BIR Ruling No. 011-07

May 31, 2007 BIR RULING NO. 011-07 DA-108-04, BIR Ruling No. 006-97 Sec. 32 (B) (7) (b), 105, 108, 119, NIRC Power Sector Assets and Liabilities Management Corporation (PSALM) 2/F SGV II Building 6758 Ayala Avenue Makati City Attention: Ms. Nieves L. Osorio President & CEO Gentlemen : This refers to your letter of November 14, 2006 requesting for confirmation of the tax implications of certain transactions arising from or relating to privatization of National Transmission Corporation ("TRANSCO") through the award by the Power Sector Asset and Liabilities Management Corporation ("PSALM") to the winning bidder ("Concessionaire") of the concession to construct, install, improve, expand, operate, maintain, rehabilitate, repair and refurbish the high voltage and medium voltage transmission system owned by TRANSCO; operate any Related Business; and temporarily operate and manage the subtransmission assets of TRANSCO until the disposal thereof to qualified distribution utilities, all in compliance with Republic Act No. 9136, otherwise known as the Electric Power Industry Reform Act of 2001 ("EPIRA") and its Implementing Rules and Regulations ("IRRs"). I. BACKGROUND A. The EPIRA The State, through the EPIRA, has declared its policy to ensure the quality, reliability, security and affordability of electric power supply; enhance the inflow of private capital and broaden the ownership base of the electric power sector; protect public interest on the rates and services of electric utilities; and conduct an orderly and transparent privatization of the assets and liabilities of the National Power Corporation ("NPC"). 1 Toward this end, the EPIRA has provided the legal framework for, among other things: (a) the privatization of the NPC; (b) the assumption by the national government (mainly through the PSALM) of NPC's financial obligations up to P200 Billion; (c) the restructuring of the electric power industry; (d) the creation of TRANSCO as a wholly-owned corporation of PSALM; (e) the transfer to TRANSCO of NPC's nationwide franchise, powers, functions, rights, liabilities and assets pertaining to the transmission of electricity; (f) the regulation of TRANSCO's transmission rates by the Energy Regulatory Commission; and (g) the privatization of TRANSCO; and (h) the remittance of TRANSCO's net profits to PSALM. 2 Section 21 of the EPIRA outlines the process for the TRANSCO privatization. Basically, the concession will be awarded in open competitive bidding to a qualified party either through an outright sale or a concession contract. The buyer/concessionaire shall be responsible for the improvement, expansion, operation, and/or maintenance of its transmission assets and the operation of any related business. The award shall result in maximum present value of proceeds to the national government. In case a concession contract is awarded, the concessionaire shall have a contract period of twenty-five (25) years, subject to review and renewal for a maximum period of another twenty-five (25) years. In this connection, the President of the Philippines approved on October 4, 2002 the Privatization Plan, including the TRANSCO privatization by way of concession, as endorsed by the Joint Congressional Power Commission ("JCPC") through JCPC Resolution 2002-1 dated March 13, 2002. For the first and second public biddings conducted to carry out the TRANSCO privatization, there was only one party that submitted a pre-qualification proposal in the first round and one party that submitted an expression of interest in the second round. As such, the Privatization Bid and Awards Committee ("PBAC") declared both public biddings as failed biddings. Thereafter, the proposed negotiated sale of the TRANSCO assets was also terminated because the terms and conditions, including the price, of the investors' proposals were highly unique and complex. On October 12, 2004, a notice was served that the award of the Concession agreement would again be made through public bidding under a new concession structure. B. Draft Concession Agreement Pursuant to Section 21 of the EPIRA, PSALM and TRANSCO have prepared and evolved several drafts of the Concession Agreement. As originally envisioned in the first and second bidding processes, the concession structure would allow the Concessionaire to participate in the Transmission and Subtransmission systems business even prior to the date that a franchise has been awarded by Congress to the Concessionaire. The privatization process via the award of the Concession over the Transmission assets (including Subtransmission assets pending their sale to qualified Distribution Utilities by TRANSCO), was to be implemented in two phases: (a) Award Date, when the Concession is awarded and all throughout the Non-Franchise Period; and (b) Franchise Date, when the Concessionaire is granted a congressional franchise enabling it to act as a public utility and operate the transmission system. Prior to the Award Date, the parties will have to comply with certain conditions precedent. 