SGV & Co.

February 8, 2007 BIR RULING [DA-080-07] BIR Ruling No. DA-608-2006 SGV & Co. 6760 Ayala Avenue Makati City Attention: Mr. Joel L. Tan-Torres Partner, Tax Services Gentlemen : This refers to your letter dated January 17, 2007 requesting for and on behalf of your client, Samsung Electro-Mechanics Philippines Corporation (Semphil) , for confirmation of your opinion that the following direct costs and expenses incurred by the company are deductible from gross revenue for purposes of computing the 5% gross income tax ("GIT"): cDIHES 1. Agency fees; 2. Transportation expense (inbound); 3. Remuneration of expatriates directly involved in production; and 4. Communications costs. As represented, Semphil, with Securities and Exchange Commission Registration No. A1997-14224 dated July 31, 1997, was registered with the Philippine Economic Zone Authority (PEZA) on October 16, 1997 as an Ecozone Export Enterprise under Registration No. 97-074 to engage in the 1) manufacture of multi-layer chip capacitor and thick film chip resistor; 2) manufacture of micro-chip tantalum capacitor; 3) manufacture of crystal oscillator; 4) manufacture of ultra high chip capacitor; 5) manufacture of array resistor; 6) manufacture of slim capacitor for camera module and Ipod & MP3; 7) manufacture of oscillation IC for WLAN and bluetooth module; and 8) trading and distribution of Samsung electronic parts and components for various electronic and communication devices to PEZA-registered export enterprises at Calamba Premier International Park in Calamba, Laguna. The electric and electronic products, components and parts that Semphil manufactures are exported 100%. Semphil has a supply and manufacturing arrangement with affiliates and non-affiliates in various countries including Korea, Hong Kong, Thailand, China and the United States. Semphil purchases raw materials from its parent in Korea, Samsung Electro-Mechanics Co., Ltd. (Semco), and other overseas vendors, processes some of the raw materials into semi-finished products, processes semi-finished goods and further processes reprocessed goods into finished goods which are all sold to affiliates abroad, as well as to other foreign companies. TEcADS There are four (4) major types of expenses incurred by Semphil in the production process. These expenses are included in the costing of inventoriable goods. The nature of these expenses is described as follows: 1. Agency fees Semphil hires contractors to provide additional workers in the production area. These workers remain the employees of the agency. These expenses are booked under the account of "Variable Wages Common" and are specifically allocated to the production cost center; 2. Transportation expense (inbound) Semphil incurs freight, transfer, handling, brokerage and insurance costs in importing raw materials from various overseas vendors including its parent company (Semco); 3. Remuneration of expatriates directly involved in production A number of expatriates who supervise the production are employed by Semphil; 4. Communications costs These pertain to domestic and international communication expenses such as mobile phone/telephone charges, network/server charges, SAP charges, IT management and consultancy fees and internet connection which are basically used in the transmission of technical production data of Semphil's registered products. These communication facilities allow Semphil the use of advanced communication features such as the voice over internet protocol, video conference, internet and email, which are used to facilitate the production of its products. In reply, please be informed that this Office had occasion to rule in BIR Ruling No. DA 608-06 dated October 11, 2006 that the aforesaid expenses incurred by PEZA-registered enterprise are deductible in computing its gross income subject to the 5% rate, viz: ". . . Section 24 of R.A. No. 7916, otherwise known as the 'Special Economic Zone Act of 1995,' as amended by R.A. No. 8748 provides that 'SEC. 24. Exemption from National and Local Taxes . Except for real property taxes on land owned by developers, no taxes, local and national, shall be imposed on business establishments operating within the ecozone, in lieu thereof, five percent (5%) of the gross income earned by all business enterprises within the ecozone shall be paid and remitted as follows: AaDSTH a) Three percent (3%) to the National Government; b) Two percent (2%) which shall be directly remitted by the business establishments to the treasurer's office of the municipality or city where the enterprise is located. xxx xxx xxx' 'Gross income earned' is defined under Section 3 of Revenue Regulations (RR) 11-2005 as: 'SEC. 3. Gross Income Earned. For purposes of implementing the tax incentive of registered Special Economic Zone (ecozone) enterprises in Section 24 of Republic Act No. 7916, the term 'gross income earned' shall refer to gross sales or gross revenues derived from business activity within the ecozone, net of sales discount, sales returns and allowances and minus costs of sales or direct costs but before any deduction is made for administrative, marketing, selling and/or operating expenses or incidental losses during a given taxable period.' The above definition is reduced to the following formula: Gross sales/revenues xxxx Less: Sales Discounts xxxxx Sales xxxxx Returns/Allowances Direct costs (cost of sales) xxxxx Other Manufacturing xxxxx xxxx Costs Gross taxable income xxxx ==== The same section likewise provides for a list of direct costs deductible from gross income for purposes of determining the taxable base, to wit: 'For purposes of computing the total five percent (5%) tax rate imposed, the following direct costs are included in the allowable deductions to arrive at gross income earned for specific type of enterprises: 1. Ecozone Export Enterprises, Free Trade Enterprises and Domestic Market Enterprises: - Direct salaries, wages or labor expenses - Production supervision salaries - Raw materials used in the manufacture of products - Decrease in Good in Process Account (Intermediate goods) - Decrease in Finished Goods Account - Supplies and fuels used in production - Depreciation of machinery and equipment used in production, and of that portion of the building owned or constructed that is used exclusively in the production of goods - Rent and utility charges associated with building equipment and warehouses used in production - Financing charges associated with fixed assets used in production the amount of which were not previously capitalized.' In interpreting the scope of the foregoing list, this Office had occasion to rule that the allowable deductions enumerated therein are not exclusive; meaning, as long as the costs can be attributed in producing the product, they are allowed as deductions for purposes of computing the 5% final tax. (BIR Rulings DA 519-2006 dated August 25, 2006 and DA 556-2006 dated September 18, 2006). Thus, in order to compute for the gross income earned, the cost of sales or direct costs which may be deducted from revenues should be defined. cHITCS In this regard, Article 24 of Executive Order 226, otherwise known as the Omnibus Investments Code of the Philippines, provides that the Generally Accepted Accounting Principles (GAAP) governs in determining the direct costs, thus: 'Art. 24. "Production Costs" shall mean the total of the cost of direct labor, raw materials, and manufacturing overhead, determined in accordance with generally accepted accounting principles, which are incurred in manufacturing or processing the products of registered enterprise.' The GAAP in the Philippines in determining the cost of a production/inventory is embodied in Philippine Accounting Standard No. 2 (PAS/IAS 2). Paragraph 34 thereof requires that there shall be a corresponding recording of the cost of production for every product or inventory sold. Paragraph 10 of the same standard further provides that the cost of the product/inventory shall include all the costs incurred in producing the product, thus: 'The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.' Moreover, Paragraphs 12 and 15 of the same PAS/IAS state: '12. The costs of conversion of inventories include costs directly related to the units of production, such as direct labor. They also include a systematic allocation of fixed and variable overheads that are incurred in converting materials into finished goods. Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation of maintenance of factory buildings and equipment and the cost of factory management and administration. Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and indirect labor. DHacTC xxx xxx xxx 15. Other 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. . . .'" Applying the foregoing discussion to the instant case, this Office hereby rules as follows: 1. On the deductibility of Agency fees In BIR Ruling DA 608-2006 dated October 11, 2006, the BIR ruled that in order for commission and service charges to be considered as deductible expense, they should be directly related to the production process. Thus, only the expenses specifically allocated to production cost centers are deductible for purposes of the 5% GIT. Commission and service charges are the same nature as agency fees. In the case of Semphil, it engages the services of contractors to provide contractual workers, to perform or complete a specific job, work or service with a definite and/or pre-determined period. These workers complement the regular workforce, primarily during peak season. Since agency fees incurred by Semphil are directly related to the production process, said fees are deductible for purposes of the 5% GIT. 2. On the deductibility of Transportation expense (inbound) BIR Ruling No. DA-608-2006, provides that cost of freight-in expense (shipment of vendors) is part of cost of sales (part of landed cost of materials). Thus, transportation expenses associated with the acquisition of raw materials and factory supplies may be deductible for 5% GIT purposes if they are related to raw materials and factory supplies used in Semphil's registered activity. Accordingly, transportation expense (inbound) incurred by Semphil i.e., freight, transfer, handling, brokerage and insurance costs in importing raw materials from various overseas vendors including its parent company (Semco) provided they will be used in Semphil's registered activity, is considered deductible for purposes of the 5% GIT. 3. On the deductibility of remuneration of expatriates directly involved in production Rule XX, Section 2 of the PEZA IRR includes direct salaries, wages or labor expenses and production/service supervision salaries among the allowable deductions for purposes of computing the 5% GIT. Rule I, Section 2 (vv) of the PEZA IRR defines "direct labor wage" as follows: "Direct Labor Wage refers to compensation for labor directly used in the production or manufacturing process up to and including the services of the production foreman, but shall exclude labor for maintenance of production, machinery and equipment. Compensation shall cover salaries and wages, including other payments such as bonuses and cost of living allowances, which form part of the laborer's or employee's taxable earnings. " CSIHDA Moreover, Section 1 of Revenue Regulations No. 11-05 includes direct salaries, wages or labor expenses and production/service supervision salaries among the allowable deductions for 5% GIT purposes. Since you represented that Semphil's expatriates are directly involved in the production operations, remuneration paid to them is deductible expense for purposes of the 5% GIT. 4. On the deductibility of Communications costs The BIR ruled in BIR Ruling DA-608-2006 that communication costs such as local telephone charges and communication facilities expenses are deductible for 5% GIT purposes to the extent that they are associated with building, equipment and warehouse used in production of Sephil. Thus, the cost attributable to administrative functions should be segregated and excluded as part of allowable deduction. If specific identification is not possible, allocation based on relevant data like internet/email usage, or number of production and administrative personnel may be used if applicable. HCITAS In view of the foregoing, communication costs incurred by Semphil in the transmission of technical production data to be used to facilitate the production of its products are likewise deductible for purposes of computing the 5% GIT. 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. Very truly yours, (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service