BIR Ruling No. 004-06

February 28, 2006 BIR RULING NO. 004-06 Sec. 43, NIRC 000-00 V.C. Mamalateo & Associates Unit 6-C, Lansbergh Place 170 T. Morato Ave. corner Castor St., Quezon City Attention: Atty. Vic. C. Mamalateo Managing Partner Gentlemen : This refers to your letter dated October 20, 2005 requesting on behalf of your client, Manila Electric Co . (MERALCO), for confirmation of your opinion that its refunds payable under the proposed fixed-credit-to-bill with option to cash payment scheme or post-dated check scheme with restrictions/qualifications for Phases IV-A and IV-B of the refund package, at the option of the customers, is not considered realized income subject to income tax and value added tax at the time the instruction to offset is received by MERALCO from its customers. FACTUAL BACKGROUND On April 30, 2003, the Philippine Supreme Court ordered, with finality, MERALCO to refund to its customers P0.167 per kilowatt-hour (kWh) starting with the company's billing cycles beginning February 1994 or credit the same against future consumption. The said refund was to be implemented in four phases, with Phases I-III now finished. On September 3, 2004, MERALCO submitted its proposed mechanism for the implementation of the refund to customers falling under Phase IV of the refund scheme. In its Order issued on December 21, 2004, the Energy Regulatory Commission (ERC) approved the said proposal with a modification to the effect that Phase IV-A of the refund will be effected within eighteen (18) months instead of thirty-six (36) months starting January 2005 until June 2006. In the same Order, MERALCO was likewise directed to submit its proposal on the implementation of Phase IV-B of the refund scheme, specially on the refund note mode. On January 28, 2005, MERALCO filed its "Manifestation and Motion" praying that the implementation of Phase IV-A of the refund scheme be deferred in view of its receipt of a letter from the Bureau of Internal Revenue (BIR), informing MERALCO of BIR's intent to impose a withholding tax on the amount to be refunded to MERALCO's customers under Phase IV. MERALCO alleged that for purposes of the orderly implementation of the refund, the issuance of the BIR regulation on the withholding tax is necessary. On February 13, 2005, the BIR issued Revenue Regulations No. 8-2005, ordering MERALCO to withhold creditable income tax at the following rates: (1) on gross amount of refund given by MERALCO to customers with active contracts as classified by MERALCO twenty-five percent (25%); and (2) to customers with terminal contracts thirty-two percent (32%). Consequently, MERALCO filed on May 30, 2005 its "Submission of Amended Proposal on Phase IV." In the said submission, MERALCO proposed the following: 1. That the refund periods be modified as follows: Phase IV-A Active Services : From January 2005 June 2006 (ERC Order) To July 2005 December 2006 Terminated : From May 2006 to November 2006 Phase IV-B Active Services : From July 2005 September 2010 To October 2005 December 2010 Terminated : From January 2008 to June 2008 Terminated services pertain to those services whose contracts were terminated on or before April 30, 2003. II) That similar to the first three phases of the refund, the refund coverage is from February 1994 May 2003 (112 months). The computation of the Gross Refund Amount (GRA) will be based on the total billed kWh during the time the customer was being served by MERALCO based on records. The refundable amount will be equivalent to the GRA less applicable deductions like arrears and the withholding tax imposed by BIR. III) In this phase, the refundable amount shall be refunded to the customer in equal amounts over a period of time through post-dated checks (PDC), fixed credit to bills or cash. The registered customer must first submit the appropriate Tax Identification Number (TIN) and all other required documents before the refund can be released. IV) That the refund scheme shall be as follows: Active Services If the GRA is P2,000 or less, the refund shall be in full at the start of the refund period; Otherwise, refund mode is through PDCs, credit to bill or cash, at the option of the customer: 1) For customers opting for the PDC mode six (6) PDCs corresponding to the quarterly refundable amount shall be issued. The PDCs shall have sequential quarterly maturity dates beginning on the first month of the calendar quarter (5 quarters), maturity at the end of every quarter. The issuance of the PDCs will be given at the latest, two (2) months after ERC approval of the refund scheme to allow for the transmittal of the letters and give the customers ample time to reply and inform MERALCO of their preferred option and comply with the requirements. The PDCs are crossed checks for deposit to payee's account upon maturity. 2) For customers not opting for the PDC made, the other options are either fixed month credit to bill or claim in cash, except for the first month of implementation when the refundable amount will be automatically credited to bills. If the registered customer or his authorized representative requests the suspension of the refund for whatever reason the refund will be released in check at the end of the refund period, i.e., in June 2006. If the registered customer or his authorized representative requests for the termination of services for whatever reason, the customer will have the option to either receive the remaining refund through PDCs, spread over the refund period or through a refund check to be released at the end of the refund period, i. e., in June 2006. Terminated Services Refund mode shall be in the form of a refund check payable to the registered customer. Phase IV-B Active Services Twenty-one (21) PDCs corresponding to the quarterly refundable amount shall issued. The PDCs shall have sequential quarterly maturity dates beginning on the first month of