2uptax07 On the other hand, in the current and third bidding process and in the most recent draft of the Concession Agreement dated August 18, 2006 ("DCA") it is provided that the Concession, together with the rights, privileges, interests in and obligations pertaining thereto, shall take effect on the Commencement Date. In this connection, the most recent draft of the Direct Agreement dated August 18, 2006, states that the Concession shall not commence until certain conditions precedent have been satisfied. Among these conditions precedent is that the Congress of the Republic of the Philippines shall have granted a franchise to the Concessionaire to carry out the Concession for a term of not less than 25 years on terms that are not materially inconsistent with the Concession Agreement. Hence, the current concession structure will consist only of one phase and will start on the Commencement Date, when the Concessionaire is granted a congressional franchise enabling it to act as a public utility and operate the transmission system. Moreover, the current concession structure has the following salient features: (1) 25-year Concession The Concession Period shall be for twenty-five (25) years but may be extended by the parties. The parties shall meet on or about the 20th anniversary of the Commencement Date to consider whether and on what terms the Concession Period should be extended. However, the Concession Period shall not be extended beyond the 50th anniversary of the Commencement Date or for longer than the remaining term of the Concessionaire's congressional franchise. 3 The Concessionaire shall remit to PSALM a Concession Fee, as follows: (a) The Concession Fee as contained in the Financial Bid shall be denominated in US Dollars and paid in the manner described in (b) below, and subject to adjustment based on several factors, including, among others, reduction in the value of TRANSCO's assets as a result of the disposal of subtransmission assets. 4 Included in the Concession Fee is the consideration for the transfer to the Concessionaire of the Transferable Assets. (b) The Concession Fee shall consist of the following: (i) Commencement Fee, which is 25% of the Concession Fee, to be paid to PSALM in US dollars on the Commencement Date; 5 and (ii) Deferred Payments representing the balance of the Concession Fee, to be converted to Philippine Peso at a fixed exchange rate and paid to PSALM with interest in semi-annual installments on each semi-annual payment date. 6 All throughout the Concession Period, TRANSCO shall retain title to all Transmission Assets and Grid, assets comprising Projects under Construction or New Projects, and all easements, rights of way or other real estate interests, including Documented Property Rights acquired by the Concessionaire. 7 SIHCDA However, the Concessionaire shall have full use of the said assets and the exclusive right to collect and retain for its own account all of the revenues earned from their use. 8 The Concessionaire shall assume all of the responsibilities of an owner of the said properties during the Concession Period, including the obligation to pay license fees, taxes, renewal fees and other charges payable in respect of such properties that fall due for payment during the Concession Period. 9 Furthermore, the Concessionaire, at its own cost and expense, shall: (a) design, develop, finance, construct and complete all New Projects, as authorized by ERC, that are necessary for the fulfillment of the Concessionaire's responsibilities as the Grid Owner and System Operator, 10 and (b) acquire Documented Property Rights necessary to carry out its responsibilities during the Concession Period, either in its own name or in TRANSCO's name but for the benefit of the Concessionaire. 11 The Concessionaire shall also manage the construction and completion of all Projects Under Construction, and fund any cost overruns occurring after the Commencement Date in relation to such projects, or cost in excess of funding that TRANSCO is responsible for providing. 12 In this connection, on the Commencement Date, TRANSCO is obliged to make available sufficient funding to allow the Concessionaire to complete the Projects Under Construction and should TRANSCO fail to provide such funding, the Concessionaire shall be entitled to reduce the Concession Fee by the actual costs reasonably incurred by the Concessionaire in completing the Projects Under Construction. 