April 13, 2007

BIR RULING NO. 009-07

RR19-86 00-000

Romulo Mabanta Buenaventura

Sayoc & De Los Angeles
30th Floor, Citibank Tower
8741 Paseo de Roxas
Makati City

Attention: Atty. Priscilla B. Valer

Gentlemen :

This refers to your letter dated August 28, 2006 stating that your client,
IBM Philippines, Inc. (IBM) is a domestic corporation duly organized and
existing under the laws of the Philippines for the purpose of carrying on the
business of merchants, brokers, traders, lessors, importers, exporters, and
dealers in and with business machines, office equipment,
telecommunications equipment and goods, wares, merchandise and
commodities of every description, and to conduct and carry on all business
appertaining thereto; that in the course of its business, IBM leases business
machines, computers, and office equipment to customers; that the leases
are documented through a Term Lease Master Agreement and a Lease
Supplement which embodies the specific terms and conditions of the lease;
that IBM offers three (3) types of leases to customers, namely: (1) full payout
lease; (2) fair market value or residual value lease; and (3) operating lease;
that a full payout lease is one where the monthly lease payments (MLPs)
during the non-cancellable term of the lease are sufficient to pay for the
leased equipment; at the end of the lease term, the leased equipment has no
more residual value and the customer is granted the option to purchase the
leased equipment for a nominal consideration of P500; that a fair market
value or residual value lease (hereinafter "FMV lease") is one where the total
MLPs during the non-cancellable term of the lease, which in no case less
than 730 days, is not sufficient to pay for the leased equipment; that 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 equipment to
IBM; (b) renew the lease; or (c) purchase the same at its fair market value;
that an operating lease is an ordinary lease where the customer pays
monthly rentals for the use of the equipment and returns the leased
equipment to IBM at the end of the lease; that in accordance with generally
accepted accounting principles or the Philippine Financial Reporting
Standards, IBM's leases are classified for financial accounting purposes into
either a finance lease or an operating lease; that a lease is treated as a
finance lease whenever the terms of the lease transfer substantially all the
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 risks and rewards of ownership to the customer; that if the present value of
the minimum lease payments equals or exceeds 90% of the fair market
value of the leased equipment, it is deemed that substantially all the risks
and rewards of ownership are transferred to the customer; hence, the lease
is treated as a finance lease; that all other leases are classified as operating
leases; that under Revenue Regulations No. 19-86, a lease arrangement may
be treated either as an operating lease, a finance lease or a conditional sale
depending on the substance of the transaction; that however, due to the
absence of clear and definitive guidelines on the characterization, tax
treatment and invoicing of leases, there are instances when IBM and its
customers differ in the characterization, tax treatment and the invoicing
practice with respect to full payout and FMV leases; that Section 4.02 of
Revenue Regulations No. 19-86 provides that where the true character of
the transaction cannot be definitely determined from the terms and
conditions of the agreement, the Commissioner shall make a determination
on the basis of all relevant facts and circumstances; and that further, Section
5 of Revenue Regulations No. 19-86 provides that a lessor engaged in the
business of leasing may secure an advance ruling to recognize the existence
of a lease.
Finally, in your letter dated March 28, 2007, it was stated that
normally, in an FMV lease, the fair market value at the end of the lease
averages about 30% of the original cost of the equipment; that the fair
market value is determined by IBM Global Asset Recovery Services Unit; that
the value of the equipment leased can range from P100,000 up to as high as
P100 million; and that although the equipment leased consist mostly of high
value computer servers, storage devices and equipment, IBM Philippines can
provide financing for personal computers.
Based on the foregoing representations, you now request for ruling on
the following:
A. Full Payout Lease
1. Whether a lease documented through the Term Lease Master
Agreement and the Full Payout Lease Supplement should be
taxed as a finance lease or as a conditional sale;
2. Should the MLPs in a full payout lease be invoiced upfront or
