BIR Ruling No. 012-06

October 30, 2006 BIR RULING NO. 012-06 R.A. 8763; DA-050-2004; 026-2002; 7-2004 000-00 Home Guaranty Corporation 5th Floor, Welding Industries Building Sen. Gil J. Puyat Avenue, Makati City Attention: Mr. Gonzalo Benjamin A. Bongolan President Gentlemen : This refers to your letter dated July 5, 2005 requesting for confirmation of your position that BIR Ruling No. DA-050-2004 dated February 6, 2004 reiterating BIR Ruling No. 026-2002 dated June 7, 2002 still apply to your proposed new Home Guaranty Corporation ("HGC") Zero-Coupon Bonds, with regard to the tax treatment of the said bonds with face/maturity value of Twelve Billion Pesos (P12,000,000,000) to be issued by HGC to nineteen (19) or less investors. It is represented that in its meeting on June 20, 2005, the HGC Board of Directors has granted Management authority to issue new HGC Zero-Coupon Bonds; that the target issue date for this proposed new issue of HGC Zeroes is August 2005; and that HGC is proposing to issue the Zero-Coupon Bonds with the following salient features, to wit: TERMS OF THE PROPOSED HGC ZERO-COUPON BONDS ISSUE (The "HGC Zeroes") Issuer : Home Guaranty Corporation (HGC) Instrument : Zero-Coupon Bonds Form of the Issue : Scripless through RoSS of the Bureau of the Treasury (BTr) Underwriter/Arranger : Development Bank of the Philippines Registrar and : Bureau of Treasury ("BTr") Paying Agent Investors : Nineteen (19) or less Status of the Bonds : The Bonds shall constitute direct, unconditional obligations of Issuer Amount : PHP 12.0 Billion (Face/Maturity Value) Purpose : To finance the guaranty servicing requirements of HGC. Security : - Unconditional ROP guaranty on principal and interest obligations as provided for in Section 18(a) and (b) of RA 8763 : - Borrowings of the Corporation are secured by corporate assets. : - Establishment of a Debt Repayment or Sinking Fund (DRSF) with the BTr for payment of the face value upon maturity, to be built up over the term of the bond issue. HGC will remit an amount of not less than 40% of its projected annual ending cash balances starting on the second year and onwards to the DSRF. The amount equivalent to the maturity value shall have been fully remitted at least 6 months prior to maturity date. Eligibility : - Eligible as alternative compliance to Presidential Decree No. 717 or the Agri-Agra Law (BSP letter dated ________, 2005). - Eligible as Reserves for Trust and other Fiduciary Duties, when the remaining maturity of the bonds reaches three (3) years - Eligible as an alternative form of compliance with the balanced housing provision under the Urban Development Housing Act (UDHA) of 1992 as approved by the Housing and Land Use Regulatory Board (HLURB) (Board Resolution No. 782, Series of 2005) in its meeting of 20 July 2005. - Qualified as Admitted Asset or Reserve Investments of Insurance Companies (OIC letter dated ________, 2005) Issue Price : To be issued at a discount to par Mode of Offer : Dutch Auction Yield to Maturity : To be determined during auction subject to a yield ceiling of 80% of 7-year Bloomberg's MART 1 Rate. The aforementioned 7-year MART 1 Rate shall be set two (2) days before Issue Date. Tenor : Seven (7) years Principal Repayment : Full payment upon maturity AaCcST Taxes : - Interests or income from the HGC-Zero Coupon Bonds in excess of the weighted average of the tax exempt rate of 10.15% though not subject to the twenty percent (20%) withholding tax, shall nevertheless be taxable - All costs representing the documentary stamp tax in the original issuance of the HGC Zeroes at the rate of P0.30 for every P200.00 of the face value thereof, shall be for the account of the HGC. - The transfer, however, of the HGC-Zeroes bearer form in the secondary market by way of simple delivery to the buyer is not subject to a documentary stamp tax unless tax transfer thereof carries with it a renewal or issuance of new instruments in the name of the transferee to replace the old ones. (BIR Ruling No. 026-2002 dated June 27, 2002) - Trading gains shall be exempt from taxation. Ownership of the Bond : Title to the HGC Bonds passes by transfer and registration in the Registry of Scripless Securities (RoSS) maintained by the BTr. Persons appearing as registered owners in the RoSS shall be treated as the absolute owners of the relevant HGC Bonds for all purposes. Prospective investors who are not Government Securities Eligible Dealers (GSED) but wish to register legal title under their own names in the RoSS are advised to make the necessary arrangements with a GSED and the BTr for the opening of a RoSS sub-account. Issue Date: : September 2006 Maturity Date : September 2013 In reply, please be informed that BIR Ruling Nos. 026-2002 and DA-050-2004 still apply to the tax treatment of your proposed new HGC Zero-Coupon Bonds, particularly on the following: 1. Interest or income earned from the HGC Bonds (i.e., the discount to face value) up to the extent of the weighted average interest rate of 