Investments in Long-Term Debt Securities Classified as "Deposit Substitute Instruments"

October 25, 1999 BIR RULING NO. 166-99 Sec. 32 (B) (7) (g)-166-99 Aegon Life Insurance (Philippines), Inc. 8th Floor, The World Centre 330 Sen. Gil J. Puyat Avenue Makati City Attention: Mr . Conrado S . de la Cruz Vice President and COO Gentlemen : This refers to your letter dated August 11, 1999, requesting for a confirmatory ruling to the effect that 1. Investments in long-term debt securities such as bonds, debentures, and government securities like Treasury Bills and Central Bank Certificates of Indebtedness should not be classified as "Deposit Substitute Instruments" but "Certificates of Indebtedness"; and cdll 2. Interest or yield from these securities (long-term bonds, debentures and certificates of indebtedness, including those in government securities) are excluded from the 20% final withholding tax on deposit substitutes and is part of the gains excluded from the sale, exchange or retirement of these investments securities and, therefore, exempt from income tax pursuant to Section 32(B)(7) of the 1997 Tax Code. It is represented that AEGON Life Insurance (Philippines), Inc. (AEGON), is a domestic life insurance company; that to qualify as an approved investment, AEGON has long-term investments in the Philippines, which are being required by the Insurance Law, as implemented by the Insurance Commission; that its investments on long-term debt securities such as bonds, debentures, certificates of indebtedness, and government securities like Treasury Bills and Central Bank Certificates of Indebtedness (CBCIs), with maturities of more than 5 years, are still being subjected to the 20% final withholding tax, such instruments being treated as "deposit substitute instruments; that AEGON however, believes that with the amendment of the Tax Code, the present treatment and taxability of "deposit substitutes" as income or yield from Philippines investments in bonds, debentures and certificates of indebtedness, with more than five (5) years maturity should also be changed, and therefore, the gains, including interests and other earnings derived from the sale or exchange or retirement of the same are exempt from income tax pursuant to Section 32(B)(7)(g) of the 1997 Tax Code (Exclusions from Gross Income); and that AEGON is of the opinion that the following matters should be considered in the light of the foregoing amendments, viz: "1. The word BOND is known in financial markets worldwide as a paper, generally in the form of a certificate, that described the details of a loan or borrowing transaction and which, at present, is used more generally to describe a vast and varied market in debt securities. Debentures are corporate bonds backed by the credit of the issuer rather than by a specific assets to distinguish them from asset-backed bonds or mortgage bonds. Bonds are generally certificates of indebtedness since they are issued in certificate form. Commercial papers are also required, under the registration requirement of the SEC, to be issued in certificate form. "2. Bonds are issued around the world to provide businesses and governments with money that might be difficult or impossible to raise the other way. Issuers are looking for markets where the investors have cash reserves that they are willing to invest in debt securities. The Philippines remain a weak market bonds because of lack of government support for bond issues as well as the lack of a strong secondary market where bonds trade after they are issued. cdlex "3. It would appear that the purpose for the exclusion from gross income of the gains from these investments instruments is to encourage cash savings in these investments securities and to develop both the capital market as well as the secondary market for these investments in the same way that the Tax Reform Act of 1997, in Section 24(B)(1) and 25(A)(2), is encouraging savings from individuals by exempting from income tax "interest income received by an individual taxpayer from long-term deposit or investment in the form of savings, common or individual trust funds, deposit substitutes, investment management accounts and other investments evidenced by certificates in such form prescribed by the BSP". The term " long-term deposit or investment " has been defined as those with a maturity period of not less than five (5) years. "4. If this new provision, excluding from gross income the gains from sale, exchange or retirement of bonds, debentures or other certificates of indebtedness with maturity of more than five (5) years, is meant to give an incentive as an encouragement for investments in long-term debt securities and the development of a secondary market thereof, the following application and interpretation should be adopted; "a. The term "Sale" should be construed not only to the subsequent transfer of the instrument but to its origination and the issuance as well as since bond "flotations" are considered in the financial markets worldwide as origination and sale of these bonds. "b. Thus, the interest income earned therefrom, whether