Isla Lipana & Co.

October 23, 2007 BIR RULING [DA-552-07] BIR Ruling No. DA-439-2006 Isla Lipana & Co. 29th Floor Philamlife Tower 8767 Paseo de Roxas Makati City Attention: Mr. George J. Lavadia Principal, Tax Services Department Gentlemen : This refers to your letter dated August 31, 2005 requesting for and on behalf of your client, Futaba Corporation of the Philippines ("Futaba Philippines") , for confirmation that its royalty payments, as consideration for the transfer of technology from Futaba Corporation-Japan (Futaba-Japan), are deductible from gross revenues for purposes of computing its taxable income under the five percent (5%) final tax regime of firms registered with the Philippine Economic Zone Authority (PEZA). As represented, Futaba Philippines is a domestic corporation registered with PEZA as an Ecozone Export Enterprise on a pioneer status under PEZA Certificate of Registration No. 95-28 dated February 25, 1995. Its principal offices and manufacturing facilities are located at the Laguna Techno Park, a special economic zone. Futaba Philippines started commercial operations in May 1996. Upon registration with PEZA, the company was granted Income Tax Holiday (ITH) incentives for six (6) years. Thereafter, it was granted a one (1) year ITH extension which expired in January 2003. The company is now subject to the 5% final tax on gross income, in lieu of the payment of all other local and national taxes. Futaba Philippines entered into a Technical Assistance Agreement (TAA) with Futaba-Japan (licensor), a Japanese corporation, whereby Futaba-Japan agreed to furnish Futaba Philippines (licensee) with all available information, data and materials relating to know-how in the manufacture of certain products. The aforesaid TAA was registered with the Intellectual Property Office (IPO) and was issued Certificate of Compliance No. 1943 dated. April 1, 1997. In reply, please be informed that Section 2, Rule 1 of the Rules and Regulations (the PEZA Rules) to implement Republic Act (R.A.) No. 7916 defines gross income a 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 ." AHDacC From the foregoing, direct cost (costs of sales) are deductible from gross sales/revenues for purposes of computing a PEZA firm's taxable gross income subject to the five percent (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 other than 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 (SPAS 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)]. 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. 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 xxxx Sales Returns/allowances xxxx Direct costs (cost of sales) xxxx Other Manufacturing Costs (Factory Overhead) xxxx xxxx xxxx ==== In view of all the foregoing, this Office hereby holds that royalties arising from the Technical Assistance Agreement between Futaba-Japan and Futaba Philippines relating to know-how in the manufacture of certain products of Futaba Philippines are deductible in computing gross income that may be subject to the five percent (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 Section 51 or R.A. No. 7916 (BIR Ruling No. DA-439-2006 dated July 19, 2006) DTcACa 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.) GREGORIO V. CABANTAC Deputy Commissioner