Tax Consequences of Proposed Loan by Morgan Guaranty Trust Co. to a Domestic Corporation

July 8, 1999 BIR RULING NO. 093-99 180, 34 RP-US Tax Treaty-000-00 093-99 Sycip Salazar Hernandez & Gatmaitan Attorneys-at-Law SyCipLaw-All Asia Capital Center 105 Paseo de Roxas 1200 City of Makati Attention: Attys . Ernesto S . Taio, Jr . and Carina C . Laforteza Gentlemen : This refers to your letter dated January 28, 1997 requesting on behalf of your client, Morgan Guaranty Trust Company of New York (MGT), for a ruling on the tax consequences of a proposed loan by MGT to a Philippine domestic corporation. It is represented that MGT (the "Lender") is a non-resident corporation incorporated in New York, United States of America; that it will enter into a US Dollar loan agreement with a Philippine domestic corporation (the "Borrower") payable at the end of three (3) years from the loan drawdown date; that the loan will have a fixed interest rate which shall be payable semi-annually in arrears by the Borrower; that however, the Lender will have the option to require the Borrower to prepay all interest due on the loan drawdown date; that if the Lender exercises such option and the Borrower prepays the interest, no further payments will be due under the loan agreement except for the payment of principal at the end of the three-year period; and that you are of the opinion that the foregoing transaction will have the following tax consequences, viz: "(a) The loan agreement will be subject to the documentary stamp tax at the rate of P0.30 on each P200.00, or fractional part thereof, of the principal amount of the loan pursuant to Section 180 of the National Internal Revenue Code, as amended (the "Tax Code") "(b) The Lender will be subject to income tax of 15% on its interest income on the loan pursuant to Article 12(2) of the Convention Between Government of the United States of America and the Government of the Republic of the Philippines With Respect to Taxes on Income (the "RP-US Tax Treaty"). Under Section 50(a) of the Tax Code in relation to Section 51(a), the income will be withheld by the Borrower upon payment of the interest either semi-annually or at the loan drawdown date if the Lender requires the Borrower to prepay the interest. "(c) On the part of the Borrower, its semi-annual interest payments will be deductible as business expenses for income tax purposes in the year such payments were made. If the Borrower prepays interest at loan drawdown date, the prepaid interest is deductible and should be amortized over the three-year period. In reply, please be informed as follows: 1). Pursuant to Section 180 of the Tax Code of 1997 (also then Sec. 180 of the Tax Code, as amended) there shall be collected a documentary stamp tax on loan agreements, including those signed abroad, of Thirty centavos (P0.30) on each Two hundred pesos (P200), or fractional part thereof, of the principal amount of the loan. Hence, the subject loan agreement, whether it shall be signed in the Philippines or abroad, is subject to documentary stamp tax at rate prescribed above. 2). Section 12(2) of the RP-US Tax Treaty provides that "Article 12 " INTEREST "(1) . . . "(2) Interest derived by a resident of one of the Contracting States from sources within the other Contracting State shall not be taxed by the other Contracting State at a rate in excess of 15 percent of the gross amount of such interest." Based on the above, the Lender shall be subject to income tax of 15% on its interest income on the loan. Consequently, the final tax of 15% shall be withheld by the Borrower upon payment of the interest, i.e., either semi-annually or at the drawdown date in case of prepayment, pursuant to Section 57(A) of the Tax Code of 1997 and should be remitted to the BIR through its Collecting Agents or Authorized Agent Banks subject to the conditions provided for in Section 58(A) of the same Code. 3) On the matter whether the interest payments made by the Borrower is a duly deductible expense, Section 34(B) of the Tax Code of 1997 provides as follows, viz; "SEC. 34. Deductions from Gross Income . Except for taxpayers earning compensation income arising from personal services rendered under an employer-employee relationship where no deductions shall be allowed under this Section other than under Subsection (M) hereof, . . ., there shall be allowed the following deductions from gross income: "(A) . . . "(B) Interest . "(1) In General . The amount of interest paid or incurred within a 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 the following percentages of the interest income subjected to final tax: "Forty-one percent (41%) beginning January 1, 1998; "Thirty-nine percent (39%) beginning January 1, 1999; "Thirty-eight percent (38%) beginning January 1, 2000. "(2) Exceptions . No deduction shall be allowed in respect of interest under the succeeding subparagraphs: "(a) If within the taxable year an individual taxpayer reporting income on the cash basis incurs an indebtedness on which an interest is paid in advance through discount or otherwise: Provided, further , That if the indebtedness is payable in periodic amortizations, the amount of interest which corresponds to the amount of the principal amortized or paid during the year shall be allowed as deduction in such taxable year : "xxx xxx xxx." ( Emphasis supplied ) It is clear from the foregoing provision that the interest paid by the Borrower is an allowable deduction from the gross income subject to the conditions thus imposed in the aforequoted Sec. 34 (B) (1) and (2) of the TC of 1997. In relation to this, Section 45 of the 1997 Tax Code provides the periods for which tax deduction and credits are to be taken, thus, "SEC. 45. Period for which Deductions and Credits Taken . The deductions provided for in this Title shall be taken for the taxable year in which 'paid or accrued' or 'paid or incurred, dependent upon the method of accounting upon the basis of which the net income is computed, unless in order to clearly reflect the income, the deductions should be taken as of different period. In the case of the death of the taxpayer, there shall be allowed as deductions for the taxable year in which falls the date of death, amounts accrued up to the date of his death if not otherwise properly allowable in respect to such period or a prior period." Clearly, the Tax Code allows the recognition of expense either through the cash method or accrual method, provided that such expense recognition falls within the method of accounting upon the basis of which the net income is computed except of course in the case of a self-employed individual reporting income on the cash basis who incurs an indebtedness in which an interest is paid in advance through discount or otherwise wherein said interest expense shall be allowed as deduction only in the year when the indebtedness is fully paid. In accrual method, the determination of periodic income and financial position depends on measurement of economic resources and obligations and changes in them as the changes occur rather than simply on recording receipts and payments of money. (Statement of Financial Accounting Standards No. 1, "Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises.) Thus, income, gains, and profits are included in gross income when earned whether received or not , and expenses are allowed as deductions when incurred . (p. 404, The Law on Income Taxation, 1998 by Benjamin Teodoro and Hector de Leon) Furthermore, if the accrual method of accounting is used, the part of expenditure that has benefited current operations or has already expired is treated as an expense of the period. An expense is allowable when the liability therefor becomes fixed, such as when interest payments are already due and demandable. This method is considered under the Philippine Generally Accepted Accounting Principles (GAAP), as the best method to properly reflect revenues generated and expenses incurred during a period since there will be proper matching of costs and revenues by using this method. Thereafter, at the end of the accounting period, a portion of the prepaid interest that has already expired is treated as an expense of the period and adjusting entries are made at the end of the period to properly reflect the amortization of the prepaid interest. The amortized interest expense will then be treated as a deduction from the gross income, for purposes of computing the taxable income for the period. Accordingly, for income tax purposes, the Borrower shall deduct the interest expense in the year such payments are made. However, if he prepays the interest at loan drawdown date, the prepaid interest may be amortized over the required period. To fully reflect the revenues generated and expenses incurred, the expired portion is deducted from the prepaid interest as the expense for the taxable year within the required period. LLphil 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 the same shall be considered null and void. Very truly yours, (SGD.) BEETHOVEN L. RUALO Commissioner of Internal Revenue