Taxability of Proposed Issuance of Zero Coupon FCDU T-Notes with a Greenshoe Option

March 27, 2003 BIR RULING NO. 003-03 28 (A) (7) (b), 180 177-95 Hon. Eduardo Sergio G. Edeza Treasurer of the Philippines Bureau of the Treasurer Intramuros, Manila S i r : This refers to your letter dated September 6, 2002 seeking a confirmatory ruling on the tax consequences of the proposed issuance of a zero coupon "Foreign Currency Deposit Unit Treasury Notes" ("FCDU T-Notes") with a face value of US$250,000,000, and with a greenshoe option of another US$100,000,000, in case of oversubscription. It is represented that the Republic of the Philippines, through the Department of Finance, intends to issue a zero coupon FCDU T-Notes with the following terms and conditions, to wit: "FCDU T-Note: Summary Indicative Terms and Conditions The terms and conditions outlined below are not a comprehensive statement of all the applicable terms and conditions that would be contained in the definitive legal documentation for the transaction contemplated herein. Those matters, which are not covered or made clear, are subject to the mutual agreement of the parties. Issuer : Republic of the Philippines ("RoP" or the "Issuer") Issue : Foreign Currency Deposit Unit Treasury Notes due [September 2007] ("FCDU T-Notes or "Notes") Issue Manager & Lead Underwriter : Citicorp Capital Philippines Incorporated ("CCPI") Underwriters : Land Bank of the Philippines ("LBP"), CitiBank, China Banking Corporation ("CBC") and Banco de Oro ("BDO") Paying Agent : Citicorp International Limited ("CIL") or any other agent mutually acceptable to the Issue Manager and the Issuer Purpose/Use of Proceeds : For general funding requirement Issue Size : Up to US$250,000,000 with a greenshoe option of another US$100,000,000 in case of oversubscription Issue Price : [TBA] Will be priced at a discount to par achieve Yield to Maturity (YTM) below. Pricing is expected 2-3 Business Days prior to Issue Date at a price mutually acceptable to the Issuer and the Issue Manager Issue Price on August 20, 2002 would have been [67.08%]. Issue price does not take into account upfront tax. Yield to Maturity : 5 year US Treasuries + Mid Spread of RoP 09s over 5 year US Treasuries at time of pricing. The price of 5 year US Treasuries will be determined by the quote available on Telerate Page 500 while the mid spread of RoP 09s will be determined by the Issue Manager on or before 11 a.m. (Manila time) of the pricing setting date. YTM is priced on August 20, 2002 would have been [8.15%] p.a. Redemption Price : 100% Interest Coupon : None. Zero Coupon YTM Calculation : 30/360 Business Days : Manila, Hong Kong and New York Issue Date : At a date after all conditions precedent are met. Expected to be on or before September 23, 2002, unless extended to a date which is mutually acceptable to the Issuer and the Issue Manager. Maturity Date : 5 years from Issue Date. Form and Denomination : The FCDU T-Notes shall be in bearer form in the denomination of US$[1,000] each. Note denominations to be finalized following agreement with Issuer. Status of the Issue : The FCDU T-Notes will constitute direct, unconditional, general, unsecured and unsubordinated obligations of the RoP and will be backed by the full faith and credit of the RoP. The Notes will rank pari passu in all respects and ratably without any preference or priority among themselves and with all other outstanding direct, unconditional, general, unsecured and unsubordinated External Indebtedness (as defined in the Issuer's existing loan and bond documentation) of the Issuer. Documentation : Commitment of the parties to the issue will be subject to preparation, execution and delivery of mutually acceptable documentation based on the other similar financings, which will contain conditions precedent, representations and warranties, undertakings, illegality, severability, transferability, assignment, covenants, negative pledge, pari passu, events of default, cross default, material adverse change, indemnities, waiver of sovereign immunity (subject to customary limitations with regard to property devoted to diplomatic, military, public or government use), and other provisions deemed appropriate by the Issue Manager for this transaction. Conditions Precedent : Customary for financings of this nature and others appropriate in the judgment of the Issue Manager for this transaction, including, but not limited to: The absence of any material adverse change in the condition (financial or otherwise) of the Issuer; No Event of Default has occurred and is continuing; Payment of accrued costs and expenses (as may be required in Section 5 of the Commitment Letter); The execution and delivery of documentation in form and substance satisfactory to the Underwriting Syndicate; The Issuer having obtained all internal administrative consents and all governmental approvals necessary and appropriate; Receipt of written favorable legal opinion