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Monday, October 24, 2011

A Tax on the PEACe Bonds - Who is Left Holding the Bag?

In a ruling dated October 7, 2011 (BIR Ruling No. 370-2011), the Philippine Bureau of Internal Revenue (BIR) ruled that “the PHP 24.3 billion discount on the issuance of the PEACe Bonds should be subject to 20% Final Tax on the interest income from deposit substitutes,” as provided in Section 27(D)(1) of the TaxCode of 1997.

This ruling reversed three previous BIR Rulings made under former BIR Commissioner Rene G. Banez of the Arroyo Administration on the PEACe Bonds issued in 2001. (No. 020-2001 dated May 31, 2001 and No. 035-2001 dated August 16, 2001 and No. DA-175-01 dated September 29, 2001).

Rulings under the Negotiated Sale Mode of Purchase

The May 31 and August 16 rulings were made at the time that CODE-NGO was attempting to enter into a negotiated sale of the PEACe Bonds with the Bureau of Treasury. Under this scenario, the bonds would be sold by the government to a single entity, RCBC (as a Government Securities Eligible Dealer or GSED) who would then resell the bonds to another single entity, CODE-NGO. CODE-NGO would then simultaneously resell the bonds to RCBC Capital (with a firm underwriting commitment from RCBC Capital).

The May 31, 2001 ruling said that the PEACe Bonds were not considered to be a “public” borrowing, even if the bonds would fund the government, because the PEACe Bonds were to be issued to a single entity, CODE-NGO. Since the bonds complied with the “19-Lender Rule,” the bonds were not to be classified as “deposit substitutes.” Under Section 22 (Y) of the 1997 Tax Code, the borrowing of funds can be classified as deposit substitutes “if the funds are obtained from twenty (20) or more individuals or corporate lenders at any one time.”

However, lingering questions remained on the meaning of the word “public” and the interpretation of the phrase “at any one time.” Hence, there was a need for a second clarificatory ruling on August 16, 2001. The ruling stated that since the bonds will be “issued only to one entity, that is, RCBC,” there is no borrowing from the public. The ruling also stated that “the phrase 'at any one time' covers only the origination or original issuance of the bonds regardless of whether sale or trading is made in the secondary market.” This ruling effectively allowed RCBC/RCBC Capital to resell the bonds in the secondary market without losing the tax-exempt status of the bonds.

However, the ruling required that CODE-NGO/RCBC warrant that it is acquiring the bond for its own behalf. The ruling stated that:

“a representation or warranty should be made to the effect that the bonds are acquired upon their original issuance by the original purchaser thereof, for and on its own behalf, or on behalf of a single purchaser only, and in the latter case, that the purchaser is acquiring such bonds for its own account and not for the account of other entities.”

Ruling under Treasury Bond Auction Mode of Purchase

CODE-NGO's proposed mode of purchase, through a negotiated sale with the Bureau of Treasury proved to be problematic for the Treasury. The exclusive purchase offer would have raised the local financial community's fears of a crony deal in the making. This was primarily because the approval for such an offer lies within the Department of Finance headed by Secretary Jose Isidro Camacho, a brother of CODE-NGO chairperson, Maria Socorro Camacho-Reyes. On July 12, 2001, National Treasurer Sergio Edeza wrote a memo to Secretary Jose Isidro Camacho questioning the propriety of issuing the bonds directly to CODE-NGO because CODE-NGO was not a Government Securities Eligible Dealer. Sometime in July/August 2001, Secretary Camacho hosts the infamous “meeting between CODE-NGO and the Bureau of Treasury wherein both he and his sister are present.

On September 26, 2001, it became apparent that a negotiated sale was no longer possible when the Bureau of Treasury announced that the PEACe Bonds will be sold via auction to be held on October 2, 2001. As such, there was the possibility that the bonds may not be issued to a single entity, since there was a possibility that CODE-NGO may not win all of the PEACe Bond issue.

Very Narrow Definition of the phrase “at any one time”

Hence, there was a need for a third clarificatory ruling that was made on September 29, 2001. In that ruling, the BIR issued a ruling reiterated that the “the phrase 'at any one time' covers only the origination or original issuance of the bonds in the primary market regardless of whether sale or trading is made in the secondary market.” It also stated that the determining factor of whether or not the bonds were considered deposit substitutes was the number of purchasers/lenders at the time of origination/issuance.

