BIR Ruling [DA-129-06]

March 17, 2006 BIR RULING [DA-129-06] R.R. 16-99; RA 7916; DA 067-2005 Fernandez Aguja Law Firm CPA-Lawyers 5F JL Building Don Jose Avila cor. Don Gil Garcia Streets Cebu City Attention: Ms. Luna Mae Fulache-Aguja Partner Gentlemen : This refers to your letter dated March 6, 2006, requesting for and on behalf of your client TAIYO YUDEN (PHILIPPINES), INC., for confirmation of your opinion that royalty payments paid can be considered as a deduction for purposes of computing the Gross Income Earned subject to the 5% preferential tax. It is represented that Taiyo Yuden (Philippines), Inc . (PTY), is a company registered with the Export Processing Zone Authority as evidenced by Certificate of Registration No. 89-04 issued on January 12, 1989. It is engaged in the manufacture and export of inductor products and capacitors, LC compound filters, DB buzzer products and LF multi-layer chip inductors. On April 1, 2002, Taiyo Yuden Co, Ltd., In (JTY), a Japanese corporation with principal address at 16-20 Ueno 6-chome, Taito-ku, Tokyo Japan and PTY signed an Intellectual Property License and Technical Assistance Agreement using JTY's know-how in the manufacture of PTY's products. Article 1 of the said Technical Agreement states: "Article 1. (Intellectual Property License) HAaDcS JTY (Taiyo Yuden Co. Ltd.) shall grant PTY (Taiyo Yuden Philippines inc.) licenses under JTY's intellectual property as follows (the "JTY's IP License"): 1) JTY shall grant PTY a license to use all of the JTY's industrial property rights which are necessary for manufacture sale, modification and/or improvement of the Products, a part of such JTY's industrial property rights be listed in exhibit 1. 2) JTY shall provide and grant a further license to use proprietary and technical information as listed in Exhibit 2 and owned by JTY relating to the Products." As consideration for the Agreement, Article 3 states: "Article 3 (Consideration) 1) As a consideration for JTY's IP License, PTY shall, during the term of this agreement pay a royalty ("Royalty") being 3% of PTY's Net Sales (as defined in Exhibit 3) of the products." In reply, 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." cCESTA The above paragraph may be reduced to the following formula: Cross 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 cost (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." 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 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-64(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: DAEIHT 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. Moreover, Section 3 of Revenue Regulations No. 16-99 provides that firms established under Republic Act No. 7227 are allowed to deduct royalty payments when calculating gross income subject to the 5% final tax. Section 3 of Revenue Regulations No. 16-99 governing enterprises registered with the Subic Bay Metropolitan Authority (SBMA) modifies the definition of gross income earned to read as follows: "o. Gross Income Earned refers to gross sales or gross revenues derived from the business activity within the zone, net of sales discounts and sales returns and allowances and minus cost of sales or direct costs but before any deduction for administrative expenses or incidental losses during a given taxable period. For financial enterprises, gross income shall include interest income, gains from sales, and other income, net of allowable deductions, the following deductions shall be allowable for the calculation of gross income earned for specific types of enterprises: 1. Trading and manufacturing enterprises aACHDS Direct salaries Production supervision salaries Raw materials used in the manufacture of products Good in process (Intermediate goods) Finished goods Supplies and fuels used in production Toll manufacturing fees Commission expenses Distribution expenses Depreciation of machineries and equipment used in the production and building owned and/or constructed by SBMA-registered enterprise Equipment lease payments Rent and utility charges associated with building, equipment and warehouses, or handling of goods Financing charges associated with fixed assets Corporate management salaries Administrative salaries Marketing and sales salaries Advertising Research and development Royalty fees Travel expenses Communication expenses Outside professional services Interest and financial charges on working capital Loss on foreign exchange translation Loss on disposal of merchandise inventory xxx xxx xxx" (Emphasis supplied) Based on the abovementioned Revenue Regulations, SBMA-registered trading and manufacturing enterprises are entitled to deduct Royalty Fees in calculating their gross income earned during a given taxable period. Pursuant to Section 51 of R.A. No. 7916 (PEZA Law), these SBMA privileges have been extended to PEZA registered firms as follows: "51. Ipso-Facto Clause . All privileges, privileges, advantages or exemptions granted to special economic zones under Republic Act No. 7227, shall ipso-facto be accorded to special economic zones already created or to be created under this Act. The free port status shall not be vested upon the new special economic zones." In view of all the foregoing, this Office holds that royalties arising from the Technical Assistance Agreement between JTY and PTY to use the former's know-how in the manufacture of the latter's products should be deductible in computing 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 Section 51 of R.A. 7916. ( BIR Ruling No. DA 067-2005 dated February 28, 2005 ) 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