BIR Ruling [DA-709-06]

December 13, 2006 BIR RULING [DA-709-06] BIR Ruling No. DA-439-2006 SyCip Gorres Velayo & Co . 6760 Ayala Avenue Makati City Attention: Atty. Joel L. Tan-Torres Partner, Tax Services Gentlemen : This refers to your letter dated October 5, 2006 requesting for and on behalf of your client, Samsung Electro-Mechanics Philippines Corporation ("Semphil") , for confirmation that royalties arising from the Technical Assistance and License Agreement executed by Semphil and Samsung Electro-Mechanics Co., Ltd. (Semco) on the technical information and trademarks in the manufacture of the latter's products are deductible in computing gross income that may be subject to the five percent (5%) tax as defined under Section 2, Rule 1 of the Philippine Economic Zone Authority (PEZA) Rules and as extended to PEZA-registered firms as mandated by Section 51 of Republic Act 7916 or The Special Economic Zone Act of 1995. As represented, Semphil, with Securities and Exchange Commission (SEC) Registration No. A1997-14224 issued on July 31, 1997 was registered with the Philippine Economic Zone Authority (PEZA) on October 16, 1997 as an Ecozone Export Enterprise under PEZA Registration No. 97-074 to engage in the 1) manufacture of multi-layer chip capacitor and thick film chip resistor; 2) manufacture of micro-chip tantalum capacitor; 3) manufacture of crystal oscillator; and 4) trading and distribution of Samsung electronic parts and components for various electronic and communication devices to PEZA-registered export enterprises at Calamba Premier International Park in Calamba, Laguna. On October 1, 2000, Semco, a company incorporated under the laws of Korea with principal office in Kyunggi-do, Korea, signed a Technical Assistance and License Agreement with Semphil to grant the latter the right to use any technical information and trademarks in the manufacture of Semco's licensed products in the Philippines. Section 7 of the said Agreement states that in consideration of the license to use Semco's technical information and trademarks, Semphil shall pay royalties to Semco. In reply, please be informed that Section 2, Rule 1 of the Rules and Regulations (the PEZA Rules) to implement Republic Act (R.A.) No. 7916 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." From the foregoing, direct costs (costs of sales) are deductible from gross sales/revenues for purposes of computing a PEZA firm's taxable gross income subject to the five percent (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: CcSEIH "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 other than 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." Recording of revenues from the sale of a product is accompanied by recording of an expense for the cost of the product sold (SPAS 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. 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 xxxx Sales Returns/allowances xxxx Direct costs (cost of sales) xxxx Other Manufacturing Costs (Factory Overhead) xxxx xxxx xxxx ==== In view of all the foregoing, this Office confirms your opinion and hereby holds that royalties arising from the Technical Assistance and License Agreement between Semphil and Semco to grant Semphil the right to use any technical information and trademarks in the manufacture of Semco's licensed products in the Philippines are deductible in computing the gross income that may be subject to the five percent (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 Section 51 or R.A. No. 7916 ( BIR Ruling No. DA-439-2006 dated July 19, 2006 ) 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. EHSTcC Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service