13 The Concessionaire shall bear the risk of loss of, or damage to, all Transmission Assets and Grid, and assets comprising Projects Under Construction and New Projects. 14 In this regard, the Concessionaire shall procure and maintain, at its own expense, insurance policy against third party claims and loss of or damage to the Transmission Assets or Grid and include TRANSCO as a co-beneficiary thereof to the extent of its insurable interest. 15 In summary, the Concessionaire will pay and remit to PSALM the Concession Fee and in addition, undertake the following obligations: (a) assume the costs for New Projects and Documented Property Rights; (b) provide additional funding for the construction and completion of Projects Under Construction; (c) assume the real property taxes (RPT) on the real properties owned by TRANSCO but used by the Concessionaire, or provide reimbursement to TRANSCO for any RPT assessment with regard to said real properties, throughout the Concession Period. The abovementioned undertakings, together with the Concession Fee, constitute the entire consideration for the award of the Concession. (2) Transfer of Transferable Assets On the Commencement Date, TRANSCO shall transfer to the Concessionaire, without separate consideration, title to all of TRANSCO's Transferable Assets, consisting of all tangible movable property owned by TRANSCO based on TRANSCO's general plant equipment register, including but not limited to all vehicles, helicopter, furniture, furnishings, goods, inventory, spare parts, chattels, machines, and equipment, and all warranties and guaranties relating thereto based on the TRANSCO Asset Register of personal property. Transferable Assets exclude the Transmission Grid, Documented Property Rights and real property. 16 (3) Assignment of Intellectual Property Rights TRANSCO shall take all necessary measures, at the Concessionaire's expense, to authorize the Concessionaire to use all of TRANSCO's intellectual property rights during the Concession Period, including intellectual property rights associated with New Projects. 17 (4) Sale of Subtransmission Assets TRANSCO shall be entitled to dispose of subtransmission assets in accordance with Section 8 of the EPIRA and retain the proceeds thereof. In such an event, the Concession Fee shall be reduced by an amount equal to the reduction in value of TRANSCO's assets that the ERC requires to be made as a result of the disposal of subtransmission assets after the Commencement Date. 18 (5) Termination Date, Reversion of the Business to PSALM and Concessionaire's Receipt of Recovery Payment On Termination Date, which is the date specified under a Termination Notice or the date of expiration of the Concession Period, the Concessionaire's business shall revert to PSALM or its designee as a going concern. 19 PSALM shall remit to the Concessionaire on the Transfer Date, the Recovery Payment computed based on the formula stipulated in the DCA. 20 II. MATTERS ON WHICH RULING IS REQUESTED In connection with the above representations, the following are submitted for confirmation, to wit: (1) TRANSCO is not subject to income tax, withholding tax and VAT on the Concession Fee, and on the other costs and expenses that the Concessionaire will incur on behalf of TRANSCO, all in consideration for the award of the Concession. No VAT should be passed on to the Concessionaire. (2) TRANSCO is not subject to income tax and VAT on its transfer of title to the Transferable Assets and assignment of Intellectual Property Rights to the Concessionaire pursuant to the award of the Concession. (3) TRANSCO is not subject to income tax and VAT on the disposal of the subtransmission assets. (4) The Concessionaire is subject to VAT on its operation of the transmission business and any Related Business during the Concession Period. (5) The Concessionaire is not subject to VAT on the Recovery Payment it will receive from PSALM or its nominee upon the reversion of the transmission business to the latter. III. BIR REPLY In reply, this Office hereby confirms, as follows: (1) TRANSCO is not subject to income tax, withholding tax and VAT on the Concession Fee, and on the other costs and expenses that the Concessionaire will incur on behalf of TRANSCO, all in consideration for the award of the Concession, and that no VAT should be passed on to the Concessionaire. Income Tax Section 32(B)(7)(b) of the Tax Code, expressly excludes from gross income, the income derived from any public utility or from the exercise of any essential governmental function accruing to the Government of the Philippines. In this connection, we note that TRANSCO is a public utility, as it has succeeded to NPC's franchise. 