10.15% or below is exempt from the 20% final tax or income tax pursuant to Section 44 of the Implementing Rules and Regulations of the HGC . STcAIa As a rule, under Section 24 (B) (1), 27 (D) (1), 28 (A) (7) in relation with Section 22 (Y), all of the Tax Code of 1997, a final tax at the rate of twenty percent (20%) is imposed on "interest on any currency bank deposit and yield or any other monetary benefit from deposit substitutes and from trust funds and similar arrangements". In connection therewith, Section 2 (h) (iii) (b) of Revenue Regulations No. 17-84 considers all borrowings of the national and local government and its instrumentalities including the Central Bank of the Philippines (now Bangko Sentral ng Pilipinas), evidenced by debt instruments denoted as treasury bonds, bills, notes, certificate of indebtedness and similar instruments as "deposit substitutes" subject to the provision of Section 22 (Y) of the Tax Code which defines the term as follows: "The term "deposit substitutes" refers to alternative form of obtaining funds from the public (the term public means borrowing from 20 or more individuals 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. . . ." In the light of the aforecited Section 22 (Y) of the Tax Code, this Office has consistently opined that to be considered as "deposit substitutes" subject to twenty percent (20%) final withholding tax, the borrowing of funds must be obtained from twenty (20) or more individuals or corporate lenders at any one time. 1 The foregoing rule was subsequently modified by this Office in BIR Ruling No. 007-2004 dated July 16, 2004 where it was held that 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, and "accordingly, since government debt instruments and securities are not exempt from taxes, interest income derived therefrom shall be subject to the following: a) 20% final withholding tax imposed under Sections 24 (B) (1) and 25 (A) (2) of the Tax Code of 1997, if the bondholder is an individual citizen or a resident alien, respectively; b) 25% tax imposed under Section 25 (B) of the Tax Code of 1997, if the bondholder is a non-resident alien individual not engaged in trade or business within the Philippines; c) 20% final tax imposed under Sections 27 (D) (1) and 28 (A) (7) (a) of the Tax Code of 1997, for domestic and foreign corporations, respectively; d) 32% (now 35%) final withholding tax for nonresident foreign corporation under Section 28 (B) (1) of the Tax Code, if the bondholder is nonresident foreign corporation; and e) such other rates that may be imposed under the appropriate tax treaty to which the Philippines is a signatory." However, in the case of HGC Zeroes, this Office, in BIR Ruling No. 026-2002 dated June 27, 2002, citing Section 19 of the HGC Charter which reads as follows: "SEC. 19. Tax Exemption . Interests and yields earned or accumulated on mortgage, debentures, bonds, notes, mortgage and asset-backed securities, interest under lease, and other credit instruments, whether issued by the Corporation or covered by its guaranty in favor of natural or juridical person, in cash or in bonds, shall be exempt from all taxation to the same extent provided in Section 15(a) hereof: Provided, however , That the Corporation shall have the authority to increase the limit of such exemption in such varying amounts as shall be reflective of the social concerns of the State; Provided, further , That the exercise of said authority shall be subject to the approval of the President of the Philippines upon the recommendation of the Monetary Board of the Bangko Sentral ng Pilipinas; Provided, finally , That the Corporation shall not exercise such authority more than once every five (5) years. had ruled that interests and yields earned or accumulated on mortgage, debentures, bonds, notes, mortgage and asset-backed securities, interest under a lease, and other credit instruments, whether issued by the HGC or covered by its guaranty in favor of natural or juridical person, in cash or in bonds, shall be exempt from all taxation up to the extent of the weighted average interest rate of 10.15% as implemented by Article 44 of the Implementing Rules and Regulations of the HGC Charter which provides for the computation of the extent of tax exemption on the interest or yield earned for corporate borrowing to be utilized for capital formation purposes. In view of the 10.15% weighted average limit on interest income earnings, this Office likewise ruled to the effect that the HGC Zeroes bonds, whether issued by HGC or covered by its guaranty in favor of natural or juridical person, shall not be subject to the applicable ordinary income tax because HGC Zeroes were not classified as deposit substitutes as the borrowing of funds was obtained from less than twenty (20) investors. Neither will the interest income on HGC Zeroes, to the extent of 10.15% and below, be subject to 20% final tax because of the tax exemption provision of Sec. 19 of the HGC Charter. Accordingly in relation with Sec. 19 