Samsung Electronics Philippines Manufacturing Corporation

September 2, 2008 BIR RULING [DA-(C-056) 192-08] R.A. 7916; DA 476-03; DA 146-08 Samsung Electronics Philippines Manufacturing Corporation Block 6, Calamba Premiere International Park, Barangay Batino, Calamba City, Laguna Attention: Mr. Sang Ho Park Chief Financial Officer Gentlemen : This refers your letter dated August 26, 2008 requesting confirmation of your opinion that the following expenses related to production incurred by our company are deductible from gross revenue for purposes of computing the five percent (5%) gross income tax (GIT), to wit: Salaries & Wages of Personnel in Production Offices, Retirement Benefit, Depreciation, Consumable Supplies and Utility Expenses. IAcTaC It is represented that SEPHIL is a corporation duly organized and existing under Philippine laws with office address at the Calamba Premiere International Park-Special Economic Zone; that it is registered with PEZA as an Ecozone Export Enterprise under Registration Certificate No. 01-011 dated February 9, 2001; that it enjoys the 5% preferential tax on gross income earned in lieu of the payment of all other local and national taxes on its registered activity consisting of the design, manufacture, and sale of electronic products, including optical disk drive products, their components and parts. It is further represented that there are several expenses incurred by SEPHIL that are related to the production process, among which are: 1. Salaries and Wages of Personnel in Production Offices/Indirect Salaries This expense pertains to salaries and wages of managers, supervisors, engineers and staff in production offices. These people are responsible for the whole operation in production. They manage and supervise the daily activities in the production area which includes research & development, production planning, procurement, quality control, testing, repair etc. 2. Retirement Benefit The Company accrues retirement expense and is recorded under 'welfare expense-personal pension' for the benefit of employees. The private retirement benefit plan is already registered with the BIR for tax exemption purposes. Currently, SEPHIL is charging the said expense to administration although a portion may be attributable to production especially for those personnel who are part of direct labor and for those who act as production supervisors such as engineers, operators, line leaders & managers. DacASC 3. Depreciation Expenses These are incurred from machinery and equipment, furniture & fixtures ( e.g., computers, printers, fax machines), building space occupied by production offices and moulds consigned to subcontractors for their use to support our production requirements. 4. Consumable Supplies Expenses SEPHIL uses production and office supplies recorded under the following accounts, among others: (1) Consumable Supplies, (2) Production Supplies ( e.g. test discs, spare parts, and other equipments or tools which are considered as non-capitalized expenditures) and Operating Supplies. The Company also uses office supplies ( i.e., cleaning supplies, pantry supplies, drinking water, etc.) in its production activities. Currently, SEPHIL charges the said office supplies to administration although a portion may be attributable to production. These supplies are needed for production consumption like test disc, spare parts, other equipments & tolls which are considered as non-capitalized expenditures use for analysis, testing & quality control. 5. Utility Expenses Utility expenses consist of fuel, electricity, and water. Fuel and water are used for forklifts and generator sets used in production. Electricity provides light for building and power to machinery and equipment used in production area & offices. Based on the foregoing representations, it is your opinion that the aforementioned expenses related to production are factory overhead/other manufacturing comprising costs incurred by SEPHIL and thus deductible from gross revenue for purposes of computing the 5% GIT. 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: cCDAHE "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. The above paragraph 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 further provided for a list of allowable deductions from gross income which was interpreted by the BIR to be not exclusive (BIR Rulings DA 519-2006 and DA 556-2006); meaning, as long as the costs can be attributed in producing the product, they are allowed as deductions for purposes of computing the 5% GIT, thus : "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 expense 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 CTaIHE 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." The BIR has consistently held that in order to compute the gross income, there is a need to identify the cost of sales or direct costs which may be deducted from gross revenues. In this regard, reliance is made on Article 24 of Executive Order 226, otherwise known as the Omnibus Investment Code of the Philippines, in determining the direct costs, which provides that: "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." It is beyond doubt that the provisions of the Omnibus Investment Code are applicable to PEZA-registered enterprises. Section 23 of R.A. 7916 states: "Sec. 23. Fiscal Incentives . Business establishments operating within the ECOZONES shall be entitled to the fiscal incentives as provided for under Presidential Decree No. 66, the law creating the Export Processing Zone Authority, or those provided under Book VI of Executive Order No. 226; otherwise known as the Omnibus Investments Code of 1987." 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: STcAIa "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: "12. The costs of conversion of inventories includes 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 DA 476-03, DA 608-06 and more recently in DA 146-08 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. SEAHID Based on the discussion above, this Office is of the considered opinion that the following expenses of SEPHIL are direct costs incurred in production and, therefore, deductible for purposes of the 5% GIT, thus: 1. Indirect salaries, although they are not deductible as direct salaries, wages or labor expenses are nevertheless deductible as part of cost of sales or direct costs since they pertain to salaries of personnel assigned in production. 2. Retirement benefit expense of employees who are part of direct labor and/or production supervision of activities subject to 5% GIT forms part of direct salaries, wages or labor expenses, and production supervision salaries. 3. Depreciation of machinery and equipment, furniture & fixtures ( e.g., computers, printers, fax machines), building space occupied by production offices and moulds used by subcontractors is an expense associated with production of goods and identified in the Regulations as deductible expense. 4. Consumable supplies and office supplies ( i.e., cleaning supplies, pantry supplies, drinking water, etc.) needed for production are deductible under "Supplies and Fuels Used in Production" as specified in the Regulations. Other supplies such as test disc, spare parts, other equipments & tolls which are considered as non-capitalized expenditures used for analysis, testing & quality control also qualify as supplies used in production deductible from gross income. 5. Utility expenses attributable to production are deductible under "Rent and Utility Charges Associated with Production" as also specified in the Regulations. 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. HAaDTE Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service