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.
IEHScT

It is also represented that due to the delay in the completion of the Project,
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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(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(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)

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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
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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(3)
In Maurice P. O'Meara v. Commissioner of Internal Revenue, 4(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
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royalty income in earlier year created no tax burden.

TEcAHI

This ruling followed the doctrine laid down in North American Oil
Consolidated v. Burnet, 5(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(6) It is similar to a payment pursuant to a judgment and has the effect and
authority of res judicata. 7(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. .
. ."
DAEcIS

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."

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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.
TcSaHC

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(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.
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Isabela Cultural Corporation. 9(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)
HEScID

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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(10)
TcDIEH

This finds supports in the case of Citytrust Investment Philippines, Inc. vs.
Commissioner of Internal Revenue 11(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(12)
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Accordingly, the reversal of the excess provision amounting to US$10.533

million is not a taxable income of LHC.
cSCADE

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:
TcDAHS

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

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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
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Footnotes
1.
2.
3.

4.
5.
6.
7.
8.
9.
10.
11.
12.

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

CA-G.R. SP No. 94316.
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.
8 T.C. 622, March 27, 1947.
286 U.S. 417 (1932).
Spouses Wilfredo and Swarnie Aromin vs. Paulo Floresca, et al., G.R. No. 160994,
July 27, 2006.
Article 2037, Civil Code.
National Internal Revenue Code of 1997, as amended.
G.R. No. 172231, February 12, 2007.
Section 34 (E), Tax Code.
CTA Case No. 4443, January 18, 1994.
Emphasis supplied.

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Endnotes
1 (Popup - Popup)
1.

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

2 (Popup - Popup)
2.

CA-G.R. SP No. 94316.

3 (Popup - Popup)
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 (Popup - Popup)
4.

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

5 (Popup - Popup)
5.

286 U.S. 417 (1932).

6 (Popup - Popup)
6.

Spouses Wilfredo and Swarnie Aromin vs. Paulo Floresca, et al., G.R. No. 160994,
July 27, 2006.

7 (Popup - Popup)
7.

Article 2037, Civil Code.

8 (Popup - Popup)
8.

National Internal Revenue Code of 1997, as amended.

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9 (Popup - Popup)
9.

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

10 (Popup - Popup)
10.

Section 34 (E), Tax Code.

11 (Popup - Popup)
11.

CTA Case No. 4443, January 18, 1994.

12 (Popup - Popup)
12.

Emphasis supplied.

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