Foreign Exchange Loss Realized by Smart Communications, Inc. ("Smart") as a Consequence of a Cross Currency Swap and the Interest on Its Foreign Loan Deductible for Income Tax Purposes

December 11, 1997 BIR RULING NO. 137-97 29 000-00 137-97 Sycip Gorres Velayo & Co. 6760 Ayala Avenue Makati City Attention: Ma . Victoria A . Villaluz Gentlemen : This refers to your letter dated May 16, 1997 requesting for confirmation of your opinion that foreign exchange loss realized by Smart Communications, Inc. ("Smart") as a consequence of a cross currency swap and the interest on its foreign loan are deductible for income tax purposes. cdti It is represented that Smart is a domestic corporation duly registered and organized under and by virtue of the laws of the Philippines; that to finance its acquisition of equipment, it obtained three US Dollars ($) loans described as follows: Lender Term Interest Rate Ericsson Limited, U.K. 10 years 7.5% Ericsson Business Networks AB, Sweden 10 years 7.89% Land Bank, Far East Bank & Trust Co., United Coconut Planters Bank 6 years US$ LIBOR plus 2% that this exposes Smart to foreign exchange risks due to the fluctuation of the US Dollar-Philippine Peso conversion rates; that to hedge on foreign exchange exposure, Smart intends to enter into currency swaps with a Philippine counterparty, ("Counterparty") which is a Philippine branch of a foreign bank; that this Counterparty, on the other hand, has Philippine Peso loan obligations; that by entering into currency swaps, Smart and its Counterparty will agree to exchange cash flows by making periodic payments to each other; that the periodic payment consists of the following: a. each other's principals of the loans b. the interest on each other's loans; that Smart agrees to pay the Counterparty in Philippine currency an amount equivalent to the Counterparty's obligations and vice versa, that the Counterparty agrees to pay Smart an amount in US Dollars corresponding to Smart's obligations described above; that on each specified swap payment date, Smart will in fact be exchanging its Philippine Pesos for US Dollars; and finally, that, as a result of the foregoing, it can either realize a loss or gain on the transaction on swap payment date. In reply, please be informed that any foreign exchange loss incurred in the net swap payments made by Smart from its transactions with the Counterparty are deductible expenses under Section 29 of the Tax Code for income purposes. On the other hand, any foreign exchange gain realized in the net swap payments by Smart from its transactions with the Counterparty are subject to the 35% corporate income tax under Section 24(a) of the Tax Code. A currency swap is an agreement between two parties to exchange two payment streams in different currencies over a certain period of time. In currency swap, each party agrees to pay the other amounts calculated based on a reference amount in another currency. A currency swap allows the parties to fix their respective foreign exchange risks or hedge currency exposure arising in the normal course of business and effectively reduce their total borrowing costs. In these swap transactions, Smart is effectively paying pesos in exchange for the counterparty's payments of the dollar equivalent of the latter's obligations. This "net swap payment" of Smart can result in either a foreign exchange loss or gain. Thus, should Smart pay more pesos to the Counterparty compared to the peso equivalent of its dollar obligations, Smart would realize a foreign exchange loss. Conversely, if the peso equivalent of Smart's dollar obligation is more than the actual peso payment it makes to the counterparty, Smart may realize a taxable gain when it receives swap payments from the Counterparty. In BIR Ruling No. 206-90 dated October 30, 1990, our Office held that: "(W)hen foreign currency acquired in connection with a transaction in the regular course of business is disposed of ordinary gain or loss results from the fluctuations. (Prentice-Hall Federal Taxes, Vol. 1, par. 6261). The loss is deductible only for the year it is actually sustained. It is sustained during the year in which the loss occurs as evidenced by the completed transaction and as fixed by identifiable events occurring in that year. (par. 6570, 34 Am. Jur. 2d 1976) A closed transaction is a taxable event which has been consummated." (See also BIR Ruling No. 144-85 dated August 26, 1985) In this case, a foreign exchange loss or gain may actually be realized by Smart on the scheduled swap payment dates as it makes actual payouts to the Counterparty depending on the appreciation/depreciation of the Philippine Peso to the US dollar. Finally, in reply to your other query, the interest on Smart's US dollar Loan obtained from both the non-resident and resident lender for the purpose of financing its equipment purchase, is deductible for income tax purposes under Section 29(b) of the Tax Code. 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, and/or any of the requirements imposed in this letter are not complied with, then this ruling shall be considered null and void. (BIR Ruling No. 206-90 dated October 30, 1990) aisadc Very truly yours, LIWAYWAY VINZONS-CHATO Commissioner of Internal Revenue