periodically as the MLPs fall due;
3. Should the MLPs in a full payout lease be recognized as gross
income upfront or periodically;
4. Are the MLPs in a full payout lease subject to value-added tax (VAT)
upfront or periodically over the term of the lease; and
5. What is the applicable creditable expanded withholding tax on the
MLPs under a full payout lease.
B. FMV Lease
1. Whether a lease documented through the Term Lease Master
Agreement and the FMV or Residual Value Lease Supplement
should be taxed as a finance lease or as a conditional sale;
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 2. Should the MLPs in an FMV lease be invoiced upfront or periodically
as the MLPs fall due;
3. Should the MPLs in an FMV lease be recognized as gross income
upfront or periodically over the term of the lease. If the MLPs are
recognized as income periodically, can the leased equipment be
depreciated over the life of the lease;
4. Are the MLPs in an FMV lease subject to VAT upfront or periodically
over the term of the lease; and
5. What is the applicable creditable expanded withholding tax on the
MLPs under an FMV lease.
In reply thereto, please be informed that Section 2.01/2 of Revenue
Regulations No. 19-86 provides that —
"2.01/2. Finance lease defined — "Finance lease" or full payout
lease is a contract involving payment over an obligatory period (also
called primary or basic period) of specified rental amounts for the use
of a lessor's property, sufficient in total to amortize the capital outlay
of the lessor and to provide for the lessor's borrowing costs and
profits. The obligatory period refers to the primary or basic non-
cancellable period of the lease which in no case shall be less than 730
days. The lessee, not the lessor, exercises the choice of the asset and
is normally responsible for maintenance, insurance and such other
expenses pertinent to the use, preservation and operation of the
asset. Finance leases may be extended, after the expiration of the
primary period, by non-cancellable secondary or subsequent periods
with the rentals significantly reduced. The residual value shall in no
instance be less than five per centum (5%) of the lessor's acquisition
cost of the leased asset."
Notwithstanding the foregoing definition of finance lease, an
agreement which in form is a lease may in substance be a conditional sales
contract depending upon the intent of the parties as evidenced by the
provisions of the agreement read in the light of the facts and circumstances
existing at the time the agreement was executed. (Sec. 4.03/1, Revenue
Regulations No. 19-86) In this regard, Section 4.03/2 and Section 4.03/3 of
said Regulations set the following criteria for characterizing the transaction:
"Sec. 4.03/2. Compelling persuasive factors. — A contract or
agreement purported to be a lease shall be treated as conditional
sales contract if one or more of the following compelling persuasive
facts are present:
(A) The lessee is given the option to purchase the asset at
anytime during the obligatory period of the lease,
notwithstanding that the option price is equivalent
to or higher than the current fair market value of
the asset;
(B) The lessee acquires automatic ownership of the asset
upon payment of the stated amount of "rentals"
which under the contract he is required to make;
(C) Portions of the periodic rental payments are credited
to the purchase price of the asset;
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 (D) The receipts of payment indicate that the payment
made were partial or full payments of the asset.
"Sec. 4.03/3. Absence of compelling persuasive factors. — In
the absence of the above compelling persuasive factors or contrary
implication, an intent warranting treatment of a transaction for tax
purposes as a purchase and sale rather than as a lease or rental
agreement, may in general be said to exist if, for example, one or
more of the following conditions are present:
(a) Portions of the periodic payments are made
specifically applicable to an equity to be acquired
by the lessee.
(b) The property may be acquired under a purchase
option, at a price which is nominal in relation to the
value of the property at the time when the option
may be exercised, as determined at the time of
entering into the original agreement, or which is a
relatively small amount when compared with the
total payments which are required to be made.
Full Payout Lease
Thus, an intent warranting a treatment of a transaction for tax
purposes as a purchase and sale rather than a lease or rental agreement is
said to exist if the property may be acquired under a purchase option at a