the calendar quarter (21 quarters), maturing at the end of every quarter. The issuance of the PDCs will begin at the latest, two (2) months after ERC approval of the refund scheme to allow for the transmittal of the letters and give the customers ample time to reply and inform the MERALCO of their preferred option and comply with the requirements. The PDCs are crossed checks for deposit to payee's account upon maturity. For customers not opting for the PDC mode, the other options are either fixed monthly credit to bill or claim in cash, except for the first month of implementation when the refundable amount will be automatically credited to bills. If the registered customer or his authorized representative requests the suspension of the refund for whatever reason, the refund will be released in check at the end of the refund period; i.e. , in December 2010. If the registered customer or his authorized representative requests for the termination of service for whatever reason, the customer will have the option to either receive the remaining refund through PDCs, spread over the remaining refund period or through a refund check to be released at the end of the refund period; i.e. , in December 2010. Terminated Services Refund mode is cash/refund check or PDC 1) A customer may opt to receive the total refundable amount through a refund check in June 2008; or 2) If customer opts to receive PDCs, features and procedures will be the same as those Phase IV-B active accounts, to start at the least, two (2) months after ERC approval of the refund scheme. In the same submissions, MERALCO pointed out the following reasons for the adoption of the issuance of the PDCs, instead of the former refund note as a mode of refund, to wit: (1) contemplated cost for issuance of PDC is lower compared to issuance of refund note: (2) issuance of PDC involves minimal administrative activities compared to issuance of refund note; (3) issuance of PDC is more widely accepted in the commercial world than the new concept of refund note; and (4) the objective of providing liquidity and flexibility to a holder could be met by PDC through check discounting. MERALCO likewise conducted a survey among its Phase IV customers with active accounts and it disclosed a fifty percent (50%) acceptability of the PDC as a mode of refund. The refund amount for Phase IV involves a significant sum of P18,491 Billion or sixty-two percent (62%) of the total P30,124 Billion. Thus, in determining the period within which MERALCO should implement the refund, the ERC, as in the past, considered MERALCO's cash flow. Relative thereto, MERALCO submitted to ERC its projected cash flow, which showed negative/low available cash for the years 2006-2008, with a negative cash flow projected in the first seven (7) months of 2007. On June 29, 2005, ERC issued an Order in ERC Case No. 2001-243, finding the proposal of MERALCO to revise its refund period reasonable. However, given that the refund has further been delayed. ERC finds it equitable to increase the proposed GRA threshold for customers with active accounts under Phase IV-A from "two thousand pesos (2,000) or less" to "five thousand pesos (5,000) or less" to be entitled to a full refund at the start of the refund period. Likewise, ERC finds its necessary to include all government accounts falling under Phase IV-B within Phase IV-A, as the refund will be used for public purpose. With regard to the mode of refund, MERALCO abandoned its proposal to issue refund notes to its eligible customers. In its stead, MERALCO now proposed to issue PDC's for reasons already discussed. The PDCs shall be released to the concerned customer at the start of the implementation of the refund phase bearing maturity dates at the end of each quarter. ERC is of the opinion that the amended proposal regarding mode of refund offers more flexibility in the manner in which the options in claiming the refund amount is concerned. Customers may now choose whatever mode is most convenient to them. It is further represented that when MERALCO collected the higher amounts authorized by the then Energy Regulatory Board from its customers in 1994 to 2003, these amounts were reported as part of the taxable income of MERALCO, for which it paid the corporate income taxes based on its net taxable income during the taxable periods. When the Supreme Court ordered in 2003 the refund of the excess amounts in favor of the customers, MERALCO had no adequate funds to comply with the immediate payment of the entire amount to the customers. At that time, MERALCO made the following accounting entry: Dr. Retained Earnings . . . Cr. Refunds Payable . . . When payments of customers covered by Phase I-III were made in 2003-2004, the following entry was made: Dr. Refunds Payable . . . Cr. Cash . . . MERALCO had to go to the Energy Regulatory Commission (ERC) so that the amounts due to its customers shall be payable over a period of 36 months to 63 months, beginning with the customers whose refundable amounts are small and paying the large customers last. In order to ensure compliance with the order of the court to refund and to improve the liquidity position of MERALCO, it offered to the large customers covered in Phases IV-A and IV-B the option to receive the amounts due in cash, or in credits to be applied against its future electric bills. MERALCO follows the accounting method for reporting income and expenses in accordance with the International Financial Reporting Standards (IFRS) or International Accounting Standards (IAS) so that its financial statements could be said to be prepared in accordance with the generally accepted accounting principles. ISSUE Whether or not the refund receivables of the customers are taxable incomes to MERALCO in the year the instruction to offset is granted by the customers, either through the fixed-credit-to-bill with option to cash payment