BIR Ruling [DA-621-06]

October 18, 2006 BIR RULING [DA-621-06] 42 (E); 045-95 The Hongkong and Shanghai Banking Corporation Limited The Enterprise Center Tower 1, 6766 Ayala Avenue corner Paseo de Roxas Makati City Attention: Mr. Nelson C. Reyes Senior Vice President Financial Control Gentlemen : This refers to your letter dated August 18, 2005 stating that the Hongkong and Shanghai Banking Corporation Limited (Philippines Branch) [HSBC Phil. Branch], a corporation duly organized under and by virtue of the laws of Hongkong and authorized by the Securities and Exchange Commission (SEC) to engage in business in the Philippines, currently allocated its ratable share in Head Office expenses using the gross income method (i.e., gross income from sources within the Philippines to the total gross income); that it intends to shift its method of allocation from gross income method to departmental method; that the departmental method of allocation would result to a more reasonable and relevant allocation basis since such method demonstrates a greater link between the expenses incurred by the Head Office servicing the departments and the affected branches; that the specific Head Office departments supervise or service the branches according to the size of the branches and the nature of banking services said branches offer; that as an example: "The supervisory function of the Personal Financial Services departments (PFS department) of the Head Office is limited only to branches offering PFS or retail services. Under the gross income method of expense allocation, the expenses incurred by the PFS department are allocated across all branches whether or not these branches render PFS services and whether or not the gross revenue of such branches include revenue derived from the rendition of PFS services. Consequently, a branch having no revenue from PFS services, or which is not supervised by the PFS department, gets an allocation for a portion of the expenses of the PFS department. And since the expenses of the PFS department are allocated among all branches whether or not these branches provide PFS services, the branches that actually extend PFS services are allocated a lower share in the expenses." that under the proposed allocation method, the expenses of a Head Office department are allocated only among the branches actually being supervised or serviced by the said department; that the branches that are not being supervised or serviced by such department will not share in the allocation of the department's expenses; that in relation to the illustration provided above, PFS departmental expenses will be allocated only among the branches that actually offer PFS services to customers; that the branches that do not offer PFS services will not share in the expenses of the PFS department; that the mechanics of the proposed departmental allocation method are as follows: Periodically, each head office department shall determine the specific branches it services or supervises for the purpose of identifying the branches that will share in the department's expenses. CHcETA The departments shall then determine the appropriate basis of allocating their respective costs among the branches they supervise and/or service. The basis of allocating costs may vary among departments but has to be consistently applied and periodically updated by each department to ensure applicability and relevance. Examples of bases of allocation would include percentage of time spent in man hours or man days, number of head count, number of assigned international managers, number of visits to sites, hours of equipment utilization, etc. The departmental expenses will represent the same nature of costs included in the currently applied gross income allocation method and only the method of allocation is propose to be changed (i.e., no longer based on the ratio of branch gross income worldwide gross income). Illustration: Credit and Risk Management department (CRM department) of the Head Office reviews all credit proposals and manages the credit-related projects and systems development. Under the gross income method of head office cost allocation, the cost of CRM department is allocated among branches and/or sites according to the proportion of the gross income of each to the worldwide gross income of HSBC. Under the proposed allocation method, the same cost will be allocated among the branches and/or sites based on the number of the credit application and proposals received from each in proportion to the total number of credit applications and proposal received from all branches and/or sites. that an independent auditor will audit the allocation of the Head Office expenses to HSBC (Philippine Branches) in line with the proposed departmental allocation method and provide a report on its opinion of the audit at the end of the taxable year; that in addition, the Head Office expenses allocated to HSBC (Philippines Branches) will exclude the net losses of any operating unit or branch, income tax payments, capital expenditures and expenses directly chargeable to any branch; and that the departmental method of allocation will be consistently followed from year to year. In reply thereto, please be informed that Section 42(E) of the Tax Code of 1997 provides that "(E) Income From Sources Partly Within and Partly Without the Philippines . Items of gross income, expenses, losses and deductions, other than those specified in Subsections (A) and (C) of this Section, shall be allocated or apportioned to sources within or without the Philippines, under the rules and regulations prescribed by the Secretary of Finance, upon recommendation of the Commissioner. Where items of gross income are separately allocated to sources within the Philippines, there shall be deducted (for the purpose of computing the taxable income therefrom) the expenses, losses and other deductions properly apportioned or allocated thereto and a ratable part of other expenses, losses or other deductions which cannot definitely be allocated to some items or classes of gross income. The remainder, if any, shall be included in full as taxable income from sources within the Philippines. In the case of gross income divided from sources partly within and partly without the Philippines, the taxable income may first be computed by deducting the expenses, losses or other deductions apportioned or allocated thereto and a ratable part of any expense, loss or other deduction which cannot definitely be allocated to some items or classes of gross income; and the portion of such taxable income attributable to sources within the Philippines may be determined by processes or formulas of general apportionment prescribed by the Secretary of Finance. . . . ." IESAac Corollarily, Section 160 of Regulations No. 2 provides that "Sec. 160. Apportionment of deductions . From the items specified in section 37(a) [now Sec. 43(E) as being derived specifically from sources within the Philippines there shall be deducted the expenses, losses, and other deductions properly apportioned or allocated thereto and a ratable part of any other expenses, losses or deductions which can not definitely be allocated to some item or class of gross income. The remainder shall be included in full as net income from sources within the Philippines. The ratable part is based upon the ratio of gross income from sources within the Philippines to the total gross income. Thus, in BIR Ruling No. 045-95 dated February 24, 1995 , this Office ruled that ". . ., a resident foreign corporation is allowed to deduct from its gross income derived from sources within the Philippines, the expenses directly and clearly related to the production of Philippine-derived income or to Philippine operations (e.g. salaries of Philippine personnel, rental of office building in the Philippines), without resorting to apportionment. However, the overhead expenses incurred by the parent company in connection with the finance, administration, and research and development, all of which directly benefit its branches all over the world, including the Philippines, fall under a different category. These are items which cannot be definitely allocated or identified with the operations of the Philippine branch. Under said Section 36(b)[then Sec. 37(b) of the Tax Code, as implemented by Section 160 of Revenue Regulations No. 2, as amended, the local branch can claim as its deductible share a ratable part of such expenses based upon the ratio of the local branch's gross income to the total gross income, worldwide, of the multinational corporation or parent corporation. ( Smith Kline & French Overseas vs. Commissioner of Internal Revenue, G.R. No. 54108, January 17, 1984 ) Moreover, aside from the ratio of Philippine gross income to worldwide gross income, or Philippine net sales to worldwide net sales, any other method of allocation of ratable share in head office overhead expenses can be adopted, provided that a written permission from the Commissioner of Internal Revenue is secured and the ratio adopted is consistently followed from year to year. xxx xxx xxx" SUCH BEING THE CASE, this Office hereby GRANTS HSBC Phil. Branch permission to change its method of determining its ratable share in Head Office expenses from gross income method to the departmental allocation method to clearly and realistically reflect the income of HSBC Phil. Branch. 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