Mahle Filter Systems Philippines Corporation

June 3, 2009 BIR RULING [DA-(C-082) 273-09] R.A. 7916; DA-178-05, DA-280-05, DA-129-06, DA-57-06 & DA-439-06 Mahle Filter Systems Philippines Corporation Block 8 Lot 5, 6 & 7 PEZA Drive First Cavite Industrial Estate, Brgy. Langkaan Dasmarias, Cavite Attention: Ms. Eleonor F. Ledesma Department Head -General Accounting and Tax Gentlemen : This refers to your letter dated May 7, 2009 requesting for a ruling on the proper accounting and tax treatment of Royalty Payments made by your company to Mahle Filter Systems Japan Corporation ("MFSJ" for brevity), pursuant to Article 4 of the Technical Assistant Agreement. SECcAI As represented, Mahle Filter Systems Philippines Corporation ("MFSP" for brevity) formerly, Mahle Tennex Philippines Corporation, was incorporated and registered with the Securities and Exchange Commission (SEC) on May 27, 1996. It is registered with the Philippine Economic Zone Authority (PEZA) on June 3, 1996 and the Bureau of Internal Revenue on December 23, 1996. MFSP is primarily engaged in the business of manufacturing of air filter elements and other automotive products. Majority of its product line are now subject to 5% regime in lieu of other taxes under Republic Act No. 7916 after its income tax holiday incentive expired on September 30, 2007. It is a 100% subsidiary company of MFSJ, a corporation duly organized and operating under the laws of Japan and a manufacturer of various kinds of automotive parts. On January 1, 2007, MFSP entered into a technical know how agreement with MFSJ. Under this agreement, MFSJ will provide all the necessary and appropriate technical support and information such as product design that will enable the company to manufacture and sell certain products in various geographical areas. In consideration, the company will pay a royalty fee equivalent to 3% of the total net sales after deducting the material purchases made to MFSJ. You now request for a ruling that the royalties paid by MFSP to MFSJ under the Technical Assistant Agreement considered as part of the finished goods manufactured should be allowed as deduction from MFSP's gross sales for purposes of calculating its gross income earned subject to the 5% Gross Income Tax (GIT) Rate since the royalties derived from the transfer of technical information is a necessary overhead cost to produce air filter products. 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." EITcaH From the foregoing, direct cost (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: "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)]. CTAIHc 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 the foregoing, this Office holds that royalties arising from the Technical Assistance Agreement between MFSP and MFSJ to grant MFSP the right to use any technical information in the manufacture of MFSP's filter products and other parts for motor vehicles as well as machinery (Approved 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 of R.A. No. 7916 (BIR Ruling No. DA-439-2006 dated July 19, 2006). EHcaAI 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