Taxability of Interest Income from Trust Funds

July 22, 2005 BIR RULING NO. 003-05 Bureau of Treasury Intramuros, Manila Attention: Omar T. Cruz Treasurer of the Philippines Gentlemen : This refers to your letter requesting for clarification of certain issues relative to several BIR Rulings rendered in connection with interest income from Trust Funds ( e.g. Individual Trust Accounts, Common Trust Funds, or Individual Investment Management Accounts) being managed by the Trust Departments of Banks. In your letter, you specifically referred to BIR Ruling No. DA-012-2002, dated January 30, 2002 (citing BIR Ruling No. 30-2001), BIR Ruling No. DA-064-02 dated April 8, 2002 and BIR Ruling No. 63-2000 dated November 20, 2000. It is represented that from the above rulings, several banks and/or its Trust Departments are claiming that the interest income, derived by the Common Trust Funds (CTFs),Individual Trust Accounts (ITAs) and Individual Investment Management Accounts (IMAs) from investments in government securities (e.g. Retail Treasury Bonds) shall likewise be exempt from the 20% final tax pursuant to Sections 24(B)(1) and that consequently, the Bureau of Treasury (BTr) should not impose the 20% final tax on the CTFs, ITAs or IMAs, and that the BIR Rulings by themselves are considered tax-exemption certificates exempting the CTFs, ITAs or IMAs from the imposition of the 20% final withholding tax. You assert that the BTr is not convinced of such view from banks and that, on the other hand, you do not consider the above-mentioned BIR Rulings as tax exemption certificates granting tax exemptions to the subject "Fund/Account" itself; and, that you believe that said rulings are in effect an interpretation/declaration that such Funds, forms of which are prescribed by the BSP, are considered long-term investment provided they comply with the requirements under Section 22 (FF) of the Tax Code of 1997 (Tax Code), in which case individual investors (with the exception of non-resident alien not doing business in the Philippines) investing in such Funds are exempt from 20% final tax. THIcCA Based on the foregoing, you seek clarification on the following issues, to wit: 1. Whether or not the Common Trust Fund, Individual Trust Funds/Accounts, or the Individual Investment Management Account should be considered as a Tax-exempt Institution by virtue of such BIR Rulings, thereby considering the said rulings as tax exemption certificates granted in favor of the "Funds",and therefore enough for BTr to exempt said Funds from payment of tax. 2. Whether or not the said "Funds" are by themselves exempt from 20% final tax pursuant to Section 24 (B) (1) of the Tax Code as professed by the banks, in effect rendering all government securities/bonds as tax exempt instruments as far as such Funds/Accounts are concerned. In reply, please be informed as follows: 1. The Common Trust Fund and Individual Trust Funds/Accounts are not to be considered as tax-exempt institutions by virtue of the aforementioned BIR Rulings . The rule on the exemption of interest income that has been laid down in the said BIR Rulings pertains to the interest income derived by INDIVIDUALS investing in long term deposit or investment certificates. This does not mean, however, that the CTFs, ITAs, or IMAs are to be considered, as tax-exempt institutions by virtue of said Rulings. While it has been held that "(t)he trust instrument to be used to generate long-term deposit or investment determines the income tax exemption of the individual investor in the income earned ( BIR Ruling 30-2001 dated July 24, 2001 )",this has reference to whether such instrument qualifies as a long-term investment or deposit certificate as prescribed by the Bangko Sentral ng Pilipinas, and whether the individual holder complied with the 5-year holding period. Said exemption is not to be considered as attached to the Fund itself, but rather it applies to the income derived by said individual from his investment in such Fund, which is distributed to him by the trustee or manager of the Fund. The 20% final tax or exemption is applicable and pertains only to the interest income that the individual earns from investing his money in the Fund. This is clearly the import of Sections 24 (B) (1) and 25 (A) (2) of the Tax Code which similarly provide that a tax at the rate of 20% shall be imposed on interest income " Provided ...,That interest income from long-term deposit or investment in the form of savings, common or individual trust funds, deposit substitutes, investment management accounts and other investments evidenced by certificates in such form prescribed by the Bangko Sentral ng Pilipinas (BSP) shall be exempt from the tax imposed under this Subsection: Provided, finally ,That should the holder of the certificate pre-terminate the deposit or investment before the fifth (5th) year, a final tax shall be imposed on the entire income and shall be deducted and withheld by the depository bank from the proceeds of the long-term deposit or investment certificate based on the remaining maturity thereof: DCcHAa "Four (4) years to less than five (5) years 5%; "Three (3) years to less than four (4) years 12%;and "Less than three (3) years 20%." To reiterate, the exemption from the final tax on interest income on long-term depositor investments is extended only to individual investors who do not pre-terminate their investment. If this exemption is interpreted to mean that the Fund itself is exempt, then investments made by the trustee or manager, using the Funds, whether