scheme or post-dated check scheme (PDC) which are modes of refund authorized by the Energy Regulatory Commission. BIR REPLY We reply as follows: The existence of a liability does not create nor result in the creation of income that is subject to tax. As represented above, MERALCO had reported as part of its taxable income higher amounts it collected from its customers from years 1994 to 2003 and paid the corresponding taxes thereon for the taxable periods mentioned. Subsequently, the Supreme Court ordered in 2003 the refund of the excess amounts in favor of the customers. Due to lack of adequate funds to comply with the immediate payment of the entire amount to the customers, MERALCO had instead recognized in its books the amount refundable as a liability. MERALCO also provided a refund scheme and schedule of payment of booked liability. It further represented that when cash payment is made to customers covered by Phase I-III, MERALCO simply debited the amount refunded from the liability account Refunds Payable. Under the above set of facts, it is clear that when MERALCO recognized the liability no payments were made to its large customers. Moreover, the same amounts refundable cannot be considered as deposits made by the large customers to be applied against the future electric billings of the customers involved. In short, a liability cannot be converted into income simply because the customers instructed MERALCO to offset such receivables against their future electric bills. It would have been different if MERALCO paid the customers pursuant to the decision of the Supreme Court, and at the same time, the customers paid or gave back the same amount to MERALCO to be used against their future electric bills. In so stating this Office had considered the following legal bases: 1. At the time the decision of the Supreme Court became final and executory, MERALCO made an accounting entry in its books recognizing a liability to the customers. In the meantime, MERALCO gives customers the option to be paid in cash or credit, which may be applied against future electric bills. When the customer subsequently instructs MERALCO to offset the refund receivable against his future electric bills, the entire liability is not automatically converted into taxable income. It remains a liability for MERALCO. However, there will be gradual recognition of income equivalent to the value of services provided and billed by MERALCO to its customers. The term "income" is being characterized as follows: "Income" includes earnings, lawfully or unlawfully acquired, without consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition ( James vs. U.S ., 366 213). 'Income" means an amount of money coming to a person within a specified time, whether as payment for services, interest or profit from investment ( Conwi vs. CTA and Commissioner , 213 SCRA 83). On the other hand, "liability'' means the state of being bound or obliged in law or justice to do, pay, or make good something; the state of one who is bound in law and justice to do something which may be enforced by action (Black's Law Dictionary, Henry Campbell Black, 5th ed., 1983) . It is true that Section 44 of the 1997 Tax Code provides that "the amount of all items of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless under methods of accounting permitted under Section 43, any such amounts are to be properly accounted for as of a different period." However, this provision presupposes that the amount received by the taxpayer is an item of gross income (and not a liability account) to be liable to income tax in the year of receipt. Also, the same provision explicitly allows the use of the accrual method in reporting income. 2. MERALCO follows the accounting method for reporting income and expenses in accordance with the International Financial Reporting Standards (IFRS) or International Accounting Standards (IAS) so that its financial statements could be said to be prepared in accordance with the generally accepted accounting principles. Under the accrual method, income is recognized when the service is performed (and the bill is issued), although it is not yet paid. "Revenue from service transactions should be recognized based on performance, because performance determines the extent to which the earnings process is complete or virtually complete. Performance is the execution of a defined act or acts or occurs with the passage of time. Under the proportional performance method, where performance consists of the execution of more than one act, revenue should be recognized on the proportionate performance of each act." 1 3. The above treatment is also consistent with the accounting principle that revenues shall be matched against related expenses. This principle would be violated if MERALCO were to report the entire liability as income taxable in the period of receipt, whereas the related expenses to the earnings of income are to be paid or incurred (hence, deductible from gross income) at later periods. The income statement, therefore, would not correctly reflect the result of operations for the periods if the entire income is reported in the year of receipt, while the related expenses will be amortized over a period of three years or five years. 4. Section 43 of the Tax Code of 1997, as amended, provides that "the taxable income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal period 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 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. . . . ." Based on the discussions above, to clearly reflect the income of MERALCO, it has to report as income during the taxable year corresponding to the services provided and billed to the customer during the same year, in order to comply also with the principle of matching revenues against expenses. 