Salvador & Associates

December 4, 2008 BIR RULING [DA-(TAR-006) 491-08] RR 6-2006; RR No. 2; DA-187-2007 Salvador & Associates 815-816 Tower One & Exchange Plaza, Ayala Triangle, Ayala Avenue, 1226 Makati City Attention: Atty. Euney Marie J. Mata-Perez Partner Gentlemen : This refers to your letter dated August 22, 2008 requesting on behalf of your client, Luzon Hydro Corporation ("LHC"), for confirmation of your opinion on certain matters involving the implementation of Revenue Regulations ("RR") No. 06-2006 on the use of functional currency books. It is represented that LHC is a corporation duly organized and existing under Philippine laws. LHC was incorporated as an operator of a hydroelectric power plant in the Philippines. The revenues of LHC are all billed and settled in US Dollars. Moreover, a substantial portion of LHC's cost and expenses are likewise denominated in US Dollars. The major components of LHC's US Dollar-denominated cost and expenses are: (a) depreciation of the 70-megawatt hydroelectric power generating facility; (b) provision for doubtful accounts in relation to LHC's receivables from its contractors; (c) insurance payments; and (d) interest expense arising from US Dollar-denominated liabilities. It is also represented that beginning 2005, due to the adoption of Philippine Accounting Standard No. 21 The Effects of Changes in Foreign Exchange Rates, LHC was required to determine its functional currency and measure its results and financial position in that currency. The Securities and Exchange Commission ("SEC"), in SEC Memorandum Circular No. 14, Series of 2003, Guidelines on Preparation of Functional Currency Financial Statement, gave qualified companies the option to file functional currency financial statements, subject to compliance with certain criteria. On May 9, 2005, the SEC approved LHC's request to use US Dollars in its financial statements for the year ended December 31, 2005 and onwards. Thus, beginning January 1, 2005, LHC adopted the US Dollar as its functional currency for financial recording and reporting purposes. IEAHca RR No. 06-2006 was promulgated to prescribe the guidelines and procedures in adopting the use of functional currency, other than the Philippine Peso, in financial statements that will be submitted and books of accounts that will be maintained for internal revenue tax purposes. Finally, it is represented that the bulk of LHC's assets are US Dollar-denominated cash, receivables and property, plant and equipment which were originally acquired and recorded in US Dollars, LHC's functional currency. The bulk of its liabilities are also US Dollar-denominated loans and obligations which were likewise originally recorded and accrued in US Dollars. These liabilities include US Dollar loans obtained from various banks, as well as accruals and provisions of other US Dollar obligations. You now request confirmation of your opinion that: 1. For income tax purposes, LHC is not required to maintain two complete sets ( i.e., one in Philippine Peso and another in US Dollar) of its general journal and general ledger and other books of accounts. It is sufficient that LHC maintains a complete set of books of accounts in US Dollars, its functional currency. However, LHC shall maintain subsidiary sales journal and the subsidiary purchase journal, or their equivalents, such as the payroll register, reflecting Philippine Peso amounts as well, if the maintenance of such subsidiary journals or registers would be required for transactions subject to the other taxes ( i.e., aside from income tax), such as those for value-added tax ("VAT") and withholding tax purposes. 2. The US Dollar functional currency books of LHC shall be the company's tax base for both accounting and tax purposes. However, for purposes of preparing the Income Tax Return ("ITR") of LHC, amounts in Philippine Pesos will be used. Solely for the purpose of computing LHC's current income tax liability in the preparation of its ITR, the translation of all US Dollar or functional currency income and expense accounts to Philippine Pesos shall be done on a monthly basis using the average exchange rate for the month (under the PDS), and that 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 of the income tax liability computation of LHC; and 3. No foreign exchange gain (or loss) shall be recognized on the settlement of LHC's US Dollar or functional currency-denominated assets and liabilities, such as receivables and payables, whether present or future, including accruals and provisions of the said assets and liabilities, if the same functional currency, i.e. , US Dollars, used in obtaining and recording such assets, or incurring and recording such liabilities, as the case may be, is used in the settlement. In reply, please be informed that Section 10 of RR No. 06-2006 provides: aDIHCT "SEC. 10. Books of Accounts to be Maintained. Taxpayers who qualified hereunder should maintain their books in functional currency (if other than the Philippine peso). However, said taxpayers shall also maintain subsidiary ledgers for transactions subject to the other taxes ( i.e., aside from income tax), which will be recorded both in functional currency and in Philippine peso using the historical