It stated that:

“Corollarily, if the proposed PEACe Bonds are issued to less than twenty (20) individual or corporate lenders, the borrowing shall not be considered as “public” borrowing. Hence, the instrument shall not be classified as “deposit substitutes.” However, in the case of PEACe Bonds, since the determining factor in ascertaining whether or not such bonds are deposit substitutes is the original issuance to more than twenty (20) individuals or corporate lenders, it holds to say that the issuance to less than 20 individual or corporate lenders will necessarily exclude them from the coverage of “deposit substitutes.” Such being the case, the time element, i.e., “at any one time” required in “public borrowing” shall not apply in the instant case.”

The September 29, 2001 ruling also removed the August 16 ruling's requirement that CODE-NGO/RCBC make a representation/warranty that it was acquiring the bonds “for and on its own behalf, or on behalf of a single purchaser only”

Implications of the 2001 Rulings

These BIR ruling is very crucial. By defining the phrase “at any one time” to mean at the time the PEACe Bonds were first auctioned off to the GSEDs, it allowed the bonds to be sold in much smaller chunks in the secondary market without losing its tax-exempt status. Furthermore, there was no need to implement a tracking system to ensure that the bonds were held by no more than 19 investors throughout the life of the bond.

If the ruling deemed the phrase “at any one time” to mean for the life of the bonds, from date of issuance to date of maturity, the bonds will have to be sold in no more than 19 very large chunks of PHP 1.842 billion in face value or over PHP 535.2 million in cash value (at the time of issuance). Any investor who bought the bonds for resale at a later date will have to find another investor with the cash to buy at least PHP 535.2 million worth of PEACe Bonds in one transaction. That investor, in turn, must have the willingness to hold the bonds until maturity (10 years later) or have the capability to find another buyer just like him. The “19-Lender Rule” was meant to be throughout the life of the bond, it would severely limit the universe of potential bond buyers to very large institutional buyers of which there are very few. The limited market means that anyone who buys the bonds had better be prepared to tie up a very large amount of cash until maturity (when the bonds are repaid ten years later) if he is unable to resell the bonds. This market invariably boils down to two types of investors:

  1. Insurance Companies or other large financial companies with similar long term obligations; or
  2. Banks that need to fund the more “permanent” core of their liquidity reserve requirements with higher yielding instruments.

By eliminating the 19-Lender constraint in the secondary market, the ruling vastly expanded the market for PEACe Bonds without negating its tax-exempt status because the bonds now had more uses.

Retail Products

It allowed for the creation of retail products based on the zero-coupon bonds. According to RCBC Treasurer Jaime Panganiban, RCBC has thought of creating “principal protected products” not found locally.1

“I can create from these bonds a fund with a principal-protected product where your upside potential is unlimited and your worse return is 100 percent of your principal, because it's guaranteed by government, though we're not saying we have advanced product knowledge because these products you can easily find abroad,” he says.

Washing NPLs from a bank's own books

Since the bonds could now be sold in much smaller chunks, the bonds could ostensibly sold down to the level of a bank's own delinquent borrower and simultaneously be repurchased from the borrower in a cashless debit-credit accounting transaction that allows the borrowers delinquent loans to be reclassified from an NPL to a receivable from the borrower that is connected to the PEACe Bond and not the loan (See my previous post for a more detailed description of this process).

2004 and 2005 BIR Rulings

BIR's October 7, 2011 ruling was not the first time the BIR reversed the 2001 PEACe Bond Rulings. The BIR Rulings made in 2001 were first reversed in 2004 under BIR Commissioner Guillermo L. Parayno (also of the Arroyo Administration) by BIR Ruling No. 007-04 dated July 16, 2004, BIR Ruling No. DA-491-04 dated September 13, 2004 and BIR Ruling No. 008-05 dated July 28, 2005.

