Taxability of Zero-Coupon Bills and Future Purchases of Zero-Coupon Bonds

July 28, 2005 BIR RULING NO. 008-05 BIR Ruling No. 7-2004 & DA-491-2004 Pambansang Pangasiwaan sa Pagkain Matimyas Bldg., 101 E. Rodriguez Ave. Quezon City Attention: Mr. Gregorio Y. Tan, Jr. Administrator Gentlemen : This refers to your letter dated November 16, 2004, requesting for a ruling on the following matter, to wit: 1) Refund of the withholding taxes imposed on the zero-coupon bills amounting to P775.058 M on the basis of Section 22 (Y) of the Tax Code of 1997, as clarified by BIR Ruling No. 020-2001; and 2) Exemption from the rule enunciated in BIR Ruling No. 7-2004 with respect to future purchases of zero-coupon bonds in case your proposed long-term borrowing plan under same structure facility is approved by concerned government governing bodies. FACTUAL BACKGROUND The Pambansang Pangasiwaan sa Pagkain or the National Food Authority (NFA, for brevity) is mandated to ensure food security and stabilization of the supply and price of rice, the country's staple food. In short, NFA is focused on social services rather than on income generating activities. It purchased zero-coupon, 7-year Treasury Note, details of which are as follows: Date of Purchase Face Value Cost 12/18/03 P2,454,180,000.00 P1,334,099,410.08 12/19/03 1,045,820,000.00 568,648,331.76 P3,500,000,000.00 P1,902,747,741.84 04/29/04 5,000,000,000.00 2,721,962,046.70 P8,500,000,000.00 P4,624,709,788.54 ============== ============== These bonds are special issuance awarded by the Bureau of the Treasury (BTr) to NFA through Development Bank of the Philippines (DBP) and Land Bank of the Philippines (LBP) as part of a unique and structured loan facility approved by the Department of Finance (DOF) and Bangko Sentral ng Pilipinas (BSP). The said zero-coupon bonds will be used as loan security and payment for the long term loans, with also a maturity of 7 years. The Treasury Notes are now held in trust by DBP and LBP for the long-term loans arranged by them for NFA from the following banks. DSHcTC Amount of Loan Trustee Equitable PCI Bank P 2.5 B DBP Metrobank 1.0 DBP Land Bank of the Phils. 5.0 LBP P8.5 B ===== The request for refund presupposes that the aforementioned zero-coupon Treasury Notes have been withheld the 20% final tax being imposed on deposit substitutes notwithstanding the fact that the purchases were made prior to BIR Ruling No. 7-2004 on July 16, 2004. RULES GOVERNING THE IMPOSITION OF 20% FINAL TAX ON DEPOSIT SUBSTITUTES Under Section 22 (Y) of the Tax Code of 1997, the term "deposit substitutes" has been defined as an alternative form of obtaining funds from the public (the term 'public' means borrowing from (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 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, 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 : . . ." For practicality and consistency, this Office has attempted to prescribe a uniform interpretation of the meaning of the term " deposit substitutes ." At present, from the simple definition of the term, this Office's interpretation has evolved into two (2) sets of rules. I. The present rule as enunciated in BIR Ruling No. 7-2004 and reiterated in BIR Ruling DA-491-2004 dated September 13, 2004. The ruling applies in particular, to Treasury bonds, notes and bills being issued by the Republic of the Philippines . Notwithstanding the definition of the term "deposit substitutes" under Section 22 (Y) of the Tax Code of 1997, this Office has ruled in BIR Ruling No. 7-2004 that the 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, therefore interest income derived therefrom shall be subject to the applicable final tax rate imposed on deposit substitutes as prescribed under the Tax Code. In short, the borrowing and lending activities have been expanded in meaning as to include trading/investing in secondary market thereby making the mere issuance of a debt instrument to less than 20 lenders a public borrowing if it is expected to be traded or float in the secondary market. Further, the final tax is required to be withheld upfront. IAETDc BIR Ruling No. 7-2004 has effectively sustained BTr's contention that the mere issuance and subsequent distribution (exchange and trading) of these financial assets by government in the secondary market to other market participants, specifically, the investors, is in itself a public borrowing of the government. BTr's subsequent request for exclusion from the coverage of the above rule its proposed issuance of ROP Fixed Promissory Note in favor of a single investor without any specific detail that would warrant exclusion from the coverage was denied by this Office. 1 As a matter of consistency, this Office has reiterated said BIR Ruling No. 7-2004 and further emphasized that the matter of determining the number of lenders no longer comes into play insofar as government debt instruments and securities are concerned, particularly, Treasury bonds, notes and bills being issued by the Republic of the Philippines. In short, the new rule has in effect, reinstated Section 2 (h) (iii) (b) of Revenue Regulations No. 17-84 which considers all borrowings of the national and local government and its instrumentalities including the Central Bank of the Philippines (now the BSP), evidenced by debt instruments denoted as treasury bonds, bills, notes, certificate of indebtedness and similar instruments as "deposit substitutes." 