from the Secretary of Justice acting as counsel for the Issuer, containing customary provisions, including Confirmation on the pari passu ranking of the Issue with Issuer's External Indebtedness (as defined in existing loan and bond documentation of the Issuer); The absence of any pending or threatened litigation, investigation or proceeding that may have a material adverse effect on the condition (financial or otherwise) of the Issuer, or that purports to challenge the validity or enforceability of the Issue, the agreements or the transactions contemplated thereby and hereby; aTcHIC A long-term foreign currency debt rating of the Issuer of no lower than BB + by Standard & Poor's and Ba1 by Moody's Investor Service. Covenants : Customary financings of this nature and others appropriate in the judgment of the Issue Manager for this transaction, including, but not limited to, the following: Compliance with all relevant laws and performance of obligations; Negative pledge covenant; Prompt payment of all amounts due under the Issue; Maintenance of all necessary governmental approvals; Use of proceeds. Events of Default : Customary for financings of this nature and others appropriate in the judgment of the Issue Manager, for this transaction, upon the occurrence of which the Note holders will be entitled to accelerate the Notes, including, but not limited to, the following: Failure to pay principal and any other amount payable under the documentation for the Issue when due; Failure to pay the principal, interest or any other amount payable in excess of US$25 million under any other External Indebtedness (as defined in RoP's existing loan and bond documentation) when due, subject to fifteen days' grace period; Representations or warranties materially incorrect when made; Failure to comply with covenants, subject to the applicable cure period; The Issuer repudiates the Issue, or privately or publicly questions validity or enforceability of the documentation; Material unsatisfied judgment or order; Documentation unenforceable; In the judgment of not less than 25% of the Note holders, a material adverse change in condition (financial or otherwise) of the Issuer, including but not limited to, (a) a breach of other obligations; (b) the RoP loses its membership of the IMF and (c) the RoP at any time does not exercise full ownership of its International Monetary Assets; A general moratorium is declared with regard to the payment of the External Indebtedness (as defined in the existing loan and bond documentation) of the Issuer or the Bangko Sentral ng Pilipinas. Others : FCDU T-Notes documentation will include: Indemnification of Issue Manager, Underwriter/s and Paying Agent and their respective affiliates, officers, directors, employees, agents and advisors as set forth in the Commitment Letter; Illegality; and Customary Agency language. Out of Pocket Expenses : Waived, subject to Section 5 of Commitment Letter. Clearing System : Clearstream and Euroclear Taxation : Pending Confirmation from Bureau of Internal Revenue. Governing Law for the Issue : English Law. Upfront Fees : 0.50% flat of the Issue Size payable to the Issue Manager on Issue Date. The Issue Manager has the right to distribute the Upfront Fees to the Underwriters at its sole discretion. Legal Counsel : TBD." that the proposed issuance of the above US$-denominated T-Notes will be made by the Republic of the Philippines for its general funding requirements and targeted at the Philippine FCDU System, thus, buyers of the Issue in the primary market are banks that have FCDU licenses; that the FCDU-licensed banks in this case would purchase the whole deal on Issue Date, as stated in the following summary: " Summary of Book Building Procedures "In capital market deals, following receipt of preliminary Monetary Board approval, the underwriter/s commence marketing the deal to potential investors. As such underwriters will only prepare marketing materials when the preliminary approval is in place. "Following marketing, underwriters would then commence the bookbuilding process wherein they start collating orders from their investors base. Bookbuilding generally continues until or just before pricing date so that the underwriters can get a sense of market appetite plus the price the investors require for take up of the issue. This is typical underwriting where the underwriters guarantee the volume but not the price on the deal. "The FCDU T-Note is different in that the underwriters are going to give their commitment on a bought deal basis to the Republic. What this means is that the underwriters are committing to a price and volume BEFORE they have done any bookbuilding. Accordingly, buyers of the Issue in the primary market are banks that have FCDU licenses. The FCDU-licensed banks in this case purchase the whole deal on the Issue Date. "Regarding sell down in other underwritten deals, the position of each underwriter on issue date is normally