BIR Ruling [DA-445-06]

July 21, 2006 BIR RULING [DA-445-06] Secs. 31, 32 (A), 27 (A); Sec. 4.110, RR 16-05; Sec. 110 R.R. 2; DA 489-05; 185-95 Croley Foods Manufacturing Caloocan Industrial Subd., Gen. Luis St. Bo. Kaybiga, Caloocan City Attention: Ms. Shirley Shio Gentlemen : This refers to your letter dated August 3, 2005 requesting opinion on the income and value added tax implication of the importation of Croley Foods Manufacturing of machineries and equipments purchased through advances from stockholders. IDEScC FACTS Croley Foods Manufacturing Corporation (Croley for brevity) is engaged in the manufacture of biscuits and snack foods under the trade name "Sunflower Biscuits" among others. In 1998, it imported machineries and equipments in the amount of P26,527,750.00 for use in the manufacture of food products the cost of which was paid through advances from the stockholders. For these importations, it paid value added tax of P2,652,775.00. The said imported machineries and equipments were intended to produce "thin and crispy" crackers with the proper amount of cream in between which is every applied of the quality that would pass export standards for Croley's clients abroad. After several test runs, the machineries produced either "thin and crispy but slightly burned" or "thick but not crispy" crackers with the cream not evenly applied which were not of the desired quality for Sunflower Biscuits which were intended to be sold in the export market. In 1999, Croley initially agreed in principle with the supplier that the aforementioned machineries and equipment will be exported to the supplier due to the defect. The machineries were not recorded as capital asset and the VAT on importation were not declared in the books of accounts because of the intention to export the same. The company then tried to have the machineries and equipments exported but due to the costs of exportation and re-importation, it was agreed that repairs be undertaken locally to remedy the defect and the cost thereof to be shouldered by the supplier. Subsequently, it booked the costs of the machineries and equipment as capital asset in its books of accounts in the year 2000 but did not depreciate them because it was still in the process of instituting remedial repairs on such machines and equipment and has not used them in trade or business. Croley did not claim input tax on the same. In 2004, the defects in the machineries and equipments were finally corrected and the desired product results were attained. It started utilizing the said machineries and equipment and started the depreciation thereof in 2005. In 2002 and 2004, Croley imported two (2) biscuit machineries and parts and two (2) wrapping machines, respectively. The aforementioned equipments were acquired through advances from stockholders but have the same problem as the previously imported machineries and equipments The company could not depreciate nor export the same for repairs because of the costs entailed. The VAT on importation have all been paid. These assets and the correlative advances were booked in 2005, but they have remained idle because they have not been functioning properly. To illustrate: the biscuit transfer machine when used resulted in improper flow of transfer of biscuits; the modified panel of the biscuit machinery parts did not link with the control parts properly; one of the wrapping machines did not wrap biscuits smoothly so that the biscuits were damaged; and the other wrapping machine did not produce consistent number of pieces per package. The aforementioned assets and the correlative advances were booked in 2005. In connection with the foregoing, you now pose the following queries, to wit: 1) Can the purchase of machineries and equipment using advances from stockholders be considered taxable income? 2) Since you cannot claim for refund of the input VAT paid during the importation of the machineries and equipment, can you still credit the input VAT paid against your output VAT liability? 3) Considering the defect in the machineries, can these machineries be rendered obsolete and subsequently decommissioned by Croley? 4) What is the correct basis in recording the value of imported capital equipment, the declared value as contained in the Import Entry Declaration of the Bureau of Customs or the actual acquisition cost including incidental cost in purchasing said equipment? BIR REPLY 1) Section 31 of the Tax Code of 1997 defines taxable income as: "Sec. 31. Taxable Income Defined . The term ' taxable income ' means the pertinent items of gross income specified in this Code, less the deductions and/or personal and additional exemptions, if any, authorized for such types of income by this Code or other special laws. In connection with Section 31 as defined above, Section 32(A) in relation to Section 27(A) all of the Tax Code of 1997 defines gross income as follows: IcHSCT "(A) General Definition. Except when otherwise provided in this Title, gross income means all income derived from whatever source, including (but not limited to) the following items: "(1) Compensation for services in whatever form paid, including, but not limited to fees, salaries, wages, commissions, and similar items; "(2) Gross income derived from the conduct of trade or business or the exercise of a profession; "(3) Gains derived from dealings in property; "(4) Interests; "(5) Rents; "(6) Royalties; "(7) Dividends; "(8) Annuities; "(9) Prizes and winnings; "(10) Pensions; and "(11) Partner's distributive share from the net income of the general professional partnership. Moreover, Section 56 of Revenue Regulations No. 2 provides that: "Section 56. Contributions by shareholders . Where a corporation requires additional funds for conducting its business and obtains such needed money through voluntary process payments by its shareholders, the amounts so received being credited to its surplus account or to a special capital account, will not be considered income , although there is no increase in the outstanding shares of stock of the corporation. The payments in such circumstances are in the nature of voluntary assessments upon, and represent an additional price paid for, in shares of stock held by the individual shareholders, and will be treated as an addition to and as part of the operating capital of the company." Consistent with the foregoing provisions of law, this Office has ruled that the term "income" for purposes of the imposition of income tax, consists of realized appreciation of capital or investment and realized returns, either in the form of receipts or benefits, flowing from the use of capital, services, activities or acts of the taxpayer, or which come to the taxpayer other than as a return of capital or investment, or as a substitution of money value for something permanently lost. (BIR Ruling DA 489-05 dated December 6, 2005). Accordingly, only revenue gained from the sale of output manufactured from the commissioning period (e.g. testing or construction period) should be included in income and not deducted from the cost of the item of property, plant and equipment. For example income may be earned through using a building site as a car park until construction starts (PAS/PFRS 16). Finally, since the nature of your business is the manufacture and sale of biscuits, the intent of the stockholders from said purchase is to consider said purchase as a capital asset and no taxable income will result unless there is a flow from the use of said capital. Thus, it was proper for Croley to recognize the purchase of the aforementioned property only when the same was fit for use pursuant to PAS/PFRS No. 16. 