DA ITAD BIR Ruling No. 053-06

May 11, 2006 DA ITAD BIR RULING NO. 053-06 Articles 3 (General Definitions) and 11 (Interest) Philippines-Netherlands tax treaty; Section 28(B)(5)(a), National Internal Revenue Code of 1997; Section 2, Introductory Provisions, Administrative Code of 1987; Section 1, Article X (Local Government), The 1987 Constitution of the Republic of the Philippines Romulo Mabanta Buenaventura Sayoc & De Los Angeles Attorneys at Law 30th Floor, Citibank Tower 8741 Paseo de Roxas Makati Attention: Atty. Priscilla B. Valer Gentlemen : This refers to your letter dated September 21, 2005 on behalf of your client, NIB Capital Bank NV (NIB Bank) , requesting confirmation that the National Power Corporation (Napocor) and the Metropolitan Waterworks and Sewerage System (MWSS) cannot be considered to fall under the term "Government" or the phase "political subdivision or local authority thereof" as the terms are used under Article 11, paragraph 3(a) of the Convention between the Kingdom of the Netherlands and the Republic of the Philippines for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (Philippines-Netherlands tax treaty). Such confirmation is sought for the purpose of determining NIB Bank's entitlement to tax credits under the tax laws of the Netherlands. It is represented that NIB Bank is a foreign corporation, organized and existing under the laws of the Netherlands, with office at 2517 KJ's-Gravenhage, Carnegieplein 4, the Netherlands, as confirmed by the Certificate dated February 4, 2005 issued by the Netherlands Tax Administration at Amsterdam; that NIB Bank is not registered either as a corporation or as a partnership in the Philippines, as confirmed by the Certificate of Non-Registration of Corporation/Partnership dated November 7, 2005 issued by the Securities and Exchange Commission; that, on the other hand, Napocor and MWSS are corporations organized and existing under the laws of the Philippines, created by virtue of Republic Act No. 6395 (An Act Revising the Charter of the National Power Corporation) and Republic Act No. 6234 (An Act Creating the Metropolitan Waterworks and Sewerage System and Dissolving the National Waterworks and Sewerage Authority; and for Other Purposes), respectively; that Napocor's primary objective is to undertake the development of hydroelectric generation of power and the production of electricity from nuclear, geothermal and other sources, as well as the transmission of electric power on a nationwide basis; that MWSS' primary objective is to ensure the proper operation and maintenance of waterworks systems to insure an uninterrupted and adequate supply and distribution of potable water for domestic and other purposes, and to ensure the proper operation and maintenance of sewerage systems which are essential public services because they are vital to public health and safety; that Napocor and MWSS have corporate lives of fifty years from and after the expiration of their present corporate existence beginning, possibly, from September 10, 1971 for Napocor and from June 19, 1971 for MWSS , the dates the Republic Acts creating these corporations became effective; that Napocor issued Bonds 1 on December 11, 1995 amounting to Twelve Billion Japanese Yen (12,000,000,000), the proceeds of which to be used to finance part of the Masinloc 1 Coal-Fired Power Plan Project and that of the Northern Luzon Generation and Transmission Project; that the Bonds are serially numbered and in bearer form in the denomination of 100,000,000 each with coupons attached on issue; that the Bonds which have a redemption value of 12,000,000,000, have a bond rate of 4.65 percent per annum with interest payable semi-annually on December 11 and June 11 of every year, and with maturity date on December 11, 2015; that the interest of the Bonds are guaranteed by the Government of the Republic of the Philippines, and that the Asian Development Bank will grant a 'put option' to J.P. Morgan Trustee Ltd. for the holders of the Bonds which will entitle J.P. Morgan Trustee Ltd. to require the Asian Development Bank to purchase all of the then outstanding Bonds at a price equal to 100 percent of the aggregate principal amount of the Bonds on or after the maturity date; that the Bonds will be represented by a permanent global bond without interest coupons which is expected to be deposited with a common depository for Morgan Guaranty Trust Company of New York, Brussels Office, as operator of the Euroclear System and Cedel Bank, socit anonyme , on or about December 11, 1995; and that NIB Bank is a holder of the Bonds issued by Napocor , and, previously, even of the Notes 2 issued by MWSS which NIB Bank sold on September 19, 2005. In reply, please be informed that concerning income tax, the interests to be paid by Napocor and MWSS on the Bonds and the Notes they issued to NIB Bank are generally subject to income tax of