peso amounts or actual conversion/prevailing rate on transaction day, whichever is applicable. Said functional currency books/records must be registered with the BIR in accordance with existing rules on registration of books and may be subject to BIR audit in connection with the audit of tax liabilities." The foregoing section clearly states that a taxpayer, such as LHC, which has adopted US Dollars as its functional currency, shall necessarily maintain its books of account in US Dollars. These books shall be the basis in preparing its audited financial statements which shall be filed before the Bureau of Internal Revenue ("BIR") and SEC. As such, LHC shall no longer be required to maintain a complete set of books in Philippine Pesos. But for transactions subject to taxes other than income tax, it shall be required to maintain subsidiary ledgers which record transactions both in functional currency and in Philippine peso using the historical peso amounts or actual conversion or prevailing rate on transaction day, whichever is applicable. These other taxes would include VAT and withholding taxes. Thus, for instance, for purposes of recording input VAT in Philippines Pesos, or taxes withheld, whether creditable or final tax, LHC has to maintain subsidiary ledgers which reflect both Philippine Pesos and US Dollars, its functional currency. These subsidiary ledgers may include payroll registers. Accordingly, this Office confirms your opinion that it is sufficient that LHC maintains its general journal and general ledgers in its functional currency of US Dollars. It is not required to maintain another set of those books in Philippine Pesos. However, for purposes of computing its other tax liabilities, such as VAT and withholding taxes, it is required to maintain subsidiary ledgers showing Philippine peso amounts. Moreover, LHC's ITR should reflect, or show entries in Philippine Pesos. These amounts or entries shall be arrived at after translating the figures or amounts reflected in LHC's books or general ledgers maintained in US Dollars, its functional currency, in accordance with the procedures for translation set out in Sections 7 and 8 of RR No. 06-2006, as follows: "SEC. 7. Currency to be Used for Income Tax Purposes . The income tax returns (ITRs) of taxpayers which have adopted functional currency (other than Philippine peso) in their financial statements and books of accounts shall still be prepared in Philippine pesos. Thus, all entries in the ITR shall be in Philippine pesos. 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. Thus, after such reconciliation, the figures in the annual ITR should tally with the total annual figures in the other tax-type tax returns such as the tax returns for VAT, Percentage Tax, Withholding Tax, Documentary Stamp Tax, etc. HAaDTE Tax credits applied against the income tax due (in Philippine pesos), if any, shall be equal to the actual amounts of such credits in Philippine pesos, as shown in the supporting documents ( e.g., withholding tax certificates issued by the other party withholding agents, proof of advance payment of the tax and prior year's income tax return)." "SEC. 8. Currency to be Used in the Filing of Tax Returns Other than Income Tax. All tax returns other than the 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." Thus, LHC shall multiply the monthly balances in US Dollars of all its income statement items (both as to income and expense accounts) by the average US Dollar exchange rate for said month under the Philippine Dealing System or PDS. The translated amounts per month shall then added to arrive at the income and expenses in Philippine Pesos for the quarter or year, and the total of such amounts added shall be the basis in computing LHC's quarterly or annual income tax liability. Accordingly, this Office confirms your opinion that LHC's income tax liability or income tax expense should be reflected in its ITR in Philippine Pesos, and paid or settled to the BIR also using Philippine Pesos. However, such liability or expense shall be computed based on the amounts reflected in its books which are maintained by LHC in US Dollars, its functional currency. The income and expense items reflected in such US Dollar books shall be translated to Philippine Pesos in accordance with procedure described above. For accounting purposes also, LHC shall necessarily consider its actual income tax liability or income tax due computed in the manner described above, as such would reflect what LHC is ultimately liable for income tax purposes. Thus, for purposes of computing its income tax liabilities, it is sufficient that LHC maintains its general journal and general ledger in its functional currency of US Dollars. Section 38 of RR No. 2, otherwise known as the Income Tax Regulations, provides the basic rule on recognition of income as follows: "SEC. 38. Bases of computation. Approved standard methods of accounting will be ordinarily regarded as clearly reflecting income. A method of accounting will not, however, be regarded as clearly reflecting income unless all items of gross income and all deductions are treated with reasonable consistency. All items of gross income shall be included in the gross income for the taxable year in