BIR Ruling [DA-017-05]

January 19, 2005 BIR RULING [DA-017-05] RA 7916 DA 147-04 Toyota Autoparts Philippines, Inc . Toyota Sta. Rosa (Laguna) Complex Special Export Processing Zone Barangay Pulong Sta. Cruz Sta. Rosa, Laguna Attention: Kazuhiro Yahashi Treasurer/Comptroller Gentlemen : This refers to your letters dated November 6, 2004 and June 1, 2000 stating that Toyota Autoparts Philippines, Inc. (TAPI) is a 95% Japanese owned company duly registered with the Philippine Export Processing Zone (PEZA) under PEZA Certificate of Registration No. 95-60 issued on June 5, 1995; that its main product is automobile parts comprising of transmission for manual type and constant velocity joint; that TAPI commenced paying the 5% preferential gross income tax in 1999 and 2003 for the G-type transmission (GTM) and Constant Velocity Joint (CVJ), respectively; that TAPI, as the licensee, has entered into an agreement with Toyota Motor Corporation, as the licensor, with principal office address at No. 1 Toyota-cho, Toyota-shi, Aichi-Ken, Japan, for the technical assistance in the manufacture of transmission and constant velocity joint; and that the parties had agreed to a 3% royalty fee to be paid every 60 days after the end of each quarters. In connection therewith, you now request for an opinion that royalty payments made by TAPI, relative to the transfer of technology by Toyota Motor Corporation are deductible from the gross revenues for purposes of computing its taxable income. In reply thereto, please be informed that Section 2, Rule 1 of the Rules and Regulations to Implement Republic Act No. 7916 (the PEZA Law), otherwise known as "The Special Economic Zone Act of 1995," (the PEZA Rules) defines gross income as follows: " Gross Income for purposes of computing the special tax due under Section 24 of the Act refers to gross sales or gross revenues derived from business activity within the ECOZONE, net of sales discounts, sales returns and allowances and minus costs of sales or direct costs but before any deduction is made for administrative expenses or incidental losses during a given taxable period. The allowable deductions from "gross income" are specifically enumerated under Section 2, Rule XX of these Rules." The above paragraph may be reduced to the following formula: Gross ECOZONE Sales or Revenues Less : Sales Discounts Sales Returns Direct Costs (Costs of Sales) Gross Income Less : Allowable Deductions (Sec. 2, Rule XX) Taxable Gross Income (Subject to 5% final tax) From the foregoing, direct costs (costs of sales) are deductible from gross sales/revenues for purposes of computing a PEZA firm's taxable gross income subject to the 5% final tax. On the other hand, the cost of inventories or finished goods is defined as follows in paragraph 4 of Statement of Financial Accounting Standards (SFAS) No. 4, Summary of Generally Accepted Accounting Principles on Inventories: "In general, cost is the price paid or consideration given to acquire an asset. As applied to inventories, it represents the direct and indirect expenditures for items purchased, produced or in the process of production including the cost of production overhead. It constitutes the sum of the applicable expenditures and charges directly or indirectly incurred in bringing the inventory items to their existing condition and location." HDIaET Paragraph 5 of the same SFAS also states that: "Production overhead should be included as part of inventory cost; it is composed of costs incurred for production other than direct materials and labor and includes both variable and fixed expenses. Examples are indirect materials and indirect labor, depreciation and maintenance of factory buildings and equipment, and the cost of factory management and administration." Recording of revenue from the sale of a product is accompanied by recording of an expense for the cost of the product sold (SFAS No . 1, Sec . F.I.) . Manufacturing costs for a product include rationally and systematically assigned or allocated direct and indirect productive costs of assets or property, plant, and equipment completely or partially consumed in manufacturing the product [SFAS No . 1, Sec . F.II.A.S-6A, M-6A, S-6A(1), M-6A (1)] . In determining the aforesaid rational and systematic cost assignment or allocation, Paragraph 6 of SFAS No. 4 provides as follows: "The allocation of costs and charges to inventories requires the exercise of judgment and involves a consideration of the adequacy of the procedures of the cost accounting system in use, the soundness of the principles thereof, and their consistent application. Generally, any allocation process should consider the following principles: a. Under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges rather than as a portion of the inventory costs. b. Also, general and administrative expenses should be included as period charges, except for the portion of such expenses that may be clearly related to production and thus constitute a part of inventory costs. c. Selling expenses constitute no part of inventory costs." Moreover, Paragraph 13 of International Accounting Standards (IAS) No. 2 on Inventories further stipulates that "[o]ther costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition. For example, it may be appropriate to include non-production overhead, such as the costs of designing products for specific customers, in the cost of inventories." Thus, the treatment of royalties depends on the consideration for which such fees were paid. When the royalties relate to a system or license, royalties are treated as general and administrative expenses, which are not inventoriable costs. When, however, royalties are connected with a product design, logo, formula, or process, then the payment is capitalized as part of inventories. Therefore, payments for royalties related to the transfer of technical information and manufacturing know-how should be considered as part of the cost of manufacturing the products. IN VIEW OF THE FOREGOING, this Office holds that royalties arising from the technical assistance in the manufacture of transmission and constant velocity joint are rightfully part of the cost of finished goods and should be deductible in computing gross income, as defined under Sec. 2, Rule 1 of the PEZA Rules, which is further reduced by allowable deductions specifically enumerated under Section 2, Rule XX of the PEZA Rules. Further, the privilege accorded to SMBA enterprises under Section 3 of RR No. 16-99 to deduct royalty payments when calculating gross income subject to the 5% final tax, shall also be extended to PEZA registered firms as mandated by Sec. 51 of RA 7916. This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it will be disclosed that the facts are different, then this ruling shall be considered null and void. DAEcIS Very truly yours, (SGD.) JOSE MARIO C. BUAG Deputy Commissioner Legal & Inspection Group