Punongbayan & Araullo

July 20, 2009 BIR RULING [DA-(C-134) 385-09] DA 083-07 Punongbayan & Araullo 20th Floor, Tower 1 The Enterprise Center 6766 Ayala Avenue Makati City Attention: Atty. Fulvio D. Dawilan Tax Partner Gentlemen : This refers to your letter dated July 30, 2007 stating that your client, JFE Techno Manila, Inc. (JFE), is a domestic corporation authorized to engage in rendering and providing various technical services and assistance of whatever kind or nature in the drawing and design, as well as planning, fabrication, management, contracting and procurement of various steel frames and structures, machineries and equipment and industrial plant and other related components and accessories, including investigation, research and dissemination of data and information to the principal stockholders in respect to the economy, industry, business and investments in the Philippines; that at present, JFE provides two main services generally classified as engineering design services and production design services; that these two main services are performed by two separate divisions, the Engineering Design Division (EDD), which is housed at the Wynsum Corporate Plaza IT Building, Emerald Avenue, Ortigas Center, Pasig City, and the Production Design Division (PDD), which is housed at the Philippine Stock Exchange Center (formerly Tektite Towers), also in Ortigas Center, Pasig City; that for the services rendered by the EDD, JFE is duly registered with the Philippine Economic Zone Authority (PEZA) as an Ecozone Information Technology (IT) Enterprise; that the scope of the PEZA-registered activity shall be limited to the processing and execution of CAD Engineering Designs and Drawing; that the gross income earned from this activity is subject to the 5% preferential tax, in lieu of all national and local taxes; that on the other hand, the services under the PDD are not registered with the PEZA; that any income derived from this activity is subject to the regular income tax and such other applicable taxes; that the income and costs and expenses for EDD and PDD are accounted for separately; that among others, there are various types of costs and expenses incurred by JFE which are critical to the processing and execution of CAD Engineering Designs and Drawing; that the nature of these costs and expenses are described below: 1. Salaries and employee benefits. Salaries and employee benefits treated as part of direct costs pertain to Engineering staff composed of engineers, designers, draftsmen, and other technical employees directly involved with the processing and execution of CAD Engineering Designs and Drawing. This also includes salaries and benefits of Japanese trainers. The components of the account are the salaries and wages, social security costs, bonuses, retirement defined benefit plan, and similar benefits and facilities. 2. Depreciation and amortization. The Company classifies its property and equipment into three major groups such as office automation, leasehold improvements, and office furniture and equipment. Depreciation expenses pertaining to office automation and office furniture and equipment directly used, and leasehold improvements directly related to, the processing and execution of CAD Engineering Designs and Drawing are treated as direct costs. JFE likewise has intangible assets such as acquired computer software applications used in rendering the registered activities. The related amortization charges are also included as part of these direct costs. 3. Rental. JFE is a lessee under a non-cancelable operating lease for the use of its premises. Rental expenses are allocated based on the proportion of the area occupied. Only the rental costs pertaining to the area occupied by Engineering Staff and are used in connection with the registered activities are treated as part of direct costs. 4. Utilities. Utilities such as light, water and others are allocated based on the proportion of the area occupied. The computed utilities expenses pertaining to the area occupied by Engineering staff and are used in connection with the registered activities are included as part of direct costs. 5. Office supplies. The cost of office supplies is allocated based on the ratio of Engineering staff and administrative staff. The portion allocated to, and is directly used by, the engineering staff in the processing and execution of CAD designs and drawings is considered part of direct costs. 6. Subcontract fees. This pertains to payments to subcontractors for the performance of the subcontracted functions related to the registered activities. 7. Training. Both the engineering and administrative staffs are regularly provided with trainings. Trainings given to engineering staffs are directly connected with, and are necessary in, the performance of the registered activities; thus the related training costs incurred are treated as part of direct costs. 