Punongbayan & Araullo

December 4, 2008 BIR RULING [DA-(C-164) 499-08] DA 608-06 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 September 18, 2007 stating that your client, Suminac Philippines, Inc. (Suminac), is a domestic corporation duly organized and existing under the laws of the Philippines with principal place of business at the FCIE Compound, Barangay Langkaan, Dasmarias, Cavite; that Suminac is engaged in the business of manufacturing, importing, exporting, buying, selling or otherwise dealing in, at wholesale such goods as forklift body carriage parts and under carriage and other related products or goods of similar nature; that the gross income earned (GIE) from this activity is now subject to the 5% preferential tax, in lieu of all national and local taxes; that in relation to the business activity of Suminac, there are various types of costs and expenses incurred which are critical and necessary to the manufacturing, production and accomplishment of its PEZA-registered activities. Based on the foregoing representations, you now request for confirmation of your opinion that, pursuant to the provisions of Republic Act (R.A.) No. 7916, and its implementing rules and regulations, the following expenses incurred in the production of the registered products are treated as direct costs, and are therefore deductible from gross income for purposes of computing the 5% preferential tax, to wit: 1. Raw materials used to manufacture forklift body carriage parts and other related products and materials such as IMF paint, welding wires, welding gas, jigs, tools, safety equipment, packing materials, fuel and oil used in the manufacturing process; 2. Subcontracted labor for nesting and cutting charges of raw materials; 3. Salaries and employee benefits of Production Supervisor, Direct Labor Production, Production Control Staff, and the Design Engineering Staff involved in the manufacturing; 4. Freight-in cost for receiving, stocking, picking and shipping of goods; 5. Rental paid for the land on which the manufacturing/factory plant stands; DcITaC 6. Repairs and maintenance for the properties and equipments being used in the manufacturing operations which also includes replacement parts for machineries and equipment, service truck and forklift; 7. Depreciation charges of machineries and equipment, jig and dies, returnable rack, building and improvement and office equipment used in production; 8. Gasoline and fuel charges of service truck and forklift; 9. Cost of utilities for water and electricity used by the Production and Design Department; 10. Interest expense from the financing charge incurred in relation to the construction of building and acquisition of production assets where the financing charges were not capitalized; ETHCDS 11. Training expenses given to employees directly connected with, and are necessary in, the performance of the registered activities. In your supplemental letter dated July 29, 2008, you posit that the following costs and expenses should be allowed as deduction for purposes of computing the 5% tax. 1. Subcontract fees for nesting and cutting charges of raw materials Services of sub-contractors are acquired by Suminac for purposes of cutting the steel plate materials which Suminac utilizes in manufacturing the forklift body carriage parts and under carriage (the PEZA registered activity). As owner of these steel plates, Suminac gives specific instructions, by way of drawings, to the Subcontractor. The latter shall then perform the cutting process using plasma, gas and laser machine. Thereafter, the subcontractor delivers the plate materials to Suminac. The subcontractor performs the same services as those activities that would have been performed by the employees of Suminac if not subcontracted. Since direct salaries and wages of employees are part of the direct costs of performing the registered activities, it follows that the subcontract fees should also form part of the direct costs and deductible in computing the 5% tax. 2. Repairs and maintenance for the properties and equipments being used in the manufacturing operations which also includes replacement parts for machineries and equipment, service truck and forklift; and cCTESa 3. Depreciation charges of machineries and equipment, jig and dies, returnable rack, building and improvement and office equipment used in production. Section 3 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. This necessarily includes repairs and maintenance on the machinery and equipment. Repairs and Maintenance Taking into consideration that the above enumerated machineries and equipments, jig and dies, returnable rack, building and improvement are directly used in the production of the forklift, it follows that any repairs and maintenance undertaken thereto form part of the direct costs of Suminac as part of its overhead expense. TSIaAc The repairs and maintenance is an incidental manufacturing overhead of Suminac's cost of production. In order to meet the demand of its client, Suminac needs to ensure that the properties/machineries used are not only in good-running condition, but are likewise primed for the specific task that they are to function. Depreciation Incidentally, the depreciation expenses of the above enumerated properties form part of the manufacturing overhead expenses of Suminac. This has been confirmed by no less than the implementing rules and regulations of PEZA. 4. Gasoline and fuel charges of service truck and forklift The gasoline and fuel charges incurred by Suminac for its service truck and forklift are directly related to the manufacturing of the finished products. Taking into consideration the size and weight of the raw materials/parts used in manufacturing of the forklift, the service truck and forklift were used to transport, to load and to unload the parts from one work station to another. Hence, such gasoline and fuel costs sustained by Suminac are part of its manufacturing costs being directly related to the production of its finished product. 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 building 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 direct 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. To illustrate; 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 items of cost or expense to be considered as part of the cost is 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, in the instant case, indeed required in the production of forklift body carriage parts, then these should be considered costs deductible in computing the 5% tax. Based on the foregoing, you posit that the subcontract fees, repairs and maintenance, depreciation and gasoline and fuel charges form part of Suminac's cost of manufacturing the forklift. In reply thereto, please be informed that the term "gross income" refers to gross sales or gross revenues derived from business activity within the ECOZONE, net of sales discounts, sales returns and allowances and minus cost of sales or direct costs but before any deduction is made for administrative expenses or incidental losses during a given taxable period. The allowance 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/revenue 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: ESIcaC "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 Enterprises 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 HTDcCE - 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 the 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: a. Direct salaries, wages or labor expenses b. Production supervision salaries c. Raw materials used in the manufacture of products d. Decrease in Goods in Process Account (Intermediate Goods) e. Decrease in Finished Goods Account f. Supplies and fuels used in production TCaADS g. Depreciation of machinery and equipment used in production, and of that portion of the buildings owned or constructed that is used exclusively in the production of goods h. Rent and utility charges associated with building, equipment and warehouses used in production i. 