21 Moreover, the privatization of TRANSCO, through the award of the Concession, is mandated under Section 21 of the EPIRA. 22 In BIR Ruling No. DA-108-04, March 9, 2004, we ruled that "all payments received by TRANSCO (Commencement Fee, Deferred Payments, including the Late Payment Penalty and interest, and Extension Deposit) pursuant to the Concession Agreement are excluded from gross income for income tax purposes and consequently, exempt from withholding tax." In the said ruling, we opined that: ". . . the privatization of the Transmission system, the award by PSALM in open competitive bidding, the transmission facilities, including grid interconnections and Ancillary Services, to a qualified party either through outright sale or a concession contract, and the remittance of the proceeds of such privatization to PSALM to pay off the outstanding obligations of the NPC are essential governmental functions." In the light of the foregoing, this Office is of the opinion and it hereby rules that the Concession Fee, and the costs and other expenses that the Concessionaire will incur on behalf of TRANSCO, which represent the entire consideration for the award of the Concession, fall within the ambit of "income derived from a public utility or from the exercise of essential governmental functions accruing to the Government of the Philippines" under Section 32 (B) (7) (b) of the Tax Code of 1997. Thus, the same shall be excluded from the gross income of TRANSCO and exempt from income tax and withholding tax. This tax exemption is consistent with the objective of the EPIRA of ensuring the reliability, security and affordability of the supply of electric power to end-users. In BIR Ruling No. DA-108-04 cited above, this Office noted that "the EPIRA provides that the privatization value to the National Government of the NPC assets, including the Transmission System that has been transferred to TRANSCO, must be optimized. The more proceeds that PSALM can generate from the privatization of the Transmission system, the more resources it has to liquidate NPC's stranded debts and stranded costs and consequently, the universal charge that will be imposed to end-users may be minimized. In the light of the intention of the law to ensure the affordability of electric power to end-users, income realized by TRANSCO from the privatization of the Transmission system which shall be remitted to PSALM should be optimized." Value Added Tax TRANSCO is also not subject to VAT on the concession fee received from the Concessionaire, and the cost and expenses that the Concessionaire will incur on behalf of TRANSCO. Section 108 of the Tax Code of 1997, as amended by Republic Act No. 9337, imposes VAT on the sale or exchange of services within the Philippines. For this purpose, the phrase "sale or exchange of services" means "the performance of all kinds of services in the Philippines for others for a fee, remuneration or consideration," including among others, sales of electricity by generation companies, transmission, and distribution companies; services of franchise grantees of electric utilities, telephone and telegraph, radio and television broadcasting and all other franchise grantees except those under Section 119 of the Tax Code. aEcTDI In this connection, Section 105 of the Tax Code provides: "SEC. 105. Persons Liable. Any person who, in the course of trade or business, sells, barters, exchanges, leases goods or properties, renders services, and any person who imports goods shall be subject to the value-added tax (VAT) imposed in Sections 106 to 108 of this Code. xxx xxx xxx The phrase 'in the course of trade or business' means the regular conduct or pursuit of a commercial or an economic activity, including transactions incidental thereto, by any person regardless of whether or not the person engaged therein is a non-stock, nonprofit private organization (irrespective of the disposition of its net income and whether or not it sells exclusively to members or their guests), or government entity." Pursuant to Section 108, in relation to Section 105 of the Tax Code of 1997, as amended by Republic Act No. 9337, TRANSCO became liable for VAT on its sale of electricity transmission services in the ordinary course of its trade or business. However, TRANSCO is not subject to VAT on the privatization through the award of the Concession, as it is not made in the ordinary course of trade or business