the same be long-term or short-term investments, shall be considered exempt. To allow this would run contrary to the intention of the law which is to mobilize savings and exempt only long-term investments of individuals as a way to assist the "small savers". The transcript of the deliberations of Bicameral Conference Committee on Ways and, Means on 9 October 1997 clearly sets forth the intention of the law as follows: "Hon. TEVES. The purpose of this provision ...is to encourage savers to put their savings for a long term in a financial institution. What we want to give them is ...a long term savings certificate as a manifestation of their desire to hold on to those savings so that instead of being penalized by the present provision of a 20% withholding tax on their income if they hold on to those savings for a long period which, in turn, can be used by the financial institutions for lending on long-term investments which we need in our country anyway, this will increase the over-all savings rate of a country ... xxx xxx xxx "Chairman JAVIER. I think we have to mobilize our savings. xxx xxx xxx "Hon. TEVES. The intention ...is really to assist the small savers. Because these are the small denomination for savers who are saving five thousand and below. It is not intended for the big savers, no. These are people who normally put their money in the bank but considering that our savings rate ...is only 20% of the gross national product, we would like to see a situation wherein perhaps you can encourage more and more of our people to put their money in the bank for a longer period. ..." It is not, per se, the CTF or ITF itself that is tax-exempt; rather, it is the individual investor in the CTF or ITF in respect of his interest income therefrom, provided his investment or participation therein is evidenced by "long-term deposit or investments certificates" in the form prescribed by the BSP, and he holds on to such investment certificates for at least five years. 2. The Funds i.e. CTF, ITA or IMA are not in themselves exempt from the 20% final withholding tax on interest income derived from their investments . Since the "Funds" are not by themselves exempt from the 20% final tax under Section 24 (B) (1) of the Tax Code, government securities/bonds in which the "Funds are invested are not automatically rendered as tax-exempt instruments insofar as such Funds/Accounts are concerned even when the individual's income from the Fund is tax-exempt. SEcAIC The interest income tax liability of an individual investor in a trust account should not be confused with the interest income tax liability of the trust itself. A trust, particularly an irrevocable trust, is a separate taxable entity from the persons parties to the Trust. Thus, Section 22 (A) of the Tax Code defines a "person" who may be subject to tax as either ". . . an individual, a trust ,estate, or corporation." (emphasis supplied) This being the case, when a trust is created, there is, for tax purposes, considered as a separate taxable entity. ( Commissioner of Internal Revenue vs. Visayan Electric Company and the Court of Appeals, G.R. No. L-22611, May 27 1968 ) Consequently, exemption by an individual investor from the 20% final tax under Section 24 (B) (1) and Section 25 (A) (2) is determined separately from the taxability or exemption, as the case may be, of the trust. As a separate taxable entity, a trust is nevertheless generally taxed in the same way as an individual, pursuant to Section 60 and 61 of the Tax Code which states that "the tax imposed . . . upon individuals shall apply to the income of estates or of any kind of property held in trust," except employee's trusts qualifying under Section 60 (B), and that "(t)he taxable income of the estate or trust shall be computed in the same manner and on the same basis as in the case of an individual. . . .," Accordingly, since, for tax purposes, a trust is treated as an individual, interest/discount earned by the Funds may be exempt from the 20% final withholding tax if the conditions set forth in Sec. 24 (B) (1) in relation to Sec. 22 (FF) of the Tax Code on long term deposits or investments are complied with. Thus, government securities/bonds in which the Funds are invested shall be subject to the 20% final withholding tax on interest income, or exempted therefrom, depending on whether said securities/bonds are long-term or short term instruments under Section 22 (FF) of the Tax Code. Otherwise stated, the interest income of a trust may be exempt from the 20% final withholding tax only if the underlying investment is a long term investment or deposit as defined in Section 22 (FF), and the trust holds on to that deposit or investment for at least 5 years. Therefore, the interest income derived by CTFs and ITFs from government securities which are short-term will not be exempt from the 20% tax. This is in keeping with the intent of the law as revealed by the transcripts of the Bicameral Conference Committee aforequoted. Moreover, the Committee deliberations show the following purpose: "Hon. Diaz. There is also another benefit ...when people lock in their money for five (5) years one of the major problems of business here is you are trying to finance a long-term project with essentially short term placements, which can move to dollars, which can move to shares, which can move to something else. And this is one of the reasons why the interest rates go up and down ...that's why, we are trying to see if this can be made into a certain special type of instrument." The intent of