Deductibility of Advance Payments Made by Lessee

October 3, 1969 BIR RULING NO. 011-69 Mr. Severino Boncaras 2326 Chromium Street Sta. Ana, Manila S i r : This refers to your letter dated June 20, 1969 requesting information on the following queries: llcd " Case I . Facts: Mr. X (lessor) and "A" Company (lessee) entered into a contract of lease, for a period of 20 years, on a parcel of land owned by the lessor on which the lessee shall construct a warehouse he needs for storing his copra purchases at a monthly rental of P200.00. Such lease was duly registered with the local register of deeds. Barring acts of God and Government, any other cause beyond the control of the lessor and non-payment, of the rents by the lessee, the lessee is assured of the continued use or possession of the land during the lifetime of the lease contract. The lease contract provides, among others, an advance rental equivalent to the rents for the first 5 years and the lessee paid lessor the amount of P12,000.00 in June 1969. Question: In the light of Section 30(a)(1) of the NIRC can the lessee, for income tax purposes, claim as outright deduction the amount of P12,000.00 in 1969 notwithstanding the fact that for financial accounting purposes he shall continue to amortize the prepayment during the period covered by the advance rental? "Case II. Facts: "A" Company owns as motor launch and sold it in June 1969 to Mr. A for P1,000 payable as follows P10,000.00 down payment and the balance P90,000.00 covered by 9 promissory notes at P10,000.00 each payable monthly beginning July 30, 1969 through March 1970. Please note that this is a casual sale and the property sold did not form part of the inventory of "A" Company. Question: Can "A" Company return as income from the sale in any taxable year that proportion of the installment payments actually received in that year which the gross profit realized or to be realized when payment is completed bears to the total contract price? If so, please cite applicable regulation prescribed by the Secretary of Finance to this effect." In reply thereto, I have the honor to inform you as follows: The deductibility of advance payments made by lessee depends on the nature of such payments. It is common to find in many a lease contract a stipulation which requires the lessee to make advance payment to the lessor at the time of execution of the lease. The advance payment may be either a loan to the lessor from the lessee, or an option money for the property, or a security deposit to insure the faithful performance of certain obligations of the lessee to the lessor, or pre-paid rental. If the advance payment is really a loan to the lessor, or an option money for the property, or a security deposit for the faithful performance of certain obligations of the lessee, the lessor realizes no taxable income in the year the advance payment is received. On the other hand, the lessee may not take a deduction for the advance payment. prcd But, if the advance payment is a security deposit and the condition which make the security deposit the property of the lessor occur, then the lessor realizes a taxable income to the extent of the security deposit and the lessee is entitled to a deduction to that same extent. (Estate of George E. Baker, 13 BTA 562) If the advance payment of P12,000.00 adverted to in your inquiry is, in fact, prepaid rental, then such payment is taxable income to the lessor in the year when received. And this is true even though the lessor is on the accrual or the cash method of accounting. (Hyde Park Realty, Inc. v. Commissioner, 211 P. 2d 232) The lessor in either case is required to include the entire amount of the advance rental in his gross income for the taxable period when such advance rental is received by him. It must be added, however, that prepaid rental is taxable to the lessor only if he received such advance rental under a claim of right and without restriction as to its use. (Renwick et al. vs. U.S., 87 F. 2d 123 (CCA 7th, 1938); Hort v. Commissioner, 313 U.S. 28, 85 L. Ed. 1168, 61 S. Ct. 757 (1941); Neils Schultz, 44, BTA 146; Edwin B. Degolia, 40 BTA 845; Warren Service Corp., 39 BTA 856; George E. Baker Estate, 13 BTA 562; 2 Mertens, Federal Income Taxation 171 1942) Otherwise, such advance rental is said to be apportioned over the term of the lease (O'Day Investment Co., 13 BTA 1230; Louis Rothenberg, 5 BTA 666; R.H. Hazlett, 10 BTA 332; Roby Realty Co., 19 BTA 696; A.T. Schiro, Inc. 30 BTA 1026; Douglas Properties, Inc. 21 BTA 347; William Penn. Hotel Co. 23 BTA 566; Michigan Central R.R. Co., 28 BTA 437; Allie M. Turbeville, 31 BTA 283; Crile v. Comm., 55 F 2d 804, and