of TRANSCO, following several BIR rulings discussed below. In BIR Ruling No. 006-97, January 17, 1997 concerning the privatization of the Manila Waterworks and Sewerage System (MWSS) by way of a concession, this Office held that: "(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 [now Section 105] Tax Code, as amended by R.A. 7716);" (Emphasis ours.) Furthermore, in BIR Ruling No. 020-02, May 13, 2002, concerning the tax consequences of the privatization of NPC assets, this Office held that: "A. Transfer of assets and liabilities of NPC xxx xxx xxx 2. NPC is not liable to franchise tax or VAT on the transfer of its assets to PSALM and TRANSCO. . . . since NPC is not a VAT-taxable entity and the transfer of its assets is not necessary to carry out its primary function as a utility and neither is it done in the course of its trade or business , such transfer shall not be subject to VAT (BIR Ruling No. 113-98 dated July 23, 1998)." xxx xxx xxx In the case of TRANSCO, we note that the privatization through the award of the Concession is an activity mandated by the EPIRA, in much the same way that the MWSS privatization was mandated by Executive Order No. 311 dated March 20, 1996. Moreover, by the award of the Concession, TRANSCO shall transfer to the Concessionaire the right and obligation, among others, to carry out the operation and maintenance of the transmission system. Consequently, TRANSCO will in fact cease the conduct of the transmission business for the duration of the 25-year Concession Period. Accordingly, this office confirms that the privatization of TRANSCO through the award of the Concession is a transaction which is not in the regular course of its trade or business of transmitting electricity to the public. Thus, it shall not be subject to VAT on the Concession Fee and on the costs and expenses that the Concessionaire will incur on behalf of TRANSCO, which constitute the entire consideration for the award of the Concession. Documentary Stamp Tax Incidentally, in case any Lease Agreement covering real property will be executed by PSALM/TRANSCO and the Concessionaire, the same shall be subject to DST pursuant to Section 194 of the Tax Code of 1997. (2) TRANSCO is not subject to income tax and VAT on its transfer of title to the Transferable Assets and assignment of Intellectual Property Rights to the Concessionaire pursuant to the award of the Concession . Consistent with Item No. 1 above, this Office confirms that TRANSCO's transfer of title to the Transferable Assets and assignment of Intellectual Property Rights to the Concessionaire will not give rise to income tax and VAT liability on the part of TRANSCO. The said transfer and assignment are necessary consequences of the privatization through award of the Concession and are undertaken without a separate consideration to be paid to TRANSCO. (3) TRANSCO is not subject to income tax and VAT on its disposal of the subtransmission assets. Income tax The exemption of TRANSCO from income tax is not limited to the sale of Transmission services but includes transactions incidental to and necessarily connected with the operations of the public utility, such as a sale or transfer of the subtransmission assets. This Office has already ruled in BIR Ruling No. DA-108-04, March 9, 2004, that TRANSCO's income from the disposal of the subtransmission assets is exempt from income tax. Value Added Tax Like the privatization of the transmission system through the award of the Concession, the disposal of the subtransmission assets will be undertaken by TRANSCO not in the ordinary course of its trade or business, but in accordance with the mandate of the EPIRA. Section 8 of the EPIRA provides: xxx xxx xxx "The subtransmission functions and assets shall be segregated from the transmission functions, assets and liabilities for transparency and disposal: Provided, That, the subtransmission assets shall be operated and maintained by TRANSCO until their disposal to qualified distribution utilities which are in a position to take over the responsibility for operating, maintaining, upgrading, and expanding said assets. . . . TRANSCO shall negotiate with, and thereafter, transfer such functions, assets , and associated liabilities to the qualified distribution utility or utilities connected to such subtransmission facilities not later than two (2) years from the effectivity of this Act or the start of open access, whichever come earlier. . . " As such, this Office confirms that TRANSCO shall not be subject to VAT upon its disposal of the subtransmission assets. IECcAT Documentary Stamp Tax Any disposal of subtransmission assets constituting real