BIR's July 16, 2004 ruling (No. 007-04) stated that:

“since the object of the issuance is to obtain the required government funding, the issuance and subsequent distribution (exchange and trading) of Government debt instruments and securities in the secondary market to other market participants, specifically, the investors, is in itself a public borrowing of the government...It is, however, in the secondary market that the investing public makes the indirect investment in the borrowing entity, in this case, the Government.

...the mere issuance of government debt instruments and securities is deemed as falling within the coverage of “deposit substitutes” irrespective of the number of lenders at the time of origination.”

...the phrase “at any one time” in relation to public borrowing is deemed to refer to the flotation of the debt instrument or security. In other words, since the actual number of bondholders or investors may be at maturity date of the financial instrument, more than 20 individuals or corporation[s], the said direct lenders (origination) and indirect investors (secondary market) are deemed to be what constitute “public.”

Furthermore, the ruling stated that it “effectively modifies and supersedes BIR Ruling Nos. 020-2001 dated August 16, 2001 and DA-175-2001 dated September 28, 2001, as well as other BIR rulings dealing on the matter.”

BIR Ruling No. DA-491-04 dated September 13, 2004

This BIR ruling reiterated BIR Ruling No. 007-04, stating that the matter of determining the number of lenders does not come into play insofar as government debt instruments and securities are concerned.” The ruling reinstated the applicable provision of Revenue Regulations (Rev. Regs.) No. 17-84 which defined “deposit substitutes” to include “all borrowings of the national and local government and its instrumentalities... as evidenced by debt instruments denoted as treasury bonds, bills, notes, certificate of indebtedness and similar instruments...Consequently, the interest income derived therefrom by the corporate or institutional lender shall be subject to the twenty percent (20%) final tax imposed under Section 27(D)(1) of the Tax Code of 1997.

BIR Ruling No. 008-05 dated July 28, 2005

This BIR ruling determined that the twenty percent (20%) final tax is required to be withheld upfront.

Prospective or Retroactive? Or was it overlooked?

It is unclear as to whether Rulings No. 007-04, DA-491-04, and 008-05 were meant to be applied retroactively or prospectively. Given the lack of uproar at that time, it is safe to assume that the ruling was presumed to be prospective. In a petition before the Court of Tax Appeals, RCBC said that the BIR itself signaled that the 2004 ruling will only cover future bonds2.

It is also a distinct possibility that this ruling may have been overlooked at the time it was issued because the bondholders were not set to receive any imputed interest income until the bond matured six to seven years later. The banks affected claim to be utterly surprised by BIR's stance. However, BIR Commissioner Kim Henares strongly doubts this: “I don't believe that banks don't know about it because if you look at the history of the trading of that bond, right after we issued the 2004 ruling, the trading became markedly decreased.”3 A chart of the PEACe Bonds trading volumes provided by the Philippine Center for Investigative Journalism shows that trading in the bonds dropped to almost zero after the BIR issued its July 16, 2004 ruling. Trading only resumed in February 2006, but only sporadically and in much smaller volumes.

BIR Ruling No. 370-2011 dated October 7, 2011

The current BIR ruling states that BIR Ruling No. 007-04 makes the case that the Tax Code is clear that:

“the term “public” means borrowing from twenty or more individual or corporate lenders at any one time,” wherein “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.”

2001 Rulings Erroneous (or Anomalous?)

Furthermore, the current ruling stated that the 2001 Rulings took the PEACe Bonds:

“out of the ambit of deposit 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 law. Thus, the 2001 Rulings are null and void and cannot be given legal effect for being contrary to law. It is a basic principle in administrative law that the interpretation given by an administrative agency cannot run contrary to the law which it seeks to implement.”

The current ruling deemed 2001 Rulings erroneous but given the other controversial aspects of the PEACe bonds such as the information asymmetry, the wide bids, the vast gap in YTMs at the point of auction to the point of sale to institutional investors, the purported cronyism, it is easy to think of this “error” as anomalous.

The ruling went on to state that CODE-NGO should be held liable to pay the 20% Final Tax on interest income it realized from its purchase of the PEACe Bonds. Had CODE-NGO paid this tax at the time of issuance, it would have paid PHP 1.4 billion in addition to the PHP 10.169 billion purchase price of the PEACe Bonds. But since no final tax was paid by CODE-NGO upon issuance of the PEACe Bonds, CODE-NGO is liable to pay 20% final tax on the entire PHP 24.3 billion discount, or approximately PHP 4.86 billion.


