BIR Ruling No. 011-09

June 1, 2009 BIR RULING NO. 011-09 Sec. 34; 000-00 TeaM Energy Corporation TeaM Sual Corporation CTC Building, Roxas Boulevard Pasay City Attention: Kazunobu Takijima Vice President, Controller Gentlemen : This refers to your letter dated April 27, 2009 requesting for a ruling that the foreign exchange losses of TeaM Energy Corporation (TEC) and TeaM Sual Corporation (TSC) arising from the payment of loans for the period of January to July 2006, pre-termination of their foreign currency debt, and other foreign exchange losses from notes payable, inter-company payment and interest payments realized in 2006 are deductible expense from their gross income for tax purposes. It is represented that TEC and TSC Secured US Dollar currency denominated loans to finance the construction of their respective power generation plant facilities in years 1993 to 1996 for TEC (Pagbilao) and 1996 to 2000 for TSC (Sual). During these periods, the Philippine Peso had a foreign exchange value of approximately Php26.00 and P39.5 against the US Dollar (USS), respectively. When the Philippine Peso suffered devaluation, TEC and TSC incurred heavy foreign exchange losses. Since these loans were obtained to finance the power generation plants, foreign exchange losses were capitalized as part of the power plants. These were subjected to depreciation, however, only the realized portion were claimed as tax deductions and unrealized portion was treated as non-deductible expense and shown as reconciling item for income tax purposes. This practice was in compliance with Statement of Financial Accounting Standards (SFAS) No. 8 and was consistent with the industry practice. It is also represented that beginning January 1, 2005, TEC and TSC adopted Philippine Accounting Standards No. 21, The Effects of Changes in Foreign Exchange Rates, (PAS No. 21). PAS No. 21 removed the option to capitalize foreign exchange differences resulting from severe devaluation or a depreciation of a currency against which there is no hedging. Under the Standard, such foreign exchange differences are now recognized in profit or loss in the period in which they arise. In 2006, the loans of TEC and TSC were pre-terminated and loan payments were made by TEC and TSC for the months of January to July 2006. As a result, TEC and TSC realized foreign exchange losses. Other foreign exchange losses arising from settlement of their notes payable, inter-company payment and interest payments were also sustained by TEC and TSC in 2006 and were recognized by the companies in profit or loss in 2006. HECTaA It is finally represented that TEC and TSC computed their tax liabilities using the historical rate method (Peso Books) until June 22, 2007, the date when the consortium of Tokyo Electric Power Company International B.V. and Marubeni Corporation completed the acquisition of all outstanding shares in Mirant Asia-Pacific Limited (now known as TeaM Asia Pacific Limited) of which TEC and TSC were then subsidiaries. Based on the foregoing, you now seek an opinion that, for tax purposes, the realized foreign exchange losses from the aforementioned transactions of TEC and TSC in 2006 are deductible expense from gross income of the companies. In reply, please be informed that when TEC and TSC adopted PAS 21 in 2005, the companies, in effect, adopted the use of functional currency in their financial statements. This is because the Standard requires an entity to prepare its financial statements using the functional currency. Section 2 of Revenue Regulations (Rev. Regs.) 6-06 defines the term "functional currency" as "the currency in which the reporting entity operates, that is, the currency of the environment in which an entity primarily generates and expends cash". The rule is an entity does not have a free choice of functional currency since it is dictated by the economic effects underlying transactions, events and circumstances relevant to the reporting entity. The use of functional currency other than Philippine Peso for financial recording and reporting purposes, however, does not mean the use of such functional currency for income tax purposes. Pursuant to Section 7 of the Rev. Regs., the income tax returns (ITRs) of taxpayers which have adopted functional currency (other than Philippine peso) in their financial statements and books of accounts shall still be prepared in Philippine pesos. Thus, all entries in the ITR shall be translated in Philippine pesos. In the case of TEC and TSC, the functional currency reflecting their economic environment is the U.S. Dollars. Concomitant with the first time adoption of the Standards is the requirement that financial accounting balances be restated in their functional currency. Following the accounting rules on translation and considering that in principle the retrospective restatement is required as if PAS 21 had always been applied, only gains or losses on the translated items (now stated in the entity's functional currency) may be allowed during the entity's initial adoption of PAS 21. For non-monetary items, the translated amount shall be treated in their historical cost and any gains or losses recognized at the date of change may be charged to equity. PAS 21 states thus: "Exchange differences arising on the settlement of monetary