8. Communications. Clients being serviced are based abroad, and thus in order to accomplish the processing and execution of CAD Engineering Designs and Drawings, it is customary and necessary for JFE to incur overseas telephone calls and maintain network lines for constant communication. Communication costs are integral to the performance of the registered activities. The Company does not specifically identify the communication costs directly related to the registered activities, as doing so is too tedious and difficult for the Company. For convenience, JFE instead allocates the Communication expenses based on the ratio of the Engineering staff and administrative staff. Only the portion pertaining to the engineering staff is recognized as direct cost for purposes of the 5% preferential tax. 9. Repairs and maintenance. The property and equipment being used in the processing and execution of CAD engineering designs and drawings are delicate and thus require regular maintenance. Costs incurred in relation thereto are included as part of direct costs. CEcaTH In your supplemental letter dated May 2, 2008, you stated that the above items of costs and expenses are directly related to the Company's PEZA-registered activity, i.e., processing and execution of CAD Engineering Designs and Drawings, hence, deductible in computing the 5% gross income tax for the following reasons: 1. Subcontract fees Services of sub-contractors are availed by the Company in case the schedule of delivery of project is very tight and the existing manpower of the Company is not sufficient to meet the deadline. The subcontractors perform the same services as those activities that would have been performed by the employees if not subcontracted. Since these subcontractors merely augment the labor capacity of the Company, they also work within the Company's working premises. Since direct salaries and wages of employees are part of the direct costs of performing the registered activities, it follows that the subcontractor fees should also form part of the direct costs and deductible in computing the 5% tax. In fact, the BIR had previously ruled that although the subcontracting fees are not among those specifically enumerated under the regulations, the subject processing fees directly related to the production of the registered products partake the nature of a direct cost. 2. Communication costs Substantial portion of the Company's communication expense is the cost of leased line from the Philippines to Japan. The leased line is utilized to transmit, share and correct designs and drawings with the Company's clients overseas. The communication costs are incurred during the first until the last stage in the development of the products and the leased line is actually used to facilitate the production. The development of the Company's products requires constant communication with its clients overseas. For instance, a preliminary design/drawing is transmitted to the engineers of the clients for their comments, inputs and/or approval before it is finalized. Thus, the drawings may be tossed back and forth between the Company and its client and may be revised a number of times until it meets the requirement of the client. Taking into consideration that the designs and drawings are usually of large size/bytes, the Company needs a big pass to transfer these drawings to its clients. The leased line acquired by the Company allows the latter to pass on these large size files to its clients overseas and to receive them back without unnecessary disruptions. Therefore, the communication costs incurred by the Company are directly related to its finished product, i.e., CAD Engineering Designs and Drawings, since these are indeed necessary in the development of the Company's product. As such, these expenses should be allowed as deduction in computing the 5% gross income tax. In fact, in one ruling, the BIR confirmed that the communication costs for the use of leased lines which are used to among others, transfer files from one computer to another so that specific designs prepared by other departments can be integrated in the main design and to transfer the softcopy of the design to the parent company for their verification and review are deductible. Also, in another ruling, the BIR confirmed the deductibility of communication costs for mobile phone/telephone charges, network/server charges, SAP charges and internet connections which are incurred for the development of the designs and in the production of the registered products and are also used to transfer the softcopy of the designs to engineers. The communication costs incurred by the Company are basically of the same nature as the communication costs described in these two rulings and should therefore be allowed as deductions. 3. Repairs and Maintenance The repairs and maintenance expenses incurred by the Company consist primarily of three (3) types of expenses, which are: (1) Initial subscription and subsequent renewals of the software used in the development, processing and execution of the designs and drawings; (2) Lease of the software used in the development, processing and execution of the designs and drawings, in cases when the Company needs to acquire additional use of software to meet the demands of its clients especially during its peak season; and (3) Actual repair or upgrading of the hardware or mother board or processor in order to meet the external/internal capacity required to run the updated version of the software being used. The software is a major tool in the processing and execution of the computer aided engineering designs and drawings. Likewise, the software and hardware have to be maintained to avoid disruptions in the operation. Section 4 of Rule XX of the Implementing Rules and Regulations of Republic Act No. 7916 enumerates the items of costs and expenses which are deductible in computing the income subject to the 5% tax. These include depreciation of machinery and equipment used in production, and buildings owned or constructed as well as utility charges associated with building, equipment and warehouses used in production. Since the software is the main tool used in the production of designs and drawings, there is no doubt that the costs of the software, whether it be subscription, renewal of subscription and lease costs as well as the repair and maintenance costs for the software and hardware partake the nature of direct costs. Necessarily, these costs should form part of the allowable deductions for purposes of computing the 5% tax. In fact in a similar ruling, the BIR confirmed that the costs of the software (purchased and rented software) used for the production of engineering designs as well as the costs of maintenance thereon are deductible. Similarly, any costs incurred by the Company related to its software, being the major tool in the processing and execution of the designs and drawings should also be deductible. 