By Christian John G. Rojo, 9 July 2014
IN THE recently issued Revenue Memorandum Circular (RMC) No. 46-2014, the Bureau of Internal Revenue (BIR) clarified that a financial lease is essentially a mode of extending credit, and is therefore subject to documentary stamp tax (DST) as a loan and not as a lease.
Generally, a lease is an agreement whereby a person (lessor) binds himself to give a property to another -- (lessee) for use and enjoyment for a certain period of time in return for rental payments.
From an accounting perspective, there are two kinds of lease: operating lease and finance lease. The distinction between the two is primarily due to the application of the accounting concept of substance over form. Based on Philippine Accounting Standard (PAS) 17, which covers the accounting treatment of leases, a finance lease is a lease agreement in which substantially all the risks and rewards incidental to ownership of an asset are transferred to the lessee from the lessor. On the other hand, an operating lease is a lease other than a finance lease.
This classification has been recognized by the BIR as early as 1986 when it issued Revenue Regulations (RR) No. 19-86. Thereunder, an operating lease is a contract under which the asset is not wholly amortized during the primary period of the lease, and where the lessor does not rely solely on the rentals during the primary period for his profits, but looks for the recovery of the balance of his costs and for the rest of his profits from the sale or re-lease of the returned asset at the end of the primary lease period.
On the other hand, a finance lease or a 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. This definition of a financial lease provides no indication of a debt or credit arrangement, but focuses more on its lease classification.
However, in 2004, the BIR updated its definition by adopting the term as defined under the Financing Company Act of 1998. Therein, a finance lease was referred to as a mode of extending credit through a non-cancellable lease contract under which the lessor acquires, at the instance of the lessee, movable or immovable property in consideration of periodic payment by the lessee of a fixed amount of at least 70% of the acquisition cost. The law also defined credit to mean any loan, mortgage, finance lease, deed of trust, advance, conditional sales contract and any other contract having similar purpose or effect. This same definition was reiterated in the new RMC.
The RMC also relied on the accounting treatment of finance lease in PAS 17, where the leased asset is capitalized at the commencement of the lease in the books of accounts of the lessee, and a periodic repayment of liability is recorded rather than a periodic payment of rentals.
On the basis of these definitions and accounting treatment, the RMC clarified that a finance lease should be considered as a debt and not as a lease. As such, the BIR concluded that the appropriate DST for finance lease shall be based on Section 179 of the Tax Code, which imposes an effective DST rate of 0.5% on all debt instruments representing borrowing and lending transactions including, but not limited to, debentures, certificates of indebtedness, bonds, loan agreements and other evidences of debt having a specific maturity date.
On the other hand, under Section 194 of the Tax Code covering stamp duty lease, DST at the approximate rate of 0.1% is due on “each lease, agreement, memorandum, or contract for hire, use or rent of any lands or tenements, or portions thereof.”
Prior to the RMC, it would appear that only those lease agreements involving land and tenements were subject to DST. Under the new RMC, operating leases involving land or tenements would remain subject to 0.1% DST. However, if structured as a financial lease, the same transaction would instead be subject to the higher 0.5% DST as a debt or credit arrangement.
Moreover, all financial leases, even if involving personal property, would also be subject to 0.5% DST as a debt instrument.
Taxpayers should be mindful of this clarification by the BIR and revisit their lease arrangements if they want to be compliant with the BIR’s expected tax treatment and avoid or minimize penalties in the event of an audit.
The author is a consultant at the Tax Department of Isla Lipana & Co., the Philippine member firm of the PwC network. Readers may call (02) 845-2728 or e-mail the author at firstname.lastname@example.org for questions or feedback. The views or opinions presented in this article are solely those of the author and do not necessarily represent those of Isla Lipana & Co. The firm will not accept any liability arising from such article.