BIR Ruling [DA-098-05]

March 30, 2005 BIR RULING [DA-098-05] 27 (E); 026-01 SGV & Co. 6760 Ayala Avenue Makati City Attention: J.A. Osana Tax Division Gentlemen : This refers to your letter dated November 17, 2004 stating that your client, JDH (Philippines),Inc. (JDH) is a domestic corporation engaged in the business of marketing, selling on wholesale, distribution, export, import, purchase, barter or otherwise disposition of consumer products with office address at 29 Industria Street, Bagumbayan, Quezon City; that in the regular conduct of its distribution business, JDH enters into Distributorship Agreements with various principals, pursuant to which, JDH is obliged to do the following, among others: 1) Facilitate the sale within the Philippines of the products purchased from the various principals; 2) Arrange and maintain facilities suitable for the proper storage and supply of the products to the market place; and 3) Organize a sales force, conduct advertising and marketing activities for the promotion and sale of the products to all potential purchasers of the principals' products. aCATSI that in typical Distributorship Agreement, the principals shoulder the cost of Advertising and Promotion for the products as well as the Merchandising Consortium Expenses; that the Actual Advertising and Promotion Expenses and Merchandising Consortium Expenses subsequently incurred by JDH are reimbursed by the principal strictly on cost basis, because such expenses are shouldered by, and thus, for the account of the principals; that the cost of advertising and promotion and the merchandising consortium expense are passed on to JDH as part of the Distributors Purchase Price; that on the other hand, in the case of other Distributorship Agreements, the foregoing expenses are not made part of the Distributor's Purchase Price; that while, initially, the said expense items, based on estimates, are expressed as part of the Distributor's Purchase Price, the same are excluded or deducted therefrom when the covering sales invoices are issued to JDH; that JDH is the one that actually incurs and shoulders the Advertising and Promotion Expenses as well as Merchandising Consortium Expenses, which are reflected as such expenses in JDH's books; that for the latter type of Distribution Agreements, the parties agree to set up an Accrual Fund in an amount corresponding to the estimated advertising, promotion and merchandising consortium expenses which would have normally been included in the Distributor's Purchase Price but excluded from the sales invoice issued by the principal to JDH pursuant to the terms of these non-typical Distributorship Agreements, in other words, the amount of these expenses corresponds to the reduction in the Distributors Purchase Price; that the Accrual Fund, which has been set-up in the books of JDH, is subject to examination by the principal concerned upon the termination of the agreement; that JDH assumes the Advertising, Promotion and Merchandising Consortium Expenses in these non-typical Distributorship Agreements but the advertisement and promotion of the products are the primary concern of the principal; that while said advertisement and promotion also benefit the distributor, JDH, the main benefit inures to the principal who is the manufacturer of the goods being distributed; that although JDH makes the actual cash outlay in respect of these expenses, the terms of these agreements clearly provide that it is still the principal which sets the strategic marketing direction for its products; that any advertising activities for the products covered by non-typical Distributorship Agreements shall only be done with express authorization from the principals; that as a matter of fact, the principals even supply JDH the primary marketing support material, brand and sales presentation templates, and assist with electronic access to standard Company marketing material, the cost of all of which are drawn from the Accrual Fund; and that furthermore, in the conduct of its distribution business, JDH likewise incurs the following direct costs: a. Logistics Fee; and b. Inter-island freight charges. In connection therewith, you now request confirmation of your opinion that "1. In the circumstances described above, the Advertising and Promotion as well as Merchandising Consortium Expenses should be considered as part of the cost of the products or a direct cost, hence deductible in computing for the MCIT tax base; and "2. Logistic Fee and Inter-island Freight charges likewise being part of the cost of the products or a direct cost are also deductible in computing for the MCIT tax base." In reply thereto, please be informed that your opinion is hereby confirmed that 1. Section 27(E)(4) of the Tax Code of 1997 defines "cost of goods sold" to include all business expenses directly incurred to produce the merchandise to bring them to their present location and use. For a trading or merchandising concern, "cost of goods sold" shall include the invoice cost of the goods sold, plus import duties, freight in transporting the goods to the place where the goods are actually sold including insurance while the goods are in transit. Generally, in the ordinary or typical Distributorship Agreement, it is the principals, as the manufacturers of the products, who normally spend for the Advertising, Promotion and Merchandising Consortium expenses and pass on the same to JDH as part of the Distributors Purchase Price. Accordingly, JDH would have no trouble claiming the said expenses invoiced as part of the Distributor's Purchase Price of the products as Cost of Sales deductible against the Gross Sales for MCIT purposes. On the other hand, if JDH pays its principals the Distributor's Purchase Price exclusive or net of the said expenses, the principals in effect pass on the burden of spending for said expenses to JDH in which case JDH incurs and spends for actual Advertising and Promotion as well as the Merchandising Consortium expenses, which are recorded as such in its books. In both instances, it is clear that the Advertising, Promotion and Merchandising Consortium expenses are part of the direct cost of the products, notwithstanding the preference of the principals to either incur those expenses directly or have the Distributor incur the same directly. SUCH BEING THE CASE, the amounts incurred by JDH for Advertising and Promotion as well as Merchandising Consortium expenses, being part of the total purchase cost of JDH, should be considered as part of "cost of goods sold" for MCIT purposes. 2. On the other hand, Logistic Fee pertains to warehousing, packing and delivery charges incurred by JDH in the distribution of the products of the principal. This fee cannot be considered as forming part of "cost of goods" sold since the same is incurred and paid by JDH in order that it can perform its obligations under the Distributorship Agreement. These expenses are deemed ordinary and necessary business expenses of JDH as provided for under Section 34(A) of the Tax Code of 1997. 3. Moreover, the Inter-island freight charges which refer to expenses incurred by JDH in transporting the imported goods from the port of entry to its various warehouses located in the provinces or in cities outside the Luzon area likewise cannot be considered as part of "cost of goods sold". In BIR Ruling No. 026-01 dated June 13, 2001, this Office ruled that "...The phrase "transporting the goods to the place where the goods are actually sold" contemplates a situation where the point of origin of the goods is the place where the products were bought and thereafter transported to the place where it shall be sold or the point of destination of the goods." In the instant case, the inter-island charges were incurred by JDH to bring the goods from the port of entry, Manila, to the warehouses located in the provinces or in cities outside the Luzon area, before the goods are distributed to the customers. The expenses for "transporting the goods to the place where the goods are actually sold" should only include those incurred for the transport of the goods from point of origin to the final destination. For MCIT purposes, the port of entry (Manila) is the point of destination since from the time the goods arrive in Manila, JDH could already sell the same. If JDH decides to sell the goods in different parts of the country, any transportation expenses incurred in connection thereto constitute ordinary and necessary business expense on the part of JDH. Accordingly, the inter-island charges incurred by JDH should not form part of "cost of goods sold" for MCIT purposes. cHSIAC 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.) JOSE MARIO C. BUAG Deputy Commissioner Legal & Inspection Group