Tax Consequences of the Privatization of Operations of the Metropolitan Water and Sewerage System

January 17, 1997 BIR RULING NO. 006-97 99 29 000-00 006-97 Pangasiwaan ng Tubig at Alkantarilya sa Manila Metropolitan Waterworks & Sewerage System Katipunan Road, Balara, Quezon City Attention: Mr . Angel L . Lazaro Administrator Gentlemen : This refers to your letter dated January 13, 1997 relative to your letter dated January 3, 1997 and October 10, 1996. It is represented that the Metropolitan Water and Sewerage System (MWSS) is currently developing and implementing a program for the privatization of its operations; that the privatization of MWSS is specifically mandated by Executive Order No. 311 dated March 20 1996; that the privatization process has started and the planned schedule is to finalize the privatization transaction by December 1996; that pursuant to Section 18 of R.A. 6234, the charter of MWSS, it is provided that MWSS shall be non-profit and shall be exempt from all taxes; that its exemption however was withdrawn by Presidential Decree No. 1931 dated June 11, 1984; that Fiscal Incentives Review Board (FIRB) Resolution No. 14-89 dated July 6, 1989 did not restore the tax and duty exemption privileges previously enjoyed by MWSS but merely endorse to the Office of the President for its consideration as an Administration Bill the restoration of the tax and duty exemption privileges previously enjoyed by MWSS under the terms and conditions of its Charter R.A. 6234; that the overall privatization transaction will be in the form of a concession whereby MWSS will give the winning concessionaires the right to operate the MWSS waterworks system from drawing of raw water from existing and future sources to treatment of water and to distribution of water to households, commercial and industrial users; that a similar right will be given to operate the sewerage and sanitation system; that the waterworks system, from treatment of water to distribution of water to users, and sewerage and sanitation system will be divided into two geographical areas; that the right to operate these systems; in each geographical area will be given to one concessionaire; that there will therefore be two concessionaires, each of which will be operating the abovementioned systems in each of the two geographical areas; that with regard to the drawing of raw water to be fed to the treatment plants, the two concessionaires will form a joint venture to handle the activity; that the concession will be for a period of 25 years; that for the entire concession period, MWSS will give the concessionaires, as agents of MWSS, the right to operate the former's waterworks and sewerage/sanitation systems; that at the start of the concession period, the concessionaires will be given by MWSS the right to use all of its existing fixed assets; that the ownership of these existing fixed assets will remain with MWSS; that in consideration for all the rights, the concessionaire will make payment to MWSS periodically over the concession period for amounts that will be agreed upon by the contracting parties (concession fee);. that in addition, the concessionaires will pay a commencement fee at the start of the concession period; that the concessionaire will be obligated to improve and expand the water and sewage/sanitation services; that the concessionaires will acquire and construct additional, fixed assets; that the ownership of these fixed assets will remain with the concessionaire until the end of the concession period when the ownership will be transferred to MWSS; that for purposes of financial accounting, these fixed assets, will be recorded at cost and depreciated over their estimated useful lives; that the concessionaires may use the estimated useful lives currently being used by MWSS; that in expanding the service coverage for water and sewerage/sanitation services, the concessionaires may need to purchase rights-of-way and these rights have to be transferred to the name of MWSS, which holds the right of eminent domain as provided in its charter, that in effect, the concessionaire will be responsible for making the payment for the purchase, but the ownership of the land covering the rights-of-way will be transferred to MWSS at the time of purchase; that MWSS will give to the concessionaires the right to use the land; that for purposes of financial accounting, the right to use the assets acquired by the concessionaires during the concession period is an intangible that may be recorded by the concessionaires in their books as an assets to be titled Concession Right, at an amount equivalent to the cost of the assets transferred at the time of purchase; that the value of this Concession Right may be amortized over the remaining period of the concession agreement and the annual amortization is deductible from the taxable income of the concessionaires; that at the end of the concession period, the concessionaires will turn over to MWSS all the fixed assets that are existing at that time including those originally owned by MWSS and those acquired and constructed by the concessionaires; that in turn, MWSS may pay the concessionaires an amount, considered as an expiration value, which will be determined at the end of the concession period; that similarly, other assets, such as receivables and inventories at the end of the concession period will be transferred to MWSS at the book value of these assets in the books of the concessionaires; and that for purposes of financial accounting, each concessionaire's gain or loss on these transaction will be determined by deducting from the amount of payment to be received from MWSS, the net book value at the end of the concession period of all the assets that the concessionaires will be turning