twenty percent (20%) of the gross amount thereof, under Section 28(B)(5)(a) of the National Internal Revenue Code of 1997 (Tax Code): "SEC. 28. Rates of Income Tax on Foreign Corporation . xxx xxx xxx (B) Tax on Nonresident Foreign Corporation. xxx xxx xxx (5) Tax on Certain Incomes Received by a Nonresident Foreign Corporation. HaIESC (a) Interest on Foreign Loan . A final withholding tax at the rate of twenty percent (20%) is hereby it imposed on the amount of interest on foreign loans contracted on or after August 1, 1986; xxx xxx xxx" However, being a resident of the Netherlands, NIB Bank is entitled to the preferential income tax rates on interests under Article 11 of the Philippines-Netherlands tax treaty: "Article 11 INTEREST 1. Interest arising in one of the States and paid to a resident of the other State may be taxed in that other State. 2. However, such interest may also be taxed in the State in which it arises and according to the laws of that State, but if the recipient is the beneficial owner of the interest the tax so charged shall not exceed: a) 10 per cent of the gross amount if such interest is paid: (i) in connection with the sale on credit of any industrial, commercial or scientific equipment, or (ii) on any loan of whatever kind granted by a bank, or any other financial institution, (iii) in respect of public issues of bonds, debentures or similar obligations, b) 15 per cent of the gross amount of the interest in all other cases. 3. Notwithstanding the provisions of paragraph 2: a) interest arising in one of the States and paid in respect of a bond, debenture or other similar obligation of the Government of that State or of a political subdivision or local authority thereof shall be exempt from tax in that State; b) interest arising in one of the States and paid in respect of a loan made by or guaranteed or insured by the Government of the other State, the central bank of that other State or any agency or instrumentality (including a financial institution) owned or controlled by that Government shall be exempt from tax in the first-mentioned State. 4. The competent authorities of the States shall by mutual agreement settle the mode of application of paragraphs 2 and 3. 5. The term "interest " as used in this Article means income from Government securities, bonds or debentures, whether or not secured by mortgage but not carrying a right to participate in profits, and debt-claims of every kind as well as all other income assimilated to income from money lent by the taxation law of the State in which the income arises. Penalty charges for late payment shall not be regarded as interest for the purpose of this Article. xxx xxx xxx" Under paragraph 5, the term "interest" subject to preferential tax treatment includes income from bonds and income from debentures to which notes are generally categorized. In relation, under paragraph 2, interest is subject to the preferential income tax of (a) ten percent (10%) of the gross amount thereof if it is paid (i) in connection with the sale on credit of any industrial, commercial or scientific equipment, (ii) on a loan granted by a bank or other financial institution, or (iii) in respect of public issues of bonds, debentures or similar obligations, and (b) fifteen percent (15%) of the gross amount thereof in all other cases. More importantly, under paragraph 3, interest is exempt from income tax if (a) it is paid in respect of a bond, debenture or other similar obligation of the Government of a State or a political subdivision or a local authority thereof, or (b) it is paid in respect of a loan made by or guaranteed or insured by the Government of the other State, the central bank thereof or any agency or instrumentality or a financial institution owned or controlled by that Government. In connection therewith, you inquire on whether the exemption under paragraph 3(a) of Article 11 applies to the interest to be paid by Napocor and MWSS to NIB Bank on the subject Bonds and Notes, by reason that the word "Government" as used therein and applied to the Government of the Republic of the Philippines may include therein a government-owned or controlled corporation like Napocor and MWSS . Under paragraph 3(a), interest arising in the Philippines and derived by a resident of the Netherlands like NIB Bank is exempt from income tax if it is paid in respect of a bond, debenture or other similar obligation of the Government of the Republic of the Philippines, its political subdivision or local authority. The words "Government", "political subdivision" and "local authority" are not expressly defined in the Philippines-Netherlands tax treaty; hence, pursuant to paragraph 3, Article 3 (General Definitions) of the Philippines-Netherlands tax treaty, they must be defined in accordance with the applicable laws of the Philippines: "Article 3 GENERAL DEFINITIONS xxx xxx xxx 2. As regards the