Isla Lipana & Co.

October 17, 2007 BIR RULING [DA-539-07] R.A. 7227; RR 13-05 DA 608-06, DA 067-05, DA-057-06, DA-129-06, DA-129-06, DA-519-06 Isla Lipana & Co. 29th Floor, Philamlife Tower 8767 Paseo de Roxas 1226 Makati City Attention: Atty. Malou P. Lim Partner, Tax Services Gentlemen : This refers to your letter dated October 18, 2006 on behalf of your client, HHIC-Phil, Inc. (HHIC), requesting for confirmation of the opinion that subcontracting costs incurred by HHIC are deductible from its gross revenues for purposes of computing its taxable income under the five percent (5%) special tax regime of firms registered with the Subic Bay Freeport Zone (SBFZ). TAEcCS It is represented that HHIC is a domestic corporation engaged in the business of manufacturing and outfitting for ships and vessels, ship component fabrication, procurement, fabrication and erection of steel structures for whatever purposes, general shipbuilding and ship repair, engineering services for shipbuilding and ship repair, and all businesses necessary for a shipyard operation; that it is registered with the Securities and Exchange Commission under Company Registration No. CS200602569; that it is also duly registered with the Subic Bay Metropolitan Authority (SBMA) under Certificate No. 2006-0010 as a Subic Bay Freeport Enterprise (classified as an Infrastructure Development Enterprise as provided in SBMA Memorandum dated September 12, 2006) pursuant to the provisions of Republic Act No. 7227 with registered address at 2/F, Lot 7, Greenwoods Park, Rizal Avenue, Central Business District Area, SBFZ; and that HHIC is registered with the Bureau of Internal Revenue (BIR) as a non-VAT taxpayer under Certificate of Registration RDO Control No. 4RC0000295161 with TIN No. 243-631-837-000. It is further represented that being primarily involved in construction activities, HHIC will regularly engage the services of subcontractors with respect to the facility installation and shipbuilding work contents including steelworks. Subcontracting increases production capacity and reduces variable costs since HHIC will not have to bear, among others, the employment of workers who are less experienced as compared to specialized subcontractors. Furthermore, since HHIC does not maintain a larger workforce, it will not have to incur training, research and development expenses in relation to such workforce. The end-view of subcontracting is the attainment of efficiency through the coordination of work of specialized and independent subcontractors. aCcEHS In view of the foregoing, you are now requesting for an opinion that subcontracting costs constitute direct costs of HHIC's registered activities which includes shipbuilding, and that accordingly, pursuant to the pertinent provisions of Republic Act (RA) No. 7227, otherwise known as "The Bases Conversion Development Act of 1992" and Revenue Regulations (RR) No. 13-2005, such subcontracting costs constitute allowable deductions from gross sales or revenues for purposes of computing "gross income earned" subject to the 5% final tax. In reply, please be informed that Section 57 (a) of the Implementing Rules and Regulations (IRR) of RA No. 7227 provides that "(P)ursuant to Section 12 (c) of the Act, SBF Enterprises within the SBF shall, in lieu of paying local and national taxes, pay a five (5%) percent final tax on their gross income earned." Section 57 (b) of the IRR refers to "gross income earned" as: "gross sales or gross revenues derived from any business activity, net of returns, discounts and allowances, less costs of sales, cost of production or direct costs of services (depending on the nature of business) but before any deduction for administrative expenses and incidental losses during a given taxable period." On the other hand, Section 2 of RR No. 13-05, amending Section 3 (o) of RR No. 1-95, defines "gross income earned" as: "gross sales or gross revenues derived from business activity within the Zone, 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 financial enterprises, gross income shall include interest income, gains from sales, and other income, net of costs of funds." For purposes of computing "gross income earned", Section 57 (b) of the IRR of RA No. 7227 enumerates certain allowable deductions from gross sales or gross revenues of manufacturing, trading and infrastructure development as well as service enterprises to include, among others, "direct salaries, wages or labor expense", to wit: aDSHCc "1. For Manufacturing, Trading and Infrastructure Development Enterprises: Allowable Deductions Direct salaries, wages or labor expense Production supervision salaries Raw materials Intermediate goods Finished goods Supplies and fuels used in production Depreciation, lease payments or other expenditures on buildings and equipment Financing charges associated with fixed assets Rent and utility charges associated with buildings and equipment, warehousing or handling of goods xxx xxx xxx 2. For Service Enterprises Allowable Deductions Direct