2) Section 4.110-1 of Revenue Regulations No. 16-2005 (Consolidated VAT Regulations of 2005) implementing Section 110 of the Tax Code of 1997, as amended by R.A. No. 9337, provides: "SEC. 4.110-1. Credits For Input Tax . "Input tax" means the VAT due on or paid by a VAT-registered person on importation of goods or local purchases of goods, properties, or services, including lease or use of properties, in the course of his trade or business. It shall also include the transitional input tax and the presumptive input tax determined in accordance with Sec. 111 of the Tax Code. It includes input taxes which can be directly attributed to transactions subject to the VAT plus a ratable portion of any input tax which cannot be directly attributed to either the taxable or exempt activity. Any input tax on the following transactions evidenced by a VAT invoice or official receipt issued by a VAT-registered person in accordance with Secs. 113 and 237 of the Tax Code shall be creditable against the output tax: (a) Purchase or importation of goods (1) For sale; or (2) For conversion into or intended to form part of a finished product for sale, including packaging materials; or (3) For use as supplies in the course of business; or (4) For use as raw materials supplied in the sale of services; or (5) For use in trade or business for which deduction for depreciation or amortization is allowed under the Tax Code, xxx xxx xxx Thus, a VAT-registered person is required to recognize the input tax on its local purchases or on its importation of goods which amount of tax shall be creditable against its output tax subject, however, to the 70% cap starting November 2005 as prescribed under Section 4.110-7 (b) of RR No. 16-05. In connection with the above cited regulations, the pertinent portion of Section 4.104-4 of Revenue Regulations No. 7-95 provides: "SEC. 4.104-4. Determination of the output and input taxes and computation of VAT payable or excess tax credits. . . . "xxx xxx xxx "If at the end of any taxable quarter, the output tax exceeds the input tax, excess shall be paid by the VAT-registered person. This is termed as the VAT payable. If, however, the input tax exceeds the output tax, the excess shall be carried over the succeeding months or quarters." cSaCDT In the instant case, the Value Added Tax that were paid for the importation of capital equipment and machineries which have not been credited against the output VAT liability can still be claimed as input VAT irrespective of the fact that the machineries were imported four years back provided, however, that the same can be fully substantiated with pertinent documents such as official receipts, invoices, bills of lading, etc. (See Sec. 4.104-5 RR No. 7-95). Input VAT is a prepaid tax and the law allows that it can be credited against the output VAT. The claim for input VAT to be offset against the output VAT may be done continuously. What is limited by law is to claim a refund or tax credit certificate on such imported capital goods beyond the two (2) year period. The law limits refund of input VAT on imported capital goods on condition that the input tax claim should always be recorded with the asset account "Input Tax" in the books of claimant, with full observance of the accounting principle of timeliness, before the same can be claimed as tax credit. (BIR Ruling No. 185-95; RMC No. 42-03). In short, the input tax paid on importation should be carried as a separate asset account and should not be tacked with the property, machinery or equipment upon which the input tax is directly attributed. 3) Section 110 of Revenue Regulations No. 2 provides: "Sec. 10 Obsolescence With respect to physical property the whole or any portion of which is clearly shown by the taxpayer as being affected by economic conditions that will result in its being abandoned at a future date prior to the end of its normal useful life, so the depreciation deductions alone are insufficient to return the cost (or other basis) at the end of its economic term of usefulness, a reasonable deduction for obsolescence, in addition to depreciation, may be allowed in accordance with the facts obtaining with respect to each item of property concerning which a claim for obsolescence is made. No deductions for obsolescence will be permitted merely because, in the opinion of a taxpayer, the property may become obsolete at some later date. This allowance will be confirmed to such portion of the property on which obsolescence is definitely shown to be sustained and can not be held applicable to an entire property unless all portions thereof are affected by the conditions to which obsolescence is found to be due." The machineries and equipment may be considered obsolete subject to the above quoted provision of law. The tax treatment of such obsolescence according to Section 34(D) of the Tax Code of 1997 is to claim such obsolescence as deductible losses, to wit: "Losses actually sustained during the taxable year and not compensated for by insurance or other forms of indemnity shall be allowed as deductions" for income tax purposes (This includes loss from disposal through sale.). The gain or loss arising from the derecognition of item or property shall be included in profit or loss when the item is derecognized. 4) Cost of acquired property is the amount paid for the property in cash or the FMV of other property given in the exchange. Any cost of acquiring the property and preparing the property for use are included in the cost of the property. (Chapter 5-5 Prentice Hall's Federal Taxation 2001 Comprehensive). The correct basis in recording the value of imported capital goods consists of the total acquisition cost of importing said goods until the same is brought in the condition necessary for it to be capable of operating in the manner intended by management. Consistent with Philippine Accounting Standards, for purposes of recording the value of said goods, the total acquisition costs comprises (a) Its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates; (b) Any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management; (c) the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period. (PAF/PFRS No. 16) This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it will be ascertained that the facts are different, then this ruling shall be considered void. LexLib Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service