Tax Consequences of Pre-Termination of Lease and Cancellation of Option to Purchase

August 28, 1997 BIR RULING NO. 098-97 34 (a) 50 (b), 99 000-00 098-97 Romulo, Mabanta, Buenaventura Sayoc & Delos Angeles 30th Floor, Citibank Tower Citibank Plaza 8741 Paseo de Roxas Makati City Attention: Priscilla B . Valer, Edmundo P . Guevara and Amado R . Santiago III Gentlemen : This refers to your letter dated July 1, 1997 requesting for an opinion on the tax consequences of the pre-termination of the lease and cancellation of option to purchase affecting your client, Read Rite Philippines, Inc . (Read Rite) It is represented that Read Rite is a domestic corporation engaged in the manufacturing and export business; that it has existing long term Lease Contracts with Option to Purchase over two contiguous parcels of land with improvements (Leased Properties) with Philippine American Life Insurance Company (Philamlife), a domestic corporation engaged in the insurance business, and with PERF Realty Corporation (PERF), a domestic corporation engaged in the real estate business; that Philamlife and PERF have a prospective buyer who is willing to buy the Leased Properties free for all liens and encumbrances including Read Rite's existing leasehold rights and option to purchase, Philamlife and PERF, on the one hand, and Read Rite, on the other, are prepared to enter into an agreement wherein Read Rite will consent and agree to the pre-termination of the Lease Contracts and cancel the options to purchase stipulated therein for a certain consideration; that the amount of the consideration to be mutually agreed upon by Read Rite and Philamlife and PERF represents the pre-termination penalty, price for the cancellation of the options to purchase and indemnity for the resulting disturbance or damage arising from the lease pre-termination; that the amount of such consideration will be higher than the original cost basis of the Leased Properties; and that when the Leased Properties are released from Read Rite's leasehold rights and options to purchase, Philamlife and PERF will sell the Leased Properties to the buyer. cdpr In connection therewith, you now request for a ruling that: "1. The consideration to be received by Read Rite from Philamlife and PERF representing pre-termination penalty and price for the cancellation of the option to purchase is not subject to the creditable expanded withholding tax. "2. Said consideration is not subject to the 10% value added tax (VAT) since there is no sale, barter or exchange of goods or and properties in the ordinary course of trade or business. "3. However, the receipt of said consideration shall result in a capital gain on the part of Read Rite which gain is subject to the 35% corporate income tax. "4. In determining the gain from the sale of the Leased Properties, the consideration to be paid by Philamlife and PERF to Read Rite shall be deductible from the selling price as part of the adjusted cost basis, even though the amount of such consideration is higher than the original cost basis." In reply, I have the honor to inform you as follows: 1. Pursuant to Revenue Regulations No. 6-85, as amended, otherwise known as the Revised and Expanded Withholding Tax Regulations implementing Section 50(b) of the Tax Code, only payments to persons enumerated therein are subject to the expanded withholding tax. (BIR Ruling Nos. 101-94 dated May 3, 1994 and 12-83 dated February 3, 1983;) Accordingly, your opinion is hereby confirmed that since the payment to be received by the lessee, Read Rite, from the lessors, Philamlife and PERF, as consideration for the pre-termination of the lease contracts, cancellation of options to purchase and indemnity for the disturbance and damages arising from such pre-termination and cancellation is not among those specified in Revenue Regulations No. 6-85, as amended, such payment is not subject to the expanded withholding tax. 2. With regard to the value added tax, Section 99 of the Tax Code provides: "Sec. 99. Persons Liable . Any person who, in the ordinary course of trade or business, sells, barters, exchanges, leases goods or properties, renders services, and any person who imports goods shall be liable to the value-added tax (VAT) imposed in Sections 100 to 102 of this Code. Moreover, in BIR Ruling No. 31-83 dated March 1, 198, this Office has ruled that an option to buy, in the hands of a taxpayer who does not deal in options, is a capital asset and the sale thereof gives rise to a capital gain. Since Read Rite does not deal in leasehold rights and options in its ordinary course of trade or business, the pre-termination of the leases and cancellation of the options to purchase will not be made in the ordinary course of trade or business of Read Rite. Hence, your opinion that the pre-termination of the lease and the cancellation of the options to purchase is not subject to VAT is hereby confirmed. 