Lexmark Research & Development Corporation

January 22, 2009 BIR RULING [DA-(C-007) 031-09] R.A. 7916; DA 476-03; DA 146-08 Lexmark Research & Development Corporation Innove I.T. Plaza, Samar Loop corner Panay Road Cebu Business Park, Cebu City Attention: Lilibeth E. Peralta Finance Director Gentlemen : This refers to your letter dated January 9, 2009 requesting for confirmation of your opinion that the following direct costs and expenses incurred by your company, Lexmark Research & Development Corporation (LRDC), are deductible from gross revenue for purposes of computing the 5% gross income tax (GIT): 1. Office Supplies; 2. Postage and Other Courier (In-bound); 3. Communication; 4. Software Expense; 5. Maintenance Contract; 6. Contractual Salaries; 7. Training & Education; 8. International Travel; 9. Depreciation Furniture & Fixtures; 10. Other Welfare; and 11. Remuneration of expatriates directly involved in production. It is represented that LRDC is a corporation duly organized and existing under Philippine laws. It is registered with the Philippine Economic Zone Authority (PEZA) pursuant to the provisions of Republic Act (R.A.) No. 7916 as an Ecozone Information Technology (IT) Enterprise under Certificate of Registration No. 01-009-IT and enjoys the 5% preferential tax on gross income earned, in lieu of the payment of all other local and national taxes, on its registered activities of providing engineering design and software and hardware development services and establishing a shared service center. HDATSI It is also represented that the following types of expenses are incurred by LRDC which are critical to the development and production process as a research and development company and as a shared service center; the nature of each expense is described as follows: 1. Office Supplies account for expenses on papers and cartridges used as test media in testing printer reliability (life testing), competitive printer testing and software/firmware testing. For example, if the life of the printer is pegged with capability to print 100,000 pages, then LRDC will do the testing by printing 110,000 pages. Further test printing will be done in varied environment (where temperature is too high or too low). For the shared service center, the papers are used in printing reports, invoices, debit/credit memos and other documents used in the business process outsourcing business. This account excludes office supplies used for general administration purposes ( i.e., Human Resource & Finance) 2. Postage and Other Courier (In-bound) accounts for freight expenses on purely incoming shipments of printers, test media, tools and materials used in testing and other materials needed in production. 3. Communication Expense pertains to domestic and international communication expenses such as mobile phone/telephone charges, network/server charges, internet lines, routers and managed network service, which are basically used in the development of designs. These communication facilities allow LRDC's use of advance communication features such as the voice over internet protocol (VOIP), teleconference, internet and email, which are used to facilitate the production of a design and in the shared service center service. They are also used to transfer the softcopy of the design for review and approval. The VOIP are used for discussions on planning and development of a design. Communication cost also includes the cost of faxing technical documents and mobile phone charges incurred by employees assigned at production. This expense account excludes communication cost for administrative matters which are separately recorded and monitored. 4. Software Expense accounts for costs of MSDN Operating Systems, Visual Studio with MSDN Developer, Visual Studio with MSDN Universal, Adobe, Corel Products, Cisco, NetApps, Symantec, and Siemens NX and MS Office. These softwares are essential to the Company's software development since it deals with Microsoft platform. These are purely used for testing and design as well as in the IT infrastructure systems and CAD designs. 5. Maintenance Contract pertains to maintenance of software used purely in development of designs. This excludes maintenance expenses of software used for human resource, finance and other administrative purposes. DAcSIC 6. Contractual Salaries are salaries paid to personnel from manpower agencies who provide testing services to the Company during its developmental stage. Primary responsibility of these personnel is to simulate what a typical end-user does to Lexmark products by exposing driver through several types of testing suites and renders reports on the test results. These include running the test suites from end user perspectives, document and report any errors found in the driver when running the test suites, develop new test cases to address new functions in each product as well as new environment to stress the printer, driver and firmware, etc. 7. Training and Education are training expenses incurred in sending employees abroad to complete training on new technology, software development, firmware development, hardware development, mechanical design, electrical design, product testing and other areas in the development of a product. 8. International Travel travel expenses incurred in US, China and other countries for the training of employees for the technology and responsibility transfer from overseas to Cebu, early manufacturing involvement of engineers with LRDC's contract manufacturer to ensure that production of LRDC's printers follows specifications and standards, resolution of production related issues encountered during the production process, participate in worldwide planning to specifically identify Cebu's responsibility in developing a new product and during the production process, resolution of issues like failure in paper feed, parts availability and other printer functionality issues during the production process, to ensure that tools and parts are produced in accordance with LRDC's specifications and design and training on the use and functionality of integrated financial systems. 9. Depreciation Furniture & Fixtures pertains to the depreciation of cubicles/workstations and laboratory tables and fixtures and work benches purely used for developmental and production purposes. 10. Other Welfare expenses related to major employee activities for the year, medical health & life insurance, physical examination and other de minimis benefits. Other welfare expenses which form part of cost of sales are only those related to employees purely involved in development and shared service activity. 