SGV & Co.

November 24, 2008 BIR RULING [DA-(TAR-004) 458-08] 34 (D); RR 6-06; DA-398-05; DA-359-03 SGV & Co. 6760 Ayala Avenue Makati City Attention: Atty. Romulo S. Danao, Jr. Partner, Tax Services Gentlemen : This refers to your letter dated July 22, 2008 requesting confirmation that the current practice of your client, CBK Power Company Limited ("CBK Power" for brevity), relating to the use of functional currency, conforms to the provisions of Revenue Regulations RR No. 06-06 dated March 16, 2006 on the use of functional currency other than Philippine Peso in Financial Statements that will be submitted and in the Books of Accounts that will be maintained for internal revenue tax purposes. DHCSTa It is represented that CBK Power is a partnership duly organized and existing under and by virtue of Philippine laws, with office address at 29th Floor, LKG Tower, Ayala Avenue, Makati City; that it was organized primarily to engage in the rehabilitation, construction, and subsequent operation and maintenance of a hydroelectric power plant complex located in Caliraya, Botocan and Kalayaan in Laguna, known as the CBK Complex; that it currently uses the US dollar as its functional currency in its financial statements as the US dollar is the currency of the primary economic environment in which it operates; that for income tax reporting purposes, CBK Power translates its functional currency income and expense accounts to Philippine pesos on a monthly basis using the average exchange rate during the month (under the Philippine Dealing System or PDS) for purposes of computing its income tax liability; that the total translated amounts per month are added to arrive at the income and expenses in Philippine pesos for the quarter/year, which shall be the basis for computing CBK Power's quarterly/annual income tax liability; that CBK Power also reconciles at the end of the year, certain income and expenses in the Income Tax Return with the equivalent peso figures of such income and expenses in the subsidiary ledgers maintained to serve as the source of the figures reflected in other tax returns (VAT, EWT, etc.); that the reconciling items are then reflected in the Annual Income Tax Return. The reconciliation is due to the fact that, for purposes of reporting other taxes (VAT, EWT, etc.) in the other tax returns (VAT, EWT, etc.), CBK Power uses the historical amount or actual conversion/prevailing rate on transaction day, whichever is applicable, to convert the said income and expense accounts from functional currency into peso; that with respect to its balance sheet accounts where the original currency is the same as its functional currency, such as its US dollar-denominated loans, CBK Power no longer translates such accounts to Philippine pesos for both financial accounting and income tax purposes, hence, CBK Power does not recognize unrealized foreign exchange gains or losses from such accounts in its functional currency books nor realized foreign exchange gains or losses for income tax purposes; that on the other hand, CBK Power recognizes unrealized/realized gains or losses on balance sheet accounts where the original currency is not the same as its functional currency, such as in the case of peso-denominated receivables/payables, for financial accounting and income tax purposes. In reply, please be informed that with regard to the use of the monthly average exchange rate in translating income and expense accounts for income tax reporting purposes, paragraph 2 of Section 7 of RR No. 06-06 provides viz. : "For purposes of translating the functional currency income and expenses to Philippine Pesos, the translation shall be done on a monthly basis using the average exchange rate during the month (under the Philippine Dealing System or PDS). The total translated amounts per month shall be added to arrive at the income and expenses in Philippine pesos for the quarter/year, which shall be the basis in computing the taxpayer's income tax liability . The total figures in the ITR for the year should be reconciled with the total of the equivalent peso figures as converted from the functional currency figures in the subsidiary ledgers maintained to serve as the source of the figures reflected in tax returns other than income tax. The reconciliation of the figures shall be done at the end of the year and the reconciling items shall be reflected in the annual or final adjustment income tax return." (Emphasis supplied) HAISEa Thus, the current practice of CBK Power in converting its dollar income and expense accounts into peso using the average exchange rate during the month for the purpose of computing its income tax liability is consistent with the provisions of RR No. 06-06. CBK Power also conforms to the provisions of the regulations when it reconciles certain income and expenses with the equivalent peso figures (as converted from the US dollar) of such income and expenses in its subsidiary ledgers and as reflected in the other tax returns (VAT, EWT, etc.), with the reconciling items being reflected in the annual income tax return of CBK Power. In addition, Section 8 of RR No. 06-06 provides as follows: " Currency to be Used in the Filing of Tax Returns Other than Income Tax . All tax returns other than ITR shall likewise be filed in Philippine peso currency using historical peso amount or actual conversion/prevailing PDS rate on transaction day, whichever is applicable ." (Emphasis supplied) Consistent with the above provision, CBK Power correctly maintains subsidiary ledgers with equivalent peso figures for transactions subject to other taxes (except income tax) and uses the historical amount or actual conversion/prevailing rate on transaction day, whichever is applicable, in recording the income and expense accounts in such tax returns. With regard to balance sheet accounts where the original currency is in US dollars, such as in the case of US-dollar denominated loans, this Office believes that CBK Power should no longer translate