application of the Convention by either of the States, any term not otherwise defined shall, unless the context otherwise requires, have the meaning which it has under the laws of that State relating to the taxes which are the subject of this Convention." Concerning such laws, it is noteworthy that the Administrative Code of 1987 (Executive Order No. 292) defines the words "Government of the Republic of the Philippines" and "local government" from which the meaning of "political subdivision" and "local authority" are construed, particularly, under Section 2 of the Code: "INTRODUCTORY PROVISIONS SEC. 2. General Terms Defined . Unless the specific words of the text, or the context as a whole, or a particular statute, shall require a different meaning: (1) Government of the Republic of the Philippines refers to the corporate governmental entity through which the functions of government are exercised throughout the Philippines, including, save as the contrary appears from the context, the various arms through which political authority is made effective in the Philippines, whether pertaining to the autonomous regions, the provincial, city, municipal or barangay subdivisions or other forms of local government. xxx xxx xxx" As to "Government", generally speaking, any entity through which the functions of government are exercised is or can be included in the word "Government." Thus, the national government, the local governments (which include "political subdivisions and local authorities), and the agencies of the Government, all form part of Government. As to agencies of the Government, they refer to the various units of the Government, including a department, bureau, office, instrumentality, a local government or a distinct unit therein, and even a government-owned or controlled corporation like Napocor or MWSS (Section 2(4), Ibid .) However, whether a government-owned or controlled corporation, being an agency of the Government, can be considered as Government as it is, it should be understood that a government-owned or controlled corporation cannot be considered as such because by its very nature it does not perform governmental functions. This is made clear by the Supreme Court in National Power Corporation vs. City of Cabanatuan (G.R. No. 149110 dated April 9, 2003), where the Court ruled, in passing and among other things, that Napocor , a government-owned or controlled corporation, is an entity that does not perform governmental functions. The Court ruled thus: ''Governmental functions are those pertaining to the administration of government, and as such, are treated as absolute obligation on the part of the state to perform while proprietary functions are those that are undertaken only by way of advancing the general interest of society, and are merely optional on the government. Included in the GOCCs performing proprietary functions are 'business-like' entities such as the National Steel Corporation (NSC), the National Development Corporation (NDC), the Social Security System (SSS), the Government Service Insurance System (GSIS), and the National Water Sewerage Authority (NAWASA), among others. Petitioner (Napocor) was created to 'undertake the development of hydroelectric generation of power and the production of electricity from nuclear, geothermal and other sources, as well as the transmission of electric power on a nationwide basis. Pursuant to this mandate, petitioner generate power and sells electricity in bulk. Certainly, these activities do not partake of the sovereign functions of the government. They are purely private and commercial undertakings, albeit imbued with public interest. The public interest involved in its activities, however, does not distract from the true nature of the petitioner as a commercial enterprise, in the same league with similar public utilities like telephone and telegraph companies, railroad companies, water supply and irrigation companies, gas, coal or light companies, power plants, ice plant, among others; all of which are declared by this Court as ministrant or proprietary functions of government aimed at advancing the general interest of society. A closer reading of its charter reveals that even the legislature treats the character of the petitioner's enterprise as a 'business,' although it limits petitioner's profits to twelve percent (12%), viz: '(n) When essential to the proper administration of its corporate affairs or necessary for the proper transaction of its business or to carry out the purposes for which it was organized, to contract indebtedness and issue bonds subject to approval of the President upon recommendation of the Secretary of Finance; (o) to exercise such powers and do such things as may be reasonably necessary to carry out the business and purposes for which it was organized, or which, from time to time, may be declared by the Board to be necessary, useful, incidental