price which is nominal in relation to the value of the property at the time
when the option may be exercised, as determined at the time of entering
into the original agreement, or which is a relatively small amount when
compared with the total payments which are required to be made. IBM's full
payout lease contains a purchase option which entitles the lessee to
purchase the equipment at P500 which is a nominal price. At the end of the
lease, the lessee shall have paid for the leased equipment so it is almost
sure and there is no reason for the lessee not to exercise the option to
purchase the leased equipment. Accordingly, IBMs full payout lease should
be treated for tax purposes as a conditional sale rather than a lease in
accordance with paragraph (b) of Section 4.03/3. Such being the case, the
tax consequences of the full pay out lease are as follows:
(1) The MLPs are part of the sales price of IBM and are considered as
part of the purchase price of the equipment on the part of the vendee. (Secs.
2.05 and 3.02, Revenue Regulations No. 19-86); thus, taxable as a
conditional sale.
(2) Since the full payout lease is in essence a conditional sale rather
than a lease, IBM should issue the invoice upfront for the gross selling price
of the leased equipment which is equivalent to the MLPs payable for the
entire duration of the lease. The issuance of a sales invoice at the time the
transaction is effected is mandatory. Thus, Section 237 of the Tax Code of
1997 provides:
"Sec. 237. Issuance of Receipts or Sales or Commercial
Invoices. — All persons subject to an internal revenue tax shall, for
each sale or transfer of merchandise or for services rendered valued
at Twenty-five pesos (P25.00) or more, issue duly registered receipts
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 or sales or commercial invoices, prepared at least in duplicate,
showing the date of transaction, quantity, unit cost and description of
merchandise or nature of service: Provided, however, That in the case
of sales, receipts or transfers in the amount of one hundred pesos
(P100.00) or more, or regardless of amount, where the sale or
transfer is made by a person liable to value-added tax to another
person also liable to value-added tax; or where the receipt is issued
to cover payment made as rentals, commissions, compensations or
fees, receipts or invoices shall be issued which shall show the name,
business style, if any, and address of the purchaser, customer or
client: Provided, further, That where the purchaser is a VAT-registered
person, in addition to the information herein required, the invoice or
receipt shall further show the Taxpayer Identification Number (TIN) of
the purchaser.
"The original of each receipt or invoice shall be issued to the
purchaser, customer or client at the time the transaction is effected,
who, if engaged in business or in the exercise of profession, shall
keep and preserve the same in his place of business for a period of
three (3) years from the close of the taxable year in which such
invoice or receipt was issued, while the duplicate shall be kept and
preserved by the issuer, also in his place of business, for a like period.
"The Commissioner may, in meritorious cases, exempt any
person subject to an internal revenue tax from compliance with the
provisions of this Section."
(3) The MLPs in a full payout lease are installment payments for the
purchase of the leased equipment. Accordingly, the MLPs in a full payout
lease should be treated as the selling price for the sale of the equipment
which IBM should return as income in accordance with the method of
accounting it regularly employs in keeping its books of account or in
accordance with the installment basis allowed under Section 49 of the
National Internal Revenue Code. Thus, Section 49 (B), supra provides that —
"In the case (1) of a casual sale or other casual disposition of
personal property (other than property of a kind which would properly
be included in the inventory of the taxpayer if on hand at the close of
the taxable year), for a price exceeding One thousand pesos
(P1,000), or (2) of a sale or other disposition of real property, if in
either case the initial payments do not exceed twenty-five percent
(25%) of the selling price, the income may, under rules and
regulations prescribed by the Secretary of Finance, upon
recommendation of the Commissioner, be returned on the basis and
in the manner above prescribed in this Section. As used in this
Section, the term "initial payments" means the payments received in
cash or property other than evidences of indebtedness of the
purchaser during the taxable period in which the sale or other
disposition is made." ICAcaH

