Sycip Gorres Velayo & Co.

March 27, 2007 BIR RULING [DA-183-07] BIR Ruling No. DA-119-03, DA-362-04 & DA-217-06 Sycip Gorres Velayo & Co . 6760 Ayala Avenue Makati City Attention: Mr . Joel L . Tan-Torres Partner, Tax Services Gentlemen : This refers to your letter dated March 5, 2007 requesting on behalf of your client, Manila North Tollways Corporation ("MNTC"), for an authority to change the method of computing depreciation of its North Luzon Expressway (NLEX) Project from Straight Line Method to Output/Units of Production effective January 1, 2006. As represented, MNTC is a domestic corporation that was granted the concession to finance, design, rehabilitate, expand, operate and maintain the NLEX under a Supplemental Toll Operation Agreement (STOA) signed by MNTC, the Philippine National Construction Corp. (PNCC), and the Republic of the Philippines, acting through the Toll Regulatory Board (TRB). MNTC started construction of the NLEX in February 2003, with preparatory works beginning in 1999. Formal commercial operations of the Segments 1 to 3 (Balintawak to Sta. Ines, Pampanga) of the NLEX began on February 10, 2005. Segment 7 comprising the limited access road from Tipo to Subic has been operational since 1997. The Board of Investments (BOI) granted MNTC in September 1997 a six-year Income Tax Holiday (ITH), which was extended up to the first quarter of 2010. Initially, MNTC adopted the Straight Line Method in depreciating its property and equipment. For the civil works component of its property and equipment, MNTC made use of an estimated useful life of Twenty Six (26) years, from the start of commercial operations on February 10, 2005 up until December 31, 2030, which is the end of its fixed-term concession period. MNTC considered a change in depreciation method after reviewing the actual traffic volume in 2005 vis--vis original projections and validating the traffic projections with a recognized traffic consultant. Halcrow Fox Ltd., an independent traffic consultant, conducted an updated traffic study and submitted a report to MNTC in May 2006, showing, among others, that numerous factors ranging from increase in toll rates, petroleum prices, lower regional growth rates and the delay in planned infrastructure developments in the northern part of the country could considerably decrease the expected traffic in the NLEX. This study was further reviewed and validated by Scott Wilson Ltd., an independent technical consultant commissioned by MNTC's creditors to carry out a due diligence study. Upon consideration of the updated traffic projections and review of the practice of some toll road operators/concessionaires in Asia and Europe, MNTC considered a change in depreciation method from Straight Line Method to Output/Units of Production Method solely for the civil works portion of the NLEX, which account for more than 80% of the net book value of its property and equipment as of December 31, 2005. The Output/Units of Production Method is considered to be more reasonable since the usage of the road in terms of actual traffic volume is more reflective of the reduction in its value rather than mere passage of time which is the presumption under the Straight Line Method. In reply, please be informed that this Office had the occasion to rule in BIR Ruling No. DA-217-06 dated April 7, 2006 as follows: ". . . Section 34(F)(1) of the Tax Code of 1997 states that there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including reasonable allowance for obsolescence) of property used in trade or business. The term reasonable allowance shall include, but not limited to, an allowance computed in accordance with regulations prescribed by the Secretary of Finance, upon recommendation of the Commissioner, under any of the following methods: (a) The straight-line method; HICcSA (b) Declining-balance method, using a rate not exceeding twice the rate which would have been used had the annual allowance been computed under the method described in Subsection (F)(1); (c) The sum-of the-years-digit method; and ECaTDc (d) Any other method which may be prescribed by the Secretary of Finance upon recommendation of the Commissioner. Corollarily, Section 109 of Revenue Regulations No. 2, otherwise known as the Income Tax regulations, provides 'Section 109. Method of computing depreciation allowance . The capital sum to be replaced should be charged off over the useful life of the property, either in equal installment or in accordance with any other recognized trade practices, such as an apportionment of the capital sum over units of production. Whatever plan or method of apportionment is adopted must be reasonable and must have due regard to operating conditions during the taxable period. While the burden of proof must rest upon the taxpayer to sustain the deductions taken by him, such deductions must not be disallowed unless shown by clear and convincing evidence to be unreasonable. The reasonableness of any claim for depreciation shall be determined upon the conditions known to exist at the end of the period for which the return is made. If it develops that the useful life of the property will be longer or shorter than useful life as originally estimated under all the then known facts, the portion of the cost or other basis of the property not already provided for through depreciation allowances should be spread over the remaining useful life of the property as re-estimated in the light of the subsequent facts, and depreciation deductions taken accordingly.' The proper allowance for depreciation of any property used in the trade or business is that amount which should be set aside for the taxable year in accordance with a reasonable consistent plan whereby the aggregate of the amount so set aside, plus the salvage value, will, at the end of the useful life of the property in business, equal the basis of the property. Due regard must be given to expenditures for current upkeep. (Section 105, Revenue Regulations No. 2) [cited in BIR Ruling Nos. DA10-98 dated January 21, 1998, DA 267-98 dated June 24, 1998; and DA413-04 dated July 30, 2004] xxx xxx xxx" Depreciation is a cost allocation process that systematically and rationally allocates acquisition costs of operational assets to periods benefited by their use. The depreciation in the Output/Units of Production Method depends on the output compared to the total output expected during the useful life of the asset. More specifically in the case of MNTC, it is a method of calculating depreciation in which the assets, specifically civil works, are written off in accordance with the actual volume of vehicular traffic passing or using the road in the given year, divided by the cumulative actual and anticipated traffic over the life of the fixed-term concession period. Future periodic heavy maintenance works (mainly road resurfacing) are proposed to be depreciated using the same Units of Production Method over a period until the next scheduled maintenance works or remaining life of the concession, whichever is shorter. Moreover, as a new operator of the NLEX, MNTC is registered with the BOI and entitled to incentives which include, among others, income tax holiday for a period of six years, which was extended up to the first quarter of 2010. ADCEaH Under the ITH, MNTC will derive no tax benefit whatsoever even if the change in accounting method is retroactively applied. This finds support in BIR Ruling DA-119-03 dated April 14, 2003 citing BIR Ruling 048-96 dated April 10, 1996 where the BIR approved the change in a company's depreciation method retroactive to the date of the acquisition of its assets, viz: '. . . considering that DPI will, in essence be claiming increased depreciation charges during its ITH, the retroactive application thereof is hereby granted since no tax benefit therefrom accrues to DPI, and government collections will not be prejudiced because of such change.' Accordingly, this Office hereby grants your request for the change in MNTC's method from Straight Line Method to Output/Units of Production Method in computing depreciation allowance for the civil works component of its property and equipment retroactive to the date of the acquisition of its assets considering the existing conditions in the operation of the NLEX does not maximize the use of the said assets. Moreover, the use of the unit-of-production method best reflects the true value of the said assets and gives a more accurate estimation of their usage. In view of the existing conditions in the operation of the NLEX, MNTC's request to change its method of computing the depreciation of the civil works portion of its assets from straight line method to Output/Units of Production effective January 1, 2006 is granted. 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, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service