Tax Implication of Interest Rate Swaps, a Product Which is to be Launched by the Bank of the Philippine Islands (BPI) Along With Other Member Banks of the Bankers Association of the Philippines (BAP)

September 19, 1995 BIR RULING NO. 146-95 24,119 000-00 146-95 Bank of the Philippine Islands BPI Bldg., Ayala Ave., cor. Paseo de Roxas Makati, Metro Manila Attention: Mr . Gamaliel C. Pascual Vice-President Fixed Income Division Gentlemen : This refers to your letter dated November 23, 1993 requesting for a ruling on the tax implication of interest rate swaps, a product which is to be launched by the Bank of the Philippine Islands (BPI) along with other member banks of the Bankers Association of the Philippines (BAP). cdtech It is represented that BPI, a domestic banking corporation with an expanded commercial banking license granted by the Central Bank of the Philippines would launch an interest rate swap which is an interest rate risk hedging tool between two (2) parties; that swap is essentially an exchange of cash flows and each cash flow, in the eyes of the respective parties, is equal to the other at the start of the swap agreement; that under this arrangement, the two parties agree to make periodic payments to each other for a specified length of time; that the two parties have to agree prior to entering into a swap on the following details: (a) the notional principal amount of the swap; (b) the tenor of the swap; and (c) the indices to be applied versus the notional principal amount for determining the exact cash amounts that each party owes the other; that the principal is called notional because the principal is neither exchanged or delivered initially nor is it re-paid at maturity, and that the payments made by one party will be on the basis of a fixed index (i.e. interest rate) for the tenor of the swap while the other party's payments will be based on a floating index. In reply, please be informed that an interest rate swap is not a loan since there is no active delivery of the principal, it being merely notional. A loan requires the delivery of the object of the loan (i.e. the money) in order for the loan to be perfected. Under Article 1933 of the Civil Code, the essential elements of a loan are: (i) the delivery by the lender to the borrower of money (or other consumable goods); (ii) the borrower becomes the owner of the delivered goods; and (iii) the same amount or a greater amount (if with the interest) of goods is returned to the lender. Therefore, a loan is generally the use and forbearance of money with interests payments representing the price paid for such use. Such being the case, since interest rate swap is not a loan, but merely an exchange of cash flows between the parties, the swap payments are considered ordinary income on the part of the recipient bank/financial institutions, subject to the ordinary corporate income tax of 35% under Section 24 of the Tax Code, and to the gross receipts tax under Section 119 of the same Code, the tax to be computed on the basis of the gross amount actually received. Under Section 119 of the Tax Code as implemented by Revenue Regulations No. 12-80, the rates to be imposed on the gross receipts of banks and non-bank financial intermediaries shall be based on all items of income actually received . mere accrual shall not be considered. But once payment is received on such accrual or in cases of prepayment, then the amount actually received shall be included in the tax base. Moreover, the deductibility of the expenses on swap, if any, would depend on the nature of the activity or transaction of the bank. Thus, for income tax purposes, swap payment may be allowed as deductible expense only of regular banking activities of a bank on peso transactions. However, should there be a similar transaction under the Foreign Currency Deposit Unit (FCDU) of the same bank, the income and expense of the FCDU on interest rate swap, if any, could not be offsetted/added against the peso or regular banking activity/transaction of the same bank. In other words, this deduction applies only to the peso interest rate swap and not to the foreign currency swap. llcd Finally, although an interest rate swap transaction does not constitute a loan, it is covered by a written agreement on the obligation being transferred/exchanged, i.e., the interest rate swap; hence, it is subject to the documentary stamp tax imposed in accordance with Section 198 of the Tax Code, as amended. Very truly yours, LIWAYWAY VINZONS-CHATO Commissioner of Internal Revenue