salaries, wages or labor expense Services supervision salaries Raw materials, goods in process or finished goods used or re-sold Supplies and fuels used in rendering services Depreciation, lease payments or other expenditures on buildings and equipment Financing charges associated with fixed assets Rent and utility charges associated with buildings and equipment xxx xxx xxx Section 2 of RR 13-05 likewise includes "direct salaries, wages or labor expenses" as among the allowable deductions for purposes of determining the amount of "gross income earned." HCaDET In BIR Ruling DA 608-06 it was held that: "Although subcontracting expenses are not among those specifically enumerated under the said regulations, the subject processing fees directly related to the production of SEPHIL's registered products partake the nature of a direct cost. Accordingly, for as long as a cost or expense is determined to be in the nature of a direct cost of a business, after taking into account its nature and the process involved in the generation of its revenues, the same is allowed as deduction from gross income." (emphasis supplied) Moreover, the Philippine Generally Accepted Accounting Principles (GAAP) treats subcontracting costs incurred in connection with construction contracts as direct costs along with material and labor. Paragraph 3 of Philippine Accounting Standard (PAS) No. 11 (adopting International Accounting Standards No. 11) on Construction Contracts defines a construction contract as "a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use." In this connection, Paragraph 4 of the same PAS provides that: "a construction contract may be negotiated for the construction of a single asset such as a bridge, building, dam, pipeline, road, ship or tunnel." As to what constitute contract costs and direct costs in respect of a construction contract, Paragraphs 16 and 17, respectively, provide that: "16. Contract costs shall comprise: ECTHIA (a) costs that relate directly to the specific contract; (b) costs that are attributable to contract activity in general and can be allocated to the contract; and (c) such other costs as are specifically chargeable to the customer under the terms of the contract. 17. Costs that relate directly to a specific contract include (a) site labour costs, including site supervision; (b) costs of materials used in construction; (c) depreciation of plant and equipment used on the contract; (d) costs of moving plant, equipment and materials to and from the contract site; (e) costs of hiring plant and equipment; (f) costs of design and technical assistance that is directly related to the contract; (g) the estimated costs of rectification and guarantee work, including expected warranty costs; and (h) claims from third parties." HTSAEa The Statement of Position (SOP) 81-1 of the American Institute of Certified Public Accountants (AICPA) are instructive on the application of generally accepted accounting principles in accounting for the performance of contracts for which specifications are provided by the customer for the construction of facilities or the production of goods or for the provision of related services. This is applicable to contracts for the design and building of ships and transport vessels as well as separate contracts for the provision of services essential to the construction or production of tangible property, such as design, engineering, procurement, and construction management. Paragraph 69 of SOP 81-1 provides that contract costs should be accumulated in the same manner as inventory costs and charged to operations as the related revenue is recognized. Importantly, it further states that contract costs include all direct costs such as materials, direct labor, and subcontracts, and indirect costs. Confirming adherence to GAAP, SOP 81-1 further provides: "72. A contracting entity should apply the following general principles in accounting for costs of construction-type and those production-type contracts covered by this statement. The principles are consistent with generally accepted accounting principles for inventory and production costs in other areas, and their application requires the exercise of judgment. a. All direct costs, such as material, labor, and subcontracting costs, should be included in contract costs." In BIR Ruling Nos. DA-067-2005, DA-057-2006, DA-129-2006, DA-129-2006, and DA-519-2006, the BIR has consistently adopted the rules, principles and standards under the GAAP/PAS in determining whether certain costs or expenses constitute allowable deductions for purposes of the 5% final tax on PEZA and SBMA-registered enterprises. In view of the foregoing, this Office holds that subcontracting costs directly attributable to shipbuilding as well as other construction contracts of HHIC constitute direct costs deductible from the gross revenues of HHIC for purposes of computing "gross income earned" which would serve as the basis for computing the final tax of 5%. cHDaEI 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