Interest Expense on Loan Accrues, and Allowable as Deduction, Only when Liability to Pay is Fixed

September 13, 2004 BIR RULING NO. 012-04 RR 12-01 00-000 Kuok Philippine Properties, Inc. Level 5, Shangri-La Plaza Mall EDSA corner Shaw Boulevard Mandaluyong City Attention: Atty. Federico G. Noel, Jr. Corporate Legal Counsel Gentlemen : This refers to your letter dated October 15, 2003 requesting a ruling on the various issues relative to the amendment of the loan agreement and the deferment of the interest payment until the maturity of the loan. It is represented that Kuok Philippine Properties, Inc. (KPPI), is a publicly listed company incorporated in the Philippines. On the other hand, Rhinestone Limited (Rhinestone) is a company incorporated in Malaysia. Sometime in 1999, KPPI issued Certificates of Bonds (unsecured) with a total face value of US$50 million to Rhinestone which matured on January 29, 2002. KPPI prepaid US$12.5 million, leaving a balance of US$37.5 million. In the year 2002, KPPI and Rhinestone converted the bond into a secured long-term loan, with the total principal in the amount of US$62.5 million. The interest rate on the loan is seven percent (7%) per annum payable quarterly as provided under the Loan Agreement ("Agreement"). Unfortunately, KPPI's financial condition has not been favorable. Consequently, KPPI intends to request Rhinestone to amend the loan agreement and ask for the deferment of the interest payment until the maturity date of the loan. If Rhinestone agrees to this proposal, KPPI will record the interest expense in its books for financial accounting purposes but will not claim the expense as deduction for income tax purposes in the year recorded in the books. On the contrary, if Rhinestone will not be agreeable to the above arrangement, KPPI intends to ask Rhinestone for an alternative option involving the waiver of the interest for the first three (3) years of the loan. The charging of the interest will resume on the 4th and 5th year. DTCSHA Based on these representations, you now request a ruling on the following: 1. If the loan agreement, as amended, provides that the interest on the loan will be due upon the maturity date of the loan, will KPPI be subject to Final Withholding Tax (FWT) before the date of maturity even if the interest are accrued for financial accounting purposes on a quarterly basis? If not, when would KPPI be liable to the FWT?; 2. If Rhinestone agrees to the alternative option, i.e. , waiving the interest in the first three (3) years, when would KPPI be required to withhold FWT?; and 3. Since the interest on the loan will be paid within the 4th and 5th year, respectively, can KPPI be allowed to claim the interest paid during these years as deduction against the taxable income? In reply thereto, please be informed that Section 2.57.4 of Revenue Regulations 12-01 provides that the obligation of the payor to deduct and withhold the tax arises at the time an income payment is paid or payable, or the income payment is accrued or recorded as an expense in the payor's books whichever comes first. The term "payable" refers to the date the obligation becomes due, demandable or legally enforceable. Where the income is not yet paid or payable but the same has been recorded as an expense in the payor's book, the obligation to withhold shall arise in the last month of the return period in which the same is claimed as an expense or amortized for tax purposes. In short then, the obligation to withhold arises at the time the expense is paid, becomes due or is accrued in the books as an expense, whichever comes first. On the other hand, Section 34(B)(1) of the Tax Code of 1997 provides that the amount of interest paid or incurred within the taxable year on indebtedness in connection with the taxpayer's profession, trade or business shall be allowed as deduction from gross income, provided, however, that the taxpayer's otherwise allowable deduction for interest expense shall be reduced by an amount equal to 38% of interest income subject to final tax. As to when an expense is considered incurred for tax purposes, the U.S. Rules which have persuasive effect on Philippine Law, as specifically provided under paragraph 3 of Section 12A:51 of MERTENS' Law of Federal Income Taxation states as follows: "For a taxpayer on the accrual method, the question becomes when do the facts present themselves in such a manner that the taxpayer must recognize income or expenses. The accrual of income or expenses is permitted when the all-events test has been met. The all-events test requires: (1) fixing of a right to income or liability to pay; and (2) the availability of the reasonably accurate determination of such income or liability." The first element requires that a taxpayer's right to receive amounts in income be fixed by looking initially to the nature of the taxpayer's right to income. Generally, the taxpayer's right to receive amounts of income cannot be fixed before the time another becomes obligated to pay the income. It further