Tax Consequences for Regular and Special Issuances of Treasury Bills and Bonds

July 16, 2004 BIR RULING NO. 007-04 Sec. 22 (Y) BIR Ruling Nos. 020-2001 & DA-175-2001 Bureau of the Treasury Intramuros, Manila Attention: Hon. Mina C. Figueroa Treasurer of the Philippines Gentlemen : This refers to your letter dated April 14, 2004, seeking confirmation on the tax consequences for the regular and special issuances by the Bureau of the Treasury of Treasury bills and bonds, specifically on the following issues, to wit: "a) Whether or not all bond issuance should practically be considered public issuance, and therefore subject to 20% withholding tax, considering the difficulty of monitoring or limiting the movement of the bonds in the secondary market which eventually would violate the 19 lender rule; "b) Whether or not the phrase "at any one time" should be applied at all to a single bond issuance, considering that the same invariably reaches the primary and secondary market; and "c) Whether or not BIR Rulings No. 020-2001 dated 16 August 2001 and DA-175-2001 dated September 2001 be applied in a special issuance which on its terms is strictly, limited to particular holders which in no case should exceed 19 lenders/investors in both the primary and secondary levels. CASE BACKGROUND The Bureau of the Treasury (BTR) is mandated to issue government securities. BTR has been imposing the 20% final withholding tax on its regular issuances (even in some of its special issuances). On the other hand, the Bureau of Internal Revenue (BIR) issued several rulings which laid down the basis of identifying those financial assets (financial instruments or securities) which would effectively fall within the meaning of "deposit substitutes." The Bureau of Internal Revenue first characterized the term "deposit substitutes" based on the definition provided for in Section 22(Y) of the Tax Code of 1997, to wit: "The term "deposit substitutes" is an alternative form of obtaining funds from the public ( the term public means borrowing from twenty (20) or more individual or corporate lenders at any one time ), other than deposits, through the issuance, endorsement or acceptance of debt instruments for the borrower's account, for the purpose of relending or purchasing of receivables and other obligations, or financing their own needs or the needs of their agent or dealer. These instruments may include, but need not be limited to, banker's acceptances, promissory notes, repurchase agreements, including reverse repurchase agreements entered into by and between the Bangko Sentral ng Pilipinas (BSP) and any authorized agent bank, certificates of assignment or participation and similar instruments with recourse: . . . Thus, this Office concluded that in order to identify whether a financial asset or instrument is "deposit substitute," the borrowing must be made from twenty (20) or more individual or corporate lenders at any one time. From this conclusion, the BTR posed clarification on the meaning of the phrase "at any one time" for which the BIR held that "I. As defined in Section 22(Y) of the 1997 Tax Code, the term "deposit substitutes" as an alternative form of obtaining funds from the "public" requires that the borrowing must be made from twenty (20) or more individual or corporate lenders at any one time. . . " 1 "II. ". . . the phrase 'at any one time' covers only the origination or original issuance of the bonds regardless of whether sale or trading is made in the secondary market." 2 The above interpretation was applied on BTR's first issuance of a zero-coupon bonds a.k.a. PEACE Bonds, for which the BIR ruled, to wit: "However, in the case of PEACE Bonds, since the determining factor in ascertaining whether or not such bonds are "deposit substitutes" is the original issuance to more than twenty (20) individual or corporate lenders, it holds to say that the issuance to less than twenty (20) individual or corporate lenders will necessarily exclude them from the coverage of "deposit substitutes." Such being the case, the time element, i.e ., "at any one time required in "public borrowing" shall not apply in the instant case." This BIR's pronouncement was made in view of the representation that said Bonds would not be issued to more than nineteen (19) eligible firms/lenders in its origination; and that PEACE Bond was a special issuance. In other words, the authorized amount (up to PHP50.0 Billion) indicated in the Full Powers granted by the President would be issued only once, not in several tranches and the BTR issued PEACE Bonds in single tranche. In view of the foregoing BIR ruling, the BTR now poses for this Office consideration the following sets of scenarios, to wit: 1. DOF/BTR may be granted by the President, through Presidential Full Powers, the authority to issue, e.g. PHP200 Billion worth of Treasury Bonds in tenors of five (5), six (6), seven (7) and ten (10) years for a maximum issue size of PHP50.0 Billion per tenor. This scenario by its nature implies a multiple tranche issue consisting of several origination, and is usually offered through Auction, Over-the-Counter, or in some instances, through Tap Method. Even the maximum issue size of PHP50.0 Billion per tenor may be issued in several tranches depending on the needs of the National Government and the prevailing economic or political condition as of such a time; 2. In the above scenario, the BTR may offer bonds using the same Full Powers, through Tap (a manner of sale or offering or government securities open exclusively to Government Securities Eligible Dealers (GSEDs) and Financial Institutions in the event of an acute and protracted shortage of government securities), for any of the authorized tenors. On the standpoint of the Government, Tap window is considered a primary issuance or origination; 3. Upon the instance of DOF/BTR, and when circumstances warrant its issuance, it may be granted an Authority by the President to issue, e.g., PHP 100.0 Billion of Zero Coupon Bills or Bonds in different tenors from three (3) years up to ten (10) years, and it can be inferred by the nature of such an authority that the issue shall be in several tranches and in several manner of offering, including public offering. 