SGV & Co.

December 22, 2009 BIR RULING [DA-(OSL-038) 805-09] 34 (E); RR 5-99; RR 2; DA-08-2007, DA-423-07, DA-233-08, DA-332-08, DA-(C-111) 362-08 SGV & Co. 6760 Ayala Avenue Makati City Attention: Atty. Romulo S. Danao, Jr. Partner, Tax and Transfer Pricing Services Gentlemen : This refers to your letter dated July 17, 2009 requesting for a ruling confirming the following tax implications of the impairment of assets of Onshore Strategic Assets (SPV-AMC), Inc. (OSAI): CEcaTH 1. OSAI's non-performing loans (NPLs), which are ascertained to be uncollectible and worthless, may be considered as bad debts that can be written-off and claimed as deductible expense for income tax purposes; and 2. OSAI may claim the impairment losses from its real and other properties owned and acquired (ROPOAs) as deductible expense for income tax purposes once the losses are realized upon the sale or disposition of the ROPOAs. It is represented that OSAI is a special purpose vehicle/asset management company which acquires portfolios of non-performing assets ("NPAs") consisting of NPLs and ROPOAs; it secured loans from Banco de Oro (BDO) and United Overseas Bank Limited (UOBL) to fund its purchase of NPAs from United Overseas Bank Philippines (UOBP); the NPAs were purchased at book value and, as such, UOBL guaranteed to reimburse OSAI for any loss that OSAI may incur in the disposition or settlement of the NPAs; in 2007, Standard Bank (SB) purchased OSAI's loans from BDO and UOBL at a discounted price; with the purchase by SB of OSAI's loan, the aforesaid guaranty of UOBL has been extinguished; without UOBL's guarantee, it has been determined per independent appraisal that the realizable value of the NPAs is far less than its book value; in compliance with Philippine Accounting Standards (PAS) 36, OSAI set-up an "allowance for impairment loss" account in 2007 to reflect the true value of the NPAs; in 2008, OSAI realized the impairment loss by reducing the amount of the NPAs to its recoverable value for financial accounting purposes; specifically, the NPLs, which were ascertained to be worthless and uncollectible despite diligent efforts, were written-off from OSAI's books and the value of the ROPOAs, which have market values lower than their book values, were accordingly reduced; the subject NPLs are essentially debts due to OSAI from various debtors; the NPLs that have been written off are those that could no longer be collected despite diligent efforts of OSAI to collect the same; OSAI has repeatedly sent demand letters to the concerned creditors, but such demand letters remained unheeded; thus, you believe that there is basis for OSAI to write-off the said NPLs in its books and claim the amount write-off as a deductible expense for income tax purposes. In reply, please be informed that your opinion is hereby confirmed as follows: NPLs Section 34 (E) of the Tax Code categorically provides that bad debts are deductible from gross income provided that the prerequisites stated therein are met: "(E) Bad Debts. (1) In General. Debts due to the taxpayer actually ascertained to be worthless and charged off within the taxable year except those not connected with profession, trade or business and those sustained in a transaction entered into between parties mentioned under Section 36(B) of this Code:" . . . . Further, in Section 3 of Revenue Regulations (RR) No. 05-99, as amended, implementing Section 34 (E), enumerated the requisites for the deductibility of bad debts from gross income as follows: HEacAS "Sec. 3. Requisites for valid deduction of bad debts from gross income. The requisites for deductibility of bad debts are: (1) There must be an existing indebtedness due to the taxpayer which must be valid and legally demandable; (2) The same must be connected with the taxpayer's trade, business or practice of profession; (3) The same must not be sustained in a transaction entered into between related parties enumerated under Sec. 36(B) of the Tax Code of 1997; (4) The same must be actually charged off the books of accounts of the taxpayer as of the end of the taxable year; and (5) The same must be actually ascertained to be worthless and uncollectible as of the end of the taxable year. Before a taxpayer may charge off and deduct a debt, he must ascertain and be able to demonstrate with reasonable degree of certainty the uncollectibility of the debt. The Commissioner of Internal Revenue will consider all pertinent evidence, including the value of the collateral, if any, securing the debt and the financial condition of the debtor in determining whether a debt is worthless, or the assigning of the case for collection to an independent collection lawyer who is not under the employ of the taxpayer and who shall report on the legal obstacle and the virtual impossibility of collecting the same from the debtor and who shall issue a statement under oath showing the propriety of the deductions thereon made for alleged bad debts. Thus, where the surrounding circumstances indicate that a debt is worthless and uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment, a showing of those facts will be sufficient evidence of the worthlessness of the debt for the purpose of deduction." With regard to the fifth requirement, a taxpayer may charge off and deduct a debt only after he has ascertained and demonstrated, with reasonable degree of certainty, the uncollectibility of the debt. This Office has recognized that it is not required that the taxpayer bring the debtor to court to prove that the debt is worthless. In BIR Ruling No. DA-08-2007 dated January 09, 2007, this Office stated that: "The Court of Tax Appeals (CTA) in interpreting the above requisites held that the taxpayer is not required to be an "incorrigible optimist" in enforcing collection of a debt ( Western Pacific Corporation v. Commissioner of Internal Revenue , CTA Case No. 720, 22 May 1961 citing White Dental Mfg. vs. US , 274 US 398). He may not postpone a bad debt deduction on the basis of a mere hope of ultimate collection but rather, should exercise sound business judgment based upon information reasonably obtainable in determining worthless debts and in the examination of all the circumstances. Thus, this Office in BIR Ruling No. UN097-95 dated March 8, 1995, ruled that '. . . [B]ad debts are allowed as deductions in the year when ascertained to be worthless and not at the time when the taxpayer may finally 'give up' on the possibility of recovering any part of the debts and decide to charge them