items or translating monetary items at rates different from those at which they were translated on initial recognition during the period or in previous financial statements shall be recognized in profit or loss in the period in which they arise. When a gain or loss on non-monetary items is recognized directly in equity, any exchange component of that gain or loss shall be recognized directly in equity. Conversely, when gain or loss on a non-monetary item is recognized in profit or loss, any exchange component shall be recognized in the profit or loss." It is noted that Section 17 of Rev. Regs. No. 6-06 requires that adoption of PAS 21 with respect to Income Tax Returns for 2005 is subject to the approval of the Securities and Exchange Commission (SEC), in case of corporations, or notification to the Bureau of Internal Revenue (BIR), in case of individual, of their qualification to use functional currency. Moreover, Section 3 thereof does not allow taxpayers to change functional currency in the middle of the year except in cases, of business combinations. While TEC and TSC adopted PAS 21 in 2005, it appears that they failed to secure the required approval from the SEC. Such being the case, it was only in 2006, that they were allowed to change and use US dollars as their functional currency in accordance with Rev. Regs. No. 6-06. Consistent with the above discussion, it was only in 2006 that their financial accounting balances have been restated to their functional currency. Accordingly, this Office hereby confirms that foreign exchange losses realized by TEC and TSC arising from settlement of their loans and other payables denominated in US dollars may still be allowed as deductions in 2006. In this regard, Section 34 (A) (1) (a) and (D) of the 1997 Tax Code provides that: "SEC. 34. Deductions from Gross Income. . . . there shall be allowed the following deductions from gross income: (A) Expenses (1) Ordinary and Necessary Trade, Business or Professional Expenses (a) In General There shall be allowed as deduction from gross income all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on or which are directly attributable to, the development, management, operation and/or conduct of the trade, business . . . . (D) Losses (1) In General Losses actually sustained during the taxable year and not compensated for by insurance or other forms of indemnity shall be allowed as deductions: . . ." TAacHE In BIR Ruling No. DA166-04 dated April 5, 2004, this Office ruled that a foreign exchange loss arises from foreign currency denominated liability when the transaction is closed and terminated by the payments of said liability. This ruling found support in the case of The Coca-Cola Export Corporation vs. CIR (CTA Case No. 5238, December 19, 1997), where the Court of Tax Appeals held that: "We find nothing ambiguous nor obscure in the language of Section 29 (d)(2) [now Section 34(A)(1)(a) and (D)] of the Tax Code, insofar as the same is brought to bear upon the circumstances of the petitioner in the case at bar. The provision itself furnishes the best means of its own exposition that all losses actually sustained during the taxable year not compensated by insurance or otherwise are deductible from gross income. It does not specify that the loss must be the result of transactions in the taxable year only. What the law requires is that the loss must be actually sustained in the taxable year and not compensated by insurance or otherwise. In other words, what is needed to be entitled to a loss deduction, is for the taxpayer to prove that a closed and completed transaction sets the loss in the taxable year or in the year claimed and it is not compensated by insurance or otherwise. A closed and completed transaction is one in which the facts indicate the transaction sufficiently final to ascertain that a loss has occurred (Mertens, Law of Federal Income Taxation, Chapter 28, Page 3). Thus, applying the latin maxim "Ubi lex non distinguit nec nos distinguere debemos", where the law does not distinguish, we should not distinguish, the loss which is the result of a foreign exchange fluctuation ascertained and realized during the taxable period and not compensated by insurance or otherwise, . . . , is deductible from gross income of said taxable period, albeit it may relate to transactions of prior years." Accordingly, this Office held that foreign exchange losses sustained as a result of devaluation of the Philippine peso vis--vis the foreign currency ( e.g., US dollar) are deductible from gross income for income tax purposes when the remittance of scheduled amortization consisting of principal and interest on the foreign loan has actually been made. It was further held that any realized foreign exchange losses arising from the decrease in the value of the Philippine Peso could be treated as an ordinary and necessary business expense. (BIR Ruling Nos. 144-85, 206-90 and 137-97, In BIR Ruling No. DA-175-2003 dated May 4, 2003) This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it will be ascertained that the facts are different, and/or any of the requirements imposed in this letter are not complied with, then this ruling shall be considered null and void. Very truly yours, (SGD.) SIXTO S. ESQUIVIAS IV Commissioner of Internal Revenue