December 12, 2008

BIR RULING [DA-(C-168) 519-08]

34 (A); 45; RR 2; RR 2-98; DA-400-2004; DA-

086-2007

Salvador & Associates

815-816 Tower One & Exchange Plaza,
Ayala Triangle, Ayala Avenue,
1226 Makati City

Attention: Atty. Euney Marie J. Mata-Perez

Partner

Gentlemen :

This refers to your letter dated August 22, 2008 requesting on behalf of your
client, Luzon Hydro Corporation ("LHC"), for confirmation of your opinion that the return
by LHC of liquidated damages to the contractor of its power station as a result of a
compromise settlement is deductible from gross income since the said amount was
previously reported as taxable income when received and that its return is not subject to
any withholding tax.
It is represented that LHC entered into an agreement ("Turnkey Contract") with
Transfield Philippines, Inc. (the "Contractor") for the design, construction, installation,
completion, testing and commissioning of a power station (the "Project") on a turnkey
basis. The target completion date of the project was set on June 1, 2000 or such later
date as may be agreed upon by the parties. Under the Turnkey Contract, if the
Contractor fails to comply with the target completion date, LHC may consider it in
breach, in which case the Contractor shall be liable to LHC for liquidated damages
payable without need of demand. The liquidated damages may be collected by drawing
on the irrevocable and confirmed letters of credit ("LC") amounting to US$17.98 million
that the Contractor put up as security for the performance of its obligations pursuant to
the Turnkey Contract. IEHSc T

It is also represented that due to the delay in the completion of the Project, LHC
considered the Contractor liable for breach of contract. Thus, LHC drew against the LC
the amount of US$13.95 million (P667,674,810) and US$4.03 million (P197,515,962) in
2000 and 2001, respectively. LHC reported the amount of liquidated damages received
as part of its taxable income in its income tax returns ("ITR") for the years 2000 and
2001, respectively.
The Contractor protested the claim for liquidated damages. Thus, in November
2000, LHC and the Contractor elevated their claims and counter-claims arising from the
delay in the completion of the Project to an Arbitration Tribunal operating under the
Rules of the International Chamber of Commerce sitting in Singapore and later in
Australia. 1
It is further represented that on August 9, 2005, the Arbitration Tribunal rendered
a Final Arbitration Award (the "Arbitral Award") in the amount of US$24.533 million in
favor of the Contractor. Thus, LHC recognized as an expense for financial accounting
purposes and booked as a provision in its 2005 audited financial statements the amount
of US$24.533 million, which comprises the amount of the Arbitral Award, plus additional
sums for the return of the LC and other costs. LHC did not, however, claim such amount
as a deduction from its gross income in its 2005 ITR. Meanwhile, LHC protested the
award. Thus, when the Contractor filed before the local courts a petition applying for
confirmation or recognition and enforcement of the Arbitral Award, LHC opposed and
moved for dismissal. LHC moved for dismissal not only on the grounds sanctioned by
the Revised Rules of Court, but also on a claim that the Arbitral Award that the
Contractor sought to enforce is null and void, having been rendered contrary to public
policy. In a decision dated November 29, 2006, 2 the Court of Appeals found that the
enforcement and recognition of the Arbitral Award would be contrary to Philippine laws
and public policies and thus, it ordered that the Arbitral Award be vacated.IDAEHT

Finally, it is represented that before the issues could be finally settled, LHC and
the Contractor decided in 2008 to enter into an out-of-court settlement (the "Settlement")
to avoid a drawn out legal battle and avoid further litigation expenses. As part of the
Settlement, LHC agreed to return part of the liquidated damages amounting to US$14
million.
In connection therewith, you are requesting confirmation of your opinion that:
(a) The return or repayment by LHC in 2008 of the liquidated damages in the
amount of US$14.0 million, which was part of the sum previously reported
as gross income of LHC in the years 2000 and 2001, is an allowable
deduction from LHC's gross income for tax purposes in the year 2008, the
year of return or repayment.
(b) The adjusting entry made in LHC's books for the difference between the
amount recognized as a provision of US$24.533 million and the actual
amount paid of US$14.0 million has no tax implications since adjusting
entries for excess provisions are not recognized for tax purposes. These
are treated as reconciling items in the ITR.
(c) The payment for the return of the liquidated damages in the amount US$14.0
million to the Contractor is not subject to creditable withholding tax since it
is not among those items enumerated in the withholding tax regulations and
it does not constitute an income payment for goods or services. aAHDIc