property shall be subject to DST pursuant to Section 196 of the Tax Code of 1997. (4) The Concessionaire is subject to VAT on its operation of the transmission business and any Related Business during the Concession Period. Under Section 108 of the Tax Code, as amended by Republic Act No. 9337, the sale of services within the Philippines, including the sale of electricity by generation companies, transmission, and distribution companies, is subject to VAT. Considering that with the award of the Concession, the Concessionaire will take over from TRANSCO the operation of the transmission business, and will have the right to undertake any Related Business, this Office confirms that in the absence of an express exemption or a contrary provision under its legislative franchise, the Concessionaire shall be subject to VAT on its operation of the transmission business and any Related Business during the Concession Period. (5) Finally, the Concessionaire is not subject to VAT on the Recovery Payment it will receive from PSALM or its nominee upon the reversion of the transmission business to the latter. In BIR Ruling No. 006-97, January 17, 1997 pertaining to the MWSS privatization, this Office has ruled that the return by the Concessionaires of the assets to MWSS at the end of the concession period is not subject to VAT, to wit: ". . . 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. (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 [now, Sec. 105], Tax Code, as amended by R.A. 7716); xxx xxx xxx (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 [now, Sec. 105] of the Tax Code, as amended; xxx xxx xxx (9) The transfer to MWSS at the end of the concession 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 [now, Sec. 105] of the Tax Code, as amended; xxx xxx xxx (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 [now, Sec. 105] of the Tax Code as amended; . . . ( Emphasis ours. ) In the above ruling issued to the MWSS, all the bilateral transfers by the parties as consideration for, and specified under, the Concession Agreements are not subject to VAT because they are not made in the ordinary course of trade and business but only in compliance with the Concession Agreements and the governing law mandating privatization. In the same manner, this Office confirms that the reversion to PSALM or its nominee of the transmission business and corresponding receipt by the Concessionaire of the Recovery Payment from PSALM or its nominee, all in accordance with the Concession Agreement and the EPIRA, is not subject to VAT because the reversion of the transmission business is not a transaction in the ordinary course of trade or business of the Concessionaire. cESDCa This ruling is being 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 as null and void. Very truly yours, (SGD.) JOSE MARIO C. BUAG Commissioner of Internal Revenue Footnotes 1. Section 2, paragraphs (c), (d), (f) and (i), EPIRA. 2. Sections 2 (i), 7 to 8, 21, 32, 38, 47 and 56, EPIRA. 3. Clause 2.03, DCA. 4. Clause 6.01 and Clause 6.04 in relation to Schedule 6, DCA. 5. Clause 6.02, DCA. 6. Clause 6.03 in relation to Schedule 5, DCA. 7. Clause 5.01, DCA. 8. Clause 2.01, DCA. 9. Clause 3.03, DCA. 10. Clause 5.04, DCA. 11. Clause 5.06, DCA. 12. Clause 4.02, DCA. 13. Clause 5.02.c and d, Draft Construction Management Agreement as of August 18, 2006. 14. Clause 5.02, DCA. 15. Clause 9, DCA. 16. Clause 4.03, DCA in relation to Clause 1.02, Draft Deed of Transfer as of August 18, 2006. 17. Clause 4.05, DCA. 18. Clause 5.03 in relation to Schedule 6, DCA. 19. Clause 15.01, DCA. 20. Clause 15.06, DCA. 21. BIR Ruling No. DA-088-01, May 16, 2001; BIR Ruling No. 020-02, May 13, 2002. 22. TRANSCO Privatization. Within six (6) months from the effectivity of this Act, the PSALM Corp. shall submit a plan for the endorsement by the Joint Power Commission and the approval of the President of the Philippines. The President of the Philippines thereafter shall direct PSALM Corp. to award in open competitive bidding, the transmission facilities, including grid interconnections and ancillary services to a qualified party either through an outright sale or a concession contract. The buyer/concessionaire shall be responsible for the improvement, expansion, operation, and/or maintenance of its transmission assets and the operation of any related business. The award shall result in maximum present value of proceeds to the national government. In case a concession contract awarded, the concessionaire shall have a contract period of twenty-five (25) years, subject to review and renewal for a maximum period of another twenty-five (25) years. . . .