“Clarifying cost allocation rules for finance institutions” by Czarina R. Miranda (March 28, 2011)

SUITS THE C-SUITE By Czarina R. Miranda
Business World (03/28/2011)

Section 167 of the Income Tax Regulations recognizes that no uniform method of accounting can be prescribed for all taxpayers, and that taxpayers shall adopt such forms and systems of accounting as are, in their judgment, best suited to their purpose.

Having said that, the Bureau of Internal Revenue (BIR) has held in several rulings that there is no hard and fast rule that can guide taxpayers in allocating expenses where the business involves distinct activities (BIR Ruling Nos. 005-06 dated March 8, 2006, DA-621-06 dated Oct. 18, 2006, and DA-667-06 dated Nov. 15, 2006).

However, the BIR does have rule-making power and in the exercise of this power, it recently issued Revenue Regulations (RR) 4-2011 prescribing the “proper allocation of costs and expenses amongst income earnings of banks and other financial institutions for income tax reporting purposes.”

For depository banks, the RR applies to the operations of their regular banking unit (RBU), foreign currency deposit unit (FCDU)/expanded FCDU (EFCDU) or offshore banking unit (OBU) that are subject to different income tax regimes. An RBU is subject to regular corporate income tax of 30%, while an FCDU/EFCDU or OBU is subject to 10% final tax on its interest income from foreign currency loans granted to residents other than OBUs and FCDUs/EFCDUs.

Moreover, an FCDU/EFCDU or OBU is exempt from income tax on income derived from foreign currency transactions with nonresidents, OBUs, and local commercial banks, including branches of foreign banks authorized to transact business with FCDUs/EFCDUs.

RR 4-2011 provides that a bank may deduct only those costs and expenses attributable to the operation of the RBU to arrive at its taxable income. Any cost or expense related to or incurred in the operation of the FCDU/EFCDU or OBU is not allowed as deduction from the RBU’s taxable income.

In computing for the amount deductible from RBU operations, all costs and expenses shall be allocated as follows:

• by Specific Identification — where expenses which can be specifically identified to a particular unit (RBU, FCDU/EFCDU, or OBU) shall be reported and declared as the cost or expenses of that unit; or

• by allocation — where common expenses or costs which cannot be specifically identified to a particular unit will be allocated based on each unit’s percentage share of gross income earnings to the total gross income subject to regular income tax and final tax, including those exempt from income tax.

Interestingly, the RR states that this allocation method shall also apply to “other financial institutions” for allocating costs and expenses among income earnings derived from active business operations (subject to regular income tax), passive activities (subject to final tax), and other activities producing tax-exempt income.

Although the RR intends to formalize the rules on cost allocation of banks and other financial institutions, the BIR needs to urgently address certain issues.

For one, should these new rules cover OBUs?

Being a branch, subsidiary, or affiliate of a foreign banking corporation authorized by the Bangko Sentral ng Pilipinas (BSP) to conduct offshore banking in the Philippines, OBUs do not have a separate RBU.

They are not like depository banks licensed by the BSP to engage in foreign currency transactions, such as local or foreign banks with both an RBU and an FCDU.

The allocation rule will also apply to “other financial institutions” — a term that also deserves clarification.

In a broad sense, the term, “financial institution,” has been defined as a private (shareholder-owned) or public (government-owned) organization that acts as a channel between savers and borrowers of funds (suppliers and consumers of capital).

Two main types are:

• depository banks and credit unions that pay interest on deposits from the interest earned on loans, and

• non-depository insurance companies and mutual funds (unit trusts) that collect funds by selling their policies or shares (units) to the public and provide returns in the form of periodic benefits and profit payouts (businessdictionary.com).

Given the above definition, will the regulations apply also to insurance companies and mutual funds?

Past BIR issuances refer to “financial institutions” as banks, nonbank financial intermediaries performing quasi-banking functions, and other nonbank financial intermediaries including finance companies, but excluding insurance companies (RR 9-2004).

These also cover credit-granting institutions such as the BSP, financing companies, investment houses, government financial institutions, as well as government-owned or -controlled corporations such as the National Home Mortgage Finance Corp., Home Guaranty Corp., Home Development Mutual Fund, Social Security System, Government Service Insurance System, and others (RR 6-2004).

Furthermore, there is also the question of what the term, “gross income,” exactly means. Does it refer to total revenues/earnings, gross of expenses, or gross sales/receipts less cost of services, as has been defined in other pertinent BIR issuances?

RR 4-2011 is also silent on whether the prescribed allocation method will apply to the different types of income earned within a particular unit, say, the FCDU/EFCDU which earns different types of income like offshore and onshore income.

With respect to the allocation of costs and expenses among active, passive, and tax-exempt income, the RR does not provide if this will also apply to banks.

What it does explicitly say is that it applies to “other financial institutions.”

Moreover, the requirement is also open to debate, considering the conflicting jurisprudence on whether the allocation of costs and expenses should be allocated to passive income.

In addition, the reduction of deductible interest expense for income tax purposes by an amount equal to 33% of interest income already subjected to final tax makes tax-paid or passive income effectively subject to the 30% regular income tax; thus, expenses that may relate to such income should be allowed as deductions for regular tax purposes.

Given the foregoing issues, there is a need for the BIR to clarify RR 4-2011 so that taxpayers can adopt the prescribed method with clarity.

Considering that changes in existing tax rules are implemented to bring about reform and improvement, issuances should not be open to uncertainty or misinterpretation. The implementation and adoption of regulations will be more acceptable and efficient if these are understood easily and issued preferably in consultation with the concerned industries.

(Czarina R. Miranda is a Tax Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.