of the HGC Charter, interest income on HGC Zeroes shall still be exempt from the final withholding tax imposed on deposit substitutes at the rates so prescribed under the pertinent provisions of the Tax Code of 1997, as amended, and as ruled in BIR Ruling No. 007-2004, provided that the extent of the utilization of such fund shall not exceed the 10.15% weighted average limit. Moreover, it shall also be exempt from ordinary income tax prescribed in Secs. 24 (A) (1) (C), 27 (A) and (E), 28 (A) (1) and (2), for individual, domestic and resident foreign corporations, respectively, subject to the 10.15% weighted average limit. aEAIDH 2. Interest or income earned from the HGC Bonds in excess of the weighted average interest rate of 10.15% is subject to the 20% final withholding tax imposed by Section 27 (D) (1) of the National Internal Revenue Code . In the light of BIR Ruling No. 007-2004, supra , HGC Zeroes are now considered deposit substitutes. However, the 20% final tax rate imposed under Secs. 24 (B) (1), 27 (D) (1) and 28 (A) (7) (a) of the Tax Code of 1997, as amended, shall apply only in the interest income earned in excess of the 10.15% weighted average threshold. Furthermore, such interest income shall be subject to the following, to wit: a) 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; b) 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; c) 35% final withholding tax prescribed under Sec. 28(B)(1) of the Tax Code of 1997, as amended, for nonresident foreign corporation. Provided that effective January 1, 2009, the rate of income tax shall be thirty percent (30%); and, d) Such other rate that may be imposed under the appropriate tax treaty to which the Philippines is a signatory. 2 3. Gains arising from the sale or transfer of the HGC Zeroes in secondary market is exempt from income tax pursuant to Section 32 (B) (7) (g) of the Tax Code of 1997 . On the matter of whether gains realized from the sale or transfer of bonds in the secondary market is exempt from income tax, this Office has consistently ruled that "gains from the sale, exchange, or retirement of bonds with maturity of more than five (5) years, shall be exempt from income tax as provided for under Section 32 (B) (7) (g) of the Tax Code of 1997," 3 the pertinent portion of which reads as follows: "(g) Gains from the sale of bonds, debentures or other certificates of indebtedness . Gains realized from the sale or exchange or retirement of bonds, debentures or other certificate of indebtedness with a maturity of more than five (5) years" shall not be included in gross income and shall be exempt from taxation. Since the proposed new HGC Zero-Coupon Bonds have a tenor of 7 years, any gain realized from its sale or exchange or retirement is excluded from the gross income; hence, exempt from income tax pursuant to the above-cited Section 32 (B) (7) (g) of the Tax Code of 1997. For this purpose, the term "gain" shall refer to the gain, if any, from secondary trading which is the difference between the selling price of the bonds in the secondary market and the price at which the bonds were purchased by the seller. The term "gain" shall also include the gain (that is, the difference between the proceeds from the retirement of the bonds and the price at which such last holder acquired the bonds) realized by the last holder of the bonds when such bonds are surrendered for retirement upon their maturity. 4 For a discounted instrument, it is worthy to note that trading gains arise only when the instrument is sold above par. Otherwise stated, " trading gains " shall be the excess of the selling price over the par value or book value of the instrument. For this purpose, par value of the HGC Zeroes is the adjusted value which consists of the original purchase price plus the accumulated discount from the time of purchase up to the time of sale. 5 4. The discount, that is, the difference (or gain) between the price paid for by the original investor and the eventual amount that the investor will receive upon the retirement or redemption of the HGC Zeroes is likewise exempt from income tax pursuant to Section 32 (B) (7) (g) of the Tax Code of 1997 which states that "gains arising from sale, exchange or retirement of bonds, debentures or other certificate of indebtedness with maturity of more than five (5) years are excluded from the computation of gross income . CIaHDc As cited above, Section 19 of the HGC Charter provides that interests and yields earned or accumulated on mortgage, debentures, bonds, notes, mortgage and asset-backed securities, interests under lease, and other credit instruments, whether issued by the Corporation or covered by its guaranty in favor of natural or juridical person, shall be exempt from all taxation provided that the extent of utilization of such fund shall not exceed the 10.15% weighted average as provided in Article 44 of the Implementing Rules and Regulations. 