reduced to their hold position of the security. Hold position in this case means the position each underwriter plans to hold on its own books as an investment in such security. Sell down in the FCDU T-Notes is different because it is very unlikely that each underwriter/s position will be reduced to their hold position on Issue Date. The sell down of this issue is targeted at FCDU retail investors who can only pick up the issue when their funds become available e.g., when their existing placements mature etc. and these dates may not necessarily coincide with the issue date of the FCDU T-Notes." that you further represented that the benefits of the proposed transactions to the Republic and the domestic Capital Markets may be summarized as follows: Zero Coupon structure aids better debt management . The zero-coupon structure does not result in any cash outflow until maturity which enables better debt management and planning. The Republic achieves the objective of retaining FCDU dollars in the country . With the introduction of an attractive security into the FCDU system, the government discourages outflow of FCDU Dollars into offshore investments thereby allowing for better reserve management. Upfront withholding tax improves BIR collections . Assuming an issue size of US$250 Million, the BIR would stand to collect roughly US$6.71 Million or Pesos 342.47 Million in up front taxes, thereby bringing the net funding cost of this issuance well within the existing RP US$ yield curve. Vine and cost savings because of onshore issuance . Since the security will be offered only in the Philippines there are no registration requirements and further the RoP does not need to hold road shows or investors briefings. The above will result in both time and cost savings to the RoP. and that based on the foregoing, you request confirmation of the following: "1. The interest income shall be subject to 10% final withholding tax pursuant to Section 28(A)(7)(b) of the 1997 Tax Code . "The primary buyers of this issue will be banks with FCDU licenses and as an FCDU transaction, the discount, which is the interest on the same, shall be subject to the 10% withholding tax in the case of FCDU or OBU investor. This is based on BIR Ruling 050-2001 covering the US$T-Bills which is also applicable in this case. "The above Ruling then was issued on the same basis as the instant query except that at the time, the maturity of the US$-denominated T-bills was 364 days from Issue Date. Under the said Ruling, the Republic, through the DOF/BTr as Issuer, shall withhold from such amount of discount, the 10% final tax imposed under Section 28(A)(7)(b) of the 1977 Tax Code at the time of the issuance of the US$T-Bills. "This time however, the proposed zero coupon issuance has a maturity of five (5) years, and the counter party is advancing the position that the 10% tax on the interest income should take into account the fact that the interest thereon is earned over the lifetime of the security and not upfront, and therefore the 10% should not be deducted or withheld upfront but based on a current value. They are of the position that the withholding tax could be withheld and remitted to the BIR in accordance with BIR Ruling 177-95, the pertinent provision is hereby quoted, thus: "The total discount of coupon bearing government securities and other similar instruments with maturities of more than one (1) year shall be considered earned in the year of sale based on current values . It shall be the duty of the issuing agency to remit the corresponding 20% final income tax withheld on discounts valued at present value on every original sales in the primary market within the period specified under Revenue Regulations No. 17-84. For this purpose, the withholding tax therein shall be accompanied by a statement showing, among others, the face value of the notes, the selling price, the discount sales, the volume of transactions for the day and the aggregate volume of the authorized government notes issued. The final tax and the interest due as evidenced by internal coupon shall be due and payable upon payment on every date of payment stipulated in the covenants for its issuance and the corresponding documentary stamp tax on original issue shall be collected by the issuing agency within the prescribed period. (emphasis supplied)" "2. The calculation of the 10% tax on interest income should take into account that interest is earned over the life of the security and not up front and therefore the corresponding tax shall be remitted to BIR in accordance with BIR Ruling 177-95 . "It is noted that a zero coupon instrument is different from a coupon bearing structure in that there are no semi-annual cash payments made to security holders. Zero coupons as a result are issued at a discount to yield par at maturity. The difference between par and discount is the imputed interest earned on the security. All things being constant, the price of a zero