Definition of terms

1. Zero-coupon bond - a bond bought at a price substantially lower than its face value
(or at a deep discount), with the face value repaid at the time of maturity. It does
not make periodic interest payments, or have so-called coupons, hence the term
zero-coupon bond. However, the discount to face value constitutes the return to the
bondholder.
2. Primary markets - facilitate the issuance of new securities. Transactions in primary
markets exist between issuers and investors
3. Secondary markets - facilitate the trading of existing securities, which allows for a
change in the ownership of the securities. Transactions in primary markets exist
among investors.
4. Direct financing, the borrower and lender meet each other and exchange funds in
return for financial assets (e.g., purchasing bonds directly from the company issuing
them). This method provides certain limitations such as: (a) both borrower and
lender must desire to exchange the same amount of funds at the same time[;]and
(b) both lender and borrower must frequently incur substantial information costs
simply to find each other.
5. Semidirect financing, a securities broker or dealer brings surplus and deficit units
together, thereby reducing information costs.
6. Broker is an individual or financial institution who provides information concerning
possible purchases and sales of securities. Either a buyer or a seller of securities
may contact a broker, whose job is simply to bring buyers and sellers together.
7. Dealer also serves as a middleman between buyers and sellers, but the dealer
actually acquires the sellers securities in the hope of selling them at a later time at a
more favorable price.Frequently, a dealer will split up a large issue of primary
securities into smaller units affordable by buyers and thereby expand the flow of
savings into investment.
8. Financial market, therefore, is an agglomeration of financial transactions in
securities performed by market participants that works to transfer the funds from the
surplus units (or investors/lenders) to those who need them (deficit units or
borrowers).
Factual Background
On March 23, 2001, the Caucus of Development NGO Networks (CODE-NGO)
requested from The Department of Finance for the issuance of the Bureau of Treasury of a
10-year zero-coupon Treasury Certificate, to be initially purchased by a special vehicle then
later repackaged and sold to investors as PEACe Bonds. Profit from which shall be used to
finance NGO projects nationwide.
The BIR issued BIR Ruling No. 020-2001 (BIR 2001) on the tax treatment of such
bonds, stating that such are not considered deposit substitutes and not subject to FWT
and raising the 20-lender rule of the NIRC for the determination of deposit substitutes,
where it shall be determined at the time of issuance
The special purpose vehicle method was question by Former Treasurer Edeza, thus
an auction was announced for the P30 billion worth zero-coupon bonds, accompanying such

announcement are Auction Guidelines stating that the bonds shall not be subject to 20%
FWT.
CODE-NGO, through RCBC, was declared the winner, the bonds were issued to RCBC
for P10.17. It was then RCBC Capital sold the Government Bonds in the secondary market
for an issue price of P11,995,513,716.51. Petitioners purchased the PEACe Bonds on
different dates
On October 2011 BIR issued BIR Ruling 2011 which imposed a 20% FWT on the
Government bonds and directing BIR to withhold said tax until maturity. Thus Php 24.3
billion discount should be subject to FWT on interest income from deposit substitutes,
foregoing the 20 lender rule at the time of issuance. It further states that that the [1997]
Tax Code is clear that the term public means borrowing from twenty (20) or more
individual or corporate lenders at any one time. The word any plainly indicates that the
period contemplated is the entire term of the bond, and not merely the point of origination
or issuance. . . . Thus, by taking the PEACe bonds out of the ambit of deposits [sic]
substitutes and exempting it from the 20% Final Tax, an exemption in favour of the PEACe
Bonds was created when no such exemption is found in the law.
The PEACe Bonds was then considered subject to the final withholding tax due on the
discount or interest earned on the PEACe Bonds should be imposed and withheld not only
on RCBC/CODE NGO but also [on] all subsequent holders of the Bonds. This Prompted
petitioners, buyers of the bond, to file for certiorari, prohibition, and mandamus, with prayer
for TRO, with the Supreme Court. The TRO was granted subject to the condition that 20%
FWT shall be withheld by the petitioner banks and placed in a escrow account.
On November of 2011 the Bureau of Treasury paid the face value of the bonds but
not the amounts corresponding to the 20% FWT. Thus the courts ordered respondents to
show cause as to the non-compliance of the TRO
On December 2011, respondents filed compliance stating that they have already
released the funds except for the 20% FWT since it already became part of the public funds
and cannot be disbursed without appropriation
Issues:
1. Whether PEACe bonds are deposit substitutes
2. Whether collection of FWT violates due process, non-impairment and nonretroactivity
3. Whether the BIR is stopped from collecting the FWT
Arguments

Petitioner

1. The 2011 BIR Ruling is ultra vires because it is contrary to the 1997
National Internal Revenue Code when it declared that all government debt
instruments are deposit substitutes regardless of the 20-lender rule.