such accounts to Philippine peso for both financial accounting and tax purposes and, therefor, does not have to recognize unrealized/realized foreign exchange gains or losses from the transaction. This practice of CBK Power is more in keeping with the underlying intent and purpose of the functional currency regulations, which seeks to do away with artificial foreign exchange gains or losses that distort the real financial condition of the companies. In connection therewith, this Office has ruled in BIR Ruling No. DA-398-05 dated September 26, 2005, as follows: " Finally, the use of foreign currency for companies whose functional currency is a foreign currency will more clearly reflect income considering that the use of Philippine pesos results in artificial foreign exchange losses which distort the real financial condition of these companies . The use of foreign currency is also revenue neutral." (Emphasis supplied) Moreover, Section 11 (a) of RR 6-06 provides that: " Functional currency amounts (for both balance sheet and income statement items, including capital accounts) should be specifically identified and carried over to the functional currency financial statements in their original functional currency amounts, i.e., not translated amounts . For example, assuming the determined functional currency is the U.S. dollars (USD), all accounts denominated in USD amounts should be carried over to the functional currency financial statements." (Emphasis supplied) aDATHC With respect, however, to balance sheet accounts where the original currency is not the same as its functional currency, such as peso-denominated loans, this Office believes that CBK Power should recognize unrealized foreign exchange gains or losses for accounting purposes and, if realized, should report the gains or losses as income or expenses, respectively, for income tax purposes. Thus, this Office in BIR Ruling No. DA-359-03 dated October 10, 2003 has ruled that realized foreign exchange gains or losses should be recognized as income or expense, respectively, for income tax purposes Pertinent portions of said ruling state as follows: " There is an actual foreign exchange gain or loss realized by DPI depending on the appreciation/depreciation of the Philippine Peso to the US dollar between the time income/expense or the asset/liability is recorded in its books and the time the same is collected/paid. What DPI has reflected in its books as a liability or expense ( i.e., accounts payables, advance payments from contractees, purchase of construction materials) was the amount before the foreign exchange fluctuated, thus, since the payment of said liability was done when the peso depreciated, it suffered a foreign exchange loss when it used more pesos to pay its foreign currency obligations (The Coca-cola Export Corporation vs. Commissioner of Internal Revenue, C.T.A. Case No. 5238, December 19, 1997.) Alternatively, if DPI has reflected in its books as an asset or income (i.e., accounts receivables, advance payments to sub-contractors, construction income) an amount before the foreign exchange fluctuated, it will realize a gain when the peso depreciated at the time of collection . Section 34(D) of the 1997 Tax Code provides that losses actually sustained during the taxable year and not compensated by insurance or other forms of indemnity shall be allowed as deductions from gross income. Thus, foreign exchange losses may be allowed as a deduction if the losses have actually been incurred in the course of trade or business during the taxable year." (Underscoring supplied) Particular to the above-mentioned ruling, the Bureau laid down the instances when foreign exchange fluctuations may be considered as taxable gains and/or deductible expenses, such as "1. Exchange rate at the time of receipt of advance payments on contracts is different from the rate at the time income is earned and debited against advance payments. 2. Exchange rate at the time of recording/recognizing accounts receivables is different from the rate at the time of actual collection of the account receivables. 3. Exchange rate at the time advance payments are made to subcontractors is different from the rate at the time expenses on the sub-contract are incurred/recorded. AECacT 4. Exchange rate at the time of recording/recognizing accounts payables is different from the rate at the time accounts payables are paid. 5. Exchange rate at the time down payments for construction materials are made is different from the rate at the time of full payment/settlement of the balance on the purchase price of these materials." While the above ruling speaks of gains or losses from the conversion of the Philippine peso to the US dollar, this Office believes that the same principle can be applied by analogy to the instant case where the functional currency is the US dollar, and the US dollar has to be converted into Philippine peso upon payment of CBK Power's peso-denominated liability. The exchange rate at the time of recording or recognizing the peso-denominated loan (from peso to US dollar) can differ from the rate at the time the loan is paid and thus, realized gain or loss can be recognized or sustained, respectively on the part of CBK Power. Accordingly, CBK Power is justified in recognizing realized foreign exchange gains or losses as income or expense, respectively, for income tax purposes, where the original currency of the account is not the same as its functional currency, such as peso-denominated loans. In light of the foregoing discussions, this Office hereby confirms that the current practice of CBK Power as represented and described above conforms to the provisions of RR No. 06-06 on the use of functional currency other than Philippine Peso in Financial Statements that will be submitted and in the Books of Accounts that will be maintained for internal revenue tax purposes. 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. DACcIH Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service