BIR Ruling [DA-556-06]

September 18, 2006 BIR RULING [DA-556-06] DA-519-2006 dtd. 8/25/06 Samsung Electronics Philippines Manufacturing Corporation Block 6, Calamba Premiere International Park, Barangay Batino, Calamba City, Laguna Attention: Mr. Jeong Ho Park Chief Financial Officer Gentlemen : This refers to your letter dated September 12, 2006 requesting confirmation of your opinion that the royalty payments of Samsung Electronics Philippines Manufacturing Corporation (SEPHIL) to Samsung Electronics Corporation (SECL), in consideration of the transfer of technology from SECL to SEPHIL, are deductible from SEPHIL'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). SIacTE It is represented that SEPHIL [formerly Philippines Samsung Electronics Corporation (PSEC)] is a corporation duly organized and existing under Philippine laws with office address at the Calamba Premiere International Park-Special Economic Zone; that it is registered with PEZA as an Ecozone Export Enterprise under Registration Certificate No. 01-011 dated February 9, 2001; that said registration certificate was later amended to change the name of the company from PSEC to SEPHIL; that as a PEZA-registered enterprise, SEPHIL is entitled to a 5-year income tax holiday (ITH) for its original project consisting of the design, manufacture, and sale of electronic products, including optical disk drive products, their components and parts; that the ITH incentive will expire on October 31, 2006 and thereafter, SEPHIL will be subject to the 5% final tax on gross income in lieu of the payment of all other local and national taxes. It is further represented that on January 1, 2003, SEPHIL (as licensee) and SECL (as licensor), a corporation registered and doing business in Korea, executed a Technical Assistance Agreement whereby the latter granted the former a non-exclusive right and license to use its proprietary rights and know-how relating to the manufacture of certain licensed products; that you now request for an opinion that royalty payments made by SEPHIL, relative to the transfer of technology by SECL, are deductible from the gross revenue for purposes of computing its taxable income subject to the 5% final tax. HTCSDE In reply, please be informed that Section 2, Rule I 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 sales/revenues 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: acCTSE "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) CEDHTa 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). EcHIAC 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/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, they are allowed as deductions for purposes of computing the 5% final tax, thus: ITESAc "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: IcHTAa 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) IN VIEW OF THE FOREGOING, this Office holds that royalties arising from the Technical Assistance Agreement relating to know-how in the manufacturing of SEPHIL'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. DHEcCT 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, (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service