No DST on the amendment of the loan agreement by changing the currency denomination of the principal amount from US Dollar to Japanese Yen. The DST rate of a loan agreement is provided under Section 179 of the National Internal Revenue Code of 1997 (Tax Code), as amended by Republic Act No. 9243, which provides: "SEC. 179. Stamp Tax on All Debt Instruments. On every original issue of debt instruments, there shall be collected a documentary stamp tax of One peso (P1.00) on each Two hundred pesos (P200), or fractional part thereof, of the issue price of any such debt instruments: Provided, That for such debt instruments with terms of less than one (1) year, the documentary stamp tax to be collected shall be of a proportional amount in accordance with the ratio of its term in number of days to three hundred sixty-five (365) days: Provided, further, That only one documentary stamp tax shall be imposed on either loan agreement, or promissory notes issued to secure such loan. EcAHDT For purposes of this section, the term debt instrument shall mean instruments representing borrowing and lending transactions including but not limited to debentures, certificates of indebtedness, due bills, bonds, loan agreements. . ." From the above-stated provision, it is clear that the DST is imposed only on every original issue of debt instruments. However, any revision or amendment made in the debt instrument which is compatible with the original loan or does not extinguish the same is not subject to DST. This Office held in BIR Ruling No. DA-244-05 dated June 7, 2005 that "(4) The documentary stamp tax due on the issuance of the Senior Debt Instrument, Series "A" Subordinated Debt Instrument, Series "B" Subordinated Debt Instrument and the Additional Senior and Subordinated Debt Instruments by Balikatan shall be subject to P1.00 for every P200.00, or a fractional part thereof, of the issue value of the debt instruments pursuant to Section 179 of the Tax C od e, as amended by Republic Act No. 9 24 3. However, the subsequent assignment, transfer or amendment of such debt instruments by NHMFC shall not be subject to DST provided that there is no increase in the amount or change in the maturity date from that of the original instrument pursuant to Section 199(f) of the Tax C od e of 1997, as amended by Republic Act No. 9 24 3." Again, in BIR Ruling No. DA-340-06 dated May 26, 2006, this Office ruled that: "In several occasions, this office had the opportunity to rule on the issue of novation in relation to the application of DST. Thus, in instances such as a change of pledge or pledgors (BIR Ruling No. 188-99, dated November 29, 1999), or the mere additional collateral as supplementary security to a contract of loan (BIR Ruling Nos. 218-90, dated November 22, 1990 & UN-230-95, dated June 26, 1995), the original loan agreement is neither extinguished or replaced as the same are mere additional obligations not incompatible with the original loan, hence, no DST is payable in those instances." In this case, the amendment of the loan agreement between KMC and KRC involves the change of currency denomination or simply translation of the original loan contracted in US Dollars to its Japanese Yen equivalent. This neither extinguishes the obligation of KRC to KMC nor creates another obligation apart from the original loan. No DST, therefore, is due on the amendment of the loan agreement. DST, however, shall be due on the acknowledgment of the "Amended Loan Agreement" in accordance with Sec. 188 of the Tax Code. SDITAC 4. No documentary stamp tax on the amendment of the lease agreement by changing the currency denomination from Philippine Peso to Japanese Yen. In the same manner as the loan agreement, there is no new lease agreement that is created by the amendment of the lease agreement between KMC and KRC. The amendment merely changes the currency denomination of the lease payments from Philippine Peso to Japanese Yen. This will not affect the rental amount nor the remaining period of the lease as agreed in the original instrument. This being so, the amendment of the lease contract is not subject to DST. DST, however, shall be due on the acknowledgment of the "Amended Contract of Lease" in accordance with Sec. 188 of the Tax Code. 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