3. However, the consideration to be received by Read Rite shall form part of its gross income subject to the 35% corporate income tax since under Section 28 of the Tax Code, s amended, the term "gross income" is defined to mean all income from whatever source derived. Income, in a broad sense, means all wealth which flows into the taxpayer other than as a mere return of capital. (Section 36, Revenue Regulations No. 2, otherwise known as the Income Tax Regulations) 4. On the part of Philamlife and PERF , the consideration paid to Read Rite shall form part of the adjusted cost basis of the Leased Properties which shall be deductible from the selling price in determining the respective gains derived by Philamlife and PERF from the sale of the Leased Properties. Section 34(a) of the Tax Code provides: "(a) Computation of gain or loss . The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the basis or adjusted basis for determining gain and the loss shall be the excess of the basis or adjusted basis for determining loss over the amount realized. . . ." The basis of property acquired by purchase is its cost to the taxpayer which includes the purchase price plus incidental expenses, if any. (BIR Ruling No. 19-95 dated February 13, 1995) Further, in the case of Nelly Magallanes Lopez vs. Commissioner of Internal Revenue , CTA Case No. 2607, promulgated on April 21, 1982, the determination of the cost basis was explained as follows: "In order to determine the gain or loss in sales or exchanges of property, one must first know the cost basis of the property given in exchange , which must first be recovered or eliminated from the cost of the property received in exchange, so as to isolate the profit or gain which is to be taxed. The cost ordinarily is not only the price paid for the property but includes expenses involved in its acquisition, and capital expenses incurred on the property made thereafter. (Section 1012:2, Mertens, Ibid ., Vol. II, Ch. 1, such. 0-Page 14.) The purchase price of property includes any indebtedness to which it is acquired. ( Ibid .) "The general scheme adopted by the law in determining gain or loss is to fix the cost of the property given at a generic "unadjusted" basis, except only in such instances where cost could not be the legal basis such as when the property was acquired before March 1, 1913, in which case the fair market value as of the date is taken as basis (Mertens, Law of Federal Income Taxation, Sec. 2101, Vol. 3, 1942 Ed., pp. 356-357; Sec. 35(a) National Internal Revenue Code, as amended.) or the fair market value at the time of acquisition, if the said property was acquired after March 1, 1913 by gratuitous title, i.e., by inheritance, donation or gift. But this unadjusted cost basis must always have to be adjusted, if any, by the increase or decrease due to expenditures, repayments, depreciation , obsolescence, amortization and depletion; receipts; losses, or other items. (Mertens, Law of Federal Income Taxation , 1954-1958 Code) 1959 Ed., pp. 420-421; Ibid . Vol. 3, 1942 Ed., p. 360.) Ordinarily, the original cost of property is readily determinable and usually is the price paid for it (in cash or other property), plus the cost of acquiring it, with appropriate adjustments as aforesaid for capital expenditures, repayments, or other equivalents. ( Ibid ., Vol. 3, 1942 Ed., p. 360) (Emphasis supplied) Accordingly, your opinion is hereby confirmed that since the consideration for the pre-termination of the lease contracts and cancellation of the options to purchase are necessary expenses to prepare the leased properties for sale and free the same of the leasehold rights and options to purchase, said consideration should form part of the adjusted cost basis of the properties in the hands of Philamlife and PERF regardless of the amount of such consideration relative to the original cost basis. Finally, the document on the pre-termination of the lease contracts and the cancellation of the options to purchase shall be subject to the documentary stamp tax imposed under Section 188 of the Tax Code, as amended. 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. LLpr Very truly yours, LIWAYWAY VINZONS-CHATO Commissioner of Internal Revenue