In reply, please be informed as follows:

Return of Liquidated Damages
The payment by LHC of the sum of US$14.0 million to the Contractor, which sum
LHC previously reported as part of its taxable income, is an allowable deduction from
the gross income of LHC in 2008, whether such payment is viewed as a return of
previously reported income or as a settlement payment under an out-of-court
compromise.
Generally, the tax treatment of the return of previously-recognized income is
dependent on the tax treatment of the income previously reported. If the taxpayer
received an income and reported the same as part of taxable gross income, but later on
was made to return the said income, the taxpayer is allowed a deduction for the amount
returned against the gross income. The deduction must be made at the time of the
return. This treatment follows the rationale behind allowing sales return as a deduction
from gross sales not only for income tax but also for value-added tax ("VAT") purposes.
3

In Maurice P. O'Meara v. Commissioner of Internal Revenue, 4 the Tax Court of

the United States ruled, citing the Commissioner's own ruling, held that a taxpayer,
having properly reported royalties from property as income received in cash in 1937,
and being required by an adverse court decree to make restitution, was entitled in a
deduction for the amount repaid in cash in 1941 to the extent of the net royalties
previously reported as taxable income notwithstanding that the inclusion of royalty
income in earlier year created no tax burden. TEc AHI

This ruling followed the doctrine laid down in North American Oil Consolidated v.
Burnet, 5 where the US Supreme Court enunciated the so-called "claim-of-right"
doctrine. This doctrine provides that if a taxpayer receives earnings under a claim of
right and without restriction as to its disposition, he has received income even though
one may claim he is not entitled to the money. Should it later appear that the taxpayer
was not entitled to keep the money, the taxpayer would be entitled to a deduction in the
year of repayment.
Moreover, even if the return of US$14.0 million is viewed as an out-of-court
settlement rather than as a return of liquidated damages, it is still allowed as a
deduction. A judgment based on a compromise agreement is a judgment on the merits.
6 It is similar to a payment pursuant to a judgment and has the effect and authority of
res judicata. 7 Under Section 76 of the Income Tax Regulations, "judgments or other
binding judicial adjudication, on account of damages for patent infringement, personal
injuries, or other cause are deductible from gross income when the claim is so
adjudicated or paid, unless taken under other methods or accounting which clearly
reflect the correct deduction, less any amount of such damages as may have been
compensated for by insurance or otherwise. . . ."
Furthermore, in BIR Ruling No. DA-400-2004 dated July 22, 2004, the BIR held
that a taxpayer may claim as deductions from its gross income payments made under a
court-approved compromise agreement for the full and final settlement of the Arbitration
Case and the Court Case which the parties filed against each other. Thus, this Office
held that:

"Section 76 of Revenue Regulations (Rev. Regs.) No. 2, otherwise

known as the "Income Tax Regulations", provides that "judgments or other
binding judicial adjudication, on account of damages for patent infringement,
personal injuries, or other cause are deductible from gross income when the
claim is so adjudicated or paid, unless taken under other methods of
accounting which clearly reflect the correct deduction, less any amount of such
damages as may have been compensated for by insurance or otherwise. . . ." DAEc IS

Moreover, pursuant to Section 171 of same Rev. Regs. No. 2 "the

deductions and credits must be taken for the taxable year in which "paid or
accrued" or "paid or incurred", unless in order clearly to reflect the income
such deductions or credits should be taken as of a different period."

On the above basis, PGI may claim as deductions from its gross income
for the year 2004 the full settlement of the Historical Issues with NPC/PSALM
 under the court-approved compromise agreement in order to clearly reflect the
income of the Company. Consequently, the settlement in full of the Historical
Issues with NPC/PSALM may be allowed as deductions from PGI's gross
income for taxable year 2004."

In LHC's case, the litigation which gave rise to the payment of US$14.0 million
arose from the delay in the construction of the Project, which is central to the business
operations of LHC. Hence, there should be no question that the settlement amount arose
from LHC's business activities.
Accordingly, whether viewed as a return of previously reported income or as a
settlement payment under a compromise agreement, the US$14.0 million is deductible
from the taxable gross income of LHC in 2008 for income tax purposes. Tc SaHC

Reversal of the excess provision

The reversal of the excess provision amounting to US$10.533 million is not a
taxable transaction since such reversal is a mere correction of a previous accounting
entry. It does not involve any actual cash payments of expenses or cash receipts of
income. Neither does it involve an inflow of wealth or income.
Section 45 (A) of the Tax Code, 8 provides the statutory basis for the time of
claiming deductions. It states:

"SEC. 45. Period for which Deductions and Credits Taken. — The
deductions provided for in this Title shall be taken for the taxable year in which
'paid or accrued' or 'paid or incurred', dependent upon the method of accounting
upon the basis of which the net income is computed, unless in order to clearly
reflect the income, the deductions should be taken as of a different period. . . ."

