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Unqualified limitation on deductible interest expense

Under Section 34(B) of the Tax Code, in connection with the taxpayers trade, business
or exercise of profession, interests on indebtednesspaid or incurred by a corporate or
individual taxpayer within a taxable yearare allowed as a deduction from its gross
income. However, it is likewise provided therein that a taxpayers otherwise allowable
deduction for interest expense shall be reduced by 33 percent (effective January 1,
2009, pursuant to Republic Act 9337) of its interest income subjected to final tax.
To implement Section 34(B) of the Tax Code, Section 4(B) of Revenue Regulations (RR)
13-00 was issued. The Bureau of Internal Revenue (BIR), through Section 4(B) of RR
13-00, clarified that the limitation on deductible interest expense shall apply regardless
of the date when the investment and the interest bearing loan were made, and whether
or not a tax arbitrage scheme was entered into by the taxpayer, for as long as during the
taxable year, there is an interest expense incurred on one side and an interest income
earned on the other that was subjected to final withholding tax. This notwithstanding, in
at least two subsequent rulings issued by the BIR, it recognized the purpose of the
limitation provided under Section 34(B) of the Tax Code, i.e. to abate tax arbitrage
schemes.

In the BIR Ruling Nos. DA-315-04 and DA-083-06 dated June 8, 2004 and March 6,
2006, respectively, the BIR confirmed that there can be no uncertainty that interest
expense paid or incurred within a taxable year on indebtedness in connection with the
taxpayers trade, business or exercise of profession shall be allowed as a deduction from
the gross income. This was distinguished from a tax arbitrage scheme, wherein the
proceeds of a taxpayers loan are deposited or invested and the interest income derived
from the said investment had been subjected to final withholding tax. The BIR ruled that
the purpose of the tax arbitrage is to equalize the tax liability of the taxpayer on his
interest income and the tax benefit on his interest expense. Finding that there was no tax
arbitrage to speak of in both cases, the BIR confirmed that Section 34(B) does not apply
to the interest expenses of the applicant banks relative to their interest expenses on
savings and time deposits.

However, confronted with conflicting interpretations of the BIR and the Bangko Sentral
ng Pilipinas (BSP) of Section 34(B) of the Tax Code, the current Commissioner of
Internal Revenue (CIR) issued a directive affirming that there need not be a tax arbitrage
scheme in order that the limitation on the deductible interest expense can be applied.
This was embodied in a memorandum dated June 6, 2009 (circularized as Revenue
Memorandum Circular 31-2009 dated June 15, 2009). Per memorandum dated June 6,
2009, as provided under RR 13-00, the limitation on interest expense shall apply as long
as the taxpayer incurred interest expense and had interest income subjected to final
withholding tax in the same taxable year, regardless of whether or not a tax arbitrage
scheme was entered into by the taxpayer.
The position taken by the CIR in his memorandum dated June 6, 2009 is not barren of
legal basis. Section 34(B) of the Tax Code does not provide that there must be a tax
arbitrage scheme before the limitation on the deductible interest expense can be
applied. RR 13-00 merely interprets what is provided by law. The CIRs power to issue
such interpretation, on the other hand, is sanctioned under Section 4 of the Tax Code,
which vests in the CIR the exclusive and original jurisdiction to interpret the Tax Code
and other tax laws.
Moreover, such interpretation of Section 34(B) is not without precedent. Memorandum
dated June 6, 2009 is merely confirmatory of BIR Ruling No. 06-2000 issued on January
5, 2000 by a former CIR. Section 4(B) of RR 13-00 is likewise cited in BIR Ruling No.
DA-230-05 dated May 19, 2005. Earlier cited BIR Ruling Nos. DA-315-04 and DA-08306 may also not be deemed binding on the CIR. As held in the often quoted Supreme
Court case of Hilado v. Collector (100 Phil 288), construction of a statute by a
predecessor is not binding on the successors. Applying this ruling of the Supreme Court,
the CIR could be deemed vested with authority to revoke, repeal or abrogate previous
rulings of predecessors, if he becomes satisfied that a different construction should be
given.

In addition to the foregoing, it is well-settled that deductions are strictly construed against
taxpayers. He who claims a deduction must point to the specific provision of the statute
authorizing it, and he must be able to prove that he is entitled to it. (Western Minolco
Corp. v. Commissioner, 124 SCRA 212). It is only when there is an express mention in
the law or if the taxpayer falls within the purview of the exemption by clear legislative
intent that the rule on strict construction will not apply. (Commissioner v. Arnoldus
Carpentry Shop, 159 SCRA 199)
The legislative purpose for providing the limitation on deductible interest expense under
Section 34(B) of the Tax Code may be to abate tax arbitrage schemes wherein the
proceeds of a taxpayers loan obtained in connection with the operations of his trade,
business or exercise of profession is deposited or invested, and the interest income
derived from the said investment had been subjected to final withholding tax. However,
such legislative purpose cannot be gleaned from the letters of Section 34(B) of the Tax
Code. In this case, the remedy for taxpayers may not be to seek a favorable
interpretation from administrative agencies or even the courts but to seek an amendment
of this provision of law, for it to clearly reflect the said legislative purpose. Until then, the
BIR would have legal basis for reducing a taxpayers otherwise allowable deduction for
interest expense by 33 percent of his interest income subjected to final tax, whether the
taxpayer entered into a tax arbitrage scheme or not.