Banco De Oro, Bank of Commerce, China Banking Corporation,

Metropolitan Bank & Trust Company, Philippine Bank of Communications,

Philippine Nation Bank, Philippine Veterans Bank and Planters
Development Bank vs. Republic of the Philippines, Commissioner of
Internal Revenue, Bureau of Internal Revenue, Secretary of Finance,
Department of Finance, The National Treasurer and Bureau of Treasury
(G.R. No. 198756. January 13, 2015)i
This case involves P35 billion worth of 10-year zero-coupon treasury bonds
issued by the Bureau of Treasury (BTr) denominated as the Poverty Eradication and
Alleviation Certificates or the PEACe Bonds. These PEACe Bonds would initially be
purchased by a special purpose vehicle on behalf of Caucus of Development NGO
Networks (CODE-NGO), repackaged and sold at a premium to investors. The net
proceeds from the sale will be used to endow a permanent fund to finance
meritorious activities and projects of accredited non-government organizations
(NGOs) throughout the country. In relation to this, CODE-NGO wrote a letter to the
Bureau of Internal Revenue (BIR) to inquire as to whether the PEACe Bonds will be
subject to withholding tax of 20%. The BIR issued several rulings beginning with
BIR Ruling No.020-2001 (issued on May 31, 2001) and was subsequently reiterated
its points in BIR Ruling No. 035-200119 dated August 16, 2001 and BIR Ruling No.
DA-175-0120. The rulings basically say that in determining whether financial assets
such as a debt instrument are deposit substitute, the 20 or more individual or
corporate lenders rule should apply. Likewise, the at any one time stated in the
rules should be construed as at the time of the original issuance.
With this BTr made a public offering of the PEACe Bonds to the Government
Securities Eligible Dealers (GSED) wherby RCBC won as the highest bidder for
approximately 10.17 billion, resulting in a discount of approximately 24.83 billion.
RCBC Capital Capital entered into an underwriting agreement with CODE-NGO,
whereby RCBC Capital was appointed as the Issue Manager and Lead Underwriter
for the offering of the PEACe Bonds.
In October 7, 2011, BIR issued BIR RULING NO. 370-2011 in response to the
query of the Secretary of Finance as to the proper tax treatment of the discounts
and interest derived from Government Bonds. It cited three other rulings issued in
2004 and 2005. The above ruling states that the all treasury bonds (including PEACe
Bonds), regardless of the number of purchasers/lenders at the time of
origination/issuance are considered deposit substitutes. In the case of zero-coupon
bonds, the discount (i.e. difference between face value and purchase
price/discounted value of the bond) is treated as interest income of the
purchaser/holder.
Ruling:
The PEACe Bonds, according to the SC, requires further information for proper
determination of whether these bonds are within the purview of deposit substitutes.
The Court noted that it may seem that the lender is only CODE-NGO through RCBC.
However, the underwriting agreement reveals that the entire 35billion worth of
zero-coupon bonds were sourced directly from the undisclosed number of investors.

These are the same investors to whom RCBC Capital distributed the PEACe Bonds
all at the time of the origination or issuance. Hence, until there is information as to
whether the PEACe Bonds are found within the coverage of deposit substitutes, the
proper procedure for the BIR is to collect the unpaid final withholding tax directly
from RCBC Capital/ CODE-NGO, or any lender if such be the case.
The court also noted that according to the NIRC, Section 24, interest income
received by individuals from long term deposits or investments with a holding
period of not less than five years is exempt from final tax.
The decision provided the definition of deposit substitute 1997 National Internal
Revenue Code which placed the 20-lender rule. In particular, Section 22 (Y) states
that a debt instrument shall mean 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 borrowers own account.
The determination as to whether a deposit substitute will be imposed with 20% final
withholding tax rests on the number of lenders.
In construing the phrase at any one time provided for in the definition of
public, the Supreme Court made an analysis of how financial market works.
According to the Court, in the financial market whether this refers to capital markets
securities or money market securities, transactions happen in two venues: the
Primary and the Secondary Market. The primary market transactions happen
between issuers and investors where issuance of new securities is facilitated. The
secondary market is where the trading occurs among investors. This goes to show
that for one security, there are different and separate transactions happening
depending on the flow of the transaction. In the exact words of the Supreme Court,
an agglomeration of financial transactions in securities performed by market
participants that works to transfer the funds from the surplus units (or
investors/lenders) to those who need them (deficit units or borrowers).
When there are 20 or more lenders/investors in a transaction for a specific
bond issue, the seller is required to withhold the 20% final income tax on the
imputed interest income from the bonds. The Supreme Court cited Sections 24(B)
(1), 27(D)(1), and 28(A)(7) of the 1997 National Internal Revenue Code. These
provisions state the imposition of a final tax rate of 20% upon the amount of
interest from any currency bank deposit and yield or any other monetary benefit
from deposit substitutes. On the other hand, for instruments not considered as
deposit substitutes, these will be subjected to regular income tax. The prevailing
provision is Section 32(A). Hence, should the deposit substitute involves less than
20 lenders in a transaction, the income is considered as income derived from
whatever source.
The income is a gain from sale and should not be confused with interest
provided for in Sections 24, 27 and 28. The Supreme Court noted that the gain
referred to in Section 32 (A) pertains to that realized from the trading of bonds at
maturity rate (difference between selling price in the secondary market and that
upon purchase) or the gain realized by the last holder of the bonds when redeemed
at maturity (the difference between proceeds from retirement of bonds and the

price upon acquisition of the last holder). In the case of discounted instruments, like
the zero-coupon bonds, the trading gain shall be the excess of the selling price over
the book value or accreted value (original issue price plus accumulated discount
from the time of purchase up to the time of sale) of the instruments.
The Supreme Court finds that the BIR Rulings issued in 2001 and the assailed
BIR Rulings are defective taking into consideration the above discussions on deposit
substitutes and its tax treatment. As for the BIR Rulings issued in 2001, the SC finds
that the interpretation of the phrase at any one time, is to mean at the point of
origination alone is unduly restrictive. On the other hand, the 2011 BIR Ruling
which relied on the 2004 and 2005 BIR Rulings is void for creating a distinction
between government bonds and those issued by private corporations, when there is
none in the law. Further, it completely disregarding the 20-lender rule under the
NIRC since it says, all treasury bonds . . . regardless of the number of
purchasers/lenders at the time of origination/issuance are considered deposit
substitutes

i Disclaimer: It is still better to read the originals to understand the case fully. The digest
is based on the writers understanding of the case.