5. Further, in order that an income may be subject to income tax, such income must be received or realized during the taxable year. This finds support when the Tax Court ruled: "Under the realization principle, revenue is generally recognized when both of the following conditions are met: (a) the earning is complete or virtually complete; and (b) an exchange has taken place. This principle requires that revenues must be earned before they are received. 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 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." 2 Exchange (or exchange transaction) is a reciprocal transfer between an enterprise and another entity that results in the enterprise's acquiring assets or services or satisfying liabilities by surrendering other assets or services or incurring other obligations. 3 Thus, "exchange" as a requisite element of recognizing income requires passage of title or its approximation, not merely a contract to exchange. Hence, if a contract is made to purchase widgets (executory contract) for the buyer's inventory for a price of $1000, no book entry is made despite the existence of a legally enforceable right and a legally enforceable obligation. Instead, an entry is made on the passage of title. In many commonplace situations, a purchaser may be required to make a deposit or other advance payment on a purchase contract. However, the executory contract is still not recorded, and the recording of the advance cash payment is merely a provisional recording pending completion of the transaction. 6. Further still, three (3) factors have generally been considered significant in the realization of income. These are: a. The nature of the asset received; b. The presence of a market transaction; c. The extent to which services have been performed. 4 In this connection, revenue is conventionally recognized at a specific point the earning process of a business enterprise, usually when assets are sold or services are rendered. 5 In the case of business selling services, such as public utilities, the act or process of furnishing services, together with invoicing, usually provides the occasion for recognition of revenue. If the billings are made bimonthly, it is acceptable to record revenues currently by use of an "unbilled" receivable account. 7. Finally, income recognition is co-extensive with an asset write-up or a liability write-down. Gradual recognition of revenue is more in harmony with the facts than is recognition only on realization, recognition of unrealized gain is the desideratum. This principle has been followed by MERALCO in the last two years when it made the accounting entries, debiting Refund Liability account and crediting Cash for cash refund), or debiting Refund Liability account and crediting Accounts Receivable (for credit-to-bill refund), and then debiting Accounts Receivable and crediting Revenue, to recognize the income. By making the above entries where no actual cash transferred hands between MERALCO and its customers, MERALCO in effect recognizes the existence of legal compensation whereby both MERALCO and the customer are creditors and debtors of each other to the extent of the monthly electric bill issued by the former. Compensation shall take place when two persons, in their own right, are creditors and debtors of each other. 6 In order that compensation may be proper, it is necessary: a. That each one of the obligors be bound principally, and that he be at the same time a principal creditor of the other; b. That both debts consist in a sum of money, or if the things due are consumable, they be of the same kind, and also of the same quality if the latter has been stated; c. That the two debts be due; d. That they be liquidated and demandable; and e. That over neither of them there be any retention or controversy, commenced by third persons and communicated in due time to the debtor. (Art. 179, NCC). Based on the foregoing, this Office hereby opines that the income is deemed realized by MERALCO only when the service has been provided to the customer and a bill is issued during the month. The subsequent offsetting of the payable and receivable by MERALCO to effect payment of the income is only a mode of payment, which has no significance for the accrual of income, for income tax purposes. For value added tax purposes, this Office is of the opinion as it hereby rules that the instruction to offset the receivables against future electric bills does not form part of MERALCO's taxable gross receipts. In this case, there is no advance payment of the electric bill because the payment of such takes place during the offsetting done at the agreed periods between the customers and MERALCO. Indeed, the monthly electric bills will show the outstanding balance of the MERALCO liability, and the VAT official receipts will be issued only at the time of payment or offsetting of the receivables against the electric bill of the month. Accordingly, the amount due to the customers (recorded as Refund Payables in the books of MERALCO) payable to the customers through the fixed-credit-to-bill or PDC schemes, are not taxable incomes of MERALCO in the year the customers instructed MERALCO to apply the Refund Receivables against their future electric bills. 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, this ruling shall be become null and void. Very truly yours, (SGD.) JOSE MARIO C. BUAG Commissioner of Internal Revenue Footnotes 1. AICPA, Accounting for Services Transactions, Financial Standards Accounting Board, High Ridge Park, Stamford, Connecticut, 1978. 2. Manila Mandarin Hotels vs. Commissioner , CTA Case No. 5046, Mar. 24, 1997. 3. APB Statement No. 4 Basic Concept and Accounting Principles Underlying Financial Statements of Business Enterprises, par. 180-183. 4. AAA, 1964 Concepts and Standards Research Study Committee, The Realization Concept, 40 Acctg. Rev. 312, 314 (1965). 5. APB Statement No. 4, par. 159 (1970). 6. Art. 178, New Civil Code.