Diaz Murillo Dalupan and Company

December 17, 2007 BIR RULING [DA-656-07] R.A. 7916 & 8748; RR 11-2005 DA-476-03 & DA-608-06 Diaz Murillo Dalupan and Company 5th Floor, Don jacinto Building Dela Rosa cor. Salcedo Streets Legaspi Village, Makati City Attention: Atty. Bethuel V. Tanupan Tax & Corporate Services Manager Gentlemen : This refers to your letter dated June 6, 2007 requesting on behalf of your client, Cebu Mitsumi Inc. ("CMI" for brevity) for confirmation of your opinion that the Telephone, Telegraph, Postage and Insurance expense related to the production process of CMI be allowed as a deduction for purposes of computing the Gross Income Earned (GIE) subject to the 5% preferential tax. ECDHIc As represented, CMI is an Ecozone Export Enterprise located at MRI Special Economic Zone, Sabang, Danao City, Cebu, Philippines. The registered activity of CMI is the production of magnetic heads, floppy disk drives, connectors, flexible printed circuit, digital audio tape deck mechanism for data streamers, magnetic drums, optical heads for CD-ROM drives, CD-ROM drives, membrane switch unit, reel motor, pressed and molded parts, spindle motor, floppy disk adapter, DC micro motor, IC module, camera module and monolithic integrated circuit. For the past years, CMI classified its Telephone, Telegraph and Postage expenses with suppliers as part of Operating Expenses. Telephone, Telegraph and Postage expenses include domestic and international communication expenses such as mobile phone/telephone charges, network/server charges, and internet connections which are basically used in the development and designs and in the production of CMI's registered products. This also includes cost of faxing technical documents relating to product design and various communications with suppliers. These expenses are used both for production and administrative matters. Insurance expenses also include insurance premiums on factory buildings and all production related machineries and equipments. It is your opinion that Telephone, Telegraph, Postage and Insurance expenses are direct costs incurred in manufacturing CMI's registered products and should be deductible from gross revenues for purposes of computing the 5% GIE. Hence, this request: In reply, please be informed that this Office had occasion to rule in BIR Ruling No. DA 608-06 dated October 11, 2006 that the aforesaid expenses incurred by PEZA-registered enterprise are deductible in computing its gross income subject to the 5% rate, viz: SECATH ". . . 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) 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 discount, 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.' ASHaTc 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 type 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 aETASc Decrease in Good 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 defined. 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: HIcTDE 'Art. 24. "Production Costs " 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 production/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 labor. They also include a systematic allocation of fixed and variable 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 of 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 labor. 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. . . .'" IcESDA Applying the foregoing discussion to the instant case, this Office hereby rules as follows: 1. On the deductibility of Telephone, Telegraph and Postage Expense The BIR ruled in BIR Ruling DA-608-2006 that 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 warehouse used in production of Sephil. Thus, the cost attributable to administrative functions should be segregated and excluded as part of allowable deduction. 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. In view of the foregoing, Telephone, Telegraph and Postage Expense incurred by CMI in the transmission of production data used in the development and designs and in the production of CMI's registered products are deductible for purposes of computing the 5% GIT. 2. On the deductibility of Insurance expense Insurance expense is not included among the cost or expense items enumerated as allowable deduction to arrive at the GIE subject to the 5% preferential tax (RR No. 2-2005 as amended by RR 11-2005). Accordingly, insurance expense that includes insurance premiums on factory buildings and all production related machineries and equipments cannot be allowed as deduction for purposes of computing the GIE subject to the 5% tax. 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 as null and void. aCITEH Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service