off. (CCH, 60 Vol. 2, p: 21.009, (page 252, updated National Internal Revenue Code with Notations and Appendices, 1988 Edition, Jose Araas)' The taxpayer must take reasonable steps to collect the debt. He does not have to go to court if it can be shown that a judgment once obtained would be worthless because the debtor is insolvent or 'judgment proof'. If, in the exercise of sound business judgment a taxpayer believes there is no likelihood of recovery at any time in the future, the debt has been worthless. ( Western Pacific Corporation v. Collector of Internal Revenue , CTA Case No. 720) In applying the above principle under the circumstances, it is crystal clear that MCC need not go through the lengthy process of hiring a collection lawyer and/or filing a collection case against the Subject Cardholders since, in all probability, it will not result in the satisfaction of the debt or execution of the judgment. The debt has become worthless already. Accordingly, MCC may write-off its accounts receivable due from the Subject Cardholders and claim it as a bad debt deduction from its gross income pursuant to Section 34 (E) (1) of the Tax Code of 1997." This Office has consistently applied the foregoing requisites and the same interpretation as regards the fifth requirement in numerous rulings: BIR Ruling No. DA-136-05 dated April 7, 2005; BIR Ruling No. DA-537-06 dated September 5, 2006; BIR Ruling No. DA-696-06 dated December 11, 2006; BIR Ruling No. DA-008-07 dated January 9, 2007; BIR Ruling No. DA-423-07 dated July 27, 2007; BIR Ruling No. DA-233-08 dated April 11, 2008; BIR Ruling No. DA-332-08 dated May 30, 2008; and BIR Ruling No. DA-(C-111) 362-08 dated October 28, 2008. HCaDET Based on the above representations and legal bases, this Office finds that the requisites for deductibility of bad debts are satisfied considering that: 1) the NPLs are existing indebtedness due to OSAI which are valid and legally demandable; 2) the NPLs are undeniably connected with OSAI's business; 3) the NPLs do not involve any of OSAI's affiliates; 4) the NPLs are actually ascertained to be worthless and uncollectible; and, 5) OSAI has evidently exhausted reasonable efforts to collect payment of the NPLs. Despite these efforts, the NPLs remain to be unpaid and have, therefore, become worthless. Accordingly, we confirm your opinion that OSAI's NPLs, which are ascertained to be uncollectible and worthless, may be considered as bad debts that can be written-off and claimed as deductible expense for income tax purposes. ROPOAs In the event of a reduction in the value of the ROPOAs below cost, an impairment loss would have to be recognized for financial accounting purposes to bring down the value of the asset to its fair or realizable value and prevent an overstatement in the balance sheet (BIR Ruling No. DA-403-03 dated November 10, 2003). However, unlike the NPLs which can be ascertained to be worthless and uncollectible, an impairment loss resulting from the reduction in the value of the ROPOAs may not be considered realized for tax purposes until the ROPOAs are sold or disposed as the value of the ROPOAs may still rise or fall. Thus, such impairment loss shall be deductible for income tax purposes only upon its sale or disposition. Thus, this Office ruled in BIR Ruling No. DA-403-03 dated November 10, 2003: "As noted, the concept of 'impairment loss' is to ensure that the true value of the asset is carried in the books of the company at no more than its recoverable amount. Accounting wise, the impairment loss is recognized immediately by reducing the assets carrying amount to its recoverable value. It is adjusted through the accumulated depreciation account and therefore, classified as other operating expenses and is not to be treated as an extraordinary item. This is consistent with IAS 36 which provides that 'impairment loss recognized for an asset in prior years should be recovered if there has been a change in the estimate used to determine the asset's recoverable amount since the last impairment loss was recognized.' DTcASE In other words, if the recoverable amount of an asset that has been impaired turns out to be higher than the asset's current carrying value, the carrying amount of the asset should be increased to its new recoverable amount. The reversal of the impairment loss should be recognized immediately as income in the income statement. Thus, while under the above SFAS/IAS 36 an impairment loss account is set up at the time of the recognition of impairment loss, and which account is ultimately reversed when the asset carrying an impairment loss is disposed or sold, the Tax Code does not allow the recognition of an impairment loss as deduction for tax purposes if such loss is not actually sustained during the taxable year. Henceforth, even if impairment loss of an asset is reflected in the financial statements for financial accounting purposes, the same will not result in any tax benefit since no actual loss is sustained that may be allowed as deduction in the corporation's taxable income." This Office further ruled that "losses are, as a rule, not recognized unless evidenced by a closed and completed transaction. (Section 96, Rev. Regs. No. 2)." This principle has been consistently reiterated in the following rulings: BIR Ruling No. 144-85 dated August 26, 1985; BIR Ruling No. 206-90 dated October 30,1990; BIR Ruling No. DA-023-03] dated January 28, 2003; BIR Ruling No. DA-162-07 dated March 20, 2007; and BIR Ruling No. DA-403-03 dated November 10, 2003. In other words, the impairment loss may be claimed as a deductible expense for tax purposes only when the asset is sold or otherwise disposed of at a price below acquisition cost. Thus, OSAI may only deduct the impairment loss from its gross income for tax purposes once the ROPOAs are sold or otherwise disposed of at a price below acquisition cost. This is because it is only then that OSAI would sustain actual losses which may be validly deducted from its gross income. Accordingly, we confirm your opinion that OSAI may claim the impairment losses from the ROPOAs as deductible expense for income tax purposes once the losses are realized upon the sale or disposition of the ROPOAs. This ruling is issued on the basis of the facts as represented. However, if upon investigation it shall be disclosed that the facts are different, then this ruling shall be without force and effect insofar as the herein parties are concerned. CSaIAc Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service