ITAD Ruling No. 051-04

May 11, 2004 ITAD RULING NO. 051-04 Article 11 RP-Germany tax treaty Article 1291 of the Civil Code Section 180 of the 1997 Tax Code BIR Ruling No. 20-02, 216-89 ITAD Ruling No. 151-03 Smart Communications, Inc. Smart Tower 6799 Ayala Avenue, Makati City 1226 Attention: Ms. Rina R. Manuel Tax Manager Gentlemen : This refers to your letter dated June 17, 2003 requesting for confirmation of your opinion that interest payments to be made by Smart Communications, Inc. (Smart) to Kreditanstalt fr Wiederaufbau (KfW) upon effectivity of the Transfer Agreement shall not be subject to any withholding income tax under the RP-Germany tax treaty. It is represented that Smart is a domestic corporation duly organized and existing under Philippine laws with principal office address at Smart Tower 6799 Ayala Avenue, Makati City; that KfW is a non-resident foreign corporation duly organized and existing under and by virtue of the laws of the Federal Republic of Germany with principal office at Palmengartenstrabe 5-9, 60325 Frankfurt am Main, Germany; that KfW is not registered either as a corporation or as a partnership and has not been licensed to engage in business in the Philippines per certification issued by the Securities and Exchange Commission dated November 4, 2003; that Sampo Credit Plc (Sampo) formerly Leonia Corporate Bank Plc, is also a non-resident foreign corporation duly organized and existing under and by virtue of the laws of the Republic of Finland with office address at Unioninkatu 22, FIN-00075, SAMPO, Finland; that Nordea Bank Finland Plc (Nordea) formerly known as Merita Bank Plc is also a non-resident foreign corporation duly organized and existing under and by virtue of the laws of the Republic of Finland with registered office at Aleksanterinkatu 36B, 00100 Helsinki, Finland; that on March 7, 2000, a Loan Agreement was entered into by and between Leonia and Smart whereby the former granted the latter a term facility in the amount of US$26,983,520 to finance, among others, the design, procurement, installation, commissioning and operation of eighty-five percent (85%) of the Phase 2 Payments and Relevant Phase 3 Payments and eighty-five percent (85%) of the Finnvera Guarantee Premium as the terms are defined in the Loan Agreement where Smart was named as "Borrower'', Leonia and Merita as "Arrangers"; KfW as "Co-arranger" and Leonia as "Lender"; that on the same date, a Participation Agreement was executed between Leonia as "Lender" and certain banks/financial institutions as "'Participants"; that under the Participation Agreement, the Participants agreed to make advances to Leonia to assist it in funding the advances to Smart; that the following are the Participants and their agreed commitment to Leonia: Banks Agreed Commitment Percentage Leonia Corporate Bank Plc. US$8,994,506.67 33 1/3 Merita Bank Plc. Singapore US$8,994,506.67 33 1/3 Kreditanstalt fur Wiederaufbau US$8,994,506.67 33 1/3 that under the Participation Agreement, for any repayment of the principal or a payment of interest or fees received by Leonia from Smart, Leonia would have to immediately pay to each Participant an amount proportional to its Agreed Participation to the aggregate amount of the loan; that on May 22, 2003, a Transfer Agreement was entered into by and between Sampo and KfW stating, among others, that the Lender (Sampo) shall transfer to the transferee (KfW) all its rights, benefits and/or obligations under or arising out of the Loan Agreement as a whole and that the Participation Agreement be terminated with the effect that the Transferee shall be the sole lender under the loan facility of US$26,983,520, with no objection on the part of Smart as evidenced by the Borrower's Consent dated June 4, 2003; that a Loan Transfer Certificate was prepared by Sampo which KfW would countersign upon acceptance and procurement of the transfer of Sampo's whole participation under the Loan Agreement and that Nordea in turn would accept the Loan Transfer Certificate pursuant to the terms of the Loan Agreement so as to take effect in accordance with the terms of the Transfer Agreement dated May 22, 2003 made between Sampo, Nordea and KfW; that the Loan Transfer Certificate was acknowledged and received by Nordea on May 22, 2003. In reply, please be informed that Article 11 of the RP-Germany tax treaty provides as follows: "Article 11 "INTEREST "1. Interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State. "2. However, such interest may be taxed in the Contracting State in which it arises, and according to the law of that State, but