BIR Ruling [DA-667-06]

November 14, 2006 BIR RULING [DA-667-06] 42 (B); Sec. 160 of RR 2 #197-82; 045-95 SGV & Co . 6760 Ayala Avenue Makati City Attention: Emmanuel C. Alcantara Co-Head, Tax Services Gentlemen : This refers to your letter dated July 19, 2006 requesting on behalf of your client, Koppers Wood Products Pty. Ltd.-Philippine Branch (KWPPL-Philippine Branch), for confirmation of your opinion that KWPPL-Philippine Branch's ratable share from the overhead expenses incurred by KWPPL-Philippine Branch's parent company, Koppers Wood Products Pty. Ltd.-Australia (KWPPL-Australia), can be claimed by KWPPL-Philippine Branch as its deductible expense for income tax purposes and that the remittance of the same is not subject to Philippine taxes. Background KWPPL-Philippine Branch (formerly Koppers Timber Preservation Pty. Ltd.) is a corporation duly registered with the Securities and Exchange Commission (SEC) as Philippine branch of KWPPL-Australia, a foreign corporation duly organized and existing under the laws of Republic of New South Wales. Its is primarily engaged in the business of selling treated timber and in particular treated poles to electricity and telecommunication companies on a whole basis. KWPPL-Australia, as a parent-company, incurs certain overhead expenses in connection with the finance, administration, research and development, all of which directly benefit its branches all over the world, including the Philippines, which cannot be definitely allocated or identified with the operations of a single branch. Due to this, KWPPL-Australia charges a ratable portion of the said overhead expenses to its branches, including the Philippines. The share allocated to KWPPL-Philippine Branch is computed based on ratio which KWPPL-Philippine Branch Sales bears to Head Office Sales and evidenced by an external auditor's certificate containing the necessary information under Revenue Regulations No. 16-86. EaTCSA Based on the foregoing, you now request for confirmation of your opinion that: 1. A branch office's ratable share in the overhead expenses incurred by its parent company is a valid business expense under pertinent Philippine tax laws, rules and regulations; and 2. The remittance made by a branch office to its parent company, representing its ratable share in the overhead expenses incurred by the said parent company, being a mere reimbursement, is likewise not subject to any Philippine tax. In reply thereto, please be informed, as follows: 1. Expenditures made by a foreign corporation in conducting its business are deductible in computing its taxable income from sources within the Philippines only when allocable to the production of income from sources within the Philippines or where a ratable part of the general expenditures is apportioned to income from sources within the Philippines. The net income of a resident foreign corporation, is therefore determined by deducting from the items of gross income specified in Section 42 (E) [formerly Section 37(a)] of the National Internal Revenue Code, as amended, treated as income from sources within the Philippines, the expenses, losses, and other deductions properly apportioned or allocated thereto and a ratable part of any other expenses, losses, or deductions which cannot definitely be allocated to some item or class of gross income. The remainder, if any, is 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. Consequently, in the Supreme Court (SC) case of Commissioner of Internal Revenue vs. Court of Tax Appeals and Smith Kline & French Overseas Co. Phil. Branch (G.R. No. 54108, January 17, 1984) , the SC applied the foregoing rule stated above, to wit: " . . . it is manifest that where an expense is 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), that expense can be deducted from the gross income acquired in the Philippines without resorting to apportionment. The overhead expenses incurred by the parent company in connection with 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 however. These are items which cannot be definitely allocated or identified with the operations of the Philippine Branch. For 1971, the parent company of Smith Kline spent $1,077,739. Under section 37(b) of the Revenue Code and section 160 of the regulations, Smith Kline 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." This was similarly decided in BIR Ruling No. 045-95 dated February 24, 1995 wherein it was declared: " . . . In reply, please be informed that under Section 36(b) [then Section 37(b) of the Tax Code as implemented by Section 160 of Revenue Regulations No. 2, as amended by RevenueRegulationsNo.16-86, 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 patent corporation." In view thereof, this Office hereby confirms your opinion that a branch office's ratable share in the overhead expenses incurred by its parent company is a valid business expense under pertinent Philippine tax laws, rules and regulations. Furthermore, Revenue Regulation No. 16-86 also provides the necessary guidelines in arriving at the proper ratio, to wit: "Sec. 160. (a) Apportionment of deductions . From the items specified in Section 37(a) as being derived specifically from sources within the Philippines, there shall be deducted the expenses, losses, and other deductions properly allocated thereto and a ratable part of any other expenses, losses, and other deductions effectively connected with the business or trade conducted exclusively within the Philippines which cannot be definitely allocated to some items or class of gross income. The remainder shall be included in full as net income from sources within the Philippines. The ratable part shall be based upon any of the following ratios consistently allowed from year to year: 1. Gross income from sources within the Philippines to the total gross income. 2. Net sales in the Philippines to total net sales. 3. If any other method of allocation is adopted, a written permission from the Commissioner of Internal Revenue shall first be secured. HTaSEA (b) External Auditor's certificate. The income tax return to be filed should be accompanied by a certification from an independent and reputable Certified Public Accountant containing the following information: 1. The home office deductions for the year involved have been examined in accordance with generally accepted auditing standards and accordingly included such tests of accounting records and such other auditing procedures as were considered necessary in the circumstances; 2. The deductions pro-rated to the Philippine branch do not include: (a) net losses of any operating unit or branch; (b) income tax payment; (c) capital expenditures; and (d) expenses directly changeable to any branch. 3. The amount of allocable overhead expenses used in the pro-rata allocation to the Philippine branch is the same amount used in the pro-ration to all branches worldwide and the amount disallowed in other countries because of governmental requirement is not added back to the allocable amount; 4. Should there be an exception or qualification on the above requested certification, an explanation with supporting documents should be submitted." Accordingly, prior to the claim of a branch's share from worldwide overhead expenses as a deduction from its gross income, it must provide the necessary documents as required under the aforesaid regulations. 2. The remittance made by the KWPPL-Philippine Branch represents the payment of its ratable share in the expenses of the head office. Such payment is a mere reimbursement of expenses incurred by its Head Office (HO) or parent company through the cost sharing arrangement. The said payment is made in order to satisfy an existing obligation, that is, KWPPL-Philippine Branch's share in head office expenses, and not to distribute some of its earnings. This remittance is not meant to transfer profits, income or revenues of KWPPL-Philippine Branch to KWPPL-Australia. ( BIR Ruling No. 197-82 dated June 17, 1982 ) Such being the case, since the remittance discussed above only represents the cost sharing arrangement and not transfer of profits, income or revenues by a KWPPL-Philippine Branch to KWPPL-Australia, the same is not subject to income tax or withholding tax. AHcCDI Moreover, for the expenses to be deductible on the part of KWPPL-Philippine Branch, it is understood that KWPPL-Australia and KWPPL-Philippine Branch have exerted reasonable efforts to ensure that the method of allocation and charges is consistent with the arm's length principle as may be determined through adequate documentation. Finally, in the event that transfer pricing regulations implementing Section 50 of the Tax Code of 1997, as amended, are issued by the BIR, the parties shall comply with the requirements thereof. This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it shall be ascertained that the facts are different, then this ruling shall be without force and effect insofar as the herein parties are concerned. Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service