accordingly would increase with time to account for the accreted interest. "It is further claimed that tax on interest income should be collected in the period it is realized and in a 5-year zero all the interest is not earned in the first period i.e., the value of the instrument does not equal par at the end of the first period. Accordingly, tax on the interest earned should be collected in the same period the interest is earned otherwise the amount collected from investors would be larger than the 10% stipulated in existing rulings. "The treatment they believe should be no different than that already applied to peso FXTNs and cited in the above ruling. We reply as follows: 1. Sections 27(D)(3) and 28(A)(7)(b) of the Tax Code of 1997 read as follows: "SEC. 27. Rates of Income Tax on Domestic Corporations . xxx xxx xxx "(D) Rates of Certain Passive Incomes . xxx xxx xxx "(3) Tax on Income Derived under the Expanded Foreign Currency Deposit System . Income derived by a depository bank under the expanded foreign currency deposit system from foreign currency transactions with local commercial banks, including branches of foreign banks that may be authorized by the Bangko Sentral ng Pilipinas (BSP) to transact business with foreign currency depository system units and other depository banks under the expanded foreign currency deposit system, including interest from income foreign currency loans granted by such depository banks under the expanded foreign deposit system to residents, shall be subject to a final income tax at the rate of ten percent (10%) of such income. "Any income of nonresidents, whether individuals or corporations, from transactions with depository banks under the expanded system shall be exempt from income tax." "SEC. 28. Rates of Income Tax on Foreign Corporations . "(A) Tax on Resident Foreign Corporations . xxx xxx xxx "(7) Tax on Certain Incomes Received by a Resident Foreign Corporation . "(b) Income Derived under the Expanded Foreign Currency Deposit System . Income derived by a depository bank under the expanded foreign currency deposit system from foreign currency transactions with local commercial banks including branches of foreign banks that may be authorized by the Bangko Sentral ng Pilipinas (BSP) to transact business with foreign currency deposit system units and other depository banks under the expanded foreign currency deposit system, including interest income from foreign currency loans granted by such depository banks under the said expanded foreign currency deposit system to residents, shall be subject to final income tax at the rate of ten percent (10%) of such income." Sections 2.27 and 2.28 of Revenue Regulations No. 10-98 prescribe the withholding and remittance of tax on such interest income derived under the Foreign Currency Deposit System and Offshore Banking Units, thus "(c) Taxation of Income of an FCDU or OBU from Foreign Currency Transactions . In general, income derived by an FCDU or OBU from foreign currency transactions with residents of the Philippines, including commercial banks, local branches of foreign banks, and other depository banks under the foreign currency deposit system, shall be subject to a final withholding tax of ten percent (10%) based on gross income pursuant to Section 27(D)(3) and Section 28(A)(4) of the Code. Income from foreign currency transactions shall include interest income from lending operations, including bank charges, commissions, service fees, and net foreign exchange transaction gains. "Income from foreign currency transactions with non-residents of the Philippines shall not be subject to income tax. "The person making the income payment shall withhold and remit the tax withheld pursuant to the provisions of Section 57 and 58 of the Code. Thus, in the case of the interest payment by a resident of the Philippines on a foreign currency loan from an OBU or an FCDU, the withholding agent shall be the said resident." Based on the foregoing, this Office hereby rules that the discount earned from FCDU T-Notes is income of FCDUs of CitiBank, LBP, CBC and BDO from a foreign currency transaction with a resident, thus, falling within the purview of the aforecited Section 28(A)(7)(b) of the Tax Code of 1997, as implemented by Rev. Regs. No. 10-98. Such being the case, the Republic, through the Bureau of Treasury, shall withhold upfront from such amount of discount, the ten percent (10%) final tax imposed under said Section 28(A)(7)(b) of the Tax Code at the time of the issuance of the FCDU T-Notes. 1 It should be understood further that, a representation or warranty should be made to the effect that the FCDU T-Notes are acquired upon their original issuance by the concerned FCDUs, for and on their behalf, and not for the account of other entities. Moreover, should the concerned FCDUs realize a trading gain on the subsequent sale of the FCDU T-Notes, then the net trading gain would also be subject to the 10% final tax under Section 27(D)(3) and Section 28(A)(7)(b), both of the Tax Code of 1997. 