The ruling said that CODE-NGO/RCBC may not invoke the principle of non-retroactivity because Section 246 of the 1997 Tax Code allows for retroactivity in cases where:

  1. the taxpayer deliberately misstates or omits material facts from his return or any document required of him by the Bureau of Internal Revenue;
  2. the facts subsequently gathered by the Bureau of Internal Revenue are materially different from the facts on which the ruling is based; or
  3. the taxpayer acted in bad faith.

The BIR said that there is:

“ample legal authority to conclude that the non-retroactivity principle does not apply when the ruling involved is null and void for being contrary to law, such as the 2001 Rulings. Well-entrenched are the principles that the Government is never estopped from collecting taxes because of mistakes and errors of its agents and there are no vested rights in a wrong interpretation of the law.”

Wrong Target

Although the ruling found CODE-NGO liable for PHP 4.86 billion in taxes, it decided to collect this tax by withholding 20% of the PEACe Bonds imputed interest income prior to its payment on the maturity date. Since neither CODE-NGO nor RCBC holds the bonds, the parties affected will be the final bondholders, in other words, those institutional investors who bought the bonds in the secondary market after CODE-NGO/RCBC had sold them down.

The Department of Finance issued two directives which compounded the problem:

  1. The Department of Finance issued a Memorandum dated October 11, 2011 which barred the sale and transfer of the PEACe Bonds from October 12, 2011 until the bonds were redeemed on October 18, 2011. Institutional investors who were uncomfortable with the October 7, 2011 ruling could not rid themselves of the PEACe Bonds they held.
  2. The BIR issued Ruling No. DA-378-2011 dated October 17, 2011 which revised the previous October 7, 2011 ruling to withhold the taxes due not only from CODE-NGO/RCBC but also to all subsequent bondholders. As a consequence, all subsequent bondholders were made liable for the 20% Final Tax.

Left Holding the Bag

A total of nine banks have reportedly been adversely affected. Eight of these banks, namely Banco De Oro, Bank of Commerce, China Banking Corporation, Metropolitan Bank & Trust Company, Philippine Bank of Communications, Philippine National Bank, Philippine Veterans Bank, and Planters Development Bank, have petitioned the Supreme Court to annul the October 7, 2011 BIR Ruling. The ninth, BPI Family Bank, declined to participate in the petition but stated that it held around 5% of the PEACe bonds4. RCBC, in a separate petition, also questioned the propriety and legality of the BIR ruling5 but did not indicate as to whether it still held some PEACe Bonds.

The eight banks asked for and received the immediate issuance of a temporary restraining order (TRO) and/or Writ of Preliminary Injunction. The PHP 4.86 billion tax to be withheld was placed in escrow while the balance of PHP 30.14 billion was paid out to the bondholders. The banks have argued that the imposition of the 20% Final Tax on the PEACe Bonds was:

“extremely prejudicial to the bondholders, including petitioners who relied in good faith on the BIR declaration that the bonds are exempt from final tax...Such unilateral imposition of the 20 percent final withholding tax on the interest/discounts realized on the government bonds only on the eve of its maturity with nary any prior consultation with the petitioners and other bondholders also amounts to confiscation of the petitioners’ property without due process... Threatened refusal of the government to pay the full face value of the government bonds to its contractual undertaking and material representation at the time of their issuance, operates as a fraud on investors to their grave or irreparable injury or prejudice, which, in turn, adversely affects their perception of the Philippines as an investment destination,”

According to the petitioning banks:

“The repercussions of the Government's threatened intent of reneging on its commitment on the Government Bonds have far-reaching implications which are too important to ignore. There will be heightened perception that the Philippine Capital Markets are volatile and unpredictable...The Government will suffer from damaged credibility in terms of investor confidence (whether current or prospective, local or foreign) relative to the legitimacy of its commitments which, by reason of the 2011 BIR Ruling, may now be perceived as subject to arbitrary reversals and/or modifications.”

