SGV & Co.

July 16, 2008 BIR RULING [DA-(VAT-004) 050-08] 27 (A); 105; DA-202-07 SGV & Co. 6760 Ayala Avenue 1226 Makati City Attention: Atty. Joel L. Tan-Torres Partner, Tax Services Gentlemen : This refers to your letter dated June 23, 2008 requesting on behalf of your client Samsung Electro-Mechanics Philippines Corp. (Semphil) for confirmation of your opinion that the excess of the insurance proceeds over the net book value of Semphil's damaged assets, where the insurance proceeds are used to entirely rehabilitate/replace the assets that were damaged, is not a taxable income of Semphil under Section 27 (A) of the Tax Code, and the insurance proceeds shall not be subject to VAT pursuant to Section 105 of the Tax Code. It is represented that Semphil is a corporation duly organized and existing under Philippine laws with office address at the Calamba Premier International Park (CPIP) Special Economic Zone; that it is registered with the Philippine Economic Zone Authority (PEZA) as an Ecozone Export Enterprise to engage in the manufacture of the following products: (1) multi-layer chip capacitor and thick film chip resistor; (2) micro-chip tantalum capacitor; (3) crystal oscillator; (4) ultra high-chip capacitor; (5) array chip capacitor; (6) slim capacitor for camera module, ipod and MP3; (7) oscillation IC for WLAN and Bluetooth module; and (8) face down chip capacitor; that it is also registered to trade and distribute Samsung electronic parts and components for various electronic and communication devices to PEZA-registered export enterprises at CPIP; that on December 6, 2007, a fire occurred in the Semphil's Factory 2 in Calamba; that the building was partially damaged, and several machines and inventories were burned and contaminated when some volatile gas ignited; that the net book value of the damaged assets immediately before the casualty and fire is estimated at $3 million; that on January 4, 2008, Semphil declared the casualty loss to the Bureau of Internal Revenue, Revenue District No. 56 pursuant to Revenue Regulations No. 12-77; that in said declaration, Semphil reported a casualty loss of around $3 million; that Semphil estimates that the total cost of rehabilitating/replacing its damaged assets will amount to $4.8 million, which it anticipates will be recovered from the insurance company. AaHDSI In reply, please be informed that the aforementioned destruction of your properties due to a fire partakes the nature of an involuntary conversion of property which doctrine was relied upon by this Office in BIR Ruling No. 373-87 date November 23, 1987, BIR Ruling No. 429-88 dated September 2, 1988, and later reiterated in BIR Ruling No. 329-92 dated November 18, 1992. The doctrine of Involuntary Conversion of Property, as explained in BIR Ruling No. 329-92, is quoted, thus: "xxx xxx xxx The excess of the amount of the insurance proceeds over the net book value of the insured assets is not taxable income to the corporation, it having been used in restoring the burned assets. The rule is, where insurance proceeds are actually reinvested in similar property, no gain is recognized. ( Herder v. Helvering, 23 AFTR, p. 322)" The aforesaid Herder v. Helvering case is a discussion of the Involuntary Conversion of Property Doctrine in determining whether or not a gain from involuntary conversion of a property may be recognized as realized income subject to income tax to the recipient, theft or seizure, its expropriation or condemnation, or the threat or imminence thereof. Involuntary Conversion if property (as a result of its destruction, in whole or in part, theft or seizure, or an exercise of the power of requisition or condemnation or the threat or imminence thereof) is compulsorily or involuntarily converted into property similar or related in service or use to the property so converted, or into money which is forthwith in good faith . . . expended in the acquisition of other property, or in the acquisition of a control of a corporation owning such property, or in the establishment of a replacement fund, no gain or loss shall be recognized. If any part of the money is not so expended the gain, if any, shall be recognized, but in an amount not in excess of the money so expended (MERTENS, Chap. 20, 121, Vol. 3, pp. 337-338)" Applying the foregoing to the instance case, it is the opinion of this Office as it hereby holds that inasmuch as Semphil will use the entire insurance proceeds in rehabilitating/replacing the destroyed assets, the excess of the amount of the insurance proceeds over the net book value or the cost basis of the insured