Petitioners insist that the PEACe Bonds are not deposit substitutes as defined
under Section 22(Y) of the 1997 National Internal Revenue Code because
there was only one lender (RCBC) to whom the Bureau of Treasury issued the
Bonds.
That their income from the Bonds is a trading gain, which is exempt from
income tax. They insist that [t]hey are not lenders whose income is
considered as interest income or yield subject to the 20% FWT under Section
27 (D)(1) of the [1997 National Internal Revenue Code] because they
acquired the Government Bonds in the secondary or tertiary market.

2. The 2011 BIR Ruling cannot be applied retroactively because:

They argue that [b]y her blanket and arbitrary classification of treasury
bonds as deposit substitutes, respondent CIR not only amended and
expanded the NIRC, but effectively imposed a new tax on privately-placed
treasury bonds. Petitioners-intervenors RCBC and RCBC Capital further
argue that the 2011 BIR Ruling will cause substantial impairment of their
vested rights109 under the Bonds since the ruling imposes new conditions by
subjecting the PEACe Bonds to the twenty percent (20%) final withholding
tax notwithstanding the fact that the terms and conditions thereof as
previously represented by the Government, through respondents BTr and BIR,
expressly state that it is not subject to final withholding tax upon their
maturity.

a) It will violate the contract clause;

o

It constitutes a unilateral amendment of a material term (tax exempt status)

in the Bonds, represented by the government as an inducement and
important consideration for the purchase of the Bonds;

the tax exemption privilege relating to the issuance of the PEACe Bonds . . .
partakes of a contractual commitment granted by the Government in
exchange for a valid and material consideration [i.e., the issue price paid and
savings in borrowing cost derived by the Government,] thus protected by the
non-impairment clause of the 1987 Constitution

b) It constitutes deprivation of property without due process because

there was no prior notice to bondholders and hearing and publication;
c) It violates the rule on non-retroactivity under the 1997 National
Internal Revenue Code;
d) It violates the constitutional provision on supporting activities of nongovernment organizations and development of the capital market; and

3.

The assessment had already prescribed.

[T]he integrity of Government-issued bonds and notes will be greatly

shattered and the credit of the Philippine Government will suffer if the
sudden turnaround of the government will be allowed, and it will
reinforce investors perception that the level of regulatory risk for
contracts entered into by the Philippine Government is high, thus
resulting in higher interest rate for government-issued debt
instruments and lowered credit rating.

They point out that under Section 7 of DOF Department Order No.
141-95, the final withholding tax should have been withheld at the
time of their issuance[.] Also, under Section 203 of the 1997 National
Internal Revenue Code, internal revenue taxes, such as the final tax,
[should] be assessed within three (3) years after the last day
prescribed by law for the filing of the return.

Respondent
1) Respondent Commissioner of Internal Revenue did not act with grave
abuse of discretion in issuing the challenged 2011 BIR Ruling:

The 2011 BIR Ruling, being an interpretative rule, was issued by virtue of the
Commissioner of Internal Revenues power to interpret the provisions of the
1997 National Internal Revenue Code and other tax laws. Commissioner of
Internal Revenue is not bound by his or her predecessors rulings especially
when the latters rulings are not in harmony with the law;
Their imposition of the 20% final withholding tax is not arbitrary because they
were only performing a duty imposed by law; [t]he 2011 BIR Ruling is an
interpretative rule which merely interprets the meaning of deposit substitutes
[and upheld] the earlier construction given to the term by the 2004 and 2005
BIR Rulings. Hence, respondents argue that there was no need to observe
the requirements of notice, hearing, and publication[.]
2011 BIR Ruling is a valid exercise of the Commissioner of Internal Revenues
rule-making power; that it and the 2004 and 2005 BIR Rulings did not unduly
expand the definition of deposit substitutes by creating an unwarranted
exception to the requirement of having 20 or more lenders/purchasers; and
the word any in Section 22(Y) of the National Internal Revenue Code plainly
indicates that the period contemplated is the entire term of the bond and not
merely the point of origination or issuance.
[W]hile revenue regulations as a general rule have no retroactive effect, if
the revocation is due to the fact that the regulation is erroneous or contrary
to law, such revocation shall have retroactive operation as to affect past
transactions, because a wrong construction of the law cannot give rise to a
vested right that can be invoked by a taxpayer.

2) Rule 65 can be resorted to only if there is no appeal or any plain, speedy,

and adequate remedy in the ordinary course of law as to the nonobservance of the doctrine of exhaustion of administrative remedies and of
hierarchy of courts.

According to them, the jurisdiction to review the rulings of the

[Commissioner of Internal Revenue], after the aggrieved party exhausted the
administrative remedies, pertains to the Court of Tax Appeals.

