BIR Ruling [DA-178-05]

April 20, 2005 BIR RULING [DA-178-05] R.A. 7916; RR 16-99; DA-147-2004 Joaquin Cunanan & Co. 29th Floor, Philamlife Tower 8767 Paseo de Roxas Makati City Attention: Atty. Mary Assumption S. Bautista-Villareal Principal, Tax Services Department Gentlemen : This refers to your letter dated February 17, 2005 requesting, on behalf of your client, Kisho Sakata Electronics (P) Inc. ("KSEPI"),for a ruling on the proper tax treatment of royalty payments made by KSEPI to Kisho Electronics Co.,Ltd. ("KECL") pursuant to their Royalties Agreement. The facts, as represented, are as follows: Kisho-Phils. is a Philippine corporation registered with the Philippine Economic Zone Authority (PEZA) as an Ecozone Export Enterprise under Republic Act (RA) No. 7916, otherwise known as the Special Economic Zone Act of 1995 as evidenced by Certificate of Registration No. 95-127 dated November 27, 1995. It started its commercial operations in January 1997 and its facilities are located at the Laguna Technopark in Bian, Laguna, which is a special economic zone. Kisho-Phils. is now subject to the regime of 5% tax in lieu of all other taxes under Republic Act No. 7916, (otherwise called the PEZA law) after its income tax holiday incentive expired on December 31, 2002. Kisho-Japan, on the other hand, is a corporation existing under the laws of and is a resident of Japan. On April 1, 2000, Kisho-Phils. and Kisho-Japan executed a Royalties Agreement wherein Kisho-Japan shall render technical assistance and technical information to Kisho-Phils. for the manufacture, assembly, and/or improvement/development of certain products, i.e.,audio level meters, computer coils, coil motors and other computer parts and accessories. Technical assistance shall include the provision of drawings and specifications, list of component parts, process specifications, performance specifications, test data, lay-out of manufacturing facilities, list of machinery and equipment, and other technical information necessary to manufacture, assemble, and/or improve/develop the products. In consideration of the technical assistance and technical information provided by Kisho-Japan to Kisho-Phils.,Kisho-Phils. pays royalty fees to Kisho-Japan. Based on the foregoing, you now request for confirmation of your opinion that royalties paid by Kisho-Phils. to Kisho-Japan under their the Royalties Agreement are considered part of the finished goods manufactured, and should, therefore, be allowed as deduction from Kisho-Phils.' gross sales for purposes of calculating its "gross income earned" subject to the 5% final tax. In reply, please be informed that, under R.A. No. 7916, the 5% preferential tax rate is applied to the registered enterprise's gross income for purposes of computing the taxable base of the 5% preferential tax imposed on PEZA entities. Section 2, Rule 1 of the Rules and Regulations Implementing R.A. No. 7916, otherwise known as "The Special Economic Zone Act of 1995" or the PEZA Law, (the PEZA Rules) defines gross income as follows: "xxx xxx xxx nn. '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." (Underscoring ours.) The above paragraph may be reduced to the following formula: Gross 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) Under this provision, it is clear that direct costs (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. Cost of inventories or finished goods is further defined in paragraph .4 of the Statement of Financial Accounting Standards (SFAS) No. 4, Summary of Generally Accepted Accounting Principles on Inventories, to wit: "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 revenue 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. FII.A.S-6A; M-6A, S-6A(1),M-6A(1) ] In determining the aforesaid rational and systematic cost assignment or allocation, Paragraph 6 of SFAS No. 4 further provides: "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: 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." Based on the foregoing provisions and accounting rules and standards, the treatment of royalties for purposes of calculating the PEZA enterprise's taxable income will depend on the consideration or basis for which the royalties are paid. When the royalties relate to a system or license, royalties are treated as general and administrative expenses, and are therefore not inventoriable costs. However, when royalties are connected with a product design, logo, formula, or process, or related to the transfer of technical information and manufacturing know-how, such royalties should be considered as part of the cost of manufacturing the products and as such, capitalized as part of inventories. [ BIR Ruling No. DA-147-04 dated March 29, 2004 ] This accounting treatment was clearly recognized in Revenue Regulations (RR) No. 1-95, as amended by RR No. 16-99, implementing the tax incentives provisions of R.A. No. 7227, which are likewise extended to PEZA-registered enterprises by virtue of Section 51 of R.A. No. 7916. In Section 3(o) of RR No. 1-95, the definition of "Gross Income Earned" expressly states that Cost of Sales shall be deductible from gross sales for purposes of computing the "Gross Income Earned" subject to the 5% final tax. Moreover, the same provision also expressly provides that Goods in Process (Intermediate Goods) and Finished Goods shall be allowed as deductions for the calculation of gross income earned. We quote, for your reference, the relevant portion of Section 3(o) of RR No. 1-95 as follows: "SEC. 3. Definition . For purposes of these Regulations, the terms used herein shall be construed to have the following meanings: xxx xxx xxx o. Gross income earned refers to gross sales or gross revenue 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 deductions 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: Direct salaries, wages or labor expenses Production supervision salaries Raw materials used in the manufacture of products Goods in Process (Intermediate Goods) Finished Goods Supplies and fuels used in production Depreciation of machineries and equipment used in production, and buildings owned and/or constructed by SBMA-registered enterprise Rent and utility charges associated with building, equipment and warehouses, or handling of goods Financing charges associated with fixed assets xxx xxx xxx" (Underscoring supplied.) Accordingly, it is clear that the royalties paid by KSEPI to KECL pursuant to their Royalties Agreement are considered part of Cost of Sales, specifically the Goods in Process (Intermediate Goods) or Finished Goods account, because the technical assistance and technical information supplied by KECL to KSEPI are necessary to the manufacture of KSEPI's products, pursuant to Generally Accepted Accounting Principles as embodied in SFAS Nos. 1 and 4 and IAS No. 2. [ BIR Ruling No. DA-147-04 dated March 29, 2004 ] Hence, said royalties shall be allowed as a deduction from KSEPI's gross sales for purposes of calculating its "Gross Income Earned" subject to the 5% final tax, pursuant to Section 57(b) of the SBF Rules and Regulations and Section 3(o) of RR No. 1-95 in relation to Section 51 of R.A. No. 7916. [ BIR Ruling No. DA-147-04 dated March 29, 2004 ] DaHISE IN VIEW OF THE FOREGOING, this Office holds that royalties paid by KSEPI to KECL under their Royalties Agreement are considered part of Cost of Sales, specifically the Goods in Process (Intermediate Goods) or Finished Goods account, and as such, should be allowed as deduction from KSEPI's gross sales for purposes of calculating its "gross income earned" subject to the 5% final tax, pursuant to Section 57(b) of the SBF Rules and Regulations and Section 3(o) of RR No. 1-95 in relation to Section 51 of R.A. No. 7916. [ BIR Ruling No. DA-147-04 dated March 29, 2004 ] 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 and Inspection Group