SGV & Co.

December 16, 2008 BIR RULING [DA-(TAR-007) 540-08] 34 (F); DA-183-07; DA-119-03 SGV & Co. 6760 Ayala Avenue Makati City Attention: Atty. Veronica A. Santos Tax Division Gentlemen : This refers to your letter dated September 29, 2008, requesting on behalf of your client, STAR Infrastructure Development Corporation (SIDC), for an authority to change SIDC's method of computing the depreciation/amortization of its Toll Road Facilities Rights over its Southern Tagalog Arterial Road (STAR) Project from Straight Line to Output/Units of Production Method. The facts as you represented are as follows: 1. SIDC, a corporation formed under Philippine laws, was awarded the concession for the STAR project by the Government of the Philippines (GRP), pursuant to the "Build-Operate-Transfer" variant recognized under Republic Act (R.A.) No. 6957, as amended by R.A. No. 7718. To enable SIDC to collect toll and other charges from motorist-users, it was also granted the franchise to operate the STAR Toll Road as a public utility during the concession period. 2. SIDC signed a Toll Concession Agreement (TCA) with the Toll Regulatory Board (TRB) and the Department of Public Works and Highways (DPWH). Under said TCA, SIDC was obliged, among others, to: (a) Operate and maintain Stage 1 of the STAR Project as a toll road, provide the necessary toll operation and maintenance facilities, and provide adequate financing thereof; and (b) Design, construct, operate, and maintain Stage 2 of the STAR Project as a toll road facility and provide adequate financing thereof. 3. The STAR Project consists of two (2) stages: (1) Stage 1 consisting of 22.16 km from Sto. Tomas, Batangas to Lipa City; and (2) Stage 2 consisting of 19.74 km from Lipa City to Batangas City. 4. On July 3, 2000, SIDC was registered with the Board of investments (BOI) on pioneer status under the Omnibus Investments Code of 1987 (Executive Order No. 226). Under the terms of its BOI Registration, SIDC was entitled to an Income Tax Holiday (ITH) for six (6) years from December 2002. Upon SIDC's request, the BOI approved the movement of the ITH reckoning period from December 2002 to January 2008. ITcCaS 5. Pursuant to the TCA, the STAR Project and any stage, phase or ancillary facilities thereof of a fixed and permanent nature shall be owned by the GRP, without prejudice to the rights and entitlements of SIDC. The legal transfer of ownership of the STAR Project and/or any stage, phase, or ancillary thereof shall be deemed to occur automatically on a continuous basis in accordance with the progress of the construction and upon the GRP's issuance of a certificate of substantial completion. 6. The accounting by private-sector operators involved in providing public sector infrastructure assets and services (such as roads) is governed by International Financial Reporting Interpretations Committee (IFRIC) 12 Service Concession Arrangements. Under IFRIC 12, the operator shall recognize an intangible asset to the extent that it receives a right (a license) to charge users of the public service. A right to charge users of the public service is not an unconditional right to receive cash because the amounts are contingent on the extent that the public uses the service. This is the case applicable to SIDC, hence SIDC recognized its toll road assets as an intangible asset. 7. In accordance with IFRIC 12, SIDC's expenditures incurred in the construction of the STAR Project