discounted or added on, which is the basis of the gains from these instruments, should also be excluded from gross income and therefore exempt from income tax. If this exclusion would not include the interest income therefrom, the gain that is excluded from these bonds and other debt securities upon their sale, exchange or retirement after more than 5 years maturity, may be non-existent, even illusory, since the gain or value of these securities is determined by the interest or yield that such securities pay. The value of bonds, generally fixed income and long-term, is determined by the interest they pay and what is happening in the economy. Yield or interest, which is synonymous with gains, is what actually earned in bonds or these long-term debt securities. This is distinguished from "Return", which may be negative or positive, that is made on the investment by computing the par value of these instruments, the profit and loss from trading, and the yield or interest. So, gains can only be realized from the interest earned, which is the basis of the trading or selling price, and whatever maturity value of these instruments. dctai "5. The exclusion of the gains from these investments is given, it appears, as an incentive to their investors due to the big risks that investors take in these investments. These risks are as follows: "a. Being generally fixed income and of long term maturity, if interest rates go up, the investors-buyers lose money from these investments because the bonds or securities they hold do not pay as well as the newer ones being issued. And they will not be able to get the full amount that they have paid for the bond or these other investments if they sell or wait for redemption upon maturity. Generally, when inflation is up, interests rates go up. And conversely, when inflation is low, so are interests rates. "b. The other risks investors in these investment instruments face is the rising inflation. If the interest amount earned on these investment securities doesn't change, the value of that interest in money can be eroded by inflation. If the investor in these bonds and securities buys at pay, and holds the bond to maturity, inflation, or the shrinking value of the currency, is the worst enemy. The longer the maturity of the bond or these other securities, the greater the risk that some point inflation will rise dramatically and reduce the value of the money that the investor receives. In fact, not only the gain but the principal invested in these long-term securities also shrinks in value. Hence, your position that the gains from the sale, exchange or retirement of these instruments that are excluded from gross income should include the interests from such investments. cdlex In reply, please be informed of the following: A. For the purpose of determining whether these investments in long-term debt securities such as bonds, debentures, and government securities like Treasury Bills and Central Bank Certificates of Indebtedness shall fall within the classification of "deposit substitutes", Section 1(g) of Revenue Regulations 12-80, as first amended by Rev. Regs. 8-81 and further amended by Rev. Regs. 17-84 and last by amended Rev. Regs. 3-97 defines the term "deposit substitutes" as follows: "Deposit substitutes" shall mean an alternative form of obtaining funds from the public , other than deposits, through the issuance , endorsement, or acceptance of debt instruments for the borrower ' s own account , for purpose of relending or purchasing of receivables and other obligations . These instruments may include , but not limited to, promissory notes, repurchase agreements, certificates of assignment or participation, and similar instruments with recourse as may be authorized by the Bangko Sentral ng Pilipinas for banks and non-bank financial intermediaries : Provided, however, that debt instruments issued for interbank loans, including those between or among quasi-banks shall not be considered as deposit substitute debt instruments. "EFFECTIVE JANUARY 2, REVERSE REPURCHASE AGREEMENTS ENTERED INTO BY AND BETWEEN THE BANGKO SENTRAL NG PILIPINAS (BSP) AND ANY AUTHORIZED AGENT BANK SHALL BE CONSIDERED AS DEPOSIT SUBSTITUTES." (Emphasis supplied) Thus, "deposit substitutes" is but an alternative form of obtaining funds from the public through the issuance of debt instruments for the borrower's account, for purpose of relending or purchasing of receivables and other obligations; and it may include, among others, promissory notes, repurchase agreements, certificates of assignment or participation, and similar instruments with recourse as may be authorized by the Bangko Sentral ng Pilipinas (BSP) for banks and for non-bank financial intermediaries. Whether the above-mentioned long-term investments can be classified as "deposit substitutes instruments" or "certificates of indebtedness", Rev. Regs. No. 17-84 specifically identified, in line with foregoing the definition, the following borrowings as "deposit substitutes", viz: "(a) All interbank borrowings by or among banks and non-bank financial institutions authorized to engage in