or auxiliary to accomplish the said purpose . . ." The following pronouncements of the Court are also worth mentioning: "It is not necessary to write an extended dissertation on whether or not Napocor performs a governmental function with respect to the management and operation of the Angat Dam. It is sufficient to say that the government has organized a private corporation, put money in it and has allowed it to sue and be sued in any court under its charter (R.A. No. 6395, Sec. 3(d).) As a government owned and controlled corporation, it has a personality of its own, distinct and separate from that of the Government. ( See National Shipyards and Steel Corp. vs. CIR, et al ., L-17874, August 31, 1963, 8 SCRA 781.) Moreover, the charter provision that the Napocor can 'sue and be sued in any court' is without qualification on the cause of action and accordingly it can include a tort claim such as the one instituted by the petitioners." ( Rayo vs. Court of First Instance of Bulacan, L-55273-83 ) HTSAEa "Government-owned or controlled corporations have a personality of their own, separate and distinct from the government, their funds, therefore although considered to be public in character, are not exempt from garnishment." ( Philippine National Bank vs. Pabalan , 83 SCRA 595) "Where the government engages in a particular business thru the instrumentality of a corporation, it divests itself pro hoc vice of its sovereign character, so as to subject itself to the rules governing private corporations." ( Philippine National Bank vs. Pabalan , 83 SCRA 595) "When the government enters into commercial business, it abandons its sovereign capacity and is to be treated like any other corporation." ( Philippine National Railways vs. Union de Maquinistas, Fogoneros y Motormen , 84 SCRA 223). In view of the fact that a government-owned or controlled corporation does not perform governmental functions, it cannot be regarded as falling within the ambit of the term "Government" pursuant to the Administrative Code of 1987 and other Philippine laws in general. By the same token, a government-owned or controlled corporation like Napocor and MWSS cannot be regarded as Government under paragraph 3(b), Article 11 of the Philippines-Netherlands tax treaty. A government-owned or controlled corporation like Napocor and MWSS cannot be regarded also as a political subdivision or a local authority as the terms are used in paragraph 3(b). A political (and territorial) subdivision refers to a province, city, municipality, or barangay of the Republic of the Philippines (Section 1, Article X (Local Government), The 1987 Constitution of the Republic of the Philippines). 3 A local authority, although such term is uncommonly used in existing Philippine laws, can be taken synonymous with a local government or a political subdivision (Section 2(2), Administrative Code of 1987). 4 This being so, where Napocor and MWSS cannot be regarded as a "Government," "political subdivision," or "local authority" as the terms are used in paragraph 3(a), Article 11 of the Philippines-Netherlands tax treaty, instead of being exempt from income tax, interests to be paid by Napocor and MWSS on the Bonds and the Notes they issued to NIB Bank are subject to the lower tax of 10% based on the gross amount thereof, under paragraph 2(a)(iii) of Article 11, where such interests are paid in respect of public issues of bonds, debentures or similar obligations. However, it should be emphasized that the bonds issued under the authority of Napocor's Charter are by themselves exempt from all taxes, as clearly stated in Section 8, Republic Act No. 6395: "SEC. 8. Authority to Incur Indebtedness and Issue Bonds; Their Conditions, Privileges and Exemptions; Sinking Funds; Guarantee . (a) Domestic Indebtedness . Whenever the Board deems it necessary for the Corporation to incur indebtedness by contracting loans with domestic financial institutions or to issue bonds to carry out the purpose for which the Corporation has been organized, it shall, by resolution, approved by at least four members of the Board, so declare and state the purpose for which the proposed debt is to be incurred and such terms and conditions as it shall deem appropriate for the accomplishment of the said purpose; Provided, That in case of bond issues, the same shall be subject to the approval of the President of the Philippines upon recommendation of the Secretary of Finance. The bonds issued under the authority of this subsection shall be exempt from the payment of all taxes by the Republic of the Philippines, or by any authority, branch, division or political subdivision thereof which facts shall be stated upon the face of said bonds. Said bonds shall be receivable as security in any transaction with the Government in which such security is required . (emphasis supplied) xxx xxx xxx (b) Foreign Loan . The Corporation is