The petitioning banks also added that the unilateral amendment of a material term of the contract between the bondholder and the government was never agreed to by the petitioners, thus a violation of the contract. Moreover, the imposition of a 20% Final Withholding Tax (FWT) on the eve of the bond's maturity was done “without any prior consultation with the petitioners and other bondholders or a hearing amounted to confiscation of the petitioners' property without due process.”

Flawed Ruling

There are also strong indications that BIR did not give a lot of thought to the mechanism of collecting back taxes on the PEACe Bonds. BIR collection mechanism is flawed because:

Final Bondholders

  1. It extracts the back taxes from the funds that will be remitted to the final bondholders upon maturity, while the main beneficiaries and proponents of the erroneous 2001 rulings, namely CODE-NGO and RCBC, get away Scot-free.
  2. Moreover, the ruling extracts the 20% FWT irregardless of the length of time the bond was held. Therefore, it disproportionately punishes the more recent bondholders who will bear brunt of the taxes even though they earned the least of the imputed interest. As an example, an investor who decided to park PHP 1.0 million of his money in the supposedly risk-free PEACe Bonds for a month or two before maturity will lose 14.19% of his principal even though he earned a few months of imputed interest. Similarly, because the ruling takes away 14.19% of the bond's redemption proceeds at maturity irregardless of the bondholder's holding period, an investor who bought the bonds at its accreted value one year before its maturity will lose 2.92% of his capital instead of earning the expected 12.75% YTM on the bond. Those bought the bonds at their accreted value and who held the bonds longer will only lose the imputed interest and not principal.

Given that interest rates have gone down substantially since 2001, the bonds were most likely purchased at a premium to their accreted values, therefore it is highly likely that investors who have held the bonds for less than four years will suffer a loss of principal as well.

Subsequent Bondholders

Under BIR Ruling No. DA 278-2011 dated October 17, 2011, the BIR has found “RCBC/CODE-NGO” and “all subsequent holders” of the PEACe Bonds liable for the 20% FWT. This implies that the 20% FWT may be netted out from the sale and resale of the bonds and that the bondholder may only be liable for the taxes on the imputed interest accreted during the time the bond was held by the investor. In other words, an absolute 20% FWT becomes a 20% FWT proportionate to the imputed interest earned by the bondholder.

This arrangement is more equitable to the final bondholders. The 20% FWT would only then cut into the imputed interest earned by the bondholder over the life of his holding period and not into the principal, whether or not the bond was purchased at its accreted value or at a premium to its accreted value.

Under an absolute 20% FWT, the bond's 12.75% YTM would now range from 11.13% YTM if the bonds were bought at time of issuance to -14.19% YTM if the bonds were bought right before maturity. If the 20% FWT were proportionate to the imputed interest earned, the bond's revised YTMs would not decline so drastically: from 11.13% YTM if the bonds were bought at time of issuance to 10.26% YTM if the bonds were bought right before maturity.

Collection Problem

However, there is a problem with this scenario: The government claims it does not even know who the final bondholders are unless they come forward to claim the redemption proceeds of the bond at maturity date (although the Registry of Scripless Securities “RoSS” under the Bureau of Treasury is primarily tasked with monitoring and maintaining official records of ownership of government securities). According to BIR Commissioner Kim Henares:

“We don't have the list of the banks holding the PEACe Bonds. Supposedly under the bank secrecy law, it is supposed to be confidential. The instruction is to hold the 20% of the PHP 25 billion,”6

If this is the case, only the final bondholders would be affected. Unless the government recreates the chain of sale and resale from CODE-NGO/RCBC to the final bondholders, the final bondholders would have to recreate this process via a chain of litigation, meaning the final bondholder would have to sue the previous bondholder to collect the 20% FWT that the final bondholders are not liable for, and that previous bondholder would have to collect from the previous bondholder, and so on and so forth, until the chain of sale is retraced back to CODE-NGO/RCBC, the original bondholders. Needless to say, this would create a gigantic legal mess.

The only advantage to the current ruling is that it reduces the cash outflow of the government by 20%. But in the long run it will turn off potential investors because the bond buyers, who bought the bonds in good faith, were harmed and the bonds themselves did not prove risk free. In the future, buyers of government securities will attach a higher risk premium to government debt, especially government debt securities with all the extra features, to compensate themselves for the regulatory risk that the government will rescind these embellishments when the bonds mature, leading to higher interest rates for the entire country.

