February 10, 1998

BIR RULING [DA-049-98]

Federation of Filipino-Chinese Chambers
of Commerce & Industry Inc.
6th Floor, Federation Center
Muelle De Binondo St.
Manila
Attention: Mr. Vicente O. Yu
President
Gentlemen :
This refers to your letter dated October 28, 1997 requesting clarification
regarding the tax treatment of advance rentals/security deposits in lease contracts,
based on the following facts;
Case 1
"On October 1, 1997, Mr. A (lessor) leased his lot to X company
(lessee) for a period of ten years at a monthly rent of P1,000.00. The written
lease contract requires lessee X to make an advance rental payment equivalent
two years rentals. X Company paid a lump sum of P24,000.00 corresponding to
and credited as rentals for the first 24 months of the lease. Both the lessor and
lessee are on calendar year tax cycle."
Questions
(a) "Is Mr. A (lessor) required to declare the entire P24,000 as his
taxable income during the year it was received (1997) or can he declare only
such portion as will correspond to the rental income during the taxable year, i.e.
P3,000 for 1997; P12,000 for 1998; and P9,000.00 for 1999?"
(b) "Is X company (lessee) entitled to claim as its deductible expenses
in its income tax return for 1997 the entire P24,000.00 advance rental it paid to
lessor A; or is it allowed to deduct only P3,000.00 as rental expense in 1997, the
P12,000.00 in 1998 and finally the P9,000.00 in 1999? Obviously there was a
pre-payment of rentals up to September 1999."
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(c) "What is the tax treatment (income tax) on the part of the lessor
and on the lessee if we vary the above facts such that the advance rental
payment is stipulated to be applied or credited as rentals for the last two years of
the lease contract, that is, as rentals for October 1, 2006 to September 30,
2007?"

In reply, please be informed that in BIR Ruling No. 69-011 dated October 3,
1969, this Office citing US precedents, held that if the advance payment is, in fact,
prepaid rental, then such payment is taxable to the lessor in the year when received,
even though the lessor is on the accrual or cash method of accounting. On the part of
the lessee, such prepaid rental is to be treated as capital expenditure and he cannot
deduct in the year of payment the full amount of the prepaid rent as business expense
but must spread them over the entire remaining term of the lease.
Accordingly, and in line with the said BIR ruling which is still being enforced
by this Office to date, Mr. A (lessor) is required to declare the entire amount of
P24,000.00 as his taxable income for the year 1997 when he received the same. On
the other hand, X company (lessee) cannot deduct the entire amount of P24,000.00 as
deductible expense in its income tax return for the year 1997 but must amortize the
same over the entire period of the lease.
ITCHSa

For the same reason, the advance rental payment is reportable as income in the
year of receipt even if there is a stipulation that same is to be applied or credited as
rentals for the last two years of the contract, i.e., for October 1, 2006 to September 30,
2007.
Case II
"On September 1, 1997, Mr. B (lessor) leased an office unit to ABC
company (lessee) for a period of three (3) years at a monthly rent of P5,000.00.
Bills for electricity, telephone and water shall be paid by Lessee ABC
Company. The written lease contract requires that lessee ABC Company to
make SECURITY DEPOSIT in cash in the amount of FIFTEEN THOUSAND
PESOS. This cash security deposit will be held by the lessor Mr. B, to answer
for whatever unpaid rentals, unpaid electrical, telephone and water bills, and
damages to the leased premises, and the balance to be refunded without interest
to lessee ABC Company at the end of the lease contract. ABC Company
deposited the required security deposit of P15,000.00."
Questions
(d) "For income tax purposes, is said security deposit of P15,000.00 to
be declared as income on the part of Lessor B and correspondingly as
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deductible expense on the part of lessee ABC Company in the taxable year
1997? (Note: It is possible that the entire security deposit will be refunded to
lessee ABC Company at the end of the period of lease). For income tax
purposes, does it matter if the security deposit is mixed with the funds of lessor
Mr. B, that is, he can use it for business purposes but always subject to the
purpose for which it was provided in the contract of lease."
(c) "Is BIR Ruling No. 69-011 dated March 3, 1969 still valid and
applicable? Or has the same been rescinded or amended?"

In reply, please be informed that a security deposit is an advanced payment

received by the Lessor from the Lessee, as security for the lessee's performance of his
obligations under the lease. It is not income to the Lessor when received, as the lessor
is required to return this deposit at the end of the lease period upon fulfillment of all
the obligations of the lessee. In this respect, a security deposit is somewhat analogous
to a loan and the lessor has no income and the lessee no deduction when the deposit is
made with the lessor, and the lessor has no deduction and the lessee no income when
it is repaid. This rule applies even when the lessor has the right to commingle and use
the security deposit for his own purposes without interest during the term of the lease
. . . ." (Morten's, Chapter 12 pp. 165-166)
And in BIR Ruling No. 144-88 dated April 18, 1988, this Office ruled as
follows:
"In reply, please be informed that if the advance payment made pursuant
to a Lease Contract is in the nature of a security deposit for the faithful
performance of certain obligation of the lessee, the lessor realizes no taxable
income in the year the advance payment is received. However, if the advance
payment is a security deposit and the conditions which make the security
deposit the property of the lessor occur; then the lessor realizes a taxable
income to the extent of the security deposit and the lessee is entitled to a
deduction to that same extent. (Estate of George E. Baker, 13 BTA 562 in BIR
Ruling No. 011-69 dated October 3, 1969)". In short, the answer to the question
of whether or not the amount of P15,000.00 will be declared as income on the
part of Lessor B and correspondingly deductible expense on the part of lessee
ABC will depend on the nature of said security deposit.
STcAIa

And finally, as aforestated, BIR Ruling No. 069-11 dated March 3, 1969 is still
valid and being enforced by this Office.

Very truly yours,

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(SGD.) LIWAYWAY VINZONS-CHATO

Commissioner of Internal Revenue

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CD Technologies Asia, Inc.

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