4. Trainings The training expenses are actually on-the-job training costs for engineering staffs, meaning, these costs are incurred on an on-going project of the Company. These are usually incurred in cases where a client requires the use of different software in order to meet the design requirement. To be able to use the new technology for the specific requirements of the client, training costs are necessarily incurred on the job, i.e., in the processing and execution of the specific design. Hence, these are regularly connected with, and are necessary in, the performance of the registered activities. Thus, the same should also be deductible. Costs under the Philippine Accounting Standards Under the Philippine Accounting Standards, the costs of inventories shall comprise all costs of purchase, cost of conversion and other costs incurred in bringing the inventories to their present location and condition. 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 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 labor. Other costs are included in the costs of inventories 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. The underlying principle in determining the item of cost or expense to be considered as part of the cost if the direct relation of such item in the production of the product. If such item of cost or expense is an element in the production of the product or service, then it should be considered as part of the cost. Since the aforementioned expenses are indeed required in the production of the CAD engineering designs and drawings, then these should be considered costs deductible in computing the 5% tax. Under the above circumstances, the subcontract fees, communication costs, training and maintenance form part of the Company's cost of producing the computer-aided engineering design. In other words, these costs are incurred to finish the product of the Company. Based on the foregoing, you now request for confirmation of your opinion that 1. Pursuant to the provisions of Republic Act (R.A.) No. 7916, and its implementing rules and regulations, the aforementioned direct costs and expenses are deductible from gross income for purposes of computing the 5% preferential tax rate; 2. Communication expenses common to both the registered activity and administration shall be allocated based on the proportion of the Engineering and Administrative staff; 3. Rent and utilities expenses chargeable as direct cost shall be determined based on the proportion of the area occupied by the Engineering staff and are actually used for the registered activities and that occupied by Administrative staff, in relation to the total area occupied; and 4. Allocation of supplies expense based on the ratio of Engineering and Administrative staff is acceptable and valid. In reply thereto, please be informed the term "gross income" refers to the 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. (Sec. 2, Rule 1 of the Rules and Regulations to Implement Republic Act (R.A.) No. 7916) The above paragraph may be reduced to the following formula: Gross sales/revenues xxx Less: Sales Discounts xxx Sales Returns/Allowances xxx Direct Costs (costs of sales) xxx Other Manufacturing Costs (factory overhead) xxx xxx Gross taxable income xxx === With respect to the allowable deductions for PEZA-registered export enterprises, Section 2, Rule XX of the Implementing Rules and Regulations of R.A. No. 7916, provides as follows: "SEC. 2. Gross Income Earned; Allowable Deductions. For purposes of these Rules, Gross Income earned shall be as defined in Section 2(nn), Rules I of these Rules subject to the following allowable deductions for specific types of enterprises: 1. ECOZONE Export Enterprises, Free Trade Enterprise and Domestic Market Enterprises Direct salaries, wages or labor expenses Production supervision salaries Raw materials used in the manufacture of products Goods in process (intermediate goods) Finished goods Supplies and fuels used in production Depreciation of machinery and equipment used in production, and buildings owned or constructed by an ECOZONE Enterprise Rent and utility charges associated with building, equipment and warehouses, or handling of goods Financing charges associated with fixed assets" Corollarily, Revenue Regulations No. 11-2005 further clarified Section 2, Rule XX of Rules and Regulations implementing R.A. No. 7916, as amended, by enumerating certain production/direct costs deductible from gross income for purposes of determining the taxable base of ECOZONE Export Enterprises, Free Trade Enterprises and Domestic Market Enterprises, to wit: 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 is undisputed that the expenses listed above are applicable to PEZA-registered enterprise which manufactures and export goods. The rationale for this may be traced to the definition of Ecozone Export Enterprise provided under the implementing rules of R.A. No. 7916 which provides that this term, as used in the regulations, refers