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. Accordingly, since Suminac is engaged in the manufacturing of forklift body carriage parts and under carriage and other related products or goods of similar nature, all the direct costs and expenses incurred in the manufacture of said products are deductible in computing the taxable gross income from said activity. Thus, in accordance with the enumeration of the deductible costs and expenses in Section 2, Rule XX of the Implementing Rules and Regulations of R.A. No. 7916, as amplified in Revenue Regulations No. 11-2005, the following costs and expenses incurred by Suminac shall be allowed as deductions in computing the gross income subject to 5% tax: 1. Raw materials used to manufacture forklift body carriage parts and other related products and materials such as IMF paint, welding wires, welding gas, jigs, tools, safety equipment, packing materials, fuel and oil used in the manufacturing process; 2. Salaries and employee benefits of production supervisor, direct labor production, production control staff, and the design engineering staff involved in the manufacturing; 3. Rental paid for the land on which the manufacturing/factory plant stands; 4. Depreciation charges of machineries and equipment, jig and dies, returnable rack, building and improvement and office equipment used in production; 5. Gasoline and fuel charges of service truck and forklift; 6. Cost of utilities for water and electricity used by the production and design department; 7. Interest expense from the financing charge incurred in relation to the construction of building and acquisition of production assets where the financing charges were not capitalized. With respect to the subcontracting fees, freight in, 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 Suminac. 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 registered manufacturing activity of Suminac, which is the manufacturing of forklift body carriage parts and under carriage and other related products or goods of similar nature, the same should also be allowed as a direct cost for purposes of computing the 5% preferential tax rate. Notably, Philippine Accounting Standards (PAS) No. 2 provides for the rules in determining the costs of product/inventory. Paragraph 34 of the said PAS requires that "when the inventories are sold, the carrying amount of those inventories shall be recognized as an expense in the period in which the related revenue is recognized." This means that there should be a corresponding recording of the cost of production for every product or inventory sold. Paragraphs 10 to 18 of the same PAS enumerates the guidelines in determining the costs of inventories, which partly provides as follows: "10. 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. cEaSHC "11. The cost of purchase of inventories comprise the purchase price, import duties and other taxes (other than those subsequently recoverable by the entity from the taxing authority), and transport, freight charges and handling and other costs directly attributable to the acquisition of finished goods, materials and services. Trade discounts, rebates and other similar items are deducted in determining the costs of purchase. "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." THIAaD Accordingly, subcontract fees, freight in, and repairs and maintenance and expenses to the extent that these are used in producing the finished foods, should form part of the direct costs of Suminac. Since Suminac is engaged in manufacturing, these costs are critical and indispensable in producing the goods. Paragraph 11 provides that freight charges form part of the costs of purchases of inventories as they are directly attributable to the acquisition of finished foods, materials and services. Likewise, paragraph 12, the costs of conversion of inventories include the maintenance of factory buildings and equipment, and the cost of factory management and administration. Thus, the costs of repairs and maintenance of properties and equipment used in the manufacturing operations and the transport of raw materials, including replacement of parts, would form part of the costs of the finished products. Subcontracting costs, on the other hand, are necessary for the conversion of the raw materials and supplies into finished products. This is so because, instead of all the activities in the production process being done by Suminac, part of the activities are subcontracted to third parties, as Suminac would need to incur other types of conversion costs if part of the activity is not subcontracted. As such, the freight-in costs, the subcontracting fees and the costs of repairs and maintenance should be allowed as deduction for purposes of the 5% preferential tax rate. Finally, Section 42 of R.A. No. 7916 provides for the deductibility of training costs as follows: "Section 42. Incentive Scheme. An additional deduction equivalent to one-half (1/2) of the value of training expenses incurred in developing skilled or unskilled labor or for managerial or other management development programs incurred by enterprises in the ECOZONE can be deducted from the national government's share of three percent (3%) as provided in Section 24." ICAcaH Training expense refers to direct, ordinary and necessary expenses incurred by an ECOZONE enterprise in a training program or activity designed to develop skilled or unskilled labor, in this case Suminac insofar as it can be directly identified with the production cost. These shall include, among others, the following expenses or any combination of them: a. Training materials, books and supplies; b. Cost of raw materials and non-depreciable tools actually consumed and used during the training; c. Honoraria for resource speakers and training coordinators and other fees; d. Traveling expenses of resource speakers and training coordinators while away from home on account of the training program; e. Salaries of trainees and training staff for the duration of training; f. Traveling expenses of trainees and training staff while away from home on account of the training program; EHSADa g. Tuition, registration or similar fees paid for sponsored trainees; h. Cost of repairs of training equipment facilities and other fixed assets used in the training program, if breakdown occurs as a result of training; and i. Others such as foods, rental of venue, rental of equipment, work clothes for trainees and instructors, certificates of training, and group of insurance of trainees. (Sec. 2, Rule 1, Part 1 of the Rules and Regulations to Implement the Special Economic Zone Act of 1997) Consequently, only 1/2 of the training costs incurred by Suminac should be allowed as tax credit which can be deducted from the share of the National Government but not deductible as business expense. WHEREFORE, in view of the foregoing, this Office hereby confirms your opinion that the above-mentioned expenses, except training costs, incurred in the production of the registered products are treated as direct costs and therefore deductible from its gross income for purposes of computing the 5% preferential tax rate. 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. HaTAEc Very truly yours, (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service