The Supreme Court clarified the definition of “deposit substitutes” under the National Internal Revenue Code, particularly concerning government bonds. The court emphasized the importance of the “20-lender rule,” stating that a debt instrument is considered a deposit substitute only if funds are borrowed from twenty or more individual or corporate lenders simultaneously. This ruling impacts how interest income from bonds is taxed, ensuring that only borrowings from a wide segment of the public are subject to a 20% final withholding tax, protecting smaller, private placements from being classified as such.

PEACe Bonds and the Public Test: How Many Lenders Define a ‘Deposit Substitute’?

The Banco de Oro case revolves around the tax treatment of the Poverty Eradication and Alleviation Certificates (PEACe Bonds). These bonds, issued by the Bureau of Treasury, became subject to a 20% final withholding tax following a BIR ruling in 2011. Several banks contested this ruling, arguing that the bonds did not qualify as “deposit substitutes” under the tax code, which defines such instruments as those involving borrowings from twenty or more lenders. The core legal question was whether the PEACe Bonds, initially issued to a limited number of entities but later traded in the secondary market, met this definition and were, therefore, subject to the withholding tax.

The petitioners argued that the PEACe Bonds were not deposit substitutes because they were initially issued to a single entity, RCBC. They claimed that the subsequent participation of investors in the secondary market should not be considered when determining whether the 20-lender rule was met. Moreover, they contended that the BIR’s interpretation expanded the definition of deposit substitutes beyond what was intended by law. The petitioners also raised concerns about the government’s change in position, arguing that it violated the principle of non-impairment of contracts and deprived them of property without due process.

The respondents, however, maintained that the discount or interest income derived from the PEACe Bonds was subject to income tax and did not qualify as a trading gain. They contended that the term “any one time” in the definition of deposit substitutes should be interpreted to include the entire term of the bond, not just the initial issuance. The respondents also argued that the BIR rulings merely interpreted the term “deposit substitute” in accordance with the tax code and that the government was not estopped from imposing the withholding tax.

The Supreme Court addressed the procedural issues first, acknowledging that direct resort to the Court was justified due to the purely legal questions involved and the urgency of the matter. While normally, tax rulings are first appealed to the Court of Tax Appeals (CTA), the high court took cognizance of the petition due to the nature and importance of the issues raised to the investment and banking industry, specifically regarding the definition of government debt instruments as deposit substitutes. The court also highlighted the inconsistencies of the Bureau of Internal Revenue (BIR) on this matter, making a final ruling necessary to stabilize the financial market.

Regarding the substantive issues, the court focused on interpreting the definition of “deposit substitutes” under Section 22(Y) of the 1997 National Internal Revenue Code. The court noted that the definition includes the phrase “borrowing from twenty (20) or more individual or corporate lenders at any one time.” The court then scrutinized the meaning of “at any one time” within the context of the financial market, pointing out that financial markets facilitate the transfer of funds from lenders to borrowers through various transactions. Transactions can occur in the primary market (issuance of new securities) or secondary market (trading of existing securities). The court stated that “at any one time” should be interpreted as every transaction executed in the primary or secondary market. If funds are simultaneously obtained from 20 or more lenders/investors at any point, the bonds are deemed deposit substitutes, and the seller is required to withhold the 20% final withholding tax.

The Court emphasized the distinction between interest income and gains from the sale or redemption of bonds. While interest income represents the return for the use of money, gains from sale or exchange refer to the difference between the selling price and the purchase price of the bonds. The exemption under Section 32(B)(7)(g) of the tax code applies only to gains, not to interest income. Therefore, regardless of whether the PEACe Bonds are considered deposit substitutes, the interest income derived from them is subject to income tax.

Ultimately, the Supreme Court nullified BIR Ruling Nos. 370-2011 and DA 378-2011, finding that they erroneously disregarded the 20-lender rule. The Court stated that the BIR’s interpretation of “at any one time” to mean only at the point of origination was unduly restrictive, as well as the blanket categorization of all treasury bonds as deposit substitutes, irrespective of the number of lenders. The Bureau of Treasury was reprimanded for not releasing the 20% final withholding tax amount to the banks for escrow as initially directed by the court. The court ordered the immediate release of the withheld amounts to the bondholders, clarifying the tax treatment of government bonds and reinforcing the importance of adhering to the statutory definition of deposit substitutes.

FAQs

What was the key issue in this case?	The key issue was whether the PEACe Bonds should be classified as “deposit substitutes” under the National Internal Revenue Code, which would subject them to a 20% final withholding tax. This hinged on the interpretation of the “20-lender rule.”
What is a “deposit substitute” according to the tax code?	A deposit substitute is an alternative form of obtaining funds from the public, other than deposits, through the issuance, endorsement, or acceptance of debt instruments. To be considered a deposit substitute, the borrowing must be from twenty or more individual or corporate lenders at any one time.
How did the BIR rulings affect the PEACe Bonds?	The BIR initially ruled that the PEACe Bonds were not deposit substitutes. However, a later ruling in 2011 reversed this position, subjecting the bonds to a 20% final withholding tax, which triggered the legal challenge.
What did the Supreme Court decide about the BIR rulings?	The Supreme Court nullified the BIR rulings that classified the PEACe Bonds as deposit substitutes. The court emphasized that the 20-lender rule must be applied and that bonds are only considered deposit substitutes if they simultaneously obtain funds from 20 or more lenders/investors.
What does “at any one time” mean in the context of the 20-lender rule?	The Supreme Court interpreted “at any one time” to mean every transaction executed in the primary or secondary market. The number of lenders is to be reckoned at any transaction for the purchase or sale of securities.
Are gains from the sale of bonds taxable?	Gains realized from the sale or exchange or retirement of bonds with a maturity of more than five years are generally exempt from ordinary income tax, while interest income earned is subject to income tax. This distinction was clarified in the ruling.
What was the outcome regarding the temporary restraining order (TRO)?	The Supreme Court acknowledged that the Bureau of Treasury was justified in withholding the tax initially, as the TRO was received after the withholding had occurred. However, the court reprimanded the Bureau of Treasury for failing to release the withheld amount to the banks to be placed in escrow, as directed by the TRO.
Why was the Bureau of Treasury reprimanded?	The Bureau of Treasury was reprimanded for not complying with the court’s directive to release the withheld tax amount for placement in escrow. The Court emphasized that the Bureau of Treasury had a duty to obey the TRO until it was set aside or modified.

This case clarifies the scope of the term “deposit substitutes” and its implications for taxation, offering guidance for financial institutions and investors dealing with government bonds. The decision underscores the importance of adhering to the statutory definition and the need for consistent application of tax laws. The implications of the ruling in Banco De Oro v. Republic helps to properly implement the withholding tax system for interest on bank deposits and yields from deposit substitutes.

For inquiries regarding the application of this ruling to specific circumstances, please contact ASG Law through contact or via email at frontdesk@asglawpartners.com.

Disclaimer: This analysis is provided for informational purposes only and does not constitute legal advice. For specific legal guidance tailored to your situation, please consult with a qualified attorney.
Source: Banco de Oro v. Republic, G.R. No. 198756, January 13, 2015