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G.R. No. 198756, January 13, 2015

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.

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 borrower’s own account” The determination as to whether
a deposit substitute will be imposed with 20% final withholding tax rests on
the number of lenders.

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 SC cited Sections 24(B)
(1), 27(D)(1), and 28(A)(7) of the 1997 NIRC. 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 “gain” referred to in Section 32 (A) pertains to that realized from
the trading of bonds at maturity rate or the gain realized by the last holder of
the bonds when redeemed at maturity. 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 of the instruments.
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”