Understanding interest on intercompany foreign loans

Our fast-growing economy presents a wide array of opportunities for entrepreneurs. This is especially true with the unveiling of the “Dutertenomics” program by the government’s economic team. With a policy of increasing competitiveness and ease of doing business, foreign corporations and entities will most likely do business in the Philippines through incorporation or other means.

Expanding in the Philippines requires additional capital, which can be funded by loans. There are several concerns that foreign investors should consider when infusing capital through loans.

While obtaining foreign loans is a daunting process, it may be an effective business decision to some business owners, as it has an impact on the continuity of their business. When we speak of loans, interest — just like death, remembered during Halloween — is simply inevitable.

First, interest on the loan should be determined on an arm’s length basis. In reference to the arm’s length principle under Revenue Regulation No. 02-2013 and Revenue Memorandum Order No. 63-99 issued by the Bureau of Internal Revenue (BIR), which provides that where one member of a group of controlled entities makes a loan, or otherwise becomes a creditor and charges no interest, or charges interest at a rate which is not equal to an arms-length rate as defined in Section 50 of the Tax Code, the Commissioner may make appropriate allocations to reflect an arms-length interest for the use of such loan or advance. Simply put, in the absence of an interest imposed between intercompany loan transactions, the BIR could charge interest and subject it to final withholding taxes (FWT).

Second, interest payments to the non-resident foreign corporation (NRFC) are subject to Philippine tax. The applicable withholding tax rate on payment of interest to an NRFC is 20% of such interest on the premise that the NRFC is not engaged in trade or business in the Philippines. However, if the home state of the NRFC has a tax treaty with the Philippines, the Philippines can tax the interest expense at the treaty rate which is lower than the regular rate. To avail of this lower rate, it is prudent to observe the recently-issued BIR memorandum that requires the submission of Certificate of Residence for Tax Treaty Relief as part of certain procedural requirements for availing of tax treaty relief.

Third, there is a limit on the interest expense deductible to the Philippine affiliate. Since most interest income is subject to a fixed tax which is lower than the corporate income tax, some transactions are entered for the purpose of reducing taxes through the “tax arbitrage” scheme. To address this, the deductible interest expense in the Philippines is reduced by 33% of the amount of interest income subjected to FWT.

Fourth, there are substantiation requirements for the deductibility of interest expense. Interest paid or incurred within a taxable year on indebtedness in connection with the taxpayer’s profession, trade or business shall be allowed as a deduction from gross income. However, taxpayers should comply with the substantiation requirements of the Code, which require them, among others, to obtain and keep written evidence that the loan was used to finance work-related expenses.

Fifth, interest paid to certain related parties may not be deductible. To avail of the deduction under our domestic law, you have to ensure that both the taxpayer and the person to whom the payment has been made or to be made are not those persons under Section 36 (B) of the Tax Code, as amended or otherwise known as Related Party Interest.

Under this section of the Tax Code, there are instances where interest payment is not deductible, if:

(a) between an individual and corporation more than 50% in value of the outstanding stock of which is owned, directly or indirectly, by or for the individual; or

(b)  between two corporations more than 50% in value of the outstanding stock of each of which is owned, directly or indirectly, by or for the same individual, and if either one of such corporations is a personal holding company or foreign personal holding company.

How do we determine a personal holding company?

In determining whether a corporation is a personal holding company, there are two tests that must be applied. First, the Stock Ownership Test, where 50% in value of its outstanding stock is owned, directly or indirectly, by or for not more than five individuals. Second, the Gross Income Test, where at least 70% of the gross income is “personal holding income” or passive income such as dividends, interest, and royalties, etc. Thus, if all requirements are met, the interest expense is not deductible.

The percentage of ownership is a paramount factor in evaluating the relationship between the shareholder and the corporation for interest expense deductibility purposes. In several instances, the Court disallowed the interest expense because the creditor and debtor were related parties as defined in Sec. 36(b).

An alternative for an intercompany loan transaction is for the NRFC to extend the loan through an operating company rather than a personal holding company. While both corporations may be treated as related parties, an operating company derives mostly business income rather than passive income. In this way, the gross income requirement for a personal holding company may not be met, thus, interest income may be deductible.

Sixth, the interest must be expressed in writing. Revenue Regulation No. 13-2000 provides for the conditions for the deductibility of interest expense that must be complied with for income tax purposes. To name a few, there must be indebtedness, the indebtedness must be connected with the taxpayers’ trade or business, must be incurred within the taxable year and, most important, interest to be paid must be in writing.

Seventh, taxpayers should take into account the payment of Documentary Stamp Tax (DST) in connection with any loans.

Taxpayers engaging in foreign loan transactions tend to overlook that foreign loans are subject to DST, which the BIR usually uncovers during cases of tax assessment. The DST rate is P1.00 on each P200, or fractional part thereof, of the issue price of any such debt instruments.

Finally, the company may consider, though optional, the registration of loans with the Bangko Sentral ng Pilipinas (BSP). Under BSP rules, private sector intercompany loans generally do not require BSP approval, provided that the loan terms are market-oriented, the purpose is eligible for foreign financing, and there is no guarantee from any government entity or a bank operating in the Philippines. However, parties to the transaction may contemplate registering with the BSP to ensure the availability of foreign exchange for payment of interest and principal.

Now that the dreaded “ghost month” is finally over (where business people normally desist from starting new businesses or making paramount decisions or risks), we go about the “ber” months, taking risks through engaging in foreign loans as part of the business game plan. However, a comprehensive study of the tax implications is highly recommended prior to engagements in order to determine the best possible route to achieve the objectives without exposure to tax risks.

Maria Cristina M. Banaag is an associate with the Tax Advisory and Compliance division of P&A Grant Thornton.

As published in BusinessWorld, dated 10 October 2017