(4) Since the full payout lease is in substance a sale of goods rather
than a sale of service, the total MLPs in a full payout lease are considered
the gross selling price of the equipment subject to VAT upfront.
(5) Further, since the full payout lease is a sale of goods, the applicable
creditable withholding tax is the one percent (1%) expanded withholding tax
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 imposed on income payments made by the top ten thousand (10,000)
private corporations to their local/resident supplier of goods under Section
2.57.2(M) of Revenue Regulations No. 2-98, as amended by Revenue
Regulations No. 17-2003. Under the said Section one single purchase which
involves ten thousand pesos (P10,000) or more shall be subject to a
withholding tax. Since the full payout leases would invariably involve more
than ten thousand pesos per transaction, the total MLPs of the full payout
lease shall be subject to the 1% expanded withholding tax if the lessee has
been previously identified by the Commissioner of Internal Revenue to be
belonging to the top 10,000 private corporations.
FMV Lease
On the other hand, the FMV lease documented by the Term Lease
Master Agreement and the FMV Lease Supplement is a true finance lease
because: (i) it involves payment over an obligatory period of at least 730
days (Clause 8, Term Lease Master Agreement); (ii) the lessee, not the
lessor, is responsible for the choice of the leased asset (Clause 6, Term
Lease Master Agreement); (iii) the lessee is responsible for the delivery,
installation and acceptance of the leased equipment (Clause 11); and (iv) the
maintenance of the leased equipment is for the lessee's expense (Clause
21).
Moreover, none of the persuasive factors enumerated under Sections
4.03/2 and 4.03/3 are present. The option to purchase the leased equipment
is not exercisable anytime during the obligatory period of the lease but only
at the end of the obligatory period. The lessee does not acquire automatic
ownership of the leased equipment but has the option to purchase the same
at the end of the lease term at the fair market value of the asset.
Based on the foregoing, the tax consequences thereof are as follows:
1. The lease documented through the Term Lease Master Agreement
and the FMV Lease Supplement is a finance lease within the purview of
Revenue Regulations No. 19-86.
2. The MLPs under an FMV lease are considered rentals and shall be
invoiced periodically as the MLPs are actually or constructively received. For
VAT purposes, an FMV lease is taxed like an operating lease.
3. The MLPs under an FMV lease are considered rentals includible in the
gross income of IBM. The leased equipment under an FMV lease may be
depreciated 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 as
indicated in Annex A of Revenue Regulations No. 19-86. (Sec. 2.01, Revenue
Regulations No. 19-86)
4. Section 6.03 of Revenue Regulations No. 19-86 provides that if the
lessor is a person other than a finance or leasing company registered under
R.A. No. 5980, then the rentals resulting from the lease agreement shall be
subjected to the 4% contractor's tax which is now the 12% VAT. The MLPs
are in the nature of rentals, not the purchase price of the leased equipment.
Thus, for VAT purposes, an FMV lease is treated like an operating lease.
Accordingly, the MLPs are subject to the VAT periodically over the term of
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 the lease, not at one time at the inception of the lease.
5. The MLPs are subject to the 5% expanded withholding tax imposed
under Section 2.57.2 paragraph (C) (2) of Revenue Regulations No. 2-98, as
amended by Revenue Regulations No. 17-2003, which provides:
"(C) Rentals
xxx xxx xxx
(2) Personal Properties . — On gross rental or lease in excess of
Ten thousand pesos (P10,000) annually for the continued use or
possession of personal property used in business which the payor or
obligor has not taken or is not taking title, or in which he has no
equity, except those under financial lease arrangements with leasing
and finance companies authorized to operate under Republic Act
(R.A.) No. 8556 (Finance Company Act of 1998) — Five percent (5%).
HICSaD

Considering that IBM is not a finance company under the Finance

Company Act, the lessees should subject the MLPs paid to IBM under an FMV
lease arrangement to the 5% expanded withholding tax on rentals imposed
under Section 2.57.2 (C) of Revenue Regulations No. 2-98, as amended.
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,

(SGD.) JOSE MARIO C. BUÑAG

Commissioner of Internal Revenue

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