The Tax Code is clear that only those expenses which are "paid or accrued" or
"paid or incurred" during the taxable year are deductible for tax purposes. Mere
provisions or estimates are not deductible for tax purposes because they are neither
"paid or accrued" or "paid or incurred" during the taxable year. TAaHIE

The test of deductibility of an expense was exhaustively explained by the

Supreme Court in the fairly recent case of Commissioner of Internal Revenue vs.
Isabela Cultural Corporation. 9 Thus:

"The requisites for the deductibility of ordinary and necessary trade,

business, or professional expenses, like expenses paid for legal and auditing
services, are: (a) the expense must be ordinary and necessary; (b) it must have
been paid or incurred during the taxable year; (c) it must have been paid or
incurred in carrying on the trade or business of the taxpayer; and (d) it must be
supported by receipts, records or other pertinent papers.

The requisite that it must have been paid or incurred during the taxable
year is further qualified by Section 45 of the National Internal Revenue Code
(NIRC) which states that: "[t]he deduction provided for in this Title shall be taken
for the taxable year in which 'paid or accrued' or 'paid or incurred', dependent
upon the method of accounting upon the basis of which the net income is
computed . . .".

Accounting methods for tax purposes comprise a set of rules for

 determining when and how to report income and deductions. In the instant case,
the accounting method used by ICC is the accrual method. LibLex

Revenue Audit Memorandum Order (RAMO) No. 1-2000, provides that

under the accrual method of accounting, expenses not being claimed as
deductions by a taxpayer in the current year when they are incurred cannot be
claimed as deduction from income for the succeeding year. Thus, a taxpayer
who is authorized to deduct certain expenses and other allowable deductions
for the current year but failed to do so cannot deduct the same for the next year.

The accrual method relies upon the taxpayer's right to receive amounts
or its obligation to pay them, in opposition to actual receipt or payment, which
characterizes the cash method of accounting. \Amounts of income accrue where
the right to receive them become fixed, where there is created an enforceable
liability. Similarly, liabilities are accrued when fixed and determinable in
amount, without regard to indeterminacy merely of time of payment.

For a taxpayer using the accrual method, the determinative question is,
when do the facts present themselves in such a manner that the taxpayer must
recognize income or expense? The accrual of income and expense is permitted
when the all-events test has been met. This test requires: (1) fixing of a right to
income or liability to pay; and (2) the availability of the reasonable accurate
determination of such income or liability. (Underscoring supplied) HESc ID

In LHC's case, LHC booked a provision for a potential liability in 2005. However,
at that time, the liability was not completely certain, as LHC disputed the award. In fact,
LHC opposed the move of the Contractor to enforce the award here in the Philippines
and our Court of Appeals sustained the position of LHC.
The controversy and dispute over the enforcement of the award therefore barred
the creation of an enforceable liability against the Contractor as only the finality of the
Philippine court's decision would determine whether LHC is liable or not. In short, at that
time, the liability was contingent and the requisites under the "all-events test" were not
met. Thus, LHC did not claim as a tax deduction the expense estimate provided for.
Since the provision itself is not deductible, and in fact, was not deducted by LHC
for tax purposes, any adjustment to the provision, such as a reduction made when the
parties finally settled the arbitration case between them, cannot also be recognized as
income. Such adjustment did not give rise to any taxable transaction or inflow of income
or cash receipts into the taxpayer. This is no different from allowance for bad debts and
adjustments to the provisions thereto made every year by many taxpayers. It bears
stressing that only bad debts actually ascertained to be worthless and charged off within
the taxable year are deductible. 10 Tc DIEH

This finds supports in the case of Citytrust Investment Philippines, Inc. vs.
Commissioner of Internal Revenue 11 where the CTA held that provisions for probable
losses are not deductible expense and a reversal entry of overprovision in prior years
did not give rise to taxable income. We quote the ruling of the CTA as follows:

"Likewise, reversal of overprovision in prior years of allowance for

probable losses is merely an accounting entry which will not result to any
tangible income on the part of the petitioner; thus, no expenses can be rightly
allocated to it. In petitioner's financial statement, it noted that:
 'Allowance for Probable Losses — The Company provides
allowance for doubtful accounts based on a review by
management of the current status of all the existing receivable
(B.I.R. Records, p. 56).'

