BIR Ruling [DA-280-05]

June 23, 2005 BIR RULING [DA-280-05] R.A. 7229; RR 16-99; DA 178-2005; DA-180-2005 Joaquin Cunanan & Co. 29th Floor Philamlife Tower 8767 Paseo de Roxas Makati City Attention: Atty . George J . Lavadia Principal Gentlemen : This refers to your letter dated February 9, 2005 requesting on behalf of your client, JAE Philippines, Inc. (JAE PHILS) for confirmation of your opinion that its royalty payments as consideration for the transfer of technology from Japan Aviation Electronics Industries Limited (JAE-JAPAN), are deductible from its gross revenues for purposes of computing its taxable income under the 5% final tax regime of firms registered with the Philippine Economic Zone Authority (PEZA). It represented that JAE-PHILS is a domestic corporation registered with PEZA as an Ecozone Export Enterprise on a pioneer status under PEZA Certificate of Registration No. 96-079 dated June 19, 1996. With principal offices and manufacturing facilities located at the Gateway Business Park, Javalera, Gen. Trias, Cavite, a special economic zone, JAE-PHILS started commercial operations in September 1997. Upon registration with PEZA, the company was granted Income Tax Holiday (ITH) incentives for four (4) years. Thereafter, it was granted a one (1) year ITH extension which expired in September 2002. The company is now subject to the 5% final tax on gross income, in lieu of the payment of all other local and national taxes. JAE-PHILS entered into a Technical Assistance Agreement (TAA) with JAE-JAPAN, a Japanese corporation, whereby JAE-JAPAN (as licensor) agreed to furnish JAE-PHILS, as licensee, with all available information, data and materials relating to know-how in the manufacture of certain products. In connection therewith, you now request for an opinion that royalty payments made by JAE-PHILS., relative to the transfer of technology by JAE-JAPAN are deductible from the gross revenues for purposes of computing its taxable income. In reply, please be informed that Section 2, Rule 1 of the Rules and Regulations Implementing Republic Act (RA) 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." TIcAaH 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) From the foregoing, 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. On the other hand, the cost of inventories or finished goods is defined in paragraph 4 of the Statement of Financial Accounting Standards (SFAS) No. 4, Summary of Generally Accepted Accounting Principles on Inventories, as follows: "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." cTIESD 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. F.II.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 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: 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 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, which are not inventoriable costs. However, when 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. [ BIR Ruling Nos. DA-178-2005 and DA-180-2005 both dated April 20, 2005 ] 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 costs 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 Direct salaries Production supervision salaries Raw materials used in the manufacture of products Goods 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 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 expense Communication Expenses Outside Professional Services Interest and financial charges on working capital Loss on foreign exchange translation Loss on disposal of merchandise inventory. . . ." (Emphasis ours.) Based on the above Revenue Regulations, SBMA-registered trading and manufacturing enterprises are entitled to deduct Royalty Fees when calculating their gross income earned. By virtue of R.A. 7916 (PEZA Law), these SBMA privileges are also extended to PEZA firms as follows: "51. Ipso-Facto Clause. All privileges, benefits, 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." (Section 51 of the PEZA Law). IN VIEW OF THE FOREGOING, this Office holds that royalties arising from the Technical Service Agreement relating to know-how in the manufacturing of the company's products are rightfully part of the cost of finished goods and should be deductible in computing gross income, as defined under Sec. 2, Rule 1 of the PEZA Rules, which is further reduced by allowable deductions specifically enumerated under Section 2, Rule XX of the PEZA Rules. Further, the privilege accorded to SBMA enterprises under Section 3 of RR No. 16-99 to deduct royalty payments when calculating gross income subject to the 5% final tax, shall also be extended to PEZA registered firms as mandated by Sec. 51 of RA 7916. [ BIR Ruling Nos. DA-178-2005 and DA-180-2005 both dated April 20, 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.) JOSE MARIO C. BUAG Deputy Commissioner Legal & Inspection Group