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Interest expense limitation and tax arbitrage

Interest expense limitation and tax arbitrage by Olivier D. Aznar

At these times of economic downturn, it is not surprising to observe that debts in huge amounts are being sourced by corporate taxpayers which are in dire need of funds.  And corollary to the acquisition of debts is the cost of such debt – the interest expense.  Consequently, taxpayers having material amount of interest expense recorded in their books are at a look out to know the extent of deductible amount of interest expense for income tax computation purposes. 

Under Section 34 (B) of the 1997 Tax Code, as amended, the amount of interest paid or incurred within a taxable year on indebtedness in connection with the taxpayer’s profession, trade or business is allowed as deduction from gross income.  However, the taxpayer’s otherwise allowable deduction for interest expense should be reduced by 33% of the interest income subjected to final tax.  This is the rule on interest expense limitation.

Based on the above provision, the amount of interest expense equivalent to 33% of interest income subjected to final tax will be non-deductible, and only the remaining portion of the interest expense can be claimed as expense in the income tax computation. 
 
This limitation on the deductibility of interest expense was legislated specifically to address the tax arbitrage arising from the difference between the 20% final tax on interest income and the regular corporate income tax rate (RCIT) under which interest expense can be claimed as a deduction. 

The rate of interest limitation is actually the difference between the RCIT and the 20% final tax as a percentage of the RCIT rate, rounded off.  That is, RCIT rate less 20%, divided by the RCIT rate.  Hence, under the then 32% RCIT, the limitation is equal to (32%-20%) / 32% = 37.5%; under the 35% RCIT, (35%-20%) / 35% = 42.86%; and under the 30% RCIT, (30%-20%) / 30% = 33.33%. 

Tax arbitrage could be explained by a simplified illustration, as follows:  On January 1, 2009, Corporation X borrowed from a local bank an amount of P500,000 at a 10% annual interest (resulting to interest expense).  Immediately thereafter, the proceeds of the loan were placed in a local bank deposit account which earns a 10% annual interest rate (resulting to interest income). 

Assuming that the rule on interest expense limitation is not yet in place, the interest expense of P50,000 (10% of P500,000) will result to a tax benefit of 30% or P15,000 in 2009; while the interest income of P50,000 (10% of P500,000), being a passive income will only be subjected to final tax of 20% or P10,000.  The taxpayer would derive a net benefit of P5,000 from the combined effect of a lower rate of final tax liability and   a higher rate of tax deductibility.  Realizing the negative impact of tax arbitrage on revenue  generation, the interest expense limitation was legislated.

Revenue Regulations (RR) No. 13-00, the regulations issued to implement the interest expense limitation, specifically provides that the limitation shall apply regardless of whether or not a tax arbitrage scheme was entered into by the taxpayer for as long as, during the taxable year, there is an interest expense incurred on one side and an interest income earned on the other side, which interest income had been subjected to final withholding tax. 

This rule has also been reiterated in various rulings issued by the BIR including BIR Ruling No. 006-2000.  In this ruling, a bank-taxpayer sought for the exclusion of the interest income from its treasury bonds received from the National Government in payment of the latter’s liability to the bank-taxpayer from the application of the interest expense limitation.  The bank-taxpayer argued that it did not enter into a tax arbitrage scheme.  The BIR held that the limitation shall apply regardless of whether or not a tax arbitrage scheme was entered into by the taxpayer.

Subsequently, however, the BIR issued o ther rulings that are not consistent with the above pronouncements.  In BIR Ruling No. DA-083-06 and BIR Ruling No. DA-315-2004, the bank-taxpayers sought exemption from the limitation citing that their interest income that were subjected to the 20% final tax were derived from cash deposit that are required to be maintained with the BSP and/or other financial institutions pursuant to Banking Regulations.  In these rulings, the BIR held that the absence of intent to undertake tax arbitrage scheme negates the application of the interest limitation rule.

To address these conflicting rulings, the BIR issued Revenue Memorandum Circular (RMC) 31-09 where it held that the law is very clear and leaves no room for interpretation.  If a taxpayer incurred indebtedness and  interest expense connected with his trade or business during the taxable year and also earned interest income which had been subjected to final withholding tax, the amount of interest expense shall be subject to the limitation as provided for by law. 

It was stressed that the law did not require that there be a tax arbitrage in order that the limitation on the deduction of the interest expense can be applied.  RR No. 13-00 itself specifically provides that the limitation shall apply regardless of whether or not a tax arbitrage scheme was entered into by the taxpayer. 

The RMC further declares that the interpretation under BIR Ruling No. 006-2000 shall prevail over all other rulings issued not in consonance therewith.

 

This article is not intended to be a substitute for professional advice.  For comments and inquiries, you may e-mail the author at Olivier.Aznar@ph.gt.com.  For other tax concerns, please check out our other tax services.