BIR Ruling [DA-608-06]

October 11, 2006 BIR RULING [DA-608-06] DA-476-03 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 20, 2006 requesting for confirmation of your opinion that the following direct costs and expenses incurred by your company, Samsung Electronics Philippines Manufacturing Corporation (SEPHIL), are deductible from gross revenue for purposes of computing the 5% gross income tax (GIT): 1. External processing cost/Subcontracting expenses; 2. Communication cost; 3. Transportation expense (inbound); 4. Research & Development cost; and 5. Commission & service charges. 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 SEPHIL has a Supply and Manufacturing Agreement with Toshiba Samsung Storage Technology Korea Corp. (TSSK), a non-resident foreign corporation in Korea; that under the Agreement, TSSK will purchase finished goods, semi-finished goods and raw materials from SEPHIL; that the volume to be produced, the design of the products, and the type of the supplies and equipment to be used are subject to TSSK's specifications and approval; that SEPHIL purchases raw materials from affiliates, sells some of the raw materials to TSSK, processes some of the raw materials into semi-finished goods, processes semi-finished goods, and further processes reprocessed goods into finished goods which are all sold to TSSK; that there are, among others, five types of expenses incurred by SEPHIL critical to the production process the nature of which is described as follows: 1. External processing cost/subcontracting expenses One of the ways SEPHIL processes semi-finished goods is by consigning semi-finished goods to subcontractors within the PEZA zone for further processing into re-processed goods, SEPHIL pays these subcontractors processing fee for additional raw materials and labor cost incurred in converting SEPHIL's raw materials to an assembly which will be used in the production of SEPHIL's finished products (e.g. CD-ROM, CD-RW, DVD-Writer); 2. Communication costs These pertain to domestic and international communication expenses such as mobile phone/telephone charges, network/server charges, SAP charges, IT management & consultancy fees and internet connections which are basically used in the development of designs and in the production of SEPHIL's registered products. These communication facilities allow SEPHIL use of advance communication features such as the voice over internet protocol (VOIP), video conference, internet and email, which are used to facilitate the production of a design. They are also used to transfer the softcopy of the design to the engineers of TSSK for their review and approval. The VOIP and video conference, in particular, are used for discussions on planning and development of a design between the engineers of SEPHIL and the engineers of TSSK. Communication cost also includes the cost of faxing technical documents to TSSK and mobile phone charges incurred by employees assigned at production. These expenses are used both for production and for administrative matters; cEASTa 3. Transportation expense (inbound) SEPHIL incurs freight, transfer, handling, brokerage and insurance costs in connection with the purchase of raw materials from its affiliates based in Korea, Europe, USA, Singapore, Hongkong and Thailand; 4. Research and Development It is currently being done by the company headquarter in Korea but will be transferred in the near future to SEPHIL. Research and development cost will be incurred in connection with the development of new intellectual property which may include patents, copyrights, inventions, designs, know-how, manufacturing information and techniques, process technology and detailed design specifications. Thus, these expenses constitute direct cost of producing new designs and may be deducted from SEPHIL's gross revenues; 5. Commission & service charges . SEPHIL has income payments to contractors for the provision of additional workers in the production area. These workers remain the employees of the agency. These expenses are booked under the account "Commission and Service Charges Others" and are specifically allocated to production and administrative cost centers. Moreover, SEPHIL employs security, janitorial, pest control, landscaping and maintenance services for production and administration areas. It is your opinion that the foregoing expenses are direct costs incurred in manufacturing your registered products and should be deductible from gross revenues for purposes of computing the 5% GIT. In reply, please be informed that Section 24 of R.A. No. 7916, otherwise known as the "Special Economic Zone Act of 1995", as amended by R.A. No. 8748, provides that "SEC. 24. Exemption from National and Local Taxes . Except for real property taxes on land owned by developers, no taxes, local and national, shall be imposed on business establishments operating within the ECOZONE, in lieu thereof, five percent (5%) of the gross income earned by all business enterprises within the ECOZONE shall be paid and remitted as follows: (a) Three percent (3%) to the National Government; (b) Two percent (2%) which shall be directly remitted by the business establishments to the treasurer's office of the municipality or city where the enterprise is located. xxx xxx xxx" "Gross income earned" is defined under Section 3 of Revenue Regulations (RR) No. 11-2005 as: "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." The above definition is reduced to 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 The same section likewise provides for a list of direct costs deductible from gross income for purposes of determining the taxable base, to wit: "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." In interpreting the scope of the foregoing list, this Office had occasion to rule that the allowable deductions enumerated therein are 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. (BIR Rulings DA 519-2006 dated August 25, 2006 and DA 556-2006 dated September 18, 2006). Thus, in order to compute for the gross income earned, the cost of sales or direct costs which may be deducted from revenues should be identified. ICDSca In this regard, Article 24 of Executive Order 226, otherwise known as the Omnibus Investment Code of the Philippines, provides that the Generally Accepted Accounting Principles (GAAP) governs in determining the direct costs, thus: "Art. 24. "Production Cost" shall mean the total of the cost of direct labor, raw materials, and manufacturing overhead, determined in accordance with generally accepted accounting principles, which are incurred in manufacturing or processing the products of registered enterprise." The GAAP in the Philippines in determining the cost of a product/inventory is embodied in Philippine 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. Paragraph 10 of the same standard further provides that the cost of the product/inventory shall include all the costs incurred in producing the product, thus: "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." Moreover, Paragraphs 12 and 15 of the same PAS/IAS state: "12. 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 equipment, 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. ETDHaC xxx xxx xxx 15. Other 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 cost of inventories." Applying the foregoing discussion to the instant case, this Office hereby rules as follows: 1. On the deductibility of External processing cost/subcontracting expenses Section 1 of RR 11-2005 includes cost of sales or direct costs, raw materials, direct salaries, wages or labor expenses and production supervision salaries among the allowable deductions for 5% GIT purposes. 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. 2. On the deductibility of Communication costs Communication costs such as local telephone charges and communication facilities expenses are deductible for 5% GIT purposes to the extent that they are associated with building, equipment and warehouses used in production of SEPHIL. As represented in your letter, the communication expenses incurred by SEPHIL are used both for production and for administrative matters. Such being the case, the cost attributable to administrative functions should be segregated and excluded as part of allowable deduction. Segregation of this cost may be done through specific identification if possible. If specific identification is not possible, allocation based on relevant data like internet/email usage, or number of production and administrative personnel may be used if applicable. 3. On the deductibility of Transportation expense (inbound) BIR Ruling DA-476-03 dated December 10, 2003 provides that cost of freight-in expense (shipment of vendors) is part of cost of sales (part of landed cost of materials). Thus, transportation expenses associated with the acquisition of raw materials and factory supplies may be deductible for 5% GIT purposes if they are related to raw materials and factory supplies used in SEPHIL's registered activity. 4. On the deductibility of Research and Development cost Research and development cost that will be incurred in the development of new product or design, or will result in the significant improvement of existing product or design is deductible for 5% GIT purposes. Necessarily, the product or design to be developed or enhanced should be SEPHIL's own creation and not one that is covered by a licensing agreement. 5. On the deductibility of Commission & Service charges In order to be considered as deductible expense, commission and services charges incurred should be directly related to the production process. Such being the case, only the expenses specifically allocated to production cost centers are deductible for purposes of 5% GIT. 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