quasi-banking functions evidenced by deposit substitutes instruments, except interbank call loans to cover deficiency in reserves against deposit liabilities as evidenced by interbank loan advice or repayment transfer tickets. "(b) All borrowings of the national and local government and its instrumentalities including the Central Bank of the Philippines , evidenced by debt instruments denoted as treasury bonds , bills , notes , certificates of indebtedness and similar instruments . cdll "(c) All borrowings of bank , non-bank financial intermediaries , finance companies, investment companies, trust companies, including the trust department of banks and investment houses, evidenced by deposit substitutes instruments. "xxx xxx xxx" (Sec. 2(h)(iii), Rev. Regs. 17-84) Based on the foregoing, this Office is of the opinion that the investments so thus mentioned are essentially "deposit substitutes". This was also been properly categorized as such under Section 2 of Rev. Regs. No. 17-84 (Income Taxation of Interest Income derived from Deposits and Yield from Deposit Substitutes), which provides that "(h) "Deposit substitutes" shall mean "xxx xxx xxx "(iii) In the case of other non-financial companies, including the national and local government and its instrumentalities, all borrowings through the issuance of debt instruments denoted as treasury bonds, treasury bills, treasury notes and similar instruments . (Emphasis supplied) Apparently, while the aforementioned long-term investments/borrowings like bonds and other government securities such as Treasury Bills and Central Bank Certificates of Indebtedness (CBCIs) are generally categorized as "deposit substitutes" with respect to the lender-investor point of view, it is treated as "obligations" by the issuer. Thus, the instruments issued are classified as "certificates of indebtedness". This classification is significant in the Documentary Stamp Tax Law. But with respect to Income Taxation, the issuance of such "Certificates of Indebtedness" does not remove the activity of borrowing/s from being categorized as "deposit substitute" which is but a form of obtaining funds. B. As a general rule, the interest income on currency bank deposit and yield or other monetary benefit from these "deposit substitutes " and similar arrangement derived by banks and non-bank financial intermediaries are being taxed at the final rate of 20% under Section 27(D)(1) of the 1997 Tax Code. cdll However, Section 32(B)(7)(g) of the 1997 Tax Code, provides an exception, thus, "Section 32. Gross Income . "xxx xxx xxx "(B) Exclusions from Gross Income . The following items shall not be included in gross income and shall be exempt from taxation under this Title: "xxx xxx xxx "(7) Miscellaneous Items . "xxx xxx xxx "(g) Gains from the Sale of Bonds , Debentures or other Certificate 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." The idea therefore, is to still treat bonds, debentures or other certificates of indebtedness as "deposit substitutes" the interest income, yield or gain derived therefrom subject to the 20% final tax under Section 27(D)(1) of the 1997 Tax Code, but exclude said interest income, yield or gain from the gross income if the bonds, debentures or the certificate of indebtedness have maturities of more than five (5) years. Conversely, only the income derived on these debt instruments with maturity of more than five (5) years shall be excluded from the gross income. Further, for purposes of income taxation, the interest income or yield earned from the sale of long-term bonds, whether discounted or added on, should be considered in determining the gain thus earned. The rationale behind this is that, the value of these long-term securities, is determined by the interest or yield that such securities pay, such that, a low interest earning bond cannot be sold for a higher price. The income tax on "gain" is levied in the difference between the sale price and the original purchase price, not the difference between the sale price and the market value on the stated date. (Walsh v. Brewster, Conn. 41 S.Ct. 392, 255 U.S. 536, 65 L. Ed. 762). Furthermore, the term sale is not limited to the subsequent transfer of the instrument but to its origination and issuance, as well. Thus, from the time of its issuance, we should consider the "income" which is actually the amount coming to a person within a specified time, whether as payment for the services, interest, or profit from investment. Its usual synonyms being "gain", "profit", "revenue". (Trefry v. Putnam, 116 N.E. 904, 907 227 Mass. 522, L.R.A. 1917F, 806. (Words & Phrases, Gain, page 11, Permanent Edition 18) Accordingly, your position that interest income or yields or gain from the sale of bonds, debentures and certificates of indebtedness with maturities of more than five (5) are excluded from gross income in accordance with Section 32(B)(7)(g) of the 1997 Tax Code and therefore exempt from the 20% final withholding tax on deposit substitutes is hereby confirmed. 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.) BEETHOVEN L. RUALO Commissioner of Internal Revenue