over, including the net book value of the fixed assets mentioned above. In connection therewith, you are requesting confirmation your opinion that. On Right to operate MWSS Systems and Right to Use MWSS' Existing Fixed Assets "1. The transfer by MWSS to the concessionaires of the rights to operate the former's waterworks and sewerage/sanitation systems and to use the existing fixed assets of MWSS is not subject to VAT. Similarly, the payment (concession fee) to be made periodically by the concessionaires to MWSS including the commencement fee, over the concession period in consideration for acquiring the said rights is also not subject to VAT; "2. The cost of the Concession Right (i.e., sum of the concession payments made or payable in the future) arising from the rights given by MWSS to the concessionaires to operate the former's waterworks and sewerage/sanitation systems and to use its existing fixed assets may be amortized over the concession period of 25 years and the amortization may be deducted from the gross income of the concessionaires; "3. The applicable documentary stamp on this whole transaction will be applied on the amount of commencement fee and the periodic payment for concession fee as and when such payment is made and the rate to be applied is P1 for every P1,000 (1%); On Transfer of Assets by Concessionaires to MWSS during the Concession Period "4. The transfer of ownership of the assets is not a donation subject to the 10% donor's tax; "5. The transfer of assets purchased by the concessionaires to MWSS is not subject to VAT, considering that the assets are real properties and the concessionaires are not dealers in real property; "6. The right to use the assets, acquired by the concessionaires is an intangible that may be recorded by the concessionaires in their books as an assets, to be titled Concession Right, at an amount equivalent to the cost of the assets transferred at the time of purchase. The value of this Concession Right may be amortized over the remaining period of the concession agreement and the annual amortization is deductible from the taxable income of the concessionaires; "7. The deed of conveyance or transfer involving real property shall be subject to the documentary stamp tax at P15 for every P1,000 consideration or value to be paid to the realty; On Transfer of Assets by Concessionaires to MWSS at the End of Concession period . "8. The fixed assets to be acquired and constructed by the concessionaires can be depreciated over the estimated lives currently being used by MWSS for similar assets; "9. The transfer to MWSS at the end of the concession period of the fixed assets acquired and constructed by the concessionaires is not subject to VAT; "10. The receivables that may be transferred by the concessionaires to MWSS at the end of the concession period is not subject to value added tax (VAT); "11. In computing the gain or loss on the end-of-period payment to be received by the concessionaires from MWSS, the net book value of the assets to be transferred, including the net book value of the fixed assets mentioned in item No. 9 above, will be deducted from the consideration received from MWSS; "12. The documentary stamp tax that will apply on the transfer of the fixed assets to MWSS is P15 for each P1,000 (1 1/2%) and this rate will be applied on the amount of consideration received or net book value of the fixed assets transferred, whichever is higher; "13. The transfer of the other assets, such as receivables and inventories, at the book value carried in the books of the concessionaires is not subject to documentary stamp tax." In reply thereto, please be informed as follows : (1) The transfer by MWSS to the concessionaires of the right to operate its waterworks and sewerage/ sanitation systems and to use its existing fixed assets in consideration for the payment of a commencement fee and a concession fee to be made periodically by the concessionaires to MWSS over the concession period is not subject to VAT since the transfer is not in the ordinary course of the trade or business of MWSS (Sec. 99 Tax Code, as amended by R.A. 7716); (2) Capital expenditures may not be deducted from gross income except through depreciation, depletion or amortization deductions spread over the useful life of the expenditures (par. 6060, 34 Am. Jur. 2d 1976) Thus, the cost of the Concession Right (i.e., sum of the concession payments made or payable in the future) arising from the rights given by MWSS to the concessionaires to operate its waterworks and sewerage/sanitation systems and to use its existing fixed assets may be amortized over the concession period of 25 years and the amortization may be deducted from the gross income of the concessionaires; (3) The transfer by MWSS to the concessionaires as its agents of the right to operate its waterworks and sewerage/sanitation systems and to use its existing fixed assets specifically land or tenements or portions thereof shall be subject to the documentary stamp tax imposed under Section 194 of the Tax Code, as amended by R.A. 7760; (4) The transfer of the rights of way purchased and constructed by the concessionaires during the concession period in expanding its service coverage for water and sewerage/sanitation services to MWSS is not a donation subject to donor's tax. Although the concessionaires paid for said right of way, nevertheless its ownership belongs to MWSS since it was the one who acquired said rights of way through the exercise of its right of eminent domain. The right to use the land (rights of way) to be given by MWSS to the concessionaires is an intangible asset which may be recorded by the concessionaires as "Concession Right"; (5) The transfer of assets purchased or constructed by the concessionaires during the