Imputation of interest on interest free inter-company advances

In today’s tough business climate, companies resort to different modes of generating funds to support and finance its business. These modes include selling the companies’ shares to investors or through borrowing of funds from banks, other financial institutions, and if any, from affiliate companies or the parent company. To ensure the viability of its affiliates, parent companies have often resorted to extending advances to subsidiaries and/or its affiliates, with or without interest. 

For interest bearing advances, there is no doubt as to the taxability of the gain. However, the question arises when a company extends interest-free advances to its affiliates. Does the power of the commissioner of Internal Revenue (CIR) under Section 50 of the Tax Code, to distribute, apportion, or allocate gross income or deductions between or among organizations owned or controlled by the same interest, in order to prevent tax evasion or to clearly reflect the income of such organizations include the power to impute “theoretical interests” to transactions between affiliates? Simply put, can tax authorities impute interest on interest-free advances between related parties for purposes of imposing tax on interest?

Recently, the Supreme Court, in the case of CIR vs. Filinvest Development Corporation (Filinvest case) promulgated on July 19, 2011, had the occasion to rule on the issue at hand. As a brief background, on various dates in the years 1996 and 1997, Filinvest Development Corp. (FDC) extended interest free advances to its affiliates. When the company was audited by the BIR for alleged deficiency taxes, the BIR alleged that FDC obtained interest bearing loans from banking institutions and thereby invoked its power under Section 43 of the then Tax Code (now Section 50) to allocate, distribute or apportion income or deductions between or among affiliated organizations, in order to prevent tax evasion.

In its decision, the Supreme Court ruled that the power vested under Section 43 of the 1993 NIRC and Section 179 of Revenue Regulations No. 2 does not include the power to impute “theoretical interests” to the controlled taxpayer’s transactions. In deciding the issue, the Supreme Court relied on the Civil Code provision that “no interest shall be due unless it has been expressly stipulated in writing”.

It bears stressing, however, that the transactions involved in the case of FDC were made in the years 1996 and 1997. In 1999, Revenue Memorandum Order No. 63-99 (RMO 63-99) was promulgated to provide for the guidelines in the determination of taxable income on inter-company loans or advances applying Section 50 of the Tax Code of 1997. In gist, RMO 63-99 adopts the arm’s length bargaining standard in determining the fairness of related party transaction. Arm’s length rate for purposes of RMO 63-99 “shall be the interest which was charged or would have been charged at the time the indebtedness arose in independent transaction with or between unrelated parties under similar circumstances. All relevant factors will be considered, including the amount and duration of the loan, the security involved, the credit standing of the borrower, and the interest rate prevailing at the situs of the lender or creditor for comparable loans.”

From the foregoing, the writer is of the opinion that for advances between affiliates, the BIR may apply the arms length standard and impute interest on interest-free advances invoking the CIR’s power under Section 50 of the Tax Code based on RMO 63-99 for purposes of imposing tax in the said imputed interest. Notwithstanding the pronouncement of the Supreme Court in the FDC case, the guidelines set in RMO 63-99 may still be applied by the BIR prospectively since it was promulgated after FDC’s transactions which were made during the years of 1996 and 1997. 

Further, in his concurring opinion in the FDC case, Associate Justice Leonardo De Castro opined that “the CIR cannot impute any interest income on the cash advances FDC extended to its affiliates for the simple reason that Revenue Memorandum Order (RMO) No. 63-99, which sets down the guidelines for the determination of taxable income on inter-company loans or advances, applying what is now Section 50 of the NIRC of 1997, was issued only on July 19, 1999.” He further stated that “FDC extended the cash advances to its affiliates in 1996 and 1997, when there was yet no clear regulation as to the tax treatment of loans and advances among controlled taxpayers that would have accordingly guided the concerned taxpayers and the Bureau of Internal Revenue (BIR) officials. RMO No. 63-99 cannot be applied retroactively to FDC and its affiliates as Sections 246 of the NIRC of 1997 expressly proscribes the same”.

So does this mean that all advances by companies to assist or help its affiliate that is short of capital are taxable on imputed interest even if it is non-interest bearing? It is worth noting that not all inter-company advances are covered by the application of RMO 63-99. Under RMO 63-99, it does not apply to alleged indebtedness which was, in fact, a contribution of capital or a distribution by a corporation with respect to its shares.

Bheejay D. Sanchez is a supervisor of tax of Manabat Sanagustin & Co., CPAs, the Philippine member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity.

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG in the Philippines. For comments or inquiries, please email ma[email protected] or [email protected]