assets is not recognized as realized income of Semphil and, hence, not subject to income tax under Section 27 (A) of the Tax Code of 1997. Moreover, the excess of the total replacement cost over the net book value of the damaged assets immediately before the casualty will not be a deductible loss but may be capitalized by Semphil subject to depreciation. Depreciation shall be based on the adjusted basis of the assets after rehabilitation thereof. DIESaC Revenue Regulations No. 12-77 provides that, for income tax purposes, the deductible loss sustained from casualty shall be the excess of the net book value of the ordinary assets that were totally destroyed over any proceeds from insurance and other forms of indemnity or compensation received. The excess, if any, over the net book value immediately before the casualty shall be capitalized subject to depreciation over the remaining useful life of the property. Thus, in BIR Ruling No. 429-88, supra , it was held that ". . . the excess of the total costs of reconstruction, rehabilitation, restoration and replacement of the insured assets over the total acquisition cost or adjusted basis is not a deductible loss. However, the excess shall be considered an additional capital expenditure from which depreciation may be claimed." With respect to the issue on value-added tax, Section 105 of the Tax Code of 1997, as amended by R.A. No. 9337, provides that "Sec. 105. Persons Liable. Any person who, in the course of trade or business, sells, barters, exchanges, leases goods or properties, renders services, and any person who imports goods shall be subject to the value-added tax (VAT) imposed in Sections 106 to 108 of this Code. The value-added tax is an indirect tax and the amount of tax may be shifted or passed on to the buyer, transferee or lessee of the goods, properties or services. This rule shall likewise apply to existing contracts of sale or lease of goods, properties or services at the time of the effectivity of R.A. No. 7716. The phrase "in the course of trade or business" means the regular conduct or pursuit of a commercial or an economic activity, including transactions incidental thereto, by any person regardless of whether or not the person engaged therein a non-stock, non-profit private organization (irrespective of the disposition of its net income and whether or not it sells exclusively to members or their guests), or government entity." The rationale of the phrase "in the course of trade or business" was elucidated in BIR Ruling No. DA-342-05 dated August 10, 2005, where this Office ruled as follows: cHSTEA ". . . since the aforesaid building, machinery and equipment is not held by ORCA primarily for sale to customers or held for lease in the ordinary course of its trade or business, considering that its business involves electricity, steam and CO2 generation, it follows that the sale of the same is not subject to VAT pursuant to the above-mentioned provision of the Tax Code and its implementing rules and regulations." Moreover, in BIR Ruling DA-084-2007 dated February 12, 2007, the BIR ruled that indemnification is not an actual sale of goods by the insured company to the insurance company. This Office explained in this wise: "Although HPI will be indemnified by the insurance companies for the value of the damaged assets, such indemnification can not be regarded as actual sale of goods by HPI to the insurance companies. The indemnification arises because of the happening of a fortuitous event. Besides, HPI is engaged in the business of manufacturing and supplying cement and not in the sale of cement manufacturing assets. Thus, the insurance proceeds shall not form part of HPI's gross sales for VAT purposes as the receipt of the insurance proceeds is not in the regular or ordinary course of HPI's business." Inasmuch as indemnification cannot be regarded as an actual sale of goods, the insurance proceeds derived by Semphil due to the destruction of its insured assets shall not form part of its gross sales for VAT purposes. In view of the foregoing, this Office your opinion that: 1. The excess of the insurance proceeds over the net book value of Semphil's damaged assets, where the insurance proceeds are used to rehabilitate/replace the damaged assets, is not a taxable income of Semphil under Section 27 (A) of the Tax Code of 1997; and 2. The insurance proceeds shall not form part of Semphil's gross sales for VAT purposes pursuant to Section 105 of the Tax Code of 1997. 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. TECIaH Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service