BIR Ruling [DA-658-06]

November 7, 2006 BIR RULING [DA-658-06] R.A. 7916; DA-147-04; DA-017-05; DA-147-2005 Isla Lipana & Co . 29th Floor Philamlife Tower 8767 Paseo de Roxas Makati City Attention: Alexander B. Cabrera Partner Gentlemen : This refers to your letter dated April 19, 2006 stating that your client, Muramoto Audio-Visual Philippines, Inc. (MAPLE) is an export enterprise registered with the Philippine Economic Zone Authority (PEZA) as an Ecozone enterprise; that it is primarily engaged in the manufacture and assembly of car stereos, video tape recorders and related audio-visual equipment, components and spare parts for such products; that MAPLE entered into a technical advisory agreement (Agreement) with Muramoto Industry Co., Ltd (MIC), a corporation organized and existing under the laws of Japan with principal office address at No. 1-24-3 Chome, Takatsukadai, Nishi-ku, Kobe City, Japan 651-2271; that under the Agreement, MIC agreed to provide MAPLE the exclusive right to use intangible property in the Philippines in connection with the manufacture of its electronic products consisting of car stereos, video tape recorders, audio-visual equipment, components and spare parts, among others; that the intangible property consists of technical knowledge and information (e.g. advice and design cooperation as defined in the contract) which were developed by MIC; that as part of the agreement, MIC also agrees to exclusively provide MAPLE access to MIC's worldwide intelligence system for least-cost sourcing of raw materials and packaging supplies, testing procedures and standards including laboratory analysis services; that in consideration for the use of such intangible property, MAPLE agrees to pay MIC a fee not to exceed 3% of MAPLE's total sales for each fiscal year, which shall be negotiable and agreed upon by the parties on an annual basis; and that the agreement is effective for five (5) years since its contract date, November 7, 2001, and is renewable for a period of three (3) years within 60 days from the end of each agreement. In connection therewith, you now request for confirmation of your opinion that the royalty payments made by MAPLE to MIC in consideration for the transfer of technology necessary for the continued production of MAPLE's products constitute direct costs of the payor and are, therefore, part of the cost of finished goods which are deductible from gross sales for purposes of computing its taxable gross income subject to 5% tax under Republic Act No. 7916 (the PEZA Law) otherwise known as "The Special Economic Zone Act of 1995." In reply thereto, please be informed that Section 2, Rule 1 of the Implementing Rules and Regulations of the PEZA Law 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." (Emphasis supplied) The above paragraph may be reduced to the following formula: Gross ECOZONE Sales or Revenues Less: Sales Discounts Sales Returns Cost of Sales or Direct Costs Gross Income Less: Allowable Deductions (Sec. 2, Rule XX) Taxable Gross Income (Subject to 5% final tax) Taxable Gross Income (Subject to 5% final tax) From the foregoing, cost of sales or direct costs are deductible from gross sales/revenues for purposes of computing a PEZA firm's taxable gross income subject to the 5% final tax. Article 24 of Executive Order 226, also 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." (Emphasis supplied) DaIACS The applicability of the provisions of the Omnibus Investment Code to PEZA-registered enterprises is very clear under Section 23 of R.A. 7916 which in part, read as follows: "Sec. 23. Fiscal Incentives . Business establishments operating within the ECOZONES shall be entitled to the fiscal incentives as provided for under Presidential DecreeNo.66, the law creating the Export Processing Zone Authority, or those provided under Book VI of Executive OrderNo.226, otherwise known as the OmnibusInvestmentsCodeof 1987." GAAP requires that there shall be a corresponding recording of the cost of production for every product or inventory sold (Paragraph 34, PAS/IAS 2). The GAAP in determining the cost of a product/inventory is embodied in the Philippine Accounting Standard/International Accounting Standard No. 2 (PAS/IAS 2). Paragraph 10 of the said standard provides that the cost of 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." (Emphasis supplied) Further, 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 labor. 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 labor." (Emphasis supplied) From the foregoing, only cost directly attributable to manufacturing the product shall be considered part of the cost of the product/inventory. Stated otherwise, the costs incurred other than the production cost shall not form part of the cost of the product/inventory; thus, Paragraphs 15 and 16 of PAS/IAS No. 2 provide: "15. Other costs are excluded 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. 16. Examples of costs excluded from the cost of inventories and recognized as expenses in the period in which they are incurred are: a. abnormal amounts of wasted materials, labor or other production costs; b. storage costs, unless those costs are necessary in the production process before a further production stage; c. administrative overheads that do not contribute to bringing inventories to their present location and condition; and d. selling costs. Evidently, 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 Nos. DA-147-04 dated March 29, 2004; DA-017-05 dated January 19, 2005, and DA-147-05 dated April 13, 2005 ). Revenue Regulations No. 11-2005 recognizes the fact that all direct costs relating to the finished goods shall be allowed as deduction for purposes of computing the five percent (5%) tax for ECOZONE Export Enterprises. Section 1 of the said Regulations provides that the following direct costs are included in the allowable deductions to arrive at gross income: 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 It will be noted that the Regulations specifically included "decrease in finished goods account". This means that all costs which formed part of the finished goods shall be treated as direct cost, hence, deductible for purposes of computing the 5% gross income tax. In the case of MAPLE, the direct costs of the finished goods included the royalties relating to the technical information used by MAPLE in the production of electronic products. EaCDAT The foregoing opinion finds support in BIR Ruling Nos. DA-147-04 dated March 29, 2004, DA-017-05 dated January 19, 2005 and DA-147-05 dated April 13, 2005 where it was held that the deductibility of royalties under the 5% tax regime shall depend on the consideration for which the same are being paid. Consequently, if they relate to technical information and know-how in the manufacture of products, they form part of the cost of finished goods and should be deductible in computing gross income under the 5% gross income tax regime. IN VIEW OF THE FOREGOING, this Office holds that the royalty payments made by MAPLE to MIC in consideration for the transfer of technology necessary for the continued production of MAPLE'S products are part of the cost of finished goods and are deductible from gross sales for purposes of computing its taxable gross income subject to 5% tax under Republic Act 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. Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service