which they are received by the taxpayer and deductions taken accordingly, unless in order to clearly reflect income, such amounts are to be properly accounted for as of a different period. For instance, in any case in which it is necessary to use an inventory, no accounting in regard to purchases and sales will correctly reflect income except an accrual method. A taxpayer is deemed to have received items of gross income which have been credited to or set apart for him without restriction. On the other hand, appreciation in value of property is not even an accrual of income to a taxpayer prior to the realization of such appreciation through sale or conversion of the property . . . . (Emphasis ours.) DIETHS In BIR Ruling No. DA-187-2007 dated March 27, 2007, this Office applied the "realization principle" on the recognition of foreign exchange gain or loss, and ruled that gain or loss from a foreign exchange transaction shall only be realized only upon a closed and completed transaction, i.e., there was an actual conversion of one currency to another currency. Thus, this Office enunciated the following guidelines on the recognition of foreign exchange gain or loss: "In reply, please be informed that 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." In the case of Manila Mandarin Hotels v. Commissioner of Internal Revenue, CTA Case No. 5046, March 24, 1997, the Court of Tax Appeals explained the "realization principle" as follows: "Under the realization principle, revenue is generally recognized when both of the following conditions are met: (a) the earning process is complete or virtually complete, and (b) an exchange has taken place. This principle requires that revenue must be earned before it is recorded. Thus, the amounts received in advance are not treated as revenue of the period in which they are received but as revenue of the future period or periods in which they are earned. These amounts are carried as unearned revenue, that is, liabilities to transfer goods or render services in the future until the earning process is complete. (Compilation of Statements of Financial Accounting Standards No. 1-22, pp. 41-42)". The "realization principle" is likewise reflected in Section 12 of RR No. 06-2006 where there is no recognition of foreign exchange gain or loss in investments made by a taxpayer that has adopted a functional currency (other than Philippine Peso), as follows: "SEC. 12. Treatment of Gain or Loss on Sale of Investment Under Functional Currency. An investor which invests in functional currency (other than Philippine peso) securities can compute its gain or loss from the sale of said investment using the functional currency. For example, if Company A invests in a US dollar bond at US$100,000 when the US$:P rate was US$1:40 and sells the same investment at US$102,000 when the US$:P rate was US$1:50, the computation of the capital gain shall be as follows: IcTCHD USD Pesos Selling Price 102,000 5,100,000 Cost 100,000 4,000,000 Taxable Gain 2,000 In the above illustration, the taxable gain that should be reported is only $2,000. Thus, in reporting for tax purposes of the $2,000 gain in equivalent or converted Philippine peso denomination, the equivalent peso denomination is the peso equivalent of 2,000 U.S. dollars using the conversion rate on the date of the consummation of the transaction. The above rule shall also apply to non-resident stockholders of an investee company where such investee company in the Philippines uses a functional currency other than the Philippine peso for its financial statements. However, if an investor makes an investment in Philippine peso, then it shall compute the gain or loss from sale of said investment using the Philippine peso cost and Philippine peso selling price. Since no foreign exchange gain or loss is recognized in investments in functional currency by a taxpayer that has adopted a functional currency (other than Philippine Peso), the same should also hold true for LHC's US Dollar or functional currency-denominated liabilities, including accruals and provisions thereon, if they are settled or paid in the same functional currency, i.e., US Dollars, used in incurring and recording such liabilities. Accordingly, this Office likewise confirms your opinion that no foreign exchange gain or loss should arise or be recognized if LHC's assets or liabilities are settled or paid with the same functional currency, i.e., US Dollars, which was used when they were obtained or incurred and first recorded in the books of LHC. In such case, since there is no need for conversion from one currency to another over a period of time, no changes in foreign exchange rates will affect the settlement transaction. The same holds true even in the case of accruals and provisions of assets and liabilities. No foreign exchange gain or loss could arise where the assets and liabilities are settled in US Dollars, the same functional currency used to incur and first record them in LHC's books, as the amount shown in the books matches the amount settled. In short, there is no "realization" of any foreign exchange gain or loss because of the absence of any actual conversion of one currency to another. TAaIDH 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