11. Remuneration of expatriates directly involved in production salaries and wages, fringe benefits and other welfare expenses of expatriates who are directly involved in the design and development activity. In reply, please be informed that Sec. 3 of Revenue Regulations (RR) No. 11-2005 dated April 25, 2005, in implementing R.A. 7916, defines "gross income earned" as follows: "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 discounts, 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." aEcTDI 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 also 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 types 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 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. 2. ECOZONE Developer/Operator, Facilities, Utilities and Tourism Enterprises: Direct salaries, wages or labor expense Service supervision salaries IaSCTE Direct materials, supplies used Depreciation of machineries and equipment used in the rendition of registered services, and of that portion of the building owned or constructed that is used exclusively in the rendition of registered service Rent and utility charges for buildings and capital equipment used in the rendition of registered services Financing charges associated with fixed assets used in the registered service business the amount of which were not previously capitalized." In interpreting the scope of the foregoing list, the BIR 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 identified. 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: " 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." The GAAP in the Philippines in determining the cost of a product/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: CcAIDa "12. The costs of conversion of inventories include costs directly related to the units of production, such as direct labour. 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 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 labour. 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. For example, it may be appropriate to include non-production overheads or the costs of designing products for specific customers in the cost of inventories." The foregoing principles have been applied in BIR Ruling Nos. DA-476-03 dated December 10, 2003, DA-608-06 dated October 11, 2006 and in DA-146-08 dated March 7, 2008 where the BIR ruled that the following expenses constitute direct costs and therefore, deductible expenses for purposes of 5% GIT, namely: salaries, overtime and 13th month pay, perfect attendance incentives, meal allowance, employer's share of SSS, PhilHealth and HDMF contributions; rent, water, electricity and telephone charges associated with building, equipment and warehouses used in production, supplies used in production, depreciation of machinery and equipment used in production. Applying the above discussion to the instant case, this Office now rules as follows: 1. Office Supplies Office supplies needed for production are deductible as direct costs. Likewise, office supplies used in rendition of service for the shared service center are deductible under "Direct Materials, Supplies Used" as provided under Section 1.2. of RR 11-05. (BIR Ruling DA-608-06, supra) 2. Postage and Other Courier (In-bound) Transportation expenses associated with the acquisition of printers, materials, tools used in testing and in LRDC's registered activity is part of cost of sales and may be deductible for 5% GIT. 3. Communication Considering that the communication costs recorded by LRDC as part of its cost of services only pertains to communication charges related to the registered activities of development of designs and in the performance of its shared service center activity, the same are deductible for purposes of the 5% GIT. Communication costs related to administrative expenses specifically identified and allocated shall not be claimed as deductible expenses. ITScHa 4. Software Expense The software expenses are essential to the software development service of LRDC thus, partakes the nature of a direct cost. Hence, it is allowed as deduction from gross income. 5. Maintenance Contract The subject expense representing use of, or the right to use, copyright relating to software is a direct cost and thus deductible for purposes of computing the 5% GIT. However, maintenance expenses for software used for human resource, finance and other administrative purposes are administrative expenses and shall not be allowed as deduction from gross income. 6. Contractual Salaries LRDC engages the services of contractors to provide contractual workers, to perform or complete a specific job, work or service with a definite and/or pre-determined period. These workers complement the regular workforce of the company, particularly in the testing stage. Since contractual salaries incurred by LRDC are directly related to the production process, said fees are deductible for purposes of the 5% GIT. 7. Training & Education Considering that the training and education expenses incurred by LRDC are purely related to the development and production stages of its registered activity, these expenses are considered part of cost and, therefore, deductible from gross income. (BIR Ruling No. DA-339-08 dated June 4, 2008) 8. International Travel International travel expenses are primarily administrative expenses which are not deductible from gross income. 9. Depreciation Furniture & Fixtures Considering that the subject expense actually relates to the depreciation of workstations, laboratory tables and work benches used in the production/design process of LRDC's registered products and thus partakes the nature of a direct cost, the same is allowed as deduction from gross income subject to 5% GIT. 10. Other Welfare Since the subject expense actually relates to benefits of employees directly doing production/design process of the Company's registered products, it partakes the nature of a direct cost. As such, the same is allowed as deduction from gross income. (BIR Ruling DA-146-08, supra) DEICHc 11. Remuneration of expatriates directly involved in production Remuneration paid to expatriates directly involved in the production operations are deductible for purposes of computing the 5% GIT. (BIR Ruling No. DA 080-07 dated February 8, 2007) This ruling is being issued in the basis of the foregoing facts as represented. However, if upon investigation, it will be disclosed that the facts as represented 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