BIR Ruling

January 15, 1966 Messrs. Ozaeta, Gibbs & Ozaeta 7th Floor, Magsaysay Bldg. 530 T.M. Kalaw Street Ermita, Manila Attention: Atty . Ricardo J . Romulo Gentlemen : This refers to your letter dated December 1, 1965 requesting a ruling on the following questions: LexLib (a) Are preincorporation and preproduction expenses deductible in the year incurred? (b) If not, could a portion or all of these preincorporation and preproduction expenses be charged to an intangible asset account amortizable over a period of years? (1) If so, could the local subsidiary defer taking amortization deductions until the start of production, so that the benefit of such deduction may be taken directly against profits? (2) Or, over what term could such preincorporation and preproduction expenses be amortized? It appears that your client is currently considering forming a subsidiary in the Philippines for the assembly of care and trucks; that this project would involve the construction and operation of an assembly plant with a substantial investment in land, building, equipment etc; and that it is anticipated that the local subsidiary will incur the preincorporation and preproduction expenses described in your letter and quoted as follows: "1. Preincorporation expenses . Preincorporation expenses incurred prior to the date of incorporation by the U.S. Parent Company for the local subsidiary to be incorporated. The principal portion of these expenses are legal and tax expenses incurred in the organization of the local subsidiary and the expenses incurred in connection with financial and other studies conducted by the U.S. Parent Company to determine the feasibility of entering assembly operations in the Philippines and for personnel travelling, living and other expenses incurred in connection with such studies. "2. Preproduction expenses (expenses incurred after incorporation). "(a) Administrative and commercial expenses incurred in the general direction and management of the local subsidiary as a whole (as contrasted with the expenses associated with specific activity of assembly), such as salaries, rent, and other expenses incurred by general management, public relations, finance, marketing, and industrial functions. "(b) Pre-activation expenses . So-called "preactivation" expenses incurred prior to the job-one date are attributable to supply, purchasing, and manufacturing activities. They may generally be defined as the normal expenses incurred, prior to the start of scheduled production, to place the new facility in a position to begin productive operations. "(c) Launching expenses . Launching costs are generally defined as those excess labor and overhead costs incurred because of the production of a new product. This category of expenses represents that portion of direct labor and manufactured overhead costs in excess of the amount of these costs charged to inventory." In reply thereto, I have the honor to inform you that the so-called preincorporation expenses covers organizational expenses such as the legal, tax and other expenses which are directly connected with an immediately incident to the organization of the local subsidiary. However, the expenses which will be incurred in connection with financial and other studies to be conducted by the U.S. Parent Company to determine the feasibility of entering assembly operations in the Philippines as well as the travelling and living expenses that will be incurred in connection with such studies may not be considered as organization expenses as they are remote from the organizational activities and is not directly incident to the creation of the local subsidiary. They will be incurred prior to the time the U.S. Parent Company will decide to establish and organize the local subsidiary. They are expenses for the expansion of the business of the U.S. Parent Company which may be deducted or amortized by the future local subsidiary. cdpr The term "organization expenditure" means any expenditure which (1) is incident to the creation of the corporation; (2) is chargeable to the capital account; and (3) is of a character which, if expended incident to the creation of a corporation having a limited life, would be amortized over said life (CCH, Federal Tax Reporter '61 Vol. 2, par. 2165; Mertens, LFIT, 1954-1958, Code, p. 105). Included in the organization expenditures are legal fees to organize and obtain the corporate charter, fees payable to the state for obtaining the corporate charter and other similar cost incident to the organization of the corporation. It is doubtful, however, whether expenditure incurred subsequent to the organization of the corporation, such as cost of printing stock, professional fees and commission, qualify as organization expenditures (Mertens, Vol. 7, Chap. 38, p. 105). prcd On the other hand, the so-called preproduction expenses include those incurred after incorporation (e.g., commercial, preactivation and launching expenses) but before the scheduled operation of the local subsidiary. Actually, both preincorporation and preproduction expenses are pre-operating expenditures, i.e., both are incurred before the scheduled operation of a corporation. In view of the foregoing, this Office is of the opinion and so holds that while pre-incorporation (organizational) and pre-operating expenses cannot be deducted from income as current expenses (BIR Ruling No. 62-0090, August 16, 1962), the same however, if reasonable in amount and properly itemized and capitalized, may be amortized as a reasonable allowance for depreciation (Hershey Mfg. Co. v. Comm., 43 F (2d) 298; American Federal Tax Reports, Vol. 9, p. 71). Preoperating expenses may be capitalized only if it is incurred for a depreciable property used in the taxpayer's trade or business, (Section 106, Income Tax Regulations), or for intangibles, the use of which in the trade or business is definitely limited in duration, or is known from experience to be of value in the business for only a limited period (Section 107, Ibid). The same test is applied to expenditures for designs, drawings, patterns, models, or work of an experimental nature calculated to result in improvement of the facilities or products of the business (Section 112, Ibid). But in all such cases, the depreciation allowance must be charged off under section 113 of the Income Tax Regulations, and must be supported by facts fully shown in the returns or prior thereto to the satisfaction of this Office. Except for such depreciation allowances, no deduction shall be made against any sum so set up as an asset except on the sale of other disposition of such asset at a loss or on proof of a total loss thereof (Section 112, Ibid). Very truly yours, (SGD.) MISAEL P. VERA Commissioner of Internal Revenue