4. Upon the proposal of some financial institutions and whenever necessary to meet public expenditures or for any purpose as may be authorized by law, the DOF/BTR may also be authorized to issue bills or bonds, through a special issuance. Under this scenario, the Republic (DOF/BTR) may issue the same in single tranche or in several tranches, and may likewise be offered through Auction, Tap, Firm Underwriting, or Combined Bookbuilding and Public Offering. This is differentiated from the regular issuances usually by its designated name such as, Small Denominated T-Bonds (SDT-Bonds) or like in the case of PEACE Bonds or PNs, and there art eligibilities attached to it. BTR's POSITION ON ITS REQUESTED RULING I. On the imposition of the 20% Final Tax on "deposit substitutes," if the financial assets i.e., debt instruments and securities are floated as regular issuance In the above three (3) scenarios, BTR maintains that the 20% withholding tax on deposit substitute shall be imposed regardless of whether or not there are less than twenty (20) lenders in every origination. In other words, BTR does not have to sum up the number of lenders in every issuance as it can be inferred from the nature of a regular issuance that the whole Authority, as evidenced by the Presidential Full Powers, consists of as many origination or primary issuance(s) as there are numbers of tranches, and there is an implied offering to the public in general. To do otherwise, would place National Government (NG)-Issuer in an awkward or difficult situation of monitoring how many lenders were purchasing such bonds in its origination/primary issuances, and such Tax Code provisions imposing 20% withholding tax on deposit substitutes would then make little or no sense, where its applicability is made to depend on how many lenders are the bonds/bills being issued to during its origination (which, in these cases, consists of several instances). The BTR concluded that when the National Government, through the DOF/BTR, issues Bonds or other debt instruments, and offer to the public, the said issuance is deemed public borrowing and therefore, the corresponding debt instruments or certificates (whether scripless or documented), should be considered deposit substitutes. Further, BTR posits that if it will simply apply the "20 or more lenders" rule on its regular issuances of T-Bills and T-Bonds and other government securities, which, most of the time, in actual practice, is being captured by less than twenty (20) institutional lenders (most banks and investment houses) in its origination/primary issuance, it seems that the 20% withholding tax on deposit substitutes will never apply in cases of government securities. And there is no question that debt instruments issued by the National Government are generally classified as deposit substitutes. Moreover, BTR posits that the foregoing should hold true even in cases of regular issuances of zero-coupon bills/bonds or where bonds/bills are issued at a discount. It has been an established rule that the final tax on the amount earned as discount is generally withheld on the date of issuance of the debt instrument. For tax purposes, the amount of discount which the Treasury Bills are originally sold by the Republic of the Philippines, is considered interest income already earned by the purchaser upon their issuance of the Treasury Bills. 3 II. On the imposition of the 20% Final Tax on "deposit substitutes," if the debt instruments and securities are in the nature of special issuance Under the fourth scenario, the BTR opines that in determining whether or not the 20% withholding tax on deposit substitutes shall be imposed on that particular planned/proposed issuance, the number of lenders, assuming there is a pre-conceived plan of issuing such bonds/bills in several tranches, shall be summed up to determine the actual numbers of would-be holders of such bonds during the origination, if the BIR interpretation on the 19 lender count is limited on the origination or primary issuance (defined as purchase of lenders/investors from the BTr/National Government.) BIR REPLY Section 22(Y) of the Tax Code of 1997 defines "deposit substitutes" as an alternative form of obtaining funds from the public ( the term public means borrowing from twenty (20) or more individual or corporate lenders at any time ), other than deposits, through the issuance, endorsement or acceptance of debt instruments for the borrower's own account, for the purpose of relending or purchasing of receivables and other obligations, or financing their own needs or the needs of their agent or dealer. These instruments may include, but need not be limited to, bankers' acceptances, promissory notes, repurchase agreements, including reverse repurchase agreements entered into and between the Bangko Sentral ng Pilipinas (BSP) and any authorized agent bank, certificates of assignment or participation and similar instruments with recourse: . . . "(emphasis supplied.) In previous BIR rulings