Financial vs. Tax Reporting of Inter-Company Loans
Financial Presentation vs. Tax Reporting of Inter-Company Loans
by Tata D. Panlilio
Having completed the implementation of the new Philippine Accounting Standards (PASs) as adopted from the revised International Accounting Standards (IASs) in their 2005 Financial Statements (FS) and income tax returns, companies, as well as their auditors and tax consultants, can now perhaps take more time to closely analyze issues that arose from the differences between financial presentation and tax reporting of certain transactions. Among these are inter-company loans, particularly those between parent companies and their subsidiaries.
The tax rules applicable to inter-company loans do not necessarily follow the requirements for financial reporting purposes. As such, it is crucial that companies understand these differences in order for them to explain to tax examiners and government regulatory agencies the apparent disparities in the treatment.
In general, the tax implications of a loan are as follows: (a) documentary stamp tax of P1.00 for every P200.00 of value of the debt instrument as indicated in the loan agreement is imposed; (b) interest income from loans granted by a domestic corporation or a resident corporation engaged in business in the Philippines is aggregated with all other sources of income and subjected to corporate income tax of 35% of net taxable income (i.e., gross income less allowable deductions); and (c) interest payments on loans granted by non-resident foreign corporations are subject to a final withholding tax of 20% or preferential tax rate under the applicable tax treaty.
Under PAS 32, a financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Inter-company loans or advances fall within the definition of financial instruments and as such, are required to be initially recognized at fair value pursuant to PAS 39. Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.
Generally, where the inter-company loans are granted on normal commercial terms, the fair value at the time of the grant would be equivalent to the loan amount and presentation in the FS would be straightforward. In this case, determination of the tax consequences would also be simple.
However, where the loans are not on normal commercial terms, for accounting purposes, the initial recognition, subsequent measurement, presentation in the FS and extent of disclosure depends, to a large degree, on the terms, conditions and circumstances of the loans. Notwithstanding the FS reporting, the tax rules should remain the same.
For example, if a parent company grants a loan to a subsidiary which is repayable only at the discretion of the subsidiary, in substance, the loan is a capital contribution, hence, in the FS of the subsidiary, the proceeds of the loan is recorded as a component of equity . In the FS of the parent company, the loan is recorded as part of its investment in the subsidiary. For tax purposes, even though the loan is recorded in the books of the subsidiary as a component of equity, the tax consequences mentioned earlier should not be affected.
In the case of fixed term inter-company loans, these are required under accounting rules to be recognized initially at their fair value, estimated by discounting the future loan repayments using a rate based on the rate the borrower would pay to an unrelated lender for a loan with similar conditions. Where the loan is from a parent to a subsidiary, the difference between the loan amount and the fair value (discount or premium) should be recorded as an investment in the parent’s FS and a component of equity in the subsidiary’s FS. Thus, in the FS of the parent, the loan transaction would be presented as consisting of: (a) a receivable from the subsidiary equal to the fair value of the loan; and (b) the differe
nce betwee n the fair value and loan amount as part of the investment in the subsidiary. In the FS of the subsidiary, the loan transaction would be presented as consisting of: (a) payable to the parent equal to the fair value of the loan; and (b) the difference between the fair value and loan amount as a component of equity or capital contribution. Likewise, in this example, the tax rules should remain the same notwithstanding the requirements for financial reporting purposes.
The foregoing examples illustrate that certain issues may arise from the differences between financial presentation and tax reporting of inter-company loans. While the difference between the fair value and the loan amount is recorded as part of investment or component of equity, another issue is whether this affects the debt-to-equity ratio position of the subsidiary.
More importantly, the recording of such difference following the financial reporting requirements should not be construed by the tax and regulatory authorities as having resulted in the actual issuance of shares to the parent company (or as additional paid-in capital of the latter without issuing shares) but merely presented as such to comply with the accounting rules.
It is important to keep in mind that in general, the tax rules applicable to inter-company loans remain the same despite the changes in the accounting rules. However, companies would be well-advised to understand the temporary or seeming differences arising from financial presentation vs. tax reporting purposes to enable them to sufficiently address any questions that may be raised by the tax investigators and regulatory agencies. (The author is a tax manager at Punongbayan & Araullo, member of Grant Thornton International. For comments and inquiries, please e-mail the author or call 886-5511.)