Tax Treatment of Zero Coupon Bonds (HGC Zeroes)

June 27, 2002 BIR RULING NO. 026-02 Secs. 24 (B) (1), 27 (D) (1), 28 (A) (7), 22 (Y), 180 R.A. 8763 BIR Rulings, 017-2002, 020-2001, 035-2001, 050-2001 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 letters dated April 12, 2002, May 23, 2002, May 29, 2002, June 3, 2002, June 14, 2002 and June 18, 2002 requesting for opinion on the tax treatment of the zero coupon bonds ("HGC Zeroes") with face value of Seven Billion Pesos (P7,000,000,000) to be issued by Home Guaranty Corporation ("HGC") to nineteen (19) or less investors. It is represented that HGC (then Home Insurance and Guaranty Corporation created under R.A. No. 580, as amended) is a government-owned and -controlled corporation created pursuant to Republic Act No. 8763 entitled "Home Guaranty Corporation Act of 2000" (the "HGC Charter"); that it is mandated to undertake, in cooperation with the private sector, continuing nationwide housing program which will make available decent housing at affordable cost; that HGC is specifically authorized to issue bonds, debentures, collaterals, notes and other obligations; that the interests and yields earned or accumulated therefrom are exempt from all taxes under Section 19 of the HGC Charter, as implemented by Article 44 of its Implementing Rules and Regulations, only if the utilization of the proceeds of the bonds is within the allowable allocation or a rate equivalent to the weighted average of 10.15%; that Article 44 of the Implementing Rules and Regulations of the HGC Charter provides for the aforementioned weighted average rate of 10.15% as basis in the computation of the extent of tax exemption on the interest or yield earned for corporate borrowing to be utilized for capital formation purposes; that HGC is proposing to issue bonds ("HGC Zeroes"), the salient features of which are as follows: TERMS OF THE PROPOSED HGC ZERO-COUPON BONDS ISSUE (The "HGC Zeroes") Issuer : Home Guaranty Corporation (HGC) Form of Instrument : Zero-Coupon Bonds Registrar and : Bureau of Treasury ("BTr") Paying Agent Registry of Scripless Securities (RoSS) Sinking Fund Underwriters : First Metro Investment Corporation (Issue Manager and Lead Underwriter) and/or ABN-AMRO Bank, Inc. (Lead Arranger) Placement BDO Capital & Investment Corporation (Lead Underwriter) Agents Multinational Investment Bank Corporation (Co-Lead Underwriter) Status of the Bonds : The Bonds shall constitute direct, unconditional obligation of Issuer Issue Size : P5.0 Billion (Face Maturity Value) (with Green Shoe Option up to P2.0 Billion) Purpose : To finance the guaranty servicing requirements of HGC. Security : Unconditional ROP guaranty on principal and interest/yield obligations Sec. 18(a) of R.A. No. 8763. Borrowings of the Corporation are secured by corporate assets. Establishment of Debt Repayment or Sinking Fund with the BTr that will include payment of the principal upon maturity, to be built up over the term of the bond issue. HGC will remit an amount of no less than 40% of its projected annual ending cash balances starting the second year and onwards. The amount equivalent to the maturity value shall have been fully remitted at least six months prior to maturity date. Eligibility : Eligible as alternative compliance to Presidential Decree No. 717 or the Agri-Agra Law (BSP letter dated May 02, 2002). Eligible as Reserves for Trust and other Fiduciary Duties, when the remaining maturity of the bonds reaches three (3) years (BSP letter May 02, 2002). Eligible as an alternative form of compliance to the balanced housing provision under the Urban Development Housing Act (UDHA) of 1992 as approved by the Housing and Land Use Regulatory Board on April 17, 2002. Qualified as Reserve Investments of Insurance Companies (letter from Insurance Commission (IC) dated March 19, 2002. Issue Price : To be issued at a discount to par Rate Setting of : Through Dutch Auction Yield Yield to Maturity : Fixed with a price ceiling of 90% of 5-year FXTN Mart I. The aforementioned 5-year FXTN Rate Mart I as well as the auction shall be set two (2) days before Issue Date. (subject to final determination during auction) Participation : Minimum of P400M per bid Maximum of nineteen (19) investors Maturity Date : Five (5) years and (1) day from issue date Principal : Will be paid in full upon maturity Repayment Taxes : Section 5(f) of R.A. No. 