Method of Accounting Used by Taxpayer to Report Income and Expenses

January 5, 2000 BIR RULING NO. 003-00 Punongbayan & Araullo 6/F Vernida IV Bldg. Alfaro Street, Salcedo Village Makati City Attention: Ms . Marivic C . Espao Tax Partner Gentlemen : This refers to your letter dated December 3, 1999 stating that your client, KSA Realty Corporation (KSA) a domestic corporation, is the absolute and lawful owner of the Enterprise Center Condominium Project in Makati City; that KSA started its commercial operations on September 1, 1999; that KSA derives income on rentals received from various clients as stipulated in each of the lease contracts executed by it with the lessees; that in most cases, the Contract of Lease provides for a lease term of three (3) to five (5) years and specifies the monthly rates applicable for each year; that the contract requires the payment of advance rentals equivalent to three (3) months rental plus 10% VAT; that the first advance payment, payable on or before the signing of the Contract of Lease, shall be applicable to the first quarter rental payment (after the rent-free period where the same is provided for in the Contract of Lease); that the lease term commences on delivery date which is the date when physical possession of the leased premises is tendered to the lessee; that for varying periods from commencement date, the fit-out period is observed (the fit-out period varies from weeks to months, depending on the extent of the work needed to be done on the leased premises by the lessee); that no rentals are payable during the fit-out period; that in the case of some leases, the Contract of Lease further provides for a rent-free period of one or more months from the commencement of the lease term; that for financial reporting purposes, KSA has decided to report lease income in accordance with the rules set forth under International Accounting Standard (IAS) No. 17, a new accounting standard issued by the International Accounting Standards Committee (IASC) which is an independent private sector body composed of professional accountancy bodies from 91 different countries all over the world as members; that IAS No. 17 provides that in the case of operating leases, rental income should be recognized as a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern of the earning process contained in the lease; that the rental income is recognized on a straight-line basis over the lease term even if the receipts are not recognized on such a basis; that IAS No. 17 is a newly issued accounting guideline and is operative for financial statements covering periods beginning on or after January 1, 1999; and that KSA decided to adopt such accounting method of reporting its lease income to conform with the practice of its affiliated companies abroad, and thus, achieve uniformity in the accounting policies employed by KSA and its affiliates. LexLib In connection therewith, you now request confirmation of your opinion that "1. For tax purposes, KSA can report as gross income only those rentals actually earned and advance rentals actually received during the taxable year, regardless of the accounting method it employs in reporting revenues in its books of accounts; and "2. No income may be imputed or recognized to have been received by KSA constructively or otherwise during the rent-free periods granted in the Contract of Lease during the taxable year." In reply, please be advised as follows: 1. Section 43 of the Tax Code of 1997 provides that the taxable income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner clearly reflects the income . . . In relation thereto, Section 38 of Revenue Regulations No. 2, otherwise known as the Income Tax Regulations reads "Section 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 clearly to 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 all accrual of income to a taxpayer prior to the realization of such appreciation through sale or conversion of the property." The general rule is that the taxpayer is allowed to report income and expenses in accordance with the method of accounting employed, provided such method conforms with generally accepted accounting principles. However, for income arising from rentals of property, a taxpayer must report as part of the gross income advance rentals received during the taxable year, including rentals actually earned but uncollected as of the end of such period. In the instant case, the accounting method being implemented by KSA in reporting its lease income in its books of accounts in accordance with the rules set forth under the International Accounting Standard (IAS) No. 17 will be higher in the initial months of the lease than the actual income earned during the relevant taxable period had it been determined based on the regular accrual method of accounting. In other words, under the IAS No. 17, the sum of the expected rental for the lease term is computed and divided equally over the total number of months covered by the lease. This Office interposes no objection over such treatment, with the understanding that, for income tax reporting purposes, no advance rental received for the first year is aggregated and spread over the duration of the lease periods covered by such advances. Such being the case and considering the existing practice of such industry, KSA, as lessor of the above-mentioned condominium project may report as gross income, by using the accrual method of accounting, only those rental income actually earned as well as advance payments which constitute the taxable income of KSA in the year when received. This is true even though the lessor is on the accrual or the cash method of accounting. (BIR Ruling No. 259-92) ( Hyde Park Realty, Inc. v. Commissioner, 211 F. 2d 462, Cf. Evansville Courier v. Commissioner 62 F.2d 232) 2. Article 1657 of the New Civil Code provides in part as follows: "Art. 1657. The lessee is obliged: (1) To pay the price of the lease according to the terms stipulated; The contract of lease is a consensual contract and only the owner has the right to fix the rents. Considering that in the instant case, the lease agreements provide for a rent-free period, i.e., KSA cannot require the lessee to pay any rental during this period or set apart, without restriction, a specified amount of money in its favor, to cover such payment, KSA cannot be said to have derived taxable income during the rent-free period for the lease of the said property, since no monetary consideration or other material consideration that would flow to, or any amount credited by the lessee for the account of KSA. Accordingly, KSA cannot be deemed to have realized, whether constructively or otherwise, income for the lease of the above-mentioned property during the rent-free periods granted in the Contract of Lease for the said taxable year. 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, (SGD.) BEETHOVEN L. RUALO Commissioner of Internal Revenue