Interest in parent-subsidiary borrowings

By Cesar Nickolai Soriano Jr.

People are unlikely to lend money to someone they don’t trust. Trust is the foundation of lending and borrowing and it is often more practical to borrow from someone one is familiar with.

Corporations may think the same way. Within a group, companies often prefer to lend and borrow from one another rather than negotiate with unfamiliar outsiders. Related-party loans are common because they are convenient, efficient and built on existing trust.

However, tax authorities have long worried that these can be abused. A profitable entity might be saddled with high interest charges from affiliates, reducing taxable income, while one that enjoys preferential treatments is made to incur higher interest income as this may be subjected to lower taxes or an exemption.

Banks, e-wallets invited to explain transfer fees

As such, the Philippine Tax Code and Bureau of Internal Revenue (BIR) issuances impose rules on the deductibility of interest expenses. The question is do these rules disallow interest expense on a loan between a parent and its subsidiary? The starting point is Section 34(B)(2)(b) of the Tax Code, which provides that interest expense is not deductible if it is paid between persons specified under Section 36(B).

Often, parent-subsidiary corporations are interpreted to fall under the third paragraph of Section 36(B), which states that no deductions will be allowed “except in the case of distributions in liquidation, between two corporations more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the same individual...”

As the paragraph is worded, the crucial term is “same individual.” The provision then seems to contemplate an individual stockholder who owns more than 50 percent in both the parent and the subsidiary. By plain reading, a parent-subsidiary relationship does not automatically fall under this definition.

It is worthy to note as well that it is not only interest that can be nondeductible if the transaction is between related parties. This also covers bad debts and losses in exchanges of properties.

The BIR’s Revenue Memorandum Circular 19-2024 clarified the tax treatment of interest expense. It reiterated the requirements of Revenue Regulations 13-2000, where it echoed the Tax Code that interest between related parties is nondeductible and referred to Section 36(B). Still, nothing specific is provided as to whether the term “related parties,” for purposes of deductibility of interest, covers a parent and subsidiary.

The BIR, through RR 19-2020, later provided a different definition for “related parties” and explicitly included a parent-subsidiary relationship. This was aligned with financial reporting standards (PAS 24), which intentionally cast a wider net to capture potential conflicts of interest.

While useful for financial statement disclosures, this creates an interpretation that broadens the scope of “related parties,” effectively expanding it beyond what the Tax Code provides.

It is worthy to note that RR 19-2020 was issued to implement the filing of BIR Form 1709 and not to provide details on the definition of “related parties” as it is used in Section 36(B).

This still creates a gray area since some may take the conservative position of treating the parent and subsidiary as related parties for purposes of deductibility while others would limit the definition to what is provided under Section 36(B).

The Sky Internet Inc. versus Commissioner of Internal Revenue case illustrates this. The BIR disallowed Sky Internet’s interest expense paid to its parent, citing Section 34(B)(2)(b) and Section 36(B), treating the parent and subsidiary as “related parties.”

The Court of Tax Appeals (CTA) disagreed. It emphasized that the law requires ownership by an individual and traced the ultimate individual stockholders rather than stopping at the parent corporation’s ownership. While the parent clearly owned almost 100 percent of the subsidiary, no individual shareholder owned more than 50 percent of both corporations, thus the disallowance did not apply.

This approach is consistent with the plain reading of the law. The statute uses the word “individual,” not “person.” It could have used the latter if the law intended to cover both juridical and natural persons. The Sky Internet case provides valuable insight into how courts may interpret the provision literally, and therefore may favor deductibility of parent-subsidiary interests.

For taxpayers, the implications are significant. Legally, there may be a basis to treat interest expenses between parent and subsidiary as deductible. However, it should be noted that there is still no Supreme Court case to reinforce the CTA interpretation, although it can still be given great weight as the CTA is a specialized court with the relevant expertise.

Moreover, the BIR’s issuances show a broader interpretation of “related parties” within the context of transfer pricing and financial reporting, and there can be a situation where this will be used to treat such interest as nondeductible during audits.

A taxpayer adopting a highly conservative approach may choose to follow the BIR’s interpretation and treat the interest as nondeductible, but this, though avoiding the risk of dispute, may effectively strip a taxpayer of the right to claim deductions.

If treating interest as nondeductible will significantly affect the taxpayer’s liability, there remains a legal basis for deductibility under Section 36(B)(3). However, the taxpayer should be prepared for the possibility that the BIR will insist on a broader interpretation, potentially requiring the matter to be elevated to the courts. Should a taxpayer pursue this and succeed, the case could serve as a landmark ruling clarifying the scope of Section 36(B)(3).

In either scenario, documentation of the loan, relationship to trade or business and strict compliance with transfer pricing rules and other requirements remain an important consideration.

The deductibility of interest between parent and subsidiary corporations sits at the intersection of statutory text and administrative practice. The Tax Code, by its plain wording, disallows interest only in cases involving common individual stockholders in both corporations.

Parent-subsidiary relationships do not automatically fit that mold. Yet the BIR’s broader definition of “related parties” for transfer pricing may potentially be used to disallow the parent-subsidiary interest. It remains to be seen, however, whether another case of the same facts can eventually be elevated to the CTA or even the Supreme Court.

This debate signals something important about the BIR’s enforcement approach. It is increasingly willing to align tax treatment with broader financial reporting definitions of “related parties.” However, the Tax Code can be a little narrower in relation to the deductibility of expenses.

For businesses, this means anticipating conservative enforcement, preparing for broader scrutiny of intercompany transactions and weighing the cost of litigation against compliance. Ultimately, the issue reflects how the BIR interprets its mandate, how courts may push back and how businesses must navigate the space between law and enforcement.

It should be pointed out that BIR administrative issuances are meant to implement the law but not expand it. Time and again, the Supreme Court has struck down BIR issuances and actions that contradict the very law they seek to implement.

Cesar Nickolai Soriano Jr. is a tax and legal director at Deloitte Philippines, a member firm of the Deloitte network.