the tax so charged shall not exceed: a) 10 percent 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 (iii) in respect of public issues of bonds, debentures or similar obligations, b) 15 percent of the gross amount of such interest in all other cases. "3. Notwithstanding the provisions of paragraph 2, a) interest arising in the Federal Republic of Germany and paid to the Philippine Government and the Central Bank of the Philippines shall be exempt from German tax; b) interest arising in the Republic of the Philippines and paid to the German Government, the Deutsche Bundesbank, the Kreditanstalt fuer Wiederaufbau or the Deutsche Gesellschaft fuer wirtschaftliche Zusammenarbeit (Entwicklungsgesellschaft) shall be exempt from Philippine tax. The competent authorities of the Contracting States shall determine by mutual agreement any other governmental institution to which this paragraph shall apply. "4. Notwithstanding the provisions of paragraph 2 of this Article, interest arising in a Contracting State shall be exempt from tax in that State if it is derived in respect of a loan made, guaranteed or insured by a governmental instrumentality of the other Contracting State as by Hermes Dekkung in the case of the Federal Republic of Germany and by the Central Bank in the case of the Republic of the Philippines, or any other instrumentality as is specified and agreed in letters exchanged between the competent authorities of the Contracting States. "5. The term "interest" as used in this Article means income from Government securities, bonds or debentures, whether or not secured by mortgage and whether or 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 from which the income is derived. "xxx xxx xxx" Pursuant to Article 1291 of the Civil Code, obligations may be modified by, among others, subrogating a third person to the rights of the creditor. Novation is a juridical act with a dual function: a) it extinguishes an obligation, and b) creates a new one. Manresa says that novation is the extinguishment of an obligation by the substitution or change of the obligation by a subsequent one which extinguishes or modifies the first either by changing the object or principal conditions, or by substituting the person of the debtor or subrogating a third person to the rights of the creditor (4 Tolentino, Civil Code 352; Joven de Cortes v. Venturanza , 79 SCRA 709, 722; Peterson v. Azada , 8 Phil. 432). The four essential requisites of novation are: (1) previous valid obligation, (2) the agreement of all parties to the new contract, (3) the extinguishment of the old contract, and (4) the validity of the new one. ( Tiu Siuco v. Habana , 45 Phils. 707, 712) In the instant case, all the essential requirements of novation are present. First, there is an existing valid obligation entered into by and between Smart and Sampo (formerly Leonia). Second, under the Transfer Agreement dated May 22, 2003, KfW would take over the indebtedness of Sampo, thereby subrogating KfW as lender with respect to such obligation. Furthermore, and in order to comply with the provisions of the Transfer Agreement, Smart as the borrower, consented to the transfer of the rights, benefits and obligations of Sampo to KfW in accordance with the terms of the Transfer Agreement. This process of novation resulted to the extinguishment of the previous Loan Agreement dated May 22, 2003 and completely created a new obligation between Smart and KfW, which falls within the purview of Article 1291 of the Civil Code. ( BIR Ruling No. 20-02 dated May 13, 2002 ). Based on Article 11 paragraph 3(b) of the RP-Germany tax treaty, interest arising in the Republic of the Philippines and paid to the German Government, the Deutsche Bundesbank, the Kreditanstalt fuer Wiederaufbau (KfW) or the Deutsche Gesellschaft fuer Wirtschaftliche Zusammenarbeit (Entwicklungsgesellschaft), shall be exempt from Philippine tax. Such being the case, interest payments made by Smart to KfW, arising from the new obligation between them is exempt from Philippine income tax pursuant to Article 11 of the RP-Germany tax treaty. ( BIR Ruling No. 216-89 dated October 18, 1989 ) ITCHSa Moreover, the Transfer Agreement executed by and between Smart and KfW shall be subject to the documentary stamp tax imposed under Section 180 of the Tax Code of 1997, as amended. ( BIR Ruling No. ITAD 151-03 dated October 8, 2003 ) This ruling is issued based on 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. Very truly yours, Commissioner of Internal Revenue By: (SGD.) MILAGROS V. REGALADO Assistant Commissioner, Legal Service