2 2. With respect to the calculation of the 10% tax on such interest income, please be informed that pursuant to Section 7 in relation to Section 5 of Department of Finance Order No. 141-95, Series of 1995 (Revised Rules and Regulations for the Issuance, Placement, Sale, Service and Redemption of Treasury Bills and Bonds under R.A. No. 245, as amended), which read as follows: "Section 7. Taxation . The income derived from Treasury Bills and Bonds, and instruments with recourse as authorized by Bangko Sentral ng Pilipinas (BSP), shall be subject to the 20% final income tax to be withheld on discounts valued at the time of issue on every original sale which shall be deducted by the buyer from the discounts of the T-bills/bonds and included in the remittance of the purchase price. "In the case of Treasury Bonds, the 20% final income tax shall be withheld on discounts valued at present value on every original sale . Periodic coupon payments on Treasury Bonds shall be subject to the 20% final income tax to be withheld at the time the coupon payments are made. "The documentary stamp tax on the original issue shall be for the account of the issuer. "No other taxes shall be collected on subsequent trading of the securities which have been subjected to tax under the first two paragraphs herein." ( Emphasis supplied .) Section 5 of DOF No. 141-95 reads as follows: "Section 5. Treasury Bonds . Treasury Bonds shall be issued at a discount basis, at a premium, or at par and payable on maturity of not earlier than one (1) year but not later than twenty-five (25) years. They may be offered for sale through competitive or non-competitive auction or any other method as determined appropriate by the Bureau of Treasury. The foregoing provision is consistent with the previous ruling of this Office " that the total discount of coupon bearing government securities and other similar instruments with maturities of more than one (1) year shall be considered earned in the year of sales based on the current values" such that the issuing agency shall remit "the corresponding final income tax withheld on discount valued at present value on every original sales [sic] in the primary market within the period " 3 so then specified under Revenue Regulations No. 17-84. It is noted though that the zero coupon instrument is different from a coupon bearing instrument subject of BIR Ruling No. 177-95 and to which the aforequoted provision is applicable, as there are no semi-annual cash payments made to security holders. Zero coupons are therefore issued at a discount to yield par at maturity. The difference between par and discount is the imputed interest earned on the security. As you stated, all things being constant, the price of a zero coupon instrument accordingly would increase with time to account for the accreted interest. Moreover, since payment is made at maturity, the interest earned is the accreted interest on the security, but because it is a zero coupon instrument there is no cash outflow. Applying the above Section 7 of DOF Order No. 141-95 in the instant case, this Office opines that the 10% should be present valued by the net yield on the security to ensure that the interest is taxed at 10%. Accordingly, since the interest is earned over the life of the security and not upfront, your opinion that the 10% final income tax withheld on such discounts should be valued at its present value is hereby confirmed. The Bureau of Treasury shall, therefore, withhold and remit the corresponding 10% final income tax withheld on discounts valued at present value upon original issue of the subject FCDU T-Notes. Finally, as consistently held by this Office, the issuance of the aforesaid FCDU T-Notes shall be subject to documentary stamp tax of P0.30 for every P200.00, or a fractional part thereof, based on their face value pursuant to Section 180 of the Tax Code of 1997. 4 However, the transfer of FCDU T-Notes in bearer form in the secondary market by way of simple delivery to the buyer is also not subject to the documentary stamp tax, unless the transfer carries with it a renewal and issuance of new treasury notes in the name of the transferee to replace the old ones. Hence, for this reason the secondary trading of such FCDU T-Notes in the name of the transferee will no longer be subject to DST. 5 This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation it shall be disclosed that the facts are different, then this ruling is considered null and void. ScaEIT Very truly yours, (SGD.) GUILLERMO L. PARAYNO, JR. Commissioner of Internal Revenue Footnotes 1. BIR Ruling No. 050-01 dated October 29, 2001. 2. BIR Ruling No. 050-01 dated October 29, 2001. 3. BIR Ruling No. 177-95 dated November 9, 1995. 4. BIR Ruling No. 050-01 dated October 29, 2001. 5. BIR Ruling Nos. 119-91 dated Jan. 25, 1991; 202-99 dated December 16, 1999; and 050-01 dated Oct. 29, 2001.