BIR Ruling [DA-439-06]

July 19, 2006 BIR RULING [DA-439-06] R.R. 11-2005; R.A. 7916; DA-057-2006 Dae Kyung Phils., Co., Inc. Philippine Economic Zone Authority Lot No. 1-6, Block 20, Phase 4 Main Avenue, Rosario, Cavite Attention: Ms. Merilinda C. Fajardo Accounting Asst. Manager Gentlemen : This refers to your letter dated September 2, 2005 requesting for a clarification as to whether royalty payments are still allowed as deduction from gross income subject to the 5% preferential tax. It is represented that Dae Kyung Phils., Co., Inc. (DKP) is a Philippine corporation registered with Export Processing Zone Authority, (EPZA), now PEZA as a Zone Export Enterprise under Certificate of Registration No. 93-26 dated June 03, 1993, to engage in the (1) manufacture of satellite video receiver (SVR) tuners and other components/subcomponents of the telecommunication industry, (2) manufacture of transformers, (3) manufacture of tuner for cable modem; (4) manufacture of Low Noise Block (LNB) and (5) manufacture of satellite radio antenna; that DKP is now subject to the 5% preferential tax rate in lieu of local and national taxes under the PEZA law; that DKP entered into a Technical License Agreement with Radix Electron, Inc., a corporation of organized and existing under the laws of the Republic of Korea, wherein Radix Electron, Inc. agreed to furnish DKP with all available technical information on the design, drawings, data and materials relating to technical know-how in the manufacturing of products; and that the aforesaid Technical License Agreement has been registered with the Intellectual Property Office (IPO) and has been issued Certificate of Compliance No. 5-2004-00031 dated February 27, 2004; that on December 15, 2004, DKP requested a ruling that royalty payments arising from the Technical License Agreement relating to know-how in company's products are deductible in computing the gross income subject to the 5% preferential tax rate; that BIR Ruling No. DA-067-2005 dated February 28, 2005 was issued in your favor; that however, on April 25, 2005, Revenue Regulations No. 11-2005 was released defining "Gross Income Earned" to implement the Tax Incentive Provision in Section 24 of Republic Act No. 7916, otherwise known as "The Special Economic Zone Act of 1995" revoking Section 7 of Revenue Regulations No. 2-2005 and suspending the effectivity of certain provisions of RR No. 2-2005. ASDTEa In reply, please be informed that Section 2, Rule 1 of the Rules and Regulations to Implement R.A. 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." From the foregoing, direct costs (cost 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 as follows in paragraph 4 of Statement of Financial Accounting Standards (SFAS) No. 4, Summary of Generally Accepted Accounting Principles on Inventories: "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 over that 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 revenues 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)] Moreover, Paragraph 13 of Internal 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." 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 and administrative expenses, which are not inventoriable costs. When, however, 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 No. DA-057-2006 dated February 23, 2006) Inasmuch as the subject royalties relate to the transfer of technical information and manufacturing know-how, the same are considered manufacturing costs/factory overhead, which can be deducted from the gross sales/revenue to arrive at the gross taxable income. Hence, the following formula: Gross sales/revenue xxxx Less: Sales Discounts xxxxx Sales Returns/allowances xxxxx Direct costs (cost of sales) xxxxx Other Manufacturing Costs (Factory Overhead) xxxxx xxxx Gross taxable income xxxx ==== In view of the foregoing, this Office holds that royalties arising from the Technical Assistance Agreement relating to know-how in the manufacturing of the company's products should be deductible in computing the gross income subject to the 5% preferential tax rate as defined under Section 2, Rule 1 of the PEZA Rules and as extended to PEZA registered firms as mandated by Sec. 51 of R.A. No. 7916. EaHIDC 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