Provision for probable losses, unlike bad debts written-off is not a deductible
expense as far as computing the taxable income is concerned. Conversely, a
reversal entry (overprovision) cannot be considered as income." 12

Accordingly, the reversal of the excess provision amounting to US$10.533 million

is not a taxable income of LHC. c SCADE

Withholding tax
The return of the US$14 million to the Contractor, as payee, does not constitute
an income payment subject to any kind of withholding tax.
In BIR Ruling No. DA-086-2007 dated February 13, 2007, this Office held that the
list of income payments under Revenue Regulations (RR) No. 2-98, as amended, is
exclusive and payments not listed therein are not subject to the creditable withholding
tax. Considering that the payment or return of the liquidated damages previously
received and recognized as income is not among those listed in RR No. 2-98, as
amended, the same is not subject to any withholding tax.
Furthermore, Section 2.57.2 (M), RR No. 2-98, as amended, provides:

"Sec. 2.57.2. Except as herein otherwise provided, there shall be withheld a

creditable income tax at the rates herein specified for each class of payee from
the following items of income payments to persons residing in the Philippines:
Tc DAHS

xxx xxx xxx

(M) Income payments made by the top ten thousand (10,000) private
corporations to their local/resident supplier of goods and local/resident supplier
of services other than those covered by other rates of withholding tax. — Income
payments made by any of the top ten thousand (10,000) private corporations, as
determined by the Commissioner, to their local/resident supplier of goods and
local/resident supplier of services, including non-resident alien engaged in
trade or business in the Philippines.

Supplier of goods — One percent (1%)

Supplier of services — Two percent (2%)

xxx xxx xxx

The term "regular suppliers" refers to suppliers who are engaged in business or
exercise of profession/calling with whom the taxpayer-buyer has transacted at
least six (6) transactions, regardless of amount per transaction, either in the
previous year or current year. The same rules apply to local/resident supplier of
services other than those covered by separate rates of withholding tax." IHSTDE

However, since the payment does not pertain to a payment for the supply of
goods or services, but rather, as a return of liquidated damages erroneously claimed
and received, the above provision should not apply.
In view thereof, this Office confirms your opinion that:
(a) The return or repayment by LHC in 2008 of the liquidated damages in the
amount of US$14.0 million, which was part of the sum previously reported
as gross income of LHC in the years 2000 and 2001, is an allowable
deduction from LHC's gross income for tax purposes in the year 2008, the
year of return or repayment.
(b) The adjusting entry made in LHC's books for the difference between the
amount recognized as a provision of US$24.533 million and the actual
amount paid of US$14.0 million has no tax implications since adjusting
entries for excess provisions are not recognized for tax purposes. These
are treated as reconciling items in the ITR.
(c) The payment for the return of the liquidated damages in the amount of
US$14.0 million to the Contractor is not subject to creditable withholding
tax since it is not among those items enumerated in the withholding tax
regulations and it does not constitute an income payment for goods or
services.
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, then this
ruling shall be considered null and void.

Very truly yours,

Commissioner of Internal Revenue

By:

(SGD.) JAMES H. ROLDAN

Assistant Commissioner
Legal Service

Footnotes

1. ICC International Court of Arbitration Case No. 11264/ESR/TE/MW/AVH.

2. CA-G.R. SP No. 94316.

3. Belle Corporation vs. Commissioner of Internal Revenue, CTA Case No. 5930, April 4,
2002; See Commissioner of Internal Revenue vs. Central Luzon Drug Corporation,
G.R. No. 159647, April 15, 2005, where the Supreme Court discussed the effects of
sales discounts and sales returns.

4. 8 T.C. 622, March 27, 1947.

5. 286 U.S. 417 (1932).

6. Spouses Wilfredo and Swarnie Aromin vs. Paulo Floresca, et al., G.R. No. 160994, July
27, 2006.
7. Article 2037, Civil Code.

8. National Internal Revenue Code of 1997, as amended.

9. G.R. No. 172231, February 12, 2007.

10. Section 34 (E), Tax Code.

11. CTA Case No. 4443, January 18, 1994.

12. Emphasis supplied.