6 Thus, as earlier ruled, under the foregoing Section 19 of the HGC Charter the interests and yield on HGC Zeroes are exempt from all taxation up to the extent of the weighted average interest rate of 10.15% as implemented in Article 44 of the Implementing Rules and Regulations of the HGC Charter. On the other hand, Section 32 (B) (7) (g) of the Tax Code of 1997, as amended, exempts from income tax the gains derived from sale, exchange or retirement of bonds, debentures and other certificate of indebtedness with maturity of more than 5 years. The provision of Section 32 (B) (7) (g) of the Tax Code of 1997 does not limit the exclusion of gain or income derived from the sale or exchange or retirement of the bond only to those derived by a subsequent holder. Absent such qualification, no distinction should be read into the law. Where the law provides no qualification for the grant of tax exemption, the court is not at liberty to supply one. 7 As earlier defined, the term "gain' shall also include the gain (that is, the difference between the proceeds from the retirement of the bonds and the price at which such last holder acquired the bonds) realized by the last holder of the bonds when such bonds are surrendered for retirement upon their maturity. 8 Thus, the original issue discount on HGC Zeroes may qualify for special treatment such that, it (the difference between the issue price and par) may be treated as tax-exempt income rather than capital gain, if the bonds are held to maturity. Accordingly, the interest income including the original issue discount that the investor will receive upon the retirement or redemption of the HGC Zeroes is exempt from income tax pursuant to Section 32 (B) (7) (g) of the Tax Code of 1997, provided the extent of utilization of the fund shall not exceed the 10.15% weighted average limit. The issue at hand is whether the amount discounted may be considered gain in the absence of any secondary trading on the part of the original investor, such that it shall be excluded from the computation of the taxable gross income. It is noted that HGC Zeroes shall be issued at a discount. Being a zero coupon bond, it is expected that no periodic interest payments shall be made. In this case, the investor will receive one payment at maturity. As a rule, the maturity value an investor receives is equal to the principal invested plus interest earned compounded semi-annually at the original interest rate to maturity. On the other hand, the possibility that some investors may hold the bonds to maturity contemplates a scenario that the only "gain" that such investor may derive is the discount itself. For this purpose, the term "discount" is defined as follows: "Discount The word "interest" in the Code includes "discount". When state or municipal securities are issued at a discount, amounts representing the discount received by the holder either upon the redemption or sale of the securities are tax-exempt as being equivalent to interest. As between successive holders of a tax-exempt municipal bond, the original issue discount which is tax-exempt is apportioned of the basis of the time each of the holders held the bond. The remainder of the proceeds is treated as the amount realized on the redemption or sale for the purpose of determining gain or loss. 9 Assuming that the utilization of HGC Zeroes is in excess of the 10.15% weighted average, the interest and yield earned or accumulated therefrom, including the original issue discount, shall be treated as passive income subject to the final tax rates first mentioned in Item 2 of this Ruling. 10 5. The sale or transfer of the HGC Zeroes in the secondary market is exempt from documentary stamp tax . The original issuance of the HGC Zeroes shall be subject to DST at the rate of P0.30 for every Two hundred Pesos (P200.00) or fractional part thereof of their face value pursuant to Section 180 of the Tax Code of 1997, as amended. Finally, the transfer of HGC Zeroes in bearer form in the secondary market by way of simple delivery to the buyer is not subject to the DST unless the transfer of the instruments carries with it a renewal or issuance of new instruments in the name of the transferee to replace the old ones. 11 This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it shall be disclosed that the facts are different, then this ruling shall be considered null and void. Very truly yours, (SGD.) JOSE MARIO C. BUAG Commissioner of Internal Revenue Footnotes 1. BIR Ruling No. 020-2001 dated May 31, 2001. 2. BIR Ruling No. 017-2002 dated April 29, 2002. 3. BIR Ruling Nos. 017-2001 dated April 29, 2002 and BIR Ruling No. 035-2001 dated August 16, 2001. 4. BIR Ruling No. 035-2001 dated August 16, 2001. 5. BIR Ruling No. 050-2001 dated October 29, 2001. 6. supra . 7. Republic Flour Mills, Inc. vs. Commissioner of Internal Revenue , 31 SCRA 520. 8. BIR Ruling No. 035-2001 dated August 16, 2001. 9. Mertens, The Law of Federal Taxation, Section 8.07, Vol. 1, Chapter 8, pp. 22-24. 10. Supra. 11. BIR Ruling No. 050-2001 dated October 29, 2001 and BIR Ruling No. 035-2001 dated August 16, 2001.