By: Atty. Royce Nieville P. Abes

In a recent case decided by the Supreme Court (SC) involving eight banks, an underwriter bank (acting as agent) and its principal, the issue of the taxability of interest income in a zero coupon bonds, known as Poverty Eradication and Alleviation Certificates (PEACe) Bonds, was the main subject of a controversy [Banco De Oro, et al. vs. Republic of the Philippines, et al., G.R. No 198756, promulgated on January 15, 2015 and August 16, 2016].

Generally, an interest income refers to the amount paid by the borrower to the lender for the use of the latter’s money. In a zero-coupon bond, the discount is the interest. This discount represents the difference or excess of the issue price of the zero-coupon bond and its face value upon maturity.

Under the Tax Code, a 20% FWT is imposed on interest income from deposit substitutes. The Tax Code defines deposit substitutes as “an alternative form of obtaining funds from the public (the term “public” means borrowing from twenty (20) or more individual or corporate lenders at any one time), other than deposits, through the issuance, endorsement, or acceptance of debt instruments for the borrower’s own account.”

The controversy was ignited from Bureau of Internal Revenue (BIR) flip flop or reversal of the position on the taxability of interest income from PEACe bonds. In year 2001, BIR issued a BIR ruling which confirmed that the PEACe bonds were not subject to the 20% FWT considering that the PEACe bonds will be issued to one entity and not to be considered as “deposit substitutes”. But, in year 2011, BIR made a reversal, when it ruled that PEACe Bonds should be treated as deposit substitutes subject to the 20% FWT.

In resolving the controversy, the SC interpreted the phrase “ät any one time” for purposes of determining the "20 or more lenders" or 20 lender rule, to mean every transaction executed in the primary or secondary market in connection with the purchase or sale of securities. The SC further explained by citing an example “where the financial assets involved are government securities like bonds, the reckoning of "20 or more lenders/investors" is made at any transaction in connection with the purchase or sale of the Government Bonds, namely: (1) Issuance by the Bureau of Treasury of the bonds to GSEDs in the primary market; (2) Sale and distribution by GSEDs to various lenders/investors in the secondary market; (3) Subsequent sale or trading by a bondholder to another lender/investor in the secondary market usually through a broker or dealer; or (4)  Sale by a financial intermediary-bondholder of its participation interests in the bonds to individual or corporate lenders in the secondary market.

In a motion for reconsideration and clarification by the parties, SC ruled that the existence of 20 or more lenders is reckoned on the time when the successful bidder sells or distributes, the government debts to the final holder. If upon determination of the number of holder, it turn-out that the final holder will be at least 20 or more, whether in the primary or secondary market, the debt are deemed to be deposit substitutes. The pertinent portion of the SC Resolution promulgated on August 16, 2016, held that:

 “The reckoning of the phrase “20 or more lenders” should be at the time when the petitioner-intervenor RCBC Capital sold the PEACe bonds to investors. Should the number of investor to whom petitioner-intervenor RCBC Capital distributes the PEACebonds, therefero, be found to be 20 or more, the PEACe Bonds are considered deposit substitutes subject to 20% final withholding tax. Petitioner-intervenors RCBC/CODE-NGO and RCBC Capital, as well as the final bondholders who have recourse to government upon maturity are liable to pay the 20% final withholding tax.”

Thus, the liability for 20% FWT on debt instruments considered as deposit substitutes depends on the number of lenders ät any one time. However, the SC clarified that as a result of its decision/resolution, the lender liability on the PEACe Bonds should be given prospective application. The pertinent portion of the SC Resolution, ruled that:

“The previous interpretation given to an ambiguous law by the Commissioner of Internal Revenue, who is charged to carry out its provision, are entitled to great weight, and taxpayers who relied on the same should not be prejudiced in their right. Hence, this Court’s construction should be prospective; otherwise there will be a violation of due process for failure to accord persons, especially the parties affected by it, fair notice of the special burdens imposed on them.”

But, take note that subsequent to the BIR ruling in 2011 [which is not included in the case], BIR had issued Revenue Regulations (RR) No. 14-2012 dated November 12, 2012 and Revenue Memorandum Circular (RMC) No. 77-2-12 dated November 22, 2012, which  emphasized that the mere issuance of government debt instruments and securities is deemed falling within the coverage of "deposit substitutes" (regardless of the number of lenders at the time of origination) and subject to the 20% FWT on interest income.

With the issuance of SC’s Decision and Resolution, I hope that this clarify and give relief to the taxpayer from aforesaid BIR regulations and rulings.

The SC Decision and Resolution also clarified that The Court of Tax Appeal (CTA) has jurisdiction and may take cognizance of cases directly challenging the constitutionality or validity of a tax law, regulation or administrative issuance, such as revenue order, revenue memorandum circular, and rulings. The SC also ruled that resort to the highest court at first instance, instead of the CTA, find justification on exceptional and compelling reasons – namely: 1) the nature and importance of the issues raised to the investment and banking industry with regard to a definitive declaration of whether government debt instrument are deposit substitutes under existing laws; 2) the novelty of the issue; and 3) the issuance of the temporary restraining order (TRO) effectively recognized the urgency and necessity of direct resort to the highest court.

With respect to argument that resort to the highest tribunal is not proper considering that party should have resorted to appeal to the Secretary of Finance pursuant to the Doctrine of exhaustion of administrative remedy.

The SC, in striking down this argument, applied exceptions to the exhaustion of administrative remedy in allowing a party to seek a direct judicial relief from highest court. SC found special circumstances – namely: 1) the question involved is purely legal; 2) the urgency of judicial intervention given the impending maturity of the PEACe Bonds; and 3) the futility of an appeal to the Secretary of Finance as the latter appeared to have adopted the challenged BIR rulings.

Further, the PEACe Bonds case is a recent jurisprudence for more than a half century from the case of Blue Bar Coconut Co. vs. City of Zamboanga [122 Phil 929, 930 (1965)] and Carcar Electric & Ice Plant Co., Inc. vs. Collector of Internal Revenue, [100 Phil 50, 56, and 59 (1956)], wherein the highest tribunal imposed a six (6) % legal interest, corresponding to the tax collected, on the part of the government authorities [i.e., Bureau of Treasury].