Taxability of Loan to be Extended by Lessee to Lessor According to the Terms of Their Lease Agreement

December 3, 1991 BIR RULING NO. 259-91 50 (b) 24 69-011 259-91 Gentlemen : This refers to your letter dated August 29, 1991 stating that IC is under construction to be rented out to prospective tenants purely for commercial purposes; that in order to give the prospective lessee First Priority in acquiring prime location for office and store space in the complex, and for the lessor not to increase the rentals of the premises during the existence of the lease agreement, the lessee upon the signing of the lease contract, will extend to the lessor non-interest bearing loan to be specified in the lease contract; that in other cases, upon execution of the lease agreement, the lessee will extend the same kind of loan to the lessor for purposes of improving and upgrading the facilities in the common areas of the leased complex; that in both instance, the loan to be extended by the lessee to the lessor will be payable in monthly or yearly installments, as the case may be : that in consideration of maintaining a leasehold right and the continued use and possession of the leased premises, the lessee shall pay to the lessor yearly or monthly rentals in an amount to be agreed upon by the parties, which will be payable in advance or within the period to be agreed by the parties; and that if the lessee violates any term or condition of the lease agreement, the lessor is entitled to eject the lessee. In connection therewith, you now request confirmation of your opinion to the effect that the aforementioned loan to be extended by the lessee to the lessor in accordance with the terms of the lease agreement is not subject to income tax and to the expanded withholding tax. cdtech In reply, please be informed that the tax treatment of the amount constituting the non-interest bearing loan to be extended by the lessee to the lessor upon the execution of the lease contract, and as stipulated in said contract depends on the nature of such advance payment. The advance payment may be either a loan to the lessor from the lessee, or an option money for the property, or a security deposit to insure the faithful performance of certain obligations of the lessee to the lessor, or pre-paid rental. If the advance payment is really a loan by the lessee to the lessor, which means that a valid and subsisting indebtedness exists, payable by the lessor to the lessee in monthly or yearly installments, aside from the lessee's monthly or yearly rentals on the leased property as in the instant case, the lessor realizes no taxable income in the year the loan or advance payment is received. On the other hand, the lessee may not take a deduction for that kind of advance payment. (see Gilken Corp., 10 TC 445; C.V.L. Corp. 17 TC 812; Edwin B. Golia, 40 BTA 845; Harcum v. United States, 164 F Supp. 650) If the advance payment is, in fact, pre-paid rental, then such payment is taxable income to the lessor in the year when received. And this is true even though the lessor is on the accrual or the cash method of accounting. (Hyde Park Realty, Inc. v. Commissioner, 211 F. 2d 462, Cf. Evansville Courier v. Commissioner, 62 F. 2d 232) Accordingly, the non-interest bearing loan payable in monthly or yearly installments, as the case may be, to be extended by the lessee to the lessor as required under the terms and conditions of the Contract of Lease in consideration of the undertaking of the lessors not to increase the rentals of the premises during the existence of the lease agreement and for giving the prospective lessee first priority in selecting prime location for store or office space in the commercial complex or for the purpose of improving and upgrading the facilities in the common areas of the leased complex is not considered taxable income to the lessor within the purview of Section 27 of the Tax Code, as amended. (BIR Ruling No. 69-011 dated October 3, 1969) Moreover, since the loan is not a pre-paid rental or an income payment, the same is not subject to the creditable expanded withholding tax under Revenue Regulations No. 6-85 as amended, otherwise known as the Revised and Consolidated Expanded Withholding Tax Regulations, implementing Section 50 (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. Very truly yours, (SGD.) VICTOR A. DEOFERIO, JR. Deputy Commissioner (Officer-in-Charge)