issued to BTR, 4 this Office had enunciated the rule that to be able to determine whether the financial assets, i.e. , debt instruments and securities are deposit substitutes, the "20 or more individual or corporate lenders" rule must apply. Moreover, the determination of the phrase "at any one time" for purposes of determining the "20 or more lenders" is determined at the time of the original issuance. This has been so on the basis of the fact that it is on the original issuance that the act of lending is done. Moreover, since the financial assets involved are basically debt instruments and government securities, and usually traded in the debt market, the reckoning time of determining the 20 lenders is done in the primary market considering that it is the time when the issuer "sells" the new financial asset to the public . In effect, it is the time, the borrower is said to "issue" the financial asset. After a certain period of time, the financial asset is bought or sold ( i.e. , exchanged or traded) among investors. The market where the activity takes place is referred to as the secondary market. (See page 11, Chapter I of Capital Markets Institutions and Instruments, Third Edition by Frank J. Fabozzi and Franco Modigliani). Thus, it has been concluded that the time element "at any one time" is deemed to be reckoned when the borrowing or "issuance" is done in the primary market. Subsequent trading among investors in the secondary market is merely an act of buying and selling and not borrowing in nature. This therefore, removed the secondary market from the very act of borrowing or lending itself, as a necessary element required by the term "deposit substitutes". The simplistic approach made by this Office was to merely classify the financial asset (debt instrument or a security) and determine the financial market (primary or secondary) where they are traded for the purpose of ascertaining lending activity in order to determine if the financial instrument would fall within the meaning of the term "deposit substitutes." The aforementioned BIR rulings do not deal with and reclassify the issuance into special or regular issuance. In both cases, this Office is not bound to observe the nature of the debt instrument or security [ i.e. , whether it is newly issued (primary market) or seasoned (secondary market)] nor the organizational structure of the market (e.g. auction market, over-the-counter, and intermediate market). In short, even a special issuance wherein there has been "20 or more individual or corporate lenders" warrants classification of debt instruments as "deposit substitutes." Significantly, we have noted BTR's contention and position on the matter. In short, as we understand from the discussion we had with the representative of the BTR, since the object of the issuance is to obtain the required government funding, the issuance and subsequent distribution (exchange and trading) of Government debt instruments and securities in the secondary market to other market participants, specifically, the investors, is in itself a public borrowing of the government. The financial assets ( i.e. , debt instruments and securities) in the hands of the investors represent a claim to future cash for which the borrowing entity, at maturity date, must have to pay. It is, however, in the secondary market that the investing public make the indirect investment in the borrowing entity, in this case, the Government. In view of the foregoing, this Office opines and so rules that mere issuance of government debt instruments and securities is deemed as falling within the coverage of "deposit substitutes" irrespective of the number of lenders at the time of origination. Accordingly, since government debt instruments and securities are not exempt from taxes, interest income derived therefrom shall be subject to the following: a) 20% final withholding tax imposed under Sections 24 (B) (1) and 25 (A) (2) of the Tax Code of 1997, if the bondholder is an individual citizen or a resident alien, respectively; b) 25% tax imposed under Section 25 (B) of the Tax Code, if the bondholder is a nonresident alien individual not engaged in trade or business within the Philippines; c) 20% final tax imposed under Sections 27 (D) (1) and 28 (A) (7) (a), of the Tax Code, for domestic and resident foreign corporations, respectively; d) 32% final withholding tax, for nonresident foreign corporation under, Section 28 (B) (1) of the Tax Code, if the bondholder is nonresident foreign corporation; and, e) Such other rate that may be imposed under the appropriate tax treaty which the Philippines is a signatory. Moreover, based on above discussion, the phrase "at any one time" in relation to public borrowing is deemed to refer to the flotation of the debt instrument or security. In other words, since the actual number of bondholders or investors may be, at maturity date of the financial instrument, more than 20 individuals or corporation, the said direct lenders (origination) and indirect investors (secondary market) are deemed to be what constitute "public." Finally, this ruling effectively modifies and supersedes BIR Ruling Nos. 020-2001 dated August 16, 2001 and DA-175-2001 dated September 28, 2001, as well as other BIR rulings dealing on the matter. Very truly yours, (SGD.) GUILLERMO L. PARAYNO, JR. Commissioner of Internal Revenue Footnotes 1. BIR Ruling Nos. 020-2001 dated August 16, 2001. 2. BIR Ruling No. DA-175-2001 dated September 9, 2001. 3. BIR rulings No. 186-84 dated December 7, 1984. 4. BIR Ruling Nos. 020-2001 dated August 16, 200 and DA-175-2001 dated September 9, 2001.