3) PEACe bonds are interest income.

Respondents contend that the discount/interest income derived from the

PEACe Bonds is not a trading gain but interest income subject to income
tax.126 They explain that [w]ith the payment of the PhP35 Billion proceeds
on maturity of the PEACe Bonds, Petitioners receive an amount of money
equivalent to about PhP24.8 Billion as payment for interest. Such interest is
clearly an income of the Petitioners considering that the same is a flow of
wealth and not merely a return of capital the capital initially invested in the
Bonds being approximately PhP10.2 Billion[.]

Ruling:
1. Non-exhaustion of administrative remedies;
General Rule: The power to interpret the provisions of this Code and other tax
laws shall be under the exclusive and original jurisdiction of the
Commissioner, subject to review by the Secretary of Finance.
Exception:
(1) when there is a violation of due process,
(2) when the issue involved is purely a legal question,
(3) when the administrative action is patently illegal amounting to lack
or excess of jurisdiction,
(4) when there is estoppel on the part of the administrative agency
concerned,
(5) when there is irreparable injury,
(6) when the respondent is a department secretary whose acts as an
alter ego of the President bears the implied and assumed approval of
the latter,
(7) when to require exhaustion of administrative remedies would be
unreasonable,
(8) when it would amount to a nullification of a claim,
(9) when the subject matter is a private land in land case proceedings,
(10) when the rule does not provide a plain, speedy and adequate
remedy,
(11) when there are circumstances indicating the urgency of judicial
intervention.
The exceptions under (2) and (11) are present in this case. The question
involved is purely legal, namely: (a) the interpretation of the 20-lender rule in

the definition of the terms public and deposit substitutes under the 1997
National Internal Revenue Code; and (b) whether the imposition of the 20% final
withholding tax on the PEACe Bonds upon maturity violates the constitutional
provisions on non-impairment of contracts and due process. Judicial
intervention is likewise urgent with the impending maturity of the PEACe Bonds
on October 18, 2011.
In this case, an appeal to the Secretary of Finance from the questioned 2011
BIR Ruling would be a futile exercise because it was upon the request of the
Secretary of Finance that the 2011 BIR Ruling was issued by the Bureau of
Internal Revenue. It appears that the Secretary of Finance adopted the
Commissioner of Internal Revenues opinions as his own.
2. Hierarchy of Courts;
General Rule: CTA exercises exclusive appellate jurisdiction to review
decisions of CIR
Exception: In exceptional cases, when dictated by public welfare and the
advancement of public policy, or demanded by the broader interest of justice,
or the orders complained of were found to be patent nullities, or the appeal
was considered as clearly an inappropriate remedy.
The tax provision on deposit substitutes affects not only the PEACe Bonds but
also any other financial instrument or product that may be issued and traded
in the market. Due to the changing positions of the Bureau of Internal
Revenue on this issue, there is a need for a final ruling from this court to
stabilize the expectations in the financial market.
IT IS TO BE NOTED: Non-compliance with the rules on exhaustion of administrative
remedies and hierarchy of courts had been rendered moot by this courts issuance of
the temporary restraining order enjoining the implementation of the 2011 BIR
Ruling. The temporary restraining order effectively recognized the urgency and
necessity of direct resort to this court.
3. Tax treatment of deposit substitutes
Under Sections 24(B)(1), 27(D)(1), and 28(A)(7) of the 1997 National
Internal Revenue Code, a final withholding tax at the rate of 20% is imposed
on interest on any currency bank deposit and yield or any other monetary
benefit from deposit substitutes and from trust funds and similar
arrangements.
Under the 1997 National Internal Revenue Code, Congress specifically defined
public to mean twenty (20) or more individual or corporate lenders at any
one time. Hence, the number of lenders is determinative of whether a debt
instrument should be considered a deposit substitute and consequently
subject to the 20% final withholding tax.
4. Meaning of at any one time, the 20-lender rule and Financial markets
From the point of view of the financial market, the phrase at any one time
for purposes of determining the 20 or more lenders would mean every
transaction executed in the primary or secondary market in connection with
the purchase or sale of securities.

Where the financial assets involved are government securities like bonds, the
reckoning of 20 or more lenders/investors is made at any transaction in
connection with the purchase or sale of the Government Bonds, such as:
1. Issuance by the Bureau of Treasury of the bonds to GSEDs in the primary
market;
2. Sale and distribution by GSEDs to various lenders/investors in the
secondary market;
3. Subsequent sale or trading by a bondholder to another lender/investor in
the secondary market usually through a broker or dealer; or
4. Sale by a financial intermediary-bondholder of its participation interests in
the bonds to individual or corporate lenders in the secondary market.

5.