8763 states that borrowings of HGC shall be exempt from all forms of taxation on interest and yields earned to the extent of 10.15% p.a. on the bonds. Target Auction : July 10, 2002 Date Target Issue Date : July 12, 2002 Bond Counsel : Picazo Buyco Tan Fider & Santos Law Offices For the Underwriters and/or Placement Agents that the proceeds of HGC Zeroes shall be utilized for the guaranty servicing of the existing obligation previously incurred and determined to have been utilized for capital formation purposes up to the extent of the weighted average of 10.15%;that the purpose of the bond flotation has been taken up with the Department of Finance, as disclosed in the letter of endorsement dated May 20, 2002 of Undersecretary Nieves L. Osorio of Corporate Affairs Group of the Department of Finance ("CAG-DOF"),and addressed to Ms. Ma. Cyd Tuao-Amador of the Department of Economic Research of the Bangko Sentral ng Pilipinas ("DER-BSP"),to wit: acCDSH "3. Findings "a. This Department supports the proposed flotation of HGC's P10 billion zero-coupon bonds as it will help restore HGC's credibility in the housing finance system. That credibility can only be restored if HGC is able to immediately settle its outstanding guaranty obligations to both the public and private sector. "b. In this Department's analysis of HGC's projected cash flows, different scenarios were reviewed to determine the appropriate level of bond issuance that would be able to meet HGC's guaranty obligations which at the same time ensuring the timely repayment of these zero-coupon bonds. "c. Based on our review, we found that the scenario wherein HGC would float P7.0 billion worth of zero-coupon bonds through auction [ First Metro Investments Corporation (FMIC) will fully underwrite P5.0 billion under firm commitment and the additional P2.0 billion will be the maximum amount that can be floated under the green shoe option ] and another P3.0 billion zeroes to be swapped with debenture bonds for servicing bond calls of government financial institutions (GFIs) as the most appropriate mode to satisfy HGC's outstanding guaranty claims to its creditors and meet bond maturities when due. (Findings and assumptions under this scenario is attached) "d. However, we also noted that HGC's cash flows are highly sensitive to the National Government's (NG) equity releases and on the capacity of HGC to dispose its acquired assets. Without such inflows, HGC will find it difficult to redeem the zero-coupon bonds when due and may trigger a call on the guaranty of the National Government. "e. Thus, to make the bond flotation viable, the following safeguards should be incorporated in the proposed bond flotation: Given that the underwritten commitment is only P5.0 billion, we can only allow up to maximum of P2.0 billion green shoe option to cap the issuance (through auction) at P7.0 billion. The remaining P3.0 [billion] zeroes should be swapped in exchange for GFI's unpaid outstanding guaranty calls with maturity of seven (7) years. Proceeds of the bonds should be used solely for the payment of outstanding unpaid cash guaranty calls and for servicing of outstanding debenture bond (accrued interest payments and principal redemption) A debt repayment fund for zero-coupon bonds shall be maintained and managed by the Bureau of Treasury, proceeds of which shall be used solely, for the redemption of the HGC Zero-coupon bonds. A similar fund to meet debenture bonds obligations should also be set up and managed by HGC. DOF shall monitor the performance of HGC using the approved cash flows (as agreed between HGC and DOF) as the basis of minimum performance targets. In addition to these safeguards, HGC shall be required to pay a 1% guaranty fee to the National Government on the zeroes that will be auctioned through the facilities of the Bureau of Treasury. that the Summary of Unpaid Guaranty Calls Re: Development Accounts as of May 31, 2002 shows the following: Account Principal Category % To Total Tax Weighted Total Per Exemption Average Category 1. Smokey Mountain 300,000,000 Socialized 5% 28% 11.0% 3.12% (PNB) 2. NGCHC 1,400,000,000 Socialized 23% 28% 11.0% 3.12% 3. Old Bilibid 300,000,000 Low-Cost 5% 44% 10% 4.41% Compound 4. Palawan 20,000,000 Low-Cost 0% 44% 10% 4.41% Muni-Bond 5. Imperial Homes 550,000,000 Low-Cost 9% 44% 10% 4.41% 6. Pabahay sa Riles 1,173,000,000 Low-Cost 20% 44% 10% 4.41% 