requires that income accrues to the taxpayer when there arises a fixed and unconditional right to the receipt of a sum certain, even though actual payment is to be deferred. Anent the second element, the same requires that the amount of the income or liability be determined with reasonable accuracy. However, the all-events test does not demand that the amount of income or liability be known absolutely, only that a taxpayer has at his disposal, the information necessary to compute the amount with reasonable accuracy. It would also suffice where the computation remains uncertain, if its basis is unchangeable; the test is satisfied where a computation may be unknown within the taxable year. The principle of all-events test has been applied by the Courts in determining when an expense may be accrued for tax purposes. In CTA Case No. 4844 dated June 7, 1996 ( Paramount Insurance Corporation vs. Commissioner of Internal Revenue ), the CTA ruled that under the accrual method of accounting, business expenses are deductible when the taxpayer becomes liable for them, whether or not they are paid in the same year. All the events that set the amount of the liability must have happened (including, when appropriate, economic performance), and the taxpayer must be able to figure the amount of expenses with reasonable accuracy. (Mertens, Law of Federal Income Taxation, Vol. 6, 25.20). The propriety of an accrual must be judged by the facts that a taxpayer knew, or could reasonably expected to have known, at the closing of its books for the taxable year. cACTaI Thus, the CTA ruled that the miscellaneous expenses incurred by the officers of the petitioner are deductible when the latter becomes liable for them. The petitioner is liable only when a particular officer asked for reimbursement since it is only then that such an expense can be accrued and eventually can be taken into petitioner's account. It is impossible for a taxpayer to recognize an expense without knowing its occurrence. Hence, although the receipts pertain to 1985, the same only accrue in 1986, the time when the petitioner acquire knowledge of its liability to pay for expenses not reimbursed by its officers towards the end of 1985. Moreover, in Sime Darby Pilipinas, Inc. (formerly Sime Darby International Tire Co., Inc.) vs. CIR , CTA Case No. 4448 dated August 8, 1994, the Court explained that if the taxpayer is on the accrual basis, for the purposes of determining deductions, it is necessary that there be a definite fixed liability (Law of Federal Income Taxation, Mertens, Vol. 4A, par. 25.10). In order to be accruable in the taxpayer year, a valid obligation upon which the profit (or loss in the case of the deduction) is to be determined must have existed in the year in which the obligation became binding or enforceable. As the CTA ruled, the petitioner cannot accrue its long distance calls at the time they were actually made. It would be impractical for the petitioner to claim as deductible expense the mere estimate of the costs of the long distance calls it has made. Hence the obligation on the part of the petitioner to pay or expend money which constitutes a deductible loss did not occur until it received from the telephone company the demand to pay a definite fixed amount representing the costs of the long distance phone calls made. With these representations, it is clear that an expense will only be considered accruable for tax purposes if there is a definite fixed liability and a reasonable estimate of the said liability. In the case at hand, it is worthy to note that the interest will be due and demandable from KPPI only at the date of the maturity or at the 4th and 5th year. Although, the liability attributable to the earlier years of the loan may be reasonably estimated, the all-events test requires that there be a determination of pay in order to warrant an accrual for tax purposes. ATcEDS In view of all the foregoing, this Office believes that the interest expense of KPPI on its loan from Rhinestone should be accrued for tax purposes only when the liability to pay such interest is fixed, that is, at the maturity date or at the 4th and 5th year. Consequently, it is also within this period that such expense will be allowed as deduction in the books of KPPI assuming the said expense is subjected to FWT pursuant to the requirement of Section 2.58.5 of Revenue Regulations No. 2-98, to wit. "Any income payment which is otherwise deductible under the Code shall be allowed as deduction from the payor's gross income only if it is shown that the income tax required to be withheld has been paid to the Bureau in accordance with Section 57 and 58 of the Code." On the other hand, based on the same principles, should the loan agreement be amended such that interest will be due upon the maturity date of the loan, then KPPI will be liable for the FWT at that time. ADEaHT 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 null and void. Very truly yours, (SGD.) GUILLERMO L. PARAYNO, JR. Commissioner of Internal Revenue