BIR Ruling [DA-147-05]

April 13, 2005 BIR RULING [DA-147-05] R.A. No. 7916; DA-147-04; DA-017-05; DA-147-2005 Joaquin Cunanan & Co. 29th Floor Philamlife Tower 8767 Paseo de Roxas Makati City Attention: Tammy H. Lipana Managing Partner Gentlemen : This refers to your letter dated April 5, 2005 requesting for confirmation of your opinion that the royalty payments made by Lear Automotive Services (Netherlands) B.V.-Philippine branch (LASN) to Lear Corporation (Lean) in consideration for the transfer of technology necessary for the continued production of LASN's products are part of the cost of finish goods and are deductible from gross sales for purposes of computing its taxable gross income subject to 5% tax under Republic Act No. 7916 (the PEZA Law) otherwise known as "The Special Economic Zone Act of 1995." It is represented that LASN is an export enterprise registered with the Philippine Economic Zone Authority (PEZA) under PEZA Registration No. 02-075 dated December 27, 2002; that under its registration agreement with PEZA, LASN's scope of registered activity is limited to the manufacture of automotive wire harness and the importation of raw materials, machinery, equipment, tools, goods, wares, articles, or merchandise directly used in its registered operations; that LASN entered into an agreement with Lear, a corporation organized under the laws of the State of Delaware, United States of America, for the non-exclusive right and license to use intangible property which includes product design intangibles, process intangibles, the Lear trademark and such other intangibles required in connection with the manufacturing, assembling, processing and designing the automotive wiring harness products of LASN; and that in consideration for the use of the Intangible Property, LASN, as the Licensee, will pay Lear, as the Licensor, an arm's length royalty charge according to the schedule set out under the agreement. IESDCH In reply thereto, please be informed that Section 2, Rule 1 of the Implementing Rules and Regulations of the PEZA Law defines gross income as follows: " Gross income for proposes 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 Cost of Sales or Direct Costs Gross Income Less: Allowable Deductions (Sec. 2, Rule XX) Taxable Gross Income (Subject to 5% final tax) From the foregoing, cost of sales or direct costs 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, cost of inventories or finished goods is defined in the following manner under paragraph 4 of Statement of Financial Accounting Standards (SFAS) No. 4, Summary of Generally Accepted Accounting Principles on Inventories: aEcSIH "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. " Moreover, paragraph 13 of International Accounting Standards (IAS) No. 2 on Inventories further stipulates that "costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present condition and location. For example, it may be appropriate to include non-production overhead, such as 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 administrative expenses, which are not inventoriable costs. When, however, royalties are connected with a product design, logo, formula, or process, 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-147-04 dated March 29, 2004; and DA-017-05 dated January 19, 2005). In view of the foregoing, this Office holds that the royalty payments made by LASN to Lear in consideration for the transfer of technology necessary for the continued production of LASN's products are part of the cost of finish goods and are deductible from gross sales for purposes of computing its taxable gross income subject to 5% tax under Republic Act 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 as null and void. Very truly yours, (SGD.) JOSE MARIO C. BUAG Deputy Commissioner Legal and Inspection Group