to an individual, association, partnership, corporation or other form of business organization which has been registered with the PEZA to engage in manufacturing, assembling or processing activity falling within the purview of the Act and resulting in the exportation of 100% of its production, unless a lower percentage of its production for exportation is prescribed by the PEZA Board subject to such terms and conditions as the latter may determine. However, it is to be emphasized, that ECOZONE enterprises are not necessarily manufacturer-exporters of products considering that there are also service enterprises registered as ECOZONE enterprises. To date, no separate set of deductions had been prescribed for this group of PEZA-registered enterprises. Thus, the direct costs and expenses incurred in connection with the performance of the services provided by this type of PEZA-registered enterprises are equally deductible for purposes of the 5% special tax in the same manner that raw materials and supplies used in production by PEZA-registered enterprises undertaking manufacturing activities are allowed as deductible expenses. Accordingly, since JFE is engaged in the processing and execution of CAD Engineering Design and Drawing which is registered with PEZA, the direct costs and expenses related to said activity are deductible in computing the taxable gross income from said activity. For purposes hereof, among the enumerated deductible costs and expenses under Revenue Regulations No. 11-2005 are the salaries and employee benefits, depreciation and amortization, rental, utilities and office supplies incurred by JFE which are related to the processing and execution of CAD Engineering Design and Drawing shall be deductible in computing the gross income subject to 5% tax. With respect to the subcontracting fees, training, communications and repairs and maintenance, while these types of costs and expenses are not included in the enumerations in Revenue Regulations No. 11-2005, this Office is of the opinion that these are likewise deductible expenses since these are direct costs incurred in furtherance of the PEZA-registered activities of JFE. Considering that the deductions enumerated in the said regulations are not exclusive, they are nevertheless allowed as deductions for purposes of computing the 5% final tax. Inasmuch as the particular cost can be identified as directly related to the processing and execution of CAD Engineering Design and Drawing shall be deductible in computing the gross income subject to 5% tax. Notably, paragraph 19 of the Philippine Accounting Standards (PAS) No. 2, the cost of inventories of service provider consist primarily of the labor and other costs of personnel directly engaged in providing the service, including supervisory personnel, and attributable overheads. With respect to the cost of inventories, production overhead includes 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 building and equipment, and the cost of factory management and administration. On the other hand, 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. It is clear that the subcontract fees, training expenses, communication costs and repairs and maintenance costs and expenses to the extent that these are used in delivering the services, should form part of the direct costs of JFE. For a company engaged in the processing and execution of CAD Engineering Designs and Drawings, these costs are critical and indispensable in delivering the services. Consequently, the costs of these resources should be allowed as deductions for purposes of the 5% special tax. On the issue of allocation of common expenses to income subject to the 5% tax, the costs and expenses of JFE which are related to its PEZA-registered activities are segregated and identifiable from the other costs and expenses. However, some costs and expenses incurred by JFE, such as costs of communications, rental, utilities and supplies, partly pertain to the PEZA-registered activities while some portion pertain to non-registered activities, such as costs related to administration. Accordingly, there is a need to apportion these common expenses, such that only the costs pertaining to the registered activity may be claimed as deduction from the income derived from such activity. Thus, in BIR Ruling No. DA608-06 dated October 11, 2006, this Office ruled that "segregation of cost may be done through specific identification, if possible. If specific identification is not possible, allocation based on relevant data like internet/email usage, or number of production and administrative personnel may be used if applicable." WHEREFORE, in view of the foregoing, this Office hereby confirms your opinion that 1. The aforementioned direct costs and expenses directly related to the processing and execution of CAD Engineering Designs and Drawings are deductible from gross income for purposes of computing the 5% preferential tax rate; 2. Communication expenses common to both the registered activity and administration shall be allocated based on the proportion of the Engineering and Administrative staff; 3. Rent and utilities expenses chargeable as direct cost shall be determined based on the proportion of the area occupied by the Engineering staff and are actually used for the registered activities and that occupied by Administrative staff, in relation to the total area occupied; 4. Supplies expenses shall be allocated based on the ratio of Engineering and Administrative staff. 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, (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service