2 Therefore, since government debt instruments and securities are not exempt from taxes, the interest income derived therefrom shall be subject to applicable final withholding tax rates on "deposit substitutes," as provided for in the Tax Code, or such other rate that may be imposed under the appropriate tax treaty to which the Philippines is a signatory. II. The previous rule which was amended by BIR Ruling No. 7-2004 insofar as government-issued debt instruments are concerned, requires application of the "20 lenders rule" in order that the issuance may be considered as "deposit substitutes" pursuant to Sec. 22 (Y) of the Tax Code of 1997. In short, the mere flotation of debt instruments is not considered "deposit substitutes" if there is less than twenty (20) individual or corporate lenders . In previous BIR rulings, 3 this Office has enunciated the rule that to be considered as "deposit substitutes" subject to the 20% final tax or the applicable final tax rate, the borrowing of funds must be obtained from twenty (20) or more individuals or corporate lenders at any one time. As previously clarified, for purposes of determining whether the borrowing is "public," the number of investors shall be counted at the time of origination or original issuance, regardless of whether the bonds are thereafter traded or sold in the secondary market or not. [Secondary market presupposes that the individual or corporate investor could be twenty (20) or more.] Further still, the final tax imposed on deposit substitutes is required to be withheld upfront. In fine, if the issuance does not qualify as "deposit substitutes," the income derived therefrom shall not be subject to the final withholding tax, but to the following: a) ordinary income tax at the schedular rate imposed under Section 24 (A) (1) (c) of the Tax Code, if the bondholder is an individual citizen or a resident alien; b) 20% tax if the bondholder is a nonresident alien engaged in trade or business within the Philippines under Section 25 (A) (2) of the Tax Code. DEScaT c) 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; d) corporate income tax of 32% or 2% minimum corporate income tax imposed under Section 27 (A) and 27 (E), and 28 (A) (1) and (2), respectively, of the Tax Code, for domestic and foreign corporations; e) 32% final withholding tax, for nonresident foreign corporation; and f) Such other rate that may be imposed under the appropriate tax treaty to which the Philippines is a signatory. 4 REQUESTED RULING 1. As to the propriety of claim for refund We noted that the aforementioned Zero-coupon, 7-year Treasury Notes were all issued by the BTr to NFA through DBP and LBP prior to BIR Ruling No. 7-2004, specifically, to be used as loan security and payment for NFA's long term loans with a maturity period of also 7 years. As cited above, any interest income derived from debt instruments not otherwise considered as "deposit substitutes" shall be subject to corporate income tax of 32% or 2% minimum corporate income tax (MCIT) imposed under Section 27 (A) and (E), respectively, and 28 (A) (1) and (2) of the Tax Code of 1997, in case of foreign corporations. Accordingly, since the aforementioned Treasury Notes were issued only to NFA for the abovementioned specific purpose, and at the time when the applicable rule is the "20 lenders rule," the interest income derived therefrom is exempt from the 20% final tax imposed under Sec. 27 (D) (1) of the Tax Code of 1997. However, in connection with Sec. 27 (C) of the Tax Code of 1997 and in the absence of any showing that NFA is exempt from income tax, the interest income derived from the aforementioned Zero-coupon, 7-year Treasury Notes shall be subject to either the regular corporate income imposed under Sec. 27 (A) or to MCIT imposed under Sec. 27 (E), both of the same Tax Code. Consequently, since income payments to government-owned or controlled corporation, agencies or instrumentalities are not subject to any creditable withholding tax (CWT) under Revenue Regulations No. 2-98, as amended, the interest income on said Treasury Notes is exempt from CWT. Thus, the claim for refund of the final taxes withheld is proper subject to the two-year prescriptive period under Sec. 204 of the Tax Code and to the existing BIR rules and procedure in claiming refund. 2. Exemption from the rule enunciated in BIR Ruling No. 7-2004 with respect to future purchases of zero-coupon bonds in case NFA's proposed long-term borrowing plan under the same structure facility is approved by concerned government governing bodies . CcHDSA We are of the understanding that NFA's future purchases of zero-coupon bonds shall be in pursuance of the approved structure facility of its long-term borrowing plan, with zero-coupon Treasury Note as the permitted security. As further noted in previous BTR's issuances to NFA, the aforesaid debt instrument shall actually be held in trust by the designated banks, usually government banks on behalf of NFA until the instrument's maturity date which is coincident with the term of the long-term loan. Upon maturity, the NFA shall redeem the Notes from the BTr and will use the proceeds to pay off its long-term bank-creditors. In view of the foregoing, we opine that the Treasury Note issued to NFA is not "deposit substitutes" and therefore, does not fall within the purview of BIR Ruling No. 7-2004. Furthermore, it will not run contrary to BTr's position that bond issuance should be considered as public issuance subject to 20% withholding tax since said position is premised on the practical consideration that it would be difficult for government to monitor or limit the movement of bonds in the secondary market which would eventually violate the 19 lender rule. Such being the case, we hereby rule that the proposed issuance of Treasury Notes of the same tenor as represented by NFA is not subject to the 20% final tax imposed on deposit substitutes. However, interest income derived therefrom shall be subject to the 32% regular income tax or to the 2% MCIT imposed under Secs. 27 (A) and (E) of the Tax Code of 1997, respectively, as the case may be. This effectively modifies BIR Ruling No. 7-2004 and DA-491-2004 and effectively, hereby excepts the issuance of the proposed issuance of Treasury Notes to NFA with the same tenor and under the same structure facility as previously issued to same entity from its coverage. Very truly yours, (SGD.) JOSE MARIO C. BUAG OIC-Commissioner of Internal Revenue Footnotes 1. See BIR Ruling DA-491-2004 dated September 13, 2004. 2. See BIR Ruling DA-491-2004, supra. 3. See BIR Ruling Nos. 020-2001 dated May 13, 2001; 026-02 dated June 27, 2002; 017-2002 dated April 29, 2003; DA-522-2003 dated December 16, 2003. 4. See BIR Ruling Nos. 017-2002, 026-2002, supra .