Congress to apply the exemption to long-term deposits or investments only is thus very evident. Short-term maturities or placements are clearly not within the ambit of the exemption. The above rule applies, however, only when the trust is irrevocable. An irrevocable trust ,the trust may not be revoked after its creation as in the case of a deposit of money by one in the name of the another as trustee for the benefit of a third person (beneficiary) ( Blacks Law Dictionary, by Henry Campbell Black, 6th edition ) This is to be differentiated from a revocable trust ,or where the income of the trust is for the benefit of the grantor . Income of these kinds of trusts are, by express provision of Section 63 and 64 of the Tax Code, included in computing the taxable income of the grantor . The grantor of a trust is-the person who sets up or establishes the trust; he is also referred to as the trustor or settler of the trust (see Art. 1440, Civil Code). The grantor may also be the beneficiary of the trust. IcTCHD A revocable trust is therefore only a pass thru entity, and is not, for tax purposes, a separate from those who establish or create it by pooling their money for the purpose of investment and reinvestment. Accordingly, investments made by revocable CTFs and ITAs ( e.g. ,in government securities) may be exempt from the 20% final tax on interest income only upon satisfaction of the following conditions: (1) the grantor is an individual; (2) the instrument in which the revocable CTF or ITF invests in qualifies as a long-term deposit or investment certificate. 3. No separate taxable entity is created in an Investment Management Account and interest income arising therefrom may be exempt from the 20% final withholding tax, subject to the conditions under Sections 22 (FF),24 (B) (1),25 (A) (2) . An Investment Management Account (IMA) involves an agreement primarily for financial return whereby the bank (investment manager) binds itself to handle or manage investible funds or any investment portfolio in a representative capacity as financial or managing agent, adviser, consultant or administrator of financial or investment management, advisory, consultancy or any similar arrangement which does not create or result in a trusteeship but rather a principal-agent relationship. The instruments into which the funds are invested are in the name of the principal or investment manager as agent for the principal. Commingling of funds is not allowed which explains a higher minimum amount. ( BIR Ruling No. 030-01 dated July 24, 2001 ) Clearly, no separate taxable entity is created in entering into an IMA since, in contrast to CTFs or ITAs, funds are invested in the name of the principal or investment manager and are not commingled with other trust accounts. Individual investment by virtue of an IMA may, therefore, be exempted from the 20% final withholding tax on interest, subject to the fulfillment of conditions under Sections 22 (FF),24 (B) (1),25 (A) (2). 4. Only interest income may be exempt under Section 24 (B) (1) and Section 25 (A) (2) in relation to Section 22 (FF) . It must be emphasized, however, that only interest or discount income from investments by the CTF, individual trust or individual management account shall be entitled to exemption. This is so because Section 24 (B) (1) and Section 25 (A) (2) only refer to exemption of the individual from interest income . Consequently, a CTF, individual trust or individual management account, shall be subject to tax under the applicable provisions of the Tax Code on income other than interest income. For instance, the CTF, individual trust or individual management account will be subject to the applicable income tax on gain from sale of the government securities, the 5%/10% or 1/2 of 1% tax on sale of shares of stocks, documentary stamp taxes, and to the 10% withholding tax on dividends, when investments made by the Fund give rise to the same. Such net gain or net dividends (that is, net of the said 5%/10% capital gains tax, documentary stamp tax or the withholding tax on dividends) will no longer be subject to the 20% final withholding tax when it is distributed to the investor in the CTF, individual trust or investment management account. 5. Interest income of investment by non-resident aliens on long-term deposit or investment certificates are subject to the same rules as investments of individual citizens and resident alien individuals . Lastly, the Tax Code allows exemption of interest income not only of individual citizens and resident alien individuals but also of non-resident alien individuals (engaged in trade or business in the Philippines) who invest in long-term deposit or investment certificates. While BSP Memorandum dated January 3, 2000 allows only individual resident citizens and individual resident aliens to invest in a CTF, ITA, or IMA, the same principles on exemption of investment in long-term deposit or investment certificates apply to non-resident alien individuals engaged in trade or business in the Philippines. ACcHIa This clarifies the foregoing issues with respect to the aforecited and other BIR Rulings rendered in connection with interest income derived by individuals from Trust Funds and interest income earned by a Trust Fund from investments made by the trustee/managers under trust agreements. All portions of the aforecited rulings not consistent with this ruling shall be deemed modified. This ruling is 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.) JOSE MARIO C. BUAG OIC-Commissioner of Internal Revenue