A Holiday for Hedging Contracts
A Holiday for Hedging Contracts
by: Kevin John D. Ampuan
With the constant drawbacks that the Philippine Peso have had against the US greenback, it is recommended that companies that are engaged in businesses dealing with foreign currency exchange transactions to adopt a strategy to eliminate risks involved in their foreign currency dealings.
One strategy that companies go for these days is entering into hedging contracts.
A hedging contract is basically an agreement entered into to reduce the risk of adverse price movements in an asset. A hedge is likened to taking out an insurance policy to mitigate the risks that may come with adverse price movements in the market. In the context of foreign currency exchanges, hedging involves contracting with a foreign currency broker to deliver or receive a specified foreign currency at a specified future date and at a specified exchange rate. It is akin to freezing the currency rate for use in another time.
While the ultimate goal of hedging is to protect businesses from losses, it is also possible that foreign exchange fluctuation gains (forex gains) may be earned by companies when the agreed exchange rate in the hedging contract is higher than the prevailing exchange rate at the time when the company opts to sell its foreign currency denominated income to its broker.
Here lies the issue – for companies enjoying preferential tax treatment such as Income Tax Holiday (ITH) or the 5% Gross Income Tax (GIT), are forex gains earned by them also entitled to preferential tax treatment?
In 2002, the Department of Finance (DOF) issued Revenue Regulations (RR) No. 20-2002 to provide guidance on the tax treatment of income derived by an enterprise registered with the Subic Bay Metropolitan Authority (SBMA), the Clark Development Authority (CDA), or the Philippine Economic Zone Authority (PEZA). Under the RR, income of registered enterprises from its registered activities shall be subject to such tax treatment as may be specified in its terms of registration (i.e., the 5% preferential tax rate, the income tax holiday, or the regular income tax rate, as the case may be). The RR also provides that income realized by registered enterprises that is not related to its registered activities shall be subject to the regular internal revenue taxes.
With RR No. 20-2002 in mind, can we consider forex gains from hedging transactions earned by registered enterprises as income related to their registered activities?
This question was answered by the Supreme Court (SC) in the 2019 case of Aegis PeopleSupport, Inc. v. CIR (G.R. No. 216601, dated 07 October 2019).
The subject case involves a claim for refund by the Petitioner of the income tax it paid on forex gains earned during the time the Petitioner was enjoying the ITH incentive. The main contention of the Petitioner is that its clients are based abroad so payments received for services rendered were denominated in US Dollars (USD). However, as Petitioner is operating in the Philippines, the operating expenses it incurred to render the services are paid in Philippine Peso (PHP). The difference in the currency of its service revenues and operating expenses necessitated the conversion of its USD-denominated income from its PEZA-registered activities to PHP, otherwise Petitioner will not be able to pay for its expenses. As such, Petitioner entered into the hedging contract to ensure that it has sufficient supply of PHP to finance its business expenses.
On the other hand, the BIR contended that the taxpayer was not entitled to a tax refund or the issuance of a tax credit certificate because it failed to substantiate its claim that its forex gains were attributable to its registered activity.
At the Court of Tax Appeals (CTA) level, the CTA Division denied the taxpayer’s claim for refund for insufficiency of evidence. Similarly, the CTA En Banc ruled against the taxpayer on the basis that the forex gains it realized through the conversion of its USD earnings to PHP under the hedging contract cannot be deemed effectively related or even anywhere near its registered trade or business- the taxpayer could still operate and continue its registered activity without the hedging contract.
When the case reached the SC, however, the High Court sided with the Petitioner and granted its claim for refund. In deciding for the Petitioner, the SC took into consideration the Articles of Incorporation which authorized the Petitioner to enter into hedging contracts in order to protect its gross revenues in the form of foreign currency from being severely devalued in terms of local currency. Because of this, the SC considered hedging to be related to the registered activities of the Petitioner and hence, forex gains earned from hedging are subject to preferential tax treatment.
From this Decision of the SC, one can infer that forex gains earned by registered enterprises can be entitled to preferential tax treatment provided that the hedging was done to protect the foreign currency revenues, which were earned from the performance of registered activities, from devaluation. It is also important that hedging is one of the purposes for which the registered enterprise was incorporated or registered.
Kevin John D. Ampuan is a Supervisor from the Tax Group of KPMG R.G. Manabat & Co. (KPMG RGM&Co.), the Philippine member firm of KPMG International. KPMG RGM&Co. has been recognized as a Tier 1 tax practice and Tier 1 transfer pricing practice by the International Tax Review.
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