Quiason Makalintal Barot Torres & Ibarra

August 10, 2007 BIR RULING [DA-439-07] 34 (F) (1); R.R. No. 2 BIR Ruling No. DA-119-03, DA-362-04 & DA-217-06 Quiason Makalintal Barot Torres & Ibarra 21st Floor, Robinsons-Equitable Tower 4ADB Avenue corner Pedro Poveda St. Ortigas Center, Pasig City Attention: Atty. Ruelito Q. Soriano & Atty. Benedict R. Tugonon Gentlemen : This refers to your letter dated March 29, 2007 requesting on behalf of your client, FGP Corporation ("FGP"), for an authority to change its accounting method, particularly its treatment of the acquisition of replacement gas turbine blades and vanes ("Gas Turbine Strategic Spares") to be used for San Lorenzo Power Plant, as a capital asset subject to depreciation, pursuant to Philippine Accounting Standard No. 16 ("PAS 16, Property Plant and Equipment") issued by the Philippine Accounting Standards Council. As represented, FGP is a corporation duly organized and existing under and by virtue of the laws of the Republic of the Philippines. It is a power generating company and the owner and operator of the 1000 megawatts gas-fired power generating facility located in the Municipality of Sta. Rita, Province of Batangas (the "San Lorenzo Plant"). FGP entered into an Operation & Maintenance Agreements (O&M) with Siemens Power Operations, Inc. ("Siemens"), a corporation duly organized and existing under and by virtue of the laws of the Republic of the Philippines, with address at 17th Floor Salcedo Towers, H.V. Dela Costa Street, Salcedo Village, Makati City. As the operator of the San Lorenzo Plant, Siemens is responsible for the day-to-day operations of the power plant, the maintenance and repair of the power plant complex. It is tasked to keep the power plant in good working condition, prevent it from premature deterioration and degradation and to correct, by appropriate and approved measures, any damage to or deterioration or malfunction of the power plant or any part thereof all in accordance with Good Utility Practice. The repair and maintenance of the San Lorenzo Plant requires the replacement by Siemens of the Gas Turbine Strategic Spares during major overhauls of the power plant. CDaTAI As the operator of the San Lorenzo Plant, Siemens is paid by FGP a Monthly Fixed Operating Fee and a Monthly Variable Operating Fee, among other fees. The cost of the Gas Turbine Strategic Spares forms part of the O&M Monthly Fixed Operating Fee due to Siemens. The Gas Turbine Strategic Spares are the usual items to be replaced during scheduled major overhauls of the power plant. The overhauls are scheduled approximately at the end of the useful life of the parts to be replaced (i.e. every three (3) and/or six (6) years). Siemens has provided FGP with the specific cost of the Gas Turbine Strategic Spares based on the original contract price stated in the Engineering Procurement and Construction Contract between FGP, Siemens AG & Siemens. This is the amount which FGP will assign to the Gas Turbine Strategic Spares and which will be depreciated commencing upon the actual installation of the same. Old Accounting and Tax Treatment Under previous Generally Accepted Accounting Principles ("GAAP"), FGP accounted the power plant as a single asset and depreciated it over a period of twenty-five (25) years, equivalent to the life of the power plant. CaSAcH In respect to the spare parts, in accordance with the Statements of Financial Accounting Standards ("SFAS") rules, for accounting purposes, FGP accounted the cost of the Gas Turbine Strategic Spares as part of its non-current assets. For tax purposes, the whole amount of Monthly Fixed Operating Fee, including the imputed cost of the Gas Turbine Strategic Spares, was claimed by FGP as part of its direct cost and deducted directly from its taxable income. Upon actual deployment or installation of the Gas Turbine Strategic Spares, FGP will no longer claim any deduction for income tax purposes. However, for accounting purposes, FGP will transfer the cost of the installed part from its "other non-current assets" account to the Property, Plant and Equipment ("PPE") account. Changes in Accounting Method Following the effectivity of the revision in Philippine Accounting Standards ("PAS") 16 in 2005, an entity is required to determine the depreciation change separately for each significant part of an item of property, plant and equipments. In accordance with PAS 16, FGP, in coordination and with the assistance of Siemens, divided the power plant assets into significant parts by determining the respective useful lives, cost and functionality. The division of the power plant assets into subcomponents of different significant parts resulted in a change in the estimated useful lives of certain assets, thereby accelerating the depreciation of the Gas Turbine Strategic Spares. As a result of the division, the estimated useful lives of the Gas Turbine Strategic Spares have been revised to between three (3) to six (6) years depending on its functionality instead of the previous estimated useful life of twenty-five (25) years. To comply with the requirements of PAS 16, FGP intends to implement the following changes in its accounting method effective January 1, 2007: 1. FGP will accelerate the depreciation of the replaceable turbine blades and vanes presently installed in the power plant from twenty-five (25) years to between three (3) to six (6) years. 2. FGP will capitalize the portion of the Monthly Fixed Operating Fee corresponding to the cost of the Gas Turbine Strategic Spares. New Accounting and Tax Treatment For accounting purposes, prior to the major overhaul or the deployment or installation of the Gas Turbine Strategic Spares, the capitalized portion of the Monthly Fixed Operating Fee will be presented as part of "Other non-current assets." Upon actual deployment or installation of the Gas Turbine Strategic Spares, the amount will be reclassified to the PPE account. EHSTcC For income tax purposes, FGP will only start to depreciate and claim the corresponding depreciation expenses of the capitalized cost of the Gas Turbine Strategic Spares upon the actual deployment or installation of the Gas Turbine Strategic Spares. The changes which FGP intends to implement will not result in any tax leak to the government since no additional expense will be claimed by FGP. The changes will only affect the scheduling of the depreciation claim. No amount will be duplicated or omitted as a result of the changes. HASTCa In reply, please be informed that in several occasions, this Office ruled that ". . . 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; (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 (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 of 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.' TcHCDE 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; DA413-04 dated July 30, 2004; and DA-217-06 dated April 7, 2006] 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. In view of the foregoing, this Office hereby grants your request for FPG to change its accounting method, particularly its treatment of the acquisition of replacement Gas Turbine Strategic Spares to be used for San Lorenzo Power Plant, as a capital asset subject to depreciation, pursuant to PAS 16, Property Plant and Equipment since this method best reflects the true value of the said assets and gives a more accurate estimation of their usage. 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