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Taxation of leases

Taxation of leases

by:  Ma. Vilma Cruz-Silvederio

The BIR recently issued an interesting ruling about leases, namely, BIR Ruling No. 9-2007.

Why interesting? Because this ruling addresses the treatment of a finance lease and an operating lease not only for income tax purposes but for VAT and withholding tax purposes as well.

This harmonizes the tax rules provided under Revenue Regulations No. 19-86 with the more recent tax rules issued on VAT and withholding taxes.

Revenue Regulations No. 19-86 discusses how a lease shall be treated for income tax purposes.  The importance of ascertaining the true character of a lease was highlighted. The regulations provides that if the lease is, by its nature, actually a conditional sale, the transaction shall be considered as a sale and, therefore, the lessor shall recognize a gain from the sale or disposal of the asset. On the other hand, if the transaction is a true lease, then the lessor shall report the amounts received from the transaction as rental income.

When VAT was introduced in 1987, there had been questions whether leases shall be treated as sale of services in all cases, or if the provisions of Revenue Regulations No, 19-86 will be applied to determine if the lease shall be classified as sale of goods or services.

For VAT purposes, such distinction, if applied, will affect the tax base required to be reported. From the point of view of the lessee, it has likewise been often asked whether it should treat the payments as rentals and apply the 5% creditable withholding tax, regardless of how the lessee classified the transaction under Revenue Regulations No. 19-86.

The ruling issued by the BIR addresses a query posed by a taxpayer on the appropriate income tax, VAT and withholding tax treatment of the lease arrangements covering business machines, computers and office equipment that it enters into with its customers in the course of its business. (The taxpayer in the subject ruling was not a finance company, as defined under the Financing Company Act, and, thus, was subject to VAT.)

As described in the ruling, the taxpayer has two types of leases: (1) full payout lease and (2) fair market value or residual lease. In a full payout lease, the monthly lease payments during the non-cancellable term of the lease are sufficient to pay for the leased equipment.  At the end of the lease term, the lease equipment has no more residual value and the customer is granted the option to purchase the leased equipment for a nominal consideration.

On the other hand, under the fair market value or residual value lease (FMV lease), the total monthly lease payments during the non-cancellable term of the lease (which is  in no case less than 730 days) is not sufficient to pay for the leased equipment.  The lessee is responsible for the choice of the leased equipment, the delivery, installation, acceptance and maintenance of the leased equipment. At the end of the lease term, the leased equipment will have a residual value and the customer is granted the following options: (a) return the leased equipment, (b) renew the lease, or (c) purchase the leased equipment at its fair market value.

The BIR held that the full payout lease of the taxpayer should be treated for tax purposes as a conditional sale. The monthly lease payments are part of the sales price of the taxpayer and, as such, for income tax purposes, the taxpayer should report the income from the sale in accordance with the method of accounting it regularly employs in keeping its books of accounts or in accordance with the installment basis allowed under Sec. 49 of the National Internal Revenue Code.

Moreover, since the full payout lease is in substance a sale of goods rather than a sale of service, the total monthly lease payments are considered the gross selling price of the equipment subject to VAT upfront. Hence, the taxpayer should issue the invoice upfront for the gross selling price of the leased equipment, i.e., the total monthly lease pay able for the entire duration of the lease.

BIR further ruled that if the customer of the taxpayer has been properly previously identified to be belonging to the top 10,000 private corporations, the full payout lease shall be subject to the 1% creditable withholding tax since the lease involves a purchase of goods.

As for the FMV lease, BIR held that the monthly lease payments are considered rentals includible in the gross income of the lessee-taxpayer. The leased equipment under the FMV lease may be depreciated by the taxpayer during the primary lease period but such period shall not be less than 60% of the depreciable life of 3 years, in the case of office machines.

For VAT purposes, the monthly lease payments in a FMV lease are considered rentals, not as selling price. Thus, the monthly lease payments are subject to VAT as they are actually or constructively received, not at the inception of the lease.

The taxpayer shall invoice the rentals periodically as the lease payments are received. Considering that the taxpayer is not a finance company, the lessees should subject the monthly lease payments to the 5% creditable withholding tax on rentals imposed under existing regulations.

In this ruling, BIR has successfully reconciled the tax treatment of leases.  It upheld RR 19-86 while clarifying the issues on the treatment for VAT, income and withholding tax.

However, since tax rulings are specific to the taxpayer that requested it, in general, it cannot be invoked by a taxpayer other than that to which the ruling is addressed.    Since issues resolved in the ruling are of general concern, a circular declaring the general adoption of  this position will be welcomed to ensure the uniform application of these rules for similar types of transactions.

(The author is a senior tax manager at Punongbayan & Araullo, member firm of Grant Thornton International. For comments and inquiries, please e-mail the author at Vilma.C.Cruz-Silvederio@pna.ph or call 886-5511.)