Mahle Filter Systems Philippines Corporation

September 2, 2009 BIR RULING [DA-(C-191) 486-09] RA 7916;RR 11-2005; BIR Ruling 117-99; DA 476-03; DA 519-06; DA 608-06; DA 080-07; DA 146-08 Mahle Filter Systems Philippines Corporation Block 8 Lots 5, 6, & 7 PEZA Drive First Cavite Industrial Estate Brgy. Langkaan, Dasmarias Cavite Attention: Eleonor F. Ledesma Department Head-General Accounting and Tax Gentlemen : This refers to your letter dated July 17, 2009 requesting for confirmation of your opinion that the following expenses incurred by your company, Mahle Filter Systems Philippines Corporation (MFSP), are manufacturing costs deductible from MFSP's gross revenue for purposes of computing the 5% gross income tax (GIT): DHSCEc 1. Indirect Labor; 2. Repairs and Maintenance; 3. Amortization of Software; 4. Fuel and Oil; 5. Insurance Expense; 6. Royalties; and 6. * Consultation fees for IT Services. It is represented that MFSP (formerly Mahle Tennex Philippines Corporation) is a corporation created and organized under Philippine laws; that it is registered with the Philippine Economic Zone Authority (PEZA) as an ecozone export enterprise primarily engaged in the business of manufacturing air filter elements and other automotive products; that 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; and that it incurs the following types of expenses which are critical to its production process, viz. : 1. Indirect Labor refers to the salaries, allowances and other benefits of quality control, engineering and warehouse production supervisors and leaders; 2. Repairs and Maintenance refers to labor and materials used for machines and facility maintenance used in production; 3. Amortization of Software accounts for costs of the softwares are essential to the Company's product development; 4. Fuel and Oil refers to fuel and oil supplies for machines and forklifts used in production; 5. Insurance Expense refers to insurances against fire and product liability of the raw materials and warehouse used in production; 6. Royalties refers to expenses related to technical know-how; and 7. Consultation Fees for IT Services refers to remunerations of consultants 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." The above definition is reduced to the following formula: Gross sales/revenues xxxxx Less: Sales Discounts xxxxx Sales Returns/Allowances xxxxx Direct costs (cost of sales) xxxxx Other Manufacturing Costs xxxxx xxxxx Gross taxable income xxxxx 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." 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." CHaDIT 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: "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. Indirect Labor Indirect labor expense, although not deductible as direct salaries, wages or labor expenses, is nevertheless deductible as part of cost of sales or direct costs since it pertains to salaries of personnel assigned in production. (DA-(C-056) 192-08 dated September 2, 2008) 2. Repairs and Maintenance Expenses for labor and materials for the maintenance of machines and facility used in production are manufacturing costs deductible from gross income. 3. Amortization of Software The software expenses are essential to the product development of MFSP and thus partakes the nature of a direct cost. Hence, they are allowed as deduction from gross income. 4. Fuel and Oil Fuel and oil used for machines and forklifts used in production are deductible under "Supplies and Fuels Used in Production" as provided under Section 1.2. of RR 11-05. (BIR Ruling DA-608-06, supra) 5. Insurance Expense Insurance expense incurred for insuring the raw materials and warehouse used in production against fire and product liability risks form part of the direct cost incurred in producing the product. Thus, it is deductible from gross income. 6. Royalties Royalties relating to technical know-how as discussed and held in BIR Ruling (DA-082)-273-2009 are deductible from gross income. 7. Consultation Fees for IT Services Remunerations paid to consultants directly involved in the production operations are deductible for purposes of computing the 5% GIT. TEHIaD 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