BIR Ruling [DA-672-06]

November 22, 2006 BIR RULING [DA-672-06] RA 7916; DA-658-2006; DA-581-2006; 556-2006 Fernandez Aguja Law Firm CPA-Lawyers Suite 5F JL Bldg., Don Jose Avila cor. Don Garcia Streets Cebu City Attention: Atty. Rita A.S. Fernandez Partner Gentlemen : This refers to your letter dated October 23, 2006 requesting on behalf of your client, Yamashin Cebu Filter Manufacturing Corp ("Yamashin"), for a ruling that the technical service fees/royalty payments made to Yamashin-Filter Corp. (Yamashin-Japan) be allowed as a deduction in computing its gross income earned subject to the 5% preferential tax rate. BACKGROUND Yamashin Cebu Filter Manufacturing Corp. is a corporation organized and existing under the laws of the Philippines, with principal office at Mactan Economic Zone II, Lapulapu City. It is a duly registered Philippine Economic Zone Authority (PEZA) export enterprise under Certificate of Registration No. 89-014. The Company's PEZA Registration is attached as Annex "A" of the request. Yamashin-Cebu's business activity as an Ecozone Export Enterprise consists in the manufacture of oil, air and fuel filter for hydraulic or industrial purposes and all equipment, materials, supplies used or employed in or related to the manufacture of such finished products. On the other hand, Yamashin-Filter Corporation (Yamashin-Japan) is a foreign corporation organized and existing under the laws of Japan, with principal office at 1-11-5 Nishi-Kanagawa, Kanagawa-Ku, Yokohama Japan. It is engaged in the business of manufacture filtration machine. It is a non-resident foreign corporation not registered to engage in trade or business as a corporation or as a partnership in the Philippines as evidenced by the Securities and Exchange Commission's Certificate of Non-Registration of Corporation/Partnership dated August 22, 2006. On December 3, 2001, Yamashin-Japan and Yamashin-Cebu executed a Technical Support and Service Agreement whereby Yamashin-Japan shall render technical advise, design cooperation, information, experience, quality control and business support for Yamashin-Cebu's production and manufacture of filters. Yamashin-Cebu shall pay an annual technical service fee of Twenty Eight Million Eight Hundred Thousand Yen (JPY28,800,000) per Board Resolution Dated November 23, 2005, effective November 25, 2005. Article 1 of the said Technical Support and Service Agreement states: Article 1. DEFINITIONS In this agreement, unless otherwise provided, the following terms shall have meanings set forth below: 1.1 Filters This refers to the various kinds of filters for various uses the productions and designs of which belong to the SECOND PARTY. 1.2 Technical Advice This refers to the provision or written technical instructions and information to the FIRST PARTY by the SECOND PARTY as regard to the production, assembly and manufacture of filters. Article 2. SCOPE of SERVICE 2.1 The SECOND PARTY hereby agrees to exclusively provide full assistance and furnish the FIRST PARTY with all its recent technical advice, design cooperation and business support for the production and development of filters so that the FIRST Party's capacity may be fully utilized and be able to increase its market demand and sales target. 2.2 The SECOND PARTY agrees to provide and accept the FIRST PARTY to have to its access to its Japanese and worldwide intelligence system to carry out and effect its production of up to date and state of the art filters and applications acceptable to the market and also to be able to capture in Japan or requiring the kind of services and products being produced by the FIRST PARTY. As consideration for the agreement, Article 3 states: Article 3. TECHNICAL SERVICE FEES 3.1 For the services provided under this Agreement, the FIRST PARTY shall pay to the SECOND PARTY a fee equivalent to Four Million Philippine Pesos (P4,000,000) each fiscal year effective October 1, 2001 to September 30, 2006. However, an amendment was made to the above fees through Board Resolution Dated November 23, 2005, increasing the annual technical service fees to Twenty Eight Million Eight Hundred Thousand Yen (JPY28,800,000) effective November 25, 2005. cADTSH 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 / revenue xxxx Less: Sales Discounts xxxx Sales Returns/allowances xxxx Direct Costs (cost of sales) xxxx Other Manufacturing Costs (Factory Overhead) xxxx xxxx ------- -------- Gross Taxable Income xxxx -------- ===== 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: IDaCcS 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) 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, reads as follows: "Sec. 23. Fiscal Incentives . Business establishments operating within the ECOZONES shall be entitled to the fiscal incentives as provided for under 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: TaDAIS "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 ETDHaC 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 Yamashin, the direct costs of the finished goods included the royalties relating to the technical information used by Yamashin in the production of its finished products. 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. llcd IN VIEW OF THE FOREGOING, this Office holds that the service fees/royalty payments made by Yamashin to Yamashin-Japan in consideration for the transfer of technology necessary for the continued production of Yamashin'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