When, through any of the foregoing transactions, funds are simultaneously

obtained from 20 or more lenders/investors, there is deemed to be a public
borrowing and the bonds at that point in time are deemed deposit substitutes.
Consequently, the seller is required to withhold the 20% final withholding tax
on the imputed interest income from the bonds.

Interest income v. gains from sale or redemption

The gains contemplated in Section 32(B)(7)(g) refers to:
(1) gain realized from the trading of the bonds before their maturity
date, which is the difference between the selling price of the bonds in
the secondary market and the price at which the bonds were purchased
by the seller; and
(2) gain realized by the last holder of the bonds when the bonds are
redeemed at maturity, which is the difference between the proceeds
from the retirement of the bonds and the price at which such last holder
acquired the bonds.
For discounted instruments, like the zero-coupon bonds, the trading gain shall
be the excess of the selling price over the book value or accreted value
(original issue price plus accumulated discount from the time of purchase up
to the time of sale) of the instruments.

6.

For debt instruments that are not deposit substitutes, regular income tax
applies
It must be emphasized, however, that debt instruments that do not qualify as
deposit substitutes under the 1997 National Internal Revenue Code are
subject to the regular income tax.
The phrase all income derived from whatever source in Chapter VI,
Computation of Gross Income,Section 32(A) of the 1997 National Internal

Revenue Code discloses a legislative policy to include all income not expressly
exempted as within the class of taxable income under our laws.
7.

Tax treatment of income derived from the PEACe Bonds

The transactions executed for the sale of the PEACe Bonds are:
1. The issuance of the P35 billion Bonds by the Bureau of Treasury to
RCBC/CODE-NGO at P10.2 billion; and
2. The sale and distribution by RCBC Capital (underwriter) on behalf of
CODE-NGO of the PEACe Bonds to undisclosed investors at P11.996
billion.

It may seem that there was only one lender RCBC. However, it is revealed
that the settlement dates for the sale and distribution by RCBC Capital of the
PEACe Bonds to various undisclosed investors at a purchase price of
approximately P11.996 would fall on the same day when it was issued. In
reality, therefore, the entire P10.2 billion was sourced directly from the
undisclosed number of investors to whom RCBC Capital/CODE-NGO
distributed the PEACe Bonds. At this point, however, we do not know as to
how many investors the PEACe Bonds were sold to by RCBC Capital.
Should there have been a simultaneous sale to 20 or more lenders/investors,
the PEACe Bonds are deemed deposit substitutes.

8.

The collection of tax is not barred by prescription

The three (3)-year prescriptive period under Section 203 of the 1997 National
Internal Revenue Code to assess and collect internal revenue taxes is
extended to 10 years in cases of (1) fraudulent returns; (2) false returns with
intent to evade tax; and (3) failure to file a return, to be computed from the
time of discovery of the falsity, fraud, or omission.
Thus, should it be found that RCBC Capital/CODE-NGO sold the PEACe Bonds
to 20 or more lenders/investors, the Bureau of Internal Revenue may still
collect the unpaid tax from RCBC Capital/CODE-NGO within 10 years after the
discovery of the omission.

9.

The Bureau of Internal Revenue rulings

The Bureau of Internal Revenues interpretation as expressed in the three
2001 BIR Rulings is not consistent with law. Its interpretation of at any one
time to mean at the point of origination alone is unduly restrictive.
BIR Ruling No. 370-2011 is likewise erroneous, it is, thus, declared void
because it completely disregarded the 20 or more lender rule added by
Congress in the 1997 National Internal Revenue Code. It also created a
distinction for government debt instruments as against those issued by
private corporations when there was none in the law.
This court further held that [a] memorandum-circular of a bureau head could
not operate to vest a taxpayer with a shield against judicial action [because]

there are no vested rights to speak of respecting a wrong construction of the

law by the administrative officials and such wrong interpretation could not
place the Government in estoppel to correct or overrule the same.
10. Necessity for legislative appropriation
We recall the November 15, 2011 resolution issued by this court directing
respondents to show cause why they failed to comply with the [TRO]; and
[to] comply with the [TRO] in order that petitioners may place the
corresponding funds in escrow pending resolution of the petition. The 20%
final withholding tax was effectively placed in custodia legis when this court
ordered the deposit of the amount in escrow. The Bureau of Treasury could
still release the money withheld to petitioners for the latter to place in escrow
pursuant to this courts directive. There was no legal obstacle to the release
of the 20% final withholding tax to petitioners.

Congressional appropriation is not required for the servicing of public debts in

view of the automatic appropriations clause embodied in Presidential Decree
Nos. 1177 and 1967.
The amount of P35 billion that includes the monies corresponding to
20% final withholding tax is a lawful and valid obligation of the Republic under
the Government Bonds. Since said obligation represents a public debt, the
release of the monies requires no legislative appropriation.