7. FBC-Tahanan 600,000,000 Low-Cost 10% 44% 10% 4.41% 8. FBC-UCPB 599,904,440 Medium-Cost 10% 28% 9.5% 2.62% 9. Medicion Realty 38,283,274 Medium-Cost 1% 28% 9.5% 2.62% 10. Eagleridge I 121,000,000 Medium-Cost 2% 28% 9.5% 2.62% 11. Eagleridge II 892,668,260 Medium-Cost 15% 28% 9.5% 2.62% Open Housing 0% 0% 8.5% 0.00% Total 5,994,855,974 100% 100% 10.15% ======== that the plan to raise funds through the capital market is among the strategies being resorted to by HGC as an interim measure pending the release of equity infusion from the National Government as provided in HGC's new Charter; that HGC Zeroes will be offered through an Underwriting Syndicate with First Metro Investment Corporation as Issue Manager and Lead Underwriter; that HGC undertakes to issue HGC Zeroes to not more than nineteen (19) investors; that to ensure that this restriction is carried out and complied with, the minimum amount of each bid is Four Hundred Million Pesos (P400M);that the HGC Zeroes shall be registered with the Registry of Scripless Securities (RoSS) of the BTr; and, that no new bonds shall be issued in the name of the transferees in the secondary market. In reply, please be advised as follows: 1. The 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% is exempt from income tax pursuant to Section 19 of the HGC Charter, as implemented by Article 44 of the Implementing Rules and Regulations of the HGC. Section 19 of the HGC Charter reads as follows: "SEC. 19. Tax Exemption . 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, 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." The said Section provides 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, to wit: Type of Housing Guaranty Tax Exemption on Weighted Package Allocation Interest Income Average Socialized Housing 40.0% 11.0% 4.40% Low-Cost Housing 30.0% 10.0% 3.00% Medium-Cost Housing 20.0% 9.5% 1.90% Open Housing 10.0% 8.5% 0.85% TOTAL 100.0% 10.15% ====== ====== It is noted that HGC Zeroes shall be issued at a discount. 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 on 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." 1 Moreover, in the book, Financial Engineering: A Complete Guide to Financial Innovation ,it was discussed that: "Once one recognizes the identity of the present value and the future value formulations, it becomes unnecessary to distinguish between discount rates and interest rates. Indeed, in most areas of financial practice, we dispense with the distinction and simply refer to the two collectively as the yield." 2 xxx xxx xxx "Although the term interest rate is often used to decide the rate used to take monies forward in time, there really is no difference between a discount rate and an interest rate, and practitioners often use the term yield in lieu of either." 3 Thus, considering that discount, interest and yield may be used interchangeably, the income earned from the HGC Zeroes shall be entitled to the tax exemption under Section 19 of the HGC Charter as implemented by Article 44 of the Implementing Rules and Regulations of the HGC Charter. 2. Interest or income earned from the HGC Bonds in excess of the weighted average interest rate of 10.15% is exempt from the 20% final withholding tax imposed by Section 27 (D) (1) of the Tax Code of 1997, but subject to the ordinary income tax. As a rule, under Section 24 (B) (1),27 (D) (1),28 (A) (7) in relation to 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. 4 In this instance, there is a representation that HGC undertakes to issue HGC Zeroes to not more than nineteen (19) investors. Such being the case, the same shall not be considered as deposit substitutes falling within the purview of the above definition. Hence, the withholding tax on deposit substitutes will not apply. Nevertheless, a representation or warranty should be made to the effect that the bonds are acquired upon their original issuance by the original purchaser thereof, for and on its behalf, and that the purchaser is acquiring such bonds for its own account and not for the account of other entities that would in any manner circumvent the requirements of the law. Considering, therefore, that the interest or income earned from the HGC Zeroes up to the weighted average interest rate of 10.15% is exempt from income tax pursuant to Section 19 of the HGC Charter as implemented by Article 44 of the Implementing Rules and Regulations, only