BIR Ruling [DA-519-06]

August 25, 2006 BIR RULING [DA-519-06] DA-439-2006 dtd. 07/19/06 Isla Lipana & Co. (formerly 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 November 17, 2005 requesting on behalf of your client, F. Tech Philippines Mfg., Inc. (FTP), for a confirmation of your opinion that the royalty payments of FTP to F. Tech, Inc. (FTI) in consideration of the transfer of technology from FTI and to FTP, are deductible from FTP's 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 is represented that FTP is a domestic corporation registered with PEZA as an Ecozone Export Enterprise under PEZA Certificate of Registration No. 94-42 dated June 17, 1994; that its principal office and manufacturing facilities are located at 118 North Science Avenue, Laguna Technopark, Bian, Laguna, Philippines; that a PEZA-registered enterprise, FTP is entitled to the incentives granted under Republic Act No. 7916 (PEZA Law); that FTP is now subject to the 5% final tax on gross income, in lieu of the payment of all other local and national taxes, after the expiry of its income tax holiday incentive; that on January 1, 2001, FTP (as licensee) and FTI (as licensor), a corporation registered and doing business in Japan, executed a Technical Assistance Agreement (Agreement) whereby the latter granted the former a non-exclusive right and license to use its industrial proprietary rights and know-how relating to the manufacture of certain products; that the Agreement was later amended on February 1, 2002; that you now request for an opinion that royalty payments made by FTP, relative to the transfer of technology by FTI, are deductible from the gross revenue for purposes of computing its taxable income subject to the 5% final tax. THEDcS In reply, please be informed that Section 2, Rule 1 of the Rules and Regulations to Implement Republic Act 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 (costs of sales) are deductible from gross sale/revenue for purposes of computing a PEZA firm's taxable gross income subject to the 5% final tax. The Generally Accepted Accounting Principle (GAAP) in the Philippines in determining the cost of a product/inventory is embodied in the Philippine Accounting Standard/International Accounting Standard No. 2 (PAS/IAS 2). Paragraph 34 thereof requires that there shall be a corresponding recording of the cost of production for every product or inventory sold. Further, Paragraph 10 of the same standard provides that the cost of product/inventory shall include all the costs incurred in producing the product, thus: DaAIHC "The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition." (Emphasis supplied) Moreover, paragraph 12 of the same PAS/IAS 2 states: "The costs of conversion of inventories include costs directly related to the units of production, such as direct labour. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation and maintenance of factory buildings and equipments, and the cost of factory management and administration. Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and indirect labour." (Emphasis supplied) HacADE Clearly, only the cost directly attributable in manufacturing the product shall form part of the cost of the product/inventory. Stated differently, the costs incurred other than the production cost shall not form part of the cost of the product/inventory. Thus, Paragraph 15 of PAS/IAS No. 2 further provides 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 overheads or the costs of designing products for specific customers in the costs 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 part of the cost of the product/inventory. On the other hand, when the royalties are connected with the product design, logo, formula, or process, then the payments thereof form part of the cost of the product/inventory. 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-439-2006 dated July 19, 2006). Inasmuch as the subject royalties relates 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/revenues xxxx Less: Sales Discounts xxxxx Sales Returns/Allowances xxxxx Direct costs (cost of sales) xxxxx Other Manufacturing Costs xxxxx xxxx Gross taxable income xxxx ==== Moreover, under Sec. 3 of BIR Revenue Regulations (RR) No. 11-2005 dated April 25, 2005, 'gross income earned'; shall refer 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. It further provided for a list of allowable deductions from gross income, which, however, is not exclusive; meaning, as long as the costs can be attributed in producing the product, are allowed as deductions for purposes of computing the 5% final tax; thus: EIDTAa "SEC. 3. Gross Income Earned. For purposes of implementing the tax incentive of registered Special Economic Zone (ECOZONE) enterprises in Section 24 of Republic Act No. 7916, the term 'gross income earned' shall refer 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, marketing, selling and/or operating expenses or incidental losses during a given taxable period. For purposes of computing the total five percent (5%) tax rate imposed, the following direct costs are included in the allowable deductions to arrive at gross income earned for specific types of enterprises: 1. ECOZONE Export Enterprises, Free Trade Enterprises and Domestic Market Enterprises: Direct salaries, wages or labor expenses Production supervision salaries Raw materials used in the manufacture of products Decrease in Goods in Process Account (Intermediate goods) Decrease in finished Goods Account Supplies and fuels used in production Depreciation of machinery and equipment used in production, and of that portion of the building owned or constructed that is used exclusively in the production of goods Rent and utility charges associated with building equipment and warehouses used in production Financing charges associated with fixed assets used in production the amount of which were not previously capitalized. (Emphasis supplied) EaIDAT IN VIEW OF THE FOREGOING, this office holds that royalties arising from the Technical Service Agreement relating to know-how in the manufacturing of FTP'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 I of the PEZA Rules, which is further reduced by allowable deductions specifically enumerated under Section 2, Rule XX of the PEZA Rules. 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. HSIaAT Very truly yours, (SGD.) ACIR JAMES H. ROLDAN Assistant Commissioner Legal Service