The BIR should have assessed CODE-NGO/RCBC for the PHP 4.86 billion in back taxes which would have wiped-out the endowment of the PEACe Foundation and put a big dent in RCBC's earnings and capital. But the ruling would not have angered the rest of the investment community and the country would not have to pay for the arbitrariness of the ruling in terms of higher debt costs. No one else but CODE-NGO/RCBC would have been affected and given how controversial the transaction is perceived to be even ten years later, the action would have been seen as just.

Impact on Bank's Bottom Line

The surprise imposition of the 20% Final Withholding Tax will affect the bottom line of the banks. None of them have properly accrued for the presumed tax liability and none of them have prepared themselves to receive less cash from the redemption payment of the PEACe Bonds.

To assess this impact, an analysis was made of the affected bank's holdings of government debt securities. With the exception of BPI Family Bank (who already disclosed ownership of 5% of the PEACe Bonds7), the analysis makes a critical assumption that each bank's PEACe Bonds holdings would be proportionate to their holdings of government debt securities as indicated in their latest available audited financial statements.

Under this scenario, the most adversely affected bank is Planters Development Bank with a 4.92% hit to their capital base, followed by Philippine Bank of Communications, with a 3.43% hit to capital, followed by Philippine National Bank (2.42% hit), and China Banking with a 2.06% hit to their capital. Of course, depending on the circumstances, each bank may have much higher or much lower PEACe Bonds holdings than dictated by their government debt securities holdings. So this analysis, with the exception of BPI Family bank, is just a guesstimate.

Affected Banks
Analysis of Impact of 20% Final Withholding Tax
on Affected Bank Capital
As of December 31, 2010

Total Holdings of Government Debt Securities8
(In PHP B)

PEACe Bonds Holdings
(In PHP B)

(In PHP B)

Capital Funds
(In PHP B)9

Capital Affected
(In %)
Banco De Oro
Bank of Commerce
BPI Family Bank
China Banking Corporation
Metropolitan Bank and Trust Company
Philippine Bank of Communications
Philippine National Bank
Philippine Veterans Bank
Planters Development Bank

Nevertheless, at least five of the nine banks listed above have very high absolute and relative amounts of Distressed Assets as detailed in previous blog posts in the blog “Why Banco Filipino Failed” ( The posts can be found here and here .

These five, as indicated in the table below, have a high amount of Non-Performing Assets or Distressed Assets on their balance sheets relative to their Total Capital Cushion, which is their ability to absorb losses from the deterioration of the value of their Distressed Assets. These five, namely Bank of Commerce, Philippine Bank of Communications, Philippine National Bank, Philippine Veterans Bank, and Planters Development Bank, have a Distressed Assets to Total Capital Cushion Ratio greater than 100%, which indicates a heightened risk of insolvency. A sixth bank, namely BPI Family Bank, has a ratio of 93.73%, which is borderline close to the 100% danger line.

Affected Banks
Distressed Assets to Total Capital Cushion
As of June 30, 201117

Distressed Assets
(In PHP B)18
Capital Cushion
(In PHP B)19
Distressed Assets/
Total Capital Cushion (In %)20
Banco De Oro Unibank
Bank of Commerce
BPI Family Bank21
China Banking Corporation
Metropolitan Bank and Trust Co.
Philippine Bank of Communications



Philippine National Bank
Philippine Veterans Bank
Planters Development Bank22

NPL Washing

The high incidence of distressed and near distressed banks (six out of nine banks) indicates that these banks may have used the PEACe Bonds for their ability to “window dress” bank NPLs (see a previous October 7, 2011 post “Revisiting the PEACe Bonds under the section “What else can RCBC do with the PEACe Bonds?,

Most likely, the affected banks used the PEACe Bonds to wash NPLs from their own books in cashless debit-credit accounting transactions.23

From “What else can RCBC do with the PEACe Bonds?:

For instance, an NPL that is on the bank's books for PHP 1.0 billion may only have a recoverable value of PHP 500.0 million (Step 1). The bank can sell a PHP 1.0 billion Face Value PEACe Bond (with a discounted value of PHP 500.0 million) to the delinquent borrower (Step 2). But on the books of both the bank and the delinquent borrower, the amount owed to the bank is recorded at the face value of the PEACe Bond, which is PHP 1.0 billion (Step 3). The bank then simultaneously buys back the PEACe bond from the delinquent borrower (Step 4). The repurchase of the PEACe Bond creates a payable on the right side of the bank's balance sheet and puts the bank in a situation where its has itself a shadow indebtedness to the borrower in the same exact amount as the NPL. The bank then offsets its account payable to the borrower against the NPL (of the same amount) of the delinquent borrower on the asset side (Step 5). This way, the indebtedness of the borrower remains on the accounts receivable portion of the asset side of the bank's balance sheet but it is no longer an NPL and is not connected to a loan. Thus the bank's balance sheet is laundered in a way by simply removing the stain of non-collectibility or ageing. The new receivable derived from the sale and repurchase of the PEACe Bond is after all exactly that - new.

Overstated Capital

Although the estimated impact of the abrupt imposition of the 20% FWT on bank capital is estimated to be only a 1.72% reduction in bank capital, five of the banks in question are distressed and their capital is already overstated. In some cases, the overstatement is so severe, that any additional reduction in capital from the 20% FWT may severely impair the bank's actual capital beyond the point of solvency. (See “BSP's Ampaw Accounting System”

The reason for the overstatement is that the BSP has granted regulatory relief to these banks and allowed them to:

  1. Defer the booking of realized losses arising from:

  • The Sale of Non-Performing Loans to Special Purpose Vehicles (SPVs);
  • The Acquisition by a Bank of Bank of another weaker Bank with substantial Non-Performing Assets;
  • Large Credit and Impairment Losses on financial assets of banks that are undergoing a BSP-approved Rehabilitation Plan

  1. Amortize the realized losses over a period of 10 to 20 years

As a result of this regulatory relief, losses were not realized on these banks books. Instead, the unrealized losses were swept into the “Other Assets” accounting bucket as deferred charges. Although the BSP mandated regulatory relief allowed the banks to look stronger than they are, such bookings do not comply with Philippine Financial Reporting Standards (PFRS). As a result, banks that availed of the regulatory relief show a qualified auditor's opinion that:

  1. States that the bank's booking of deferred charges does not comply with the provisions of GAAP/PFRS/PAS
  2. Discloses the impact such compliance would have on the bank's financial statements had the losses been recognized.

Banks with Qualified Auditor's Opinions on Deferred Charges
As of December 31, 201024

Deferred Charges
Unadjusted Capital Funds
Adjusted Capital Funds
% Reduction in Capital Funds
Bank of Commerce25
PHP 4.4 B
PHP 7.6 B
PHP 3.2 B
Philippine Bank of Communications26
5.9 B
3.6 B
-2.3 B
Philippine National Bank
5.6 B
33.3 B
27.7 B
Philippine Veterans Bank27
1.1 B
5.0 B
3.9 B
Planters Development Bank
1.6 B
3.7 B
2.1 B
PHP 18.6 B
PHP 49.6 B
PHP 34.6 B


Although the Aquino Administration has given some thought as to the errors of the 2001 Banez rulings on the PEACe Bonds, it seems that it has not given much thought as to the methods by which these “errors” could be rectified. Instead of targeting CODE-NGO/RCBC, the main beneficiaries and proponents of the 2001 rulings, for collection of unpaid taxes, it chose to extract these back taxes from the final bondholders. More so, it did this in a manner that disproportionately punishes the the investors who acquired the bonds on a more recent basis. The 2011 BIR rulings are undoubtedly flawed. As to whether they will weaken an already weakened banking system remains to be seen. But they have already achieved the unintended consequence of seriously damaging the government's credibility not only with regards to the sanctity of its contractual obligations but also with regards to its ability to thoroughly think through the ramifications of its decisions.