the excess thereof shall be subject to income tax, as follows: a) ordinary income tax at the schedular rate imposed under Section 24 (A) (i) (c) of the Tax Code of 1997, if the bondholder is an individual citizen or a resident alien; b) 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 of 1997; c) 25% tax imposed under Section 25 (B) of the Tax Code of 1997, if the bondholder is a nonresident alien individual not engaged in trade or business within the Philippines; d) corporate income tax of 32% or 2% minimum corporate income tax imposed under Section 27 (A) and 27 (E),and 28 (A) (1) and (2),respectively, of the Tax Code of 1997, for domestic and resident foreign corporations; e) 32% final withholding tax, for non-resident foreign corporation; and, f) such other rate that may be imposed under the appropriate tax treaty to which the Philippines is a signatory. 5 3. Gains arising from the sale or transfer of the HGC Zeroes in the secondary market are 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 are 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", 6 the pertinent portion of which reads as follows: "SEC. 32. Gross Income . (A) ... (B) Exclusions from Gross Income . The following items shall not be included in gross income and shall be exempt from taxation under this Title [on Income]: xxx xxx xxx (7) Miscellaneous Items . xxx xxx xxx (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." Since HGC Zeroes have a tenor of 5 years and 1 day, any gain realized from their sale or exchange or retirement is excluded from 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. 7 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, the 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. 8 4. Section 32 (B) (7) (g) of the Tax Code of 1997 exempts from income tax the gain realized from the redemption or retirement of bonds, as well as their sale or exchange in trade. The original issue discount does not fall within the purview of the term" gain" under the said Section. 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. In this instance, the HGC Zeroes shall be issued at a discount. Being zero coupon bonds, it is expected that no periodic interest payments shall be made thereon. Rather, the discount granted to the investor shall be amortized over the term of the bond. Section 32 (B) (7) (g) of the Tax Code of 1997 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. Thus, which it is clear that any gain from redemption or retirement of bonds will not be subject to income tax, there must, however, be a clear definition of what such gain would constitute. As earlier stated, the term "gain" shall 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. 9 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, the 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. 10 Therefore, the amount discounted from the face value of the HGC Zeroes that has been enjoyed by the original investor upfront and amortized over the term of such bonds shall not be understood to come within the meaning of the term "gain" as stated in Section 32(B)(7)(g) of the Tax Code of 1997. 5. The original issuance of the HGC Zeroes shall be subject to documentary stamp tax, while the sale or transfer thereof in the secondary market is exempt from documentary stamp tax. AaCTID The original issuance of the HGC Zeroes shall be subject to documentary stamp tax (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. 11 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. 12 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.) REN G. BAEZ Commissioner of Internal Revenue Footnotes 1. Mertens, The Law of Federal Taxation ,Section 8.07, Vol. 1, Chapter 8, pp. 22-24. 2. Marshall, John F. and Bansal, Vipul K., Financial Engineering: A Complete Guide to Financial Innovation, 1992 Edition, p. 68. 3. Ibid .,p. 78. 4. BIR Ruling No. 020-2001 dated May 31, 2001. 5. BIR Ruling No. 017-2002 dated April 29, 2002. 6. BIR Ruling Nos. 017-2002 dated April 29, 2002 and BIR Ruling No. 035-2001 dated August 16, 2001. 7. BIR Ruling No. 035-2001 dated August 16, 2001. 8. BIR Ruling No. 050-2001 dated October 29, 2001. 9. BIR Ruling No. 035-2001 dated August 16, 2001. 10. BIR Ruling No. 050-2001 dated October 29, 2001. 11. BIR Ruling No. 050-2001 dated October 29, 2001 and BIR Ruling No. 020-2001 dated May 31, 2001. 12. BIR Ruling No. 050-2001 dated October 29, 2001.