PTON Corporation

December 7, 2007 BIR RULING [DA-632-07] R.R. 11-2005; RA 7916 DA-057-2006 PTON Corporation Lot 1 & 2, Block 15, Phase III Cavite Economic Zone, Rosario Cavite, Philippines 4106 Attention: Mr. Toshiaki Ambo Executive Vice-President Gentlemen : This refers to your letter dated March 14, 2007 requesting for a ruling as to whether royalty payments can be considered as part of allowable deduction in the computation of 5% preferential rate from gross income. ESTaHC It is represented that PTON Corporation (PTON) is a PEZA registered company under Certificate of Registration No. 96-076 dated June 21, 1996; that its principal office is located at Lot 1 & 2, Blk. 15, Phase 3, Cavite Economic Zone, Rosario, Cavite; that in June 1996, PTON entered into a Technical Fee Contract with its parent company in Japan, Newton Company, Ltd., formerly Tohno Seimutsu Co., Ltd. relative to the acquisition of technical know-how in plastic molding process work and metal mold maintenance; and that PTON firmly believes that the royalty to be paid to its parent company is effectively a know-how in the manufacturing of the company's products and is rightfully part of the finished goods and therefore should be allowed as a deduction in computing the gross income subject to 5% preferential rate. In reply, please be informed that Section 2, Rule 1 of the Rules and Regulations to Implement R.A. 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." DcHSEa From the foregoing, direct costs (cost 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. 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 over that 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." DAcaIE Recording of revenues from the sale of a product is accompanied by recording of an expense for the cost of the product sold (SFAS 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)] Moreover, Paragraph 13 of Internal Accounting Standards (IAS) No. 2 on inventories further stipulates 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 overhead, such as the costs of designing products for specific customers, in the cost 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 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. (BIR Ruling No. DA-057-2006 dated February 23, 2006) AaCTcI 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 xxxxx Sales Returns/allowances xxxxx Direct costs (cost of sales) xxxxx Other Manufacturing Costs (Factory Overhead) xxxxx xxxx Gross taxable income xxxx ==== In view of the foregoing, this Office holds that royalties arising from the Technical Fee Contract relating to know-how in the manufacturing of the company's products should be deductible in computing the gross income subject to the 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 Sec. 51 of R.A. No. 7916. 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. DCcHIS Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service