1“Code-NGO under pressure to use P1.4-B gain well,” by Margarita H. Debuque, February 22, 2002, Philippine Daily Inquirer
2“Vanishing trade in PEACe Bonds: The truth, the banks, and the BIR,” by Roel Landingin, October 25, 2011, Philippine Center for Investigative Journalism
4“Banks seek SC stay order on bond tax,” October 17, 2011, Businessworld
5“RCBC asks court to review BIR ruling on tax bonds,” October 17, 2011, Manila Bulletin
6“BIR: P35-B PEACe bonds should be subject to tax”, October 17, 2011, ABS-CBN
7“Banks seek SC stay order on bond tax,” October 17, 2011, Businessworld
8Unless otherwise indicated, the banks holdings of Government Debt Securities is from their Audited Financial Statements as of December 31, 2010.
9Unless otherwise indicated, the banks Capital Funds figures are from their Audited Financial Statements as of December 31, 2010.
10Bank of Commerce latest Audited Financial Statements are as of December 31, 2009
11Bank of Commerce latest Audited Financial Statements are as of December 31, 2009
12The figures for BPI Family Bank's Government Debt Securities are not available. The figures supplied are from the banks's total investment securities holdings as of March 31, 2011 based on their Published Statement of Condition in the BSP website,
13BPI Family Bank acknowledged that it held 5% of the PEACe Bonds.
14The figures supplied are from the banks's total investment securities holdings as of March 31, 2011 based on their Published Statement of Condition in the BSP website,
15Philippine Veterans Bank's latest Audited Financial Statements are as of December 31, 2009.
16Philippine Veterans Bank's latest Audited Financial Statements are as of December 31, 2009.
17Unless otherwise indicated, the figures are based on the individual bank's Published Statement of Condition as of June 30, 2011 found in the BSP Website:
18Includes Classified Loans and Other Risk Assets, Acquired Real Estate, Non-Current Assets Held for Sale, and Other Assets. Distressed Assets may drop significantly in value if the assets such as Non-Performing Loans continue to deteriorate.
19Includes Stockholders Equity Less Other Capital Accounts Plus Allowance for Credit and Impairment Losses. This measures the bank's ability to absorb losses.
20A Ratio of Distressed Assets to Total Capital Cushion greater than 100% signals a higher risk of insolvency.
21Based on BPI Family Bank's Published Statement of Condition as of March 31, 2011 found in the BSP Website:
22Based on Planters Development Bank's Published Statement of Condition as of March 31, 2011 found in the BSP Website:
23“Laundering out losing loans,” by Dean de la Paz, March 7, 2002, Businessworld
24Unless otherwise indicated, all figures are from the individual bank's audited financial statements as of December 31, 2010.
25Audited Financial Statements as of December 31,2009. The bank has since been acquired by San Miguel Corporation
26The bank has since been acquired by the Roberto Ongpin Group.
27Audited Financial Statements as of December 31, 2009.


  1. What seems unclear in this post is whether “distressed” assets are carried on the banks' books at market or at “acquisition” basis. How would an ordinary person know? Presumably, BSP would in the course of its bank supervision function; but is BSP obliged to disclose this information?

  2. Distressed assets are generally carried on the bank's books at historical acquisition cost and not at market because bank's generally want to avoid booking losses. However, if a loan has been delinquent for some time, bank's are generally required by the BSP to book losses on the loans especially if the asset backing the loan is undergoing foreclosure.

  3. Thanks for the clarification.

    So, if a bank acquires by foreclosure a debtor's property, that property would be a distressed asset, but its acquisition cost would be close to or even below market?

  4. The property foreclosed on may be below loan value (acquisition cost for the bank) but it may also not be at market value. That's why some banks have unrecognized losses on non-performing assets they sold to Special Purpose Vehicles (SPVs). Check out The real market value of the property may still be below the value carried on the the banks' books.

  5. back to the auction for a moment.

    you claim that it is anomalous that the details of the bonds were released only days prior.

    is it anomalous coz its illegal? i.e. there is a rule that states information should be broadcast in some way in X days?

  6. But of course it depends case by case. It could also happen that a bank forecloses on a loan and acquires the collateral at below market, in which case an overall strengthening of the economy could effectively "rehabilitate" that bank.

    Nonetheless, it seems that there is a major moral hazard problem, esp. with some of the smaller banks, because they can "game" the rules to take advantage of PDIC coverage.

  7. I totally agree with you. Check this out: