Sanwa Electric Philippines, Inc.

February 13, 2007 BIR RULING [DA-089-07] R.A. 7916; DA-057-2006 Sanwa Electric Philippines, Inc. Block 2, Lots 1 & 2 First Cavite Industrial Estate Dasmarias, Cavite Attention: Mr. Yuichi Takeda President Gentlemen : This refers to your letter dated May 10, 2005 requesting a ruling as to whether or not royalties paid in consideration for the use of technical information and assistance in the manufacture of fan motor of PEZA registered enterprise could be deducted from Gross Income in computing the 5% preferential Gross Income Tax imposed under PEZA Law. TAHcCI It is represented that Sanwa Electric Philippines, Inc. (SEPI) is a PEZA registered enterprise, formerly EPZA, pursuant to the provisions of Executive Order No. 226 and now Republic Act No. 7916 as further amended by R.A. 8748; that it is engaged in the manufacture of fan motor for heaters, vending machine, refrigerator, air conditioner and related products solely for export; that it undertakes its business activities at First Cavite Industrial Estate Special Economic Zone under PEZA; that SEPI is a wholly owned subsidiary of Sanwa Electric Co., Ltd. (SANWA, formerly Sanwa Techno Co., Ltd.), a non-resident foreign corporation organized and operating under the laws of Japan; that SEPI entered into a Technical Assistance Agreement with SANWA in which SANWA shall provide SEPI during the term of the agreement technical information, management guidance and technical assistance for the use of Technical Information for the manufacture and assembly of small type motors using SANWA's know how; that the Technical Information relates to as follows: cSaADC 1. PRODUCT DESIGN such as drawings, specifications, parts list, materials standards, and test standards; 2. MANUFACTURING engineering such as equipment, specification, tool die drawings, and measurement machinery specifications; 3. PRODUCT QUALITY such as process quality standards, finished goods inspection standards, and quality inspection flowcharts; 4. PRODUCTION OF PRODUCTS such as parts inspection standards and work manuals, and DaACIH 5. OTHER INFORMATION necessary for the manufacture of PRODUCTS by SEPI that in consideration of the above-services, SEPI shall pay SANWA royalty equivalent to one percent (1%) of the Ex-factory price of all the products sold to SANWA and one and half percent (1.5%) of the Ex-factory price of all products sold to other customers; and that in addition, SEPI shall pay SANWA Three hundred thousand yen (YEN 300,000) per month for the management guidance during the term of the agreement. In reply, please be informed that Section 2, Rule 1 of the Rules and Regulations to Implement R.A. 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." HITEaS From the foregoing, direct costs (cost 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." 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 over that 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." aTEACS Recording of revenues 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)] Moreover, Paragraph 13 of Internal 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." CIHAED 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. (BIR Ruling No. DA-057-2006 dated February 23, 2006) Inasmuch as the subject royalties relate to the transfer of technical information and manufacturing know-how, the same are considered manufacturing costs/factory overhead, which can be deducted from the gross sales/revenue to arrive at the gross taxable income. Hence, the following formula: aScITE Gross sales/revenue xxxx Less: Sales Discounts xxxx Sales Returns/allowances xxxx Direct costs (cost of sales) xxxx Other Manufacturing Costs (Factory Overhead) xxxx xxxx Gross taxable income xxxx ==== In view of the foregoing, this Office holds that royalties arising from the Technical Assistance Agreement relative to the product design, logo, formula or process, in the manufacture of the company's products, the payment of which is capitalized as part of inventories, should be deductible in computing the gross income subject to the 5% preferential tax rate as defined under Section 2, Rule 1 of the PEZA Rules and as extended to PEZA registered firms as mandated by Sec. 51 of R.A. No. 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. DSETac Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service