BIR Ruling [DA-389-04]

July 20, 2004 BIR RULING [DA-389-04] Sec. 105 026-97; 113-98; 001-99 The Chief Tax and Revenue Group One-Stop Shop Inter-Agency Tax Credit and Duty Drawback Center Roxas Blvd. cor. Pablo Ocampo Sr. Street Manila S i r : This has reference to your indorsement letter dated June 14, 2002 which was forwarded to this Office by the Assistant Commissioner of the Assessment Service, this Bureau, requesting for as resolution on the issue as to whether or not the power plant income of Indo Phil Textile Mills, Inc. as stated in its Financial Statement, is subject to VAT. The issue to be resolved arose from the following facts: Indo Phil Textile Mills, Inc. (IPTMI) was established in the year 1975. Indophil Acrylic Manufacturing Corp. (IPAMC) and Indo Phil Cotton Mills, Inc. (IPCMI) were established in 1990 and 1994, respectively. IPTMI, IPAMC and IPCMI are all domestic corporations registered with the Securities and Exchange Commission and also with the Board of Investment (BOI) primarily to engage in the business of manufacturing textile and textile components. IPTMI holds 63% of the shares of IPAMC and 40% of the shares of IPCMI. Due to power crisis that the country experienced in the year 1994, these companies suffered an irregular, expensive and low quality of supply of electricity. Thus their operation was adversely affected due to the increase in the costs of production. To address this problem, IPTMI installed a power plant with a capacity of 24.80 megawatts enough to supply the power requirement of the Indo Phil Group as a whole. Resultantly, the three companies entered into an agreement to share the use of the Power Plant to reduce their overall costs where all their electrical needs will be supplied by a power plant established solely and exclusively for such purpose. The salient features of the agreement are as follows: a. IPTMI, being the largest in the group of related companies will advance the amount necessary to set up the power plant as it is also in an advantageous position to raise loans from banks; b. IPCMI and IPAMC undertook to exclusively source their quality power needs from the IPTMI Power Plant and to proportionately share on all the costs of power generation including the depreciation expenses, overheads and interest costs incurred by IPTMI on the loans obtained to purchase and set up the Power Plant; c. It was also agreed by the three companies that in case there will be a need to add or replace the generator in the future, IPCMI land IPAMC will provide the funds necessary in equal proportion. IPTMI, on the other hand, will also share in the costs thereof similar to the current arrangement. Concomitantly, the cost on the operation of the power plant is shared proportionately among the three companies and the contribution is based on the units consumed by each company as appearing on the individual meter installed in the control room. On the other hand, the interest cost and other indirect expenses like salaries of management, staff, common services like Stores, Accounts, Warehouse, HRD and other indirect overhead expenses which are not directly charged to the Power Plant are loaded to the cost per unit at year end and accordingly charged to IPCMI and IPAMC. Notwithstanding the foregoing arrangement, IPTMI reflects the contribution of IPCMI and IPAMC to the expenditure incurred by the Power Plant and other overhead expenses on its Financial Statement as income of the company. The purpose in considering the contribution as income is to meet the banking requirement that the Power Plant is making profit because IPTMI obtained substantial loans from the bank for the installation. From this representation, conflicting views arose and this office is now being requested to rule as to whether or not the contribution of IPCMI and IPAMC which was reflected by IPTMI in its Financial Statement as income is subject to value-added tax. RESOLUTION An important requirement for the imposition of the value-added tax is that a sale or transaction which is sought to be taxed must be entered into by a person in the course of any business carried on by such person. The phrase "in the course of any business" means the regular conduct or pursuit of a commercial or an economic activity, including transactions incidental thereto, regardless of whether or not the person engaged therein is a non-stock, non-profit private organization (irrespective of the disposition of its net income and whether or not it sells exclusively to members or their guests), or government entity (Section 105, 1997 Tax Code). Notwithstanding the intention of IPTMI in reflecting the contribution of IPCMI and IPAMC as income, it is best to determine whether or not the supply of electricity of IPTMI was made in the regular course of its business or can it be considered as incidental transaction to its main business. It is worth mentioning that IPTMI was formed with the following purposes: 1. To engage in the business of manufacturing a) yarns of various counts and kinds, whether of cotton, staple rayon, polyester, polyemide, silk, wool, flax or other materials of kind red character, in its pure of admixture form intended for weaving, knitting, making threads and the like, and b) textile for garment or apparel, including industrial and other allied textile products; 2. To engage in the sale or distribution of the aforesaid products, manufactured goods or articles in the Philippines or export to any other country outside the Philippines, on wholesale basis only; 3. To do everything necessary, proper, advisable or convenient for the establishment of any of the purposes, or the attainment of any of the objects or the furtherance of any of the purposes herein set forth, and to do every other act or thing incidental thereto or connected therewith which is not forbidden by any law of the Philippines or by other provision of this articles of incorporation; and 4. To purchase, acquire, hold, sell, assign, transfer, mortgage, pledge, exchange or otherwise deal in shares of capital stock of this corporation or any other corporation or corporations. A careful reading of the enumerated purposes would show that the act of supplying the electricity to IPCMI and IPAMC is not among the ventured activity of IPTMI. Though it may be considered a regular deal because IPCMI and IPAMC are dependent on the power supply of the plant, the same should not be considered a vatable transaction because it was not undertaken by IPTMI in the pursuit of its commercial or economic activity. Neither can it be considered incidental thereto because the supply of electricity does not necessarily follow the primary function of manufacturing yarns and textile. ( BIR Ruling No. 113-98 ) A transaction will be characterized as having been entered into by a person in the course of trade or business if it is (1) regularly conducted and (2) undertaken in pursuit of a commercial or economic activity. Taken as a barometer in considering a transaction as subject to VAT, it is clear that the second requisite is absent in the case of IPTMI. In addition, it is represented that the amount charged reflects only the electricity utilized by each company and other overhead expenses and that no profit is made nor is there any intention on the part of IPTMI to make profit from the transactions. Again, as provided in Section 105 of the Tax Code of 1997, value-added tax covers only persons who in the course of trade or business, sells, barters, exchanges, leases goods or properties or renders services, and any person who imports goods. Accordingly, since charges/billings made by IPTMI to its subsidiaries for their consumption of electricity generated by the power plant and other overhead expenses are purely at cost and without any profit and being merely reimbursements are not subject to the value-added tax. ( VAT Ruling No. 026-97 dated April 1, 1997 and VAT Ruling No. 001-99 dated January 6, 1999 ) Another aspect in the VAT system is the recognition of the input tax on the part of the buyer and output tax on the part of the seller. From the purchaser's perspective, the VAT on the sales by a VAT registered person from whom the said purchaser buys goods or to whom services are rendered is referred to as input tax. For the same transaction, the output tax of the seller becomes the input tax of the buyer. From the start of operation of the power plant as well as the reimbursement of expenses, IPCMI and IPAMC did not record any recognition of input tax for such payment and neither did IPTMC consider an output tax on the same transactions. The parties hereto had been consistent in its appreciation that the transaction of supplying the electricity and reimbursing the cost of production and other overhead expenses is not subject to the value-added tax. Evidently, if these corporations believe that the supply of electricity is subject to value-added tax, they could have presented a modified financial statement wherein output and input taxes, respectively, would be recorded. In closing, the income of IPTMI may have blown-up due to the power plant income, yet this Office believes that there is no economic benefit that have been imputed on the part of IPTMI because the same was expended for the actual cost of generation of the power plant as well as other overhead expenses. Considerably, this is in accord with the agreement entered into by the IPTMI, IPCMI and IPAMC in relation to the installation of the power plant. 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