Jennings & Co., Inc. v. Comm., 59 F. 2d 32) Thus, it has been held that where payment to be applied to the rent for the last year of the term of the lease is made to the lessor upon the execution of the lease and is received under a present claim of full ownership and subject to his unfettered command, the payment is income to the lessor in the year of receipt even though certain circumstances a refund may be required. (2 Mertens, FIT, 172 n. 46 (1942) citing Hirach Investment Co., BTA Memo. Op., Dkt. 105492 (Oct. 6, 1942), aff'd 143 F. 2d 912 (CCA 2d, May 19, 1944). The mere possibility of a refund of an advance payment of rent, according to one case, does not affect its taxability. (Hirsch Investment Co., Supra) On the part of the lessee, such pre-paid rental for five (5) years in the total amount of P12,000.00 is to be treated as capital expenditure. He cannot deduct in the year of payment the full amount of the pre-paid rent as business expense. He must deduct them over the entire remaining term of the lease. This is true even though the pre-paid rent had been taxed in full to the lessor in the year of receipt. (see Pig & Whistle Co., 9 BTA 668; Main and Mckenney Building Co. v. Comm., 113 F. 2d 81) LLjur With regard to question No. 2, pertinent portion of Section 43 of the Tax Code as amplified by Section 174 of Revenue Regulations No. 2 is quoted hereunder as follows: "(b) Sales of realty and casual sales of personality . In the case (1) of a casual sale or other casual disposition of personal property (other than property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year), for a price exceeding one thousand pesos, or (2) of a sale or other disposition of real property, if in either case the initial payments do not exceed twenty-five per centum of the selling price, the income may, under regulations prescribed by the Secretary of Finance, be returned on the basis and in the manner above prescribed in this section. As used in this section the term 'initial payments' means the payments received in cash or property other than evidences of indebtedness of the purchaser during the taxable period in which the sale or other disposition is made ." (Emphasis supplied) Under the aforequoted provision of law, the income from a casual sale or other casual disposition of personal property (other than property of a kind which should property be included in inventory) may be reported on the installment basis only if (1) the sale price exceeds P1,000 and (2) the initial payments do not exceed 25% of the selling price. (see Sec. 174 Rev. Regs. No. 2) The term "initial payments" is defined in the statute to' mean payments received "in cash or property other than evidences of indebtedness of the purchaser during the taxable year in which the sale or other disposition is made." This term must not be equated with what is commonly called "down payment" because its meaning is much broader than that. (2 Mertens, Op. cit. supra , at 477.) While it covers any down payment made, it goes further and includes all payments actually or constructively received during the year of sale, (Gertrude H. Sweet, 8 BTA 404; Cortland Specialty Co., 22 BTA 808; Mamie E. Einig, 19 BTA 1105). And the aggregate of all such payments determines whether or not the limit which the law has set has been exceeded. Moreover, the term "initial payments" assumes that there must be more than one payment so as to qualify the transaction as a sale on the installment plan. Under the law, initial payments do not include notes or other evidences of indebtedness issued by the purchaser to the seller at the time of sale. However, this rule is not true in this case, where as represented by you, the 9 promissory notes executed at the time of sale are to be discounted and paid to the seller at P10,000.00 monthly beginning July 30, 1969. In fine, the transaction described in Case II of your query does not comply with all of the aforementioned statutory conditions or requirements (see Sec. 174, Rev. Regs. No. 2). For while the selling price of P100,000 is clearly in excess of P1,000, the aggregate initial payments in 1969 which is the year of sale consisting of a P10,000.00 down payment plus six of the 9 promissory notes covering the balance of P90,000.00 at P10,000.00 each payable monthly beginning July 30, 1969, or in the total amount of P60,000.00 as of December 31, 1969, is in excess of 25% of P100,000.00 the selling price of the motor launch. Such being the case, the seller "A" Company, cannot report its gain in this particular transaction on the installment basis. cdt Very truly yours, (SGD.) MISAEL P. VERA Commissioner of Internal Revenue