hereby authorized to contract loans, credits, in any convertible foreign currency, or capital goods, and indebtedness from time to time from foreign governments, or any international financial institution or fund source, or to issue bonds, in such amounts and in any foreign currency on such terms and conditions as it shall deem appropriate for the accomplishment of its purposes and to enter into and execute agreements and other documents specifying such terms and conditions. xxx xxx xxx The loans, credits and indebtedness contracted under this subsection and the payment of the principal, interest and other charges thereon, as well as the importation of machinery, equipment, materials, supplies and services, by the Corporation, paid from the proceeds of any loan, credit or indebtedness incurred under this Act, shall also be exempt from all direct and indirect taxes , fees, imposts, other charges and restrictions, including import restrictions previously and presently imposed, and to be imposed by the Republic of the Philippines, or any of its agencies and political subdivisions." (emphasis supplied) Section 8 provides, among others, that loans, credits and other indebtedness like bonds incurred by Napocor , whether domestic or foreign, are exempt from all direct and indirect taxes imposed by the Republic of the Philippines, its agencies, or political subdivisions. Thus, interest arising from the issuance of the Bonds are exempt by virtue of Section 8 as aforequoted. On the other hand, this particular tax privilege given to Napocor is not available to MWSS as such privilege is lacking in Republic Act No. 6234. The Charter of MWSS simply provides: "SEC. 18. Tax Exemptions . All articles imported by the Metropolitan Waterworks and Sewerage System or the local governments for the exclusive use of their waterworks and sewerage systems particularly machineries, equipment, pipes, fire hydrants, and those related to, or connected with, the construction, maintenance, and operation of dams, reservoirs, conduits, aqueducts, tunnels, purification plants, water mains, pumping stations; or of artesian wells and springs within their territorial jurisdictions, shall be exempt from the imposition of import duties and other taxes." Therefore, interests to be paid by MWSS to NIB Bank are subject to 10% income tax. This ruling is issued on the basis of the facts as represented. However, if upon investigation it shall be disclosed that the facts are different, then this ruling shall be without force and effect insofar as the herein parties are concerned. AICDSa Very truly yours, (SGD.) JOSE MARIO C. BUAG Commissioner of Internal Revenue Footnotes 1. A bond is a written contract by a debtor to pay a final amount on an indicated future date, and to pay a periodic interest based on the principal of the bond. When the bond is said to be redeemed at par, the redemption price is equal to the face value. A bond is said to be redeemable at a premium when it contains the promise that on redemption date it will be redeemed for more than its face value. Definition of Terms 1. Face value or par value . It is the borrowed principal mentioned on the bond. 2. Redemption value . It is the final amount at which the bond will be paid on the redemption date. 3. Coupon . It is a contract of payment of interest on the face value of the bond on a corresponding date. 4. Redemption date . It is the indicated date of redeeming the bond. It may be the same as the maturity date or a different date. 5. Bond rate . It is the stated rate at which the bond promises to pay interest on its face value. 6. Redemption rate . It is the rate on the principal of the bond and it is used in computing the redemption value. 7. Investment rate or yield rate . It is the rate of profit realized by the purchaser of the bond. (Mathematics of Investment, Copyright 1988, by Antonina C. Sta. Maria, Lorina G. Salamat, Pastor B. Malaborbor, Pages 83-90.) 2. A note or promissory note is a written promise to pay a certain sum of money on a specified date. The sum of money due is called the maturity value . The date on which the money is due is called the date of maturity . If the note specifies the rate of interest, it is an interest-bearing note. If it does not, then it is a non-interest bearing note. The maturity value, instead, is specified in the note. Other features of the note are given, such as the date on which the note is made, the sum of money borrowed, the length of time until it matures, the payee and the maker. ( Ibid ., Page 14.) 3. "Section 1. The territorial and political subdivisions of the Republic of the Philippines are the provinces, cities, municipalities, and barangays. There shall be autonomous regions in Muslim Mindanao and the Cordilleras as hereinafter provided." 4. "(2) Local Government refers to the political subdivisions established by or in accordance with the Constitution."