concession period to MWSS is not subject to VAT since the transfer is not in the course of trade or business of the concessionaires pursuant to Section 99 of the Tax Code, as amended; (6) The right to use by the concessionaires of the assets acquired by MWSS through the exercise of the right of eminent domain is an intangible asset which may be recorded by the concessionaires in their books as an asset (Concession Right) at an amount equivalent to the cost of the property. The value of the concession right which is a capital expenditure may be amortized over the remaining period of the concession agreement and the annual amortization is deductible from the taxable income of the concessionaires; (7) Any deed of conveyance or transfer involving real property to be executed by the concessionaires to MWSS during the concession period shall be subject to the documentary stamp tax imposed under Section 196 of the Tax Code, as amended by R.A. 7660; (8) Pursuant to Section 29 (f) (1) of the Tax Code, as amended, there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion; wear and tear (including reasonable allowance for obsolescence) of property used in the trade or business. The term "reasonable allowance " shall include but not limited to) an allowance computed in accordance with regulations prescribed by the Secretary of Finance, under any of the following methods: (A) The straight line method; (B) Declining balance method using a rate not exceeding twice the rate which would have been used had the annual allowance been computed under the method described in paragraph (f) (1) of Section 29 of the Tax Code, as amended; (C) The sum of the years digit method; and (D) Any other method which may be prescribed by the Secretary of Finance upon recommendation of the Commissioner of Internal Revenue. The proper allowance for depreciation of any property used in the trade or business is that amount which should be set aside for the taxable year in accordance with a reasonable consistent plan whereby the aggregate of the amount so set aside, plus the salvage value, will, at the end of the useful life of the property in business, equal the basis of the property. Due regard must be given to expenditures for current upkeep. (Section 105, Revenue Regulations No. 2) Moreover, the capital sum to be replaced should be charged off over the useful life of the property, either in equal annual installments or in accordance with any other recognized trade practice, such as an apportionment of the capital sum over units of production. Whatever plan or method of apportionment is adopted must be reasonable and must have due regard to operating conditions during the taxable period. While the burden of proof must rest upon the taxpayer to sustain the deductions taken by him, such deductions must not be disallowed unless shown by clear and convincing evidence to be unreasonable. The reasonableness of any claim for depreciation shall be determined upon the conditions known to exist at the end of the period for which the return is made. If it develops that the useful life of the property will be longer or shorter than the useful life as originally estimated under all the then known facts, the portion of the cost or other basis of the property not already provided for through depreciation allowance should be spread over the remaining useful life of the property as reestimated in the light of the subsequent facts, and depreciation deductions taken accordingly. (Section 109 Revenue Regulations No. 2); Depreciation is a question of fact and is not measured by theoretical yardstick, but should be determined by a consideration of actual facts. Thus, the rates of depreciation on Bulletin "F" of the Federal Internal Revenue Service has some persuasive effect. (Limpan Investment corporation vs. Commissioner of Internal Revenue, et al., No. L-21570, July 26, 1966) The depreciation rate currently being used by MWSS for its property, plant and equipment have been determined on the basis of its particular operating conditions, experience and informed judgment as to technological improvements and economic changes. Such being the case, this Office may allow the use of the depreciation rates currently being used by MWSS for its assets for the fixed assets to be acquired and constructed by the concessionaires. (9) The transfer to MWSS at the end of the concession period of the fixed assets acquired and constructed by the concessionaires is not subject to VAT since the transfer of said assets is not in the course of trade or business of the concessionaires pursuant to Section 99 of the Tax Code, as amended; (10) The receivables that may be transferred by the concessionaires to MWSS at the end of the concession period is not likewise subject to VAT since the transfer of said receivable by the concessionaires not in the course of their trade or business pursuant to Section 99 of the Tax Code as amended; 11. In computing the gain or loss; if any on the end-of-period payment to be received by the concessionaires from MWSS, the net book value of the assets to be transferred shall be deducted from the consideration to be received by the concessionaires from MWSS; 12. The deed of conveyance or transfer involving the real properties purchased by the concessionaires during the concession period which will be transferred to MWSS at the end of the concession period shall be subject to the documentary stamp tax imposed under Section 196 of the Tax Code, as amended; 13. The transfer of the other assets, such as receivables and inventories, at the book value carried in the books of the concessionaires at the end of the concession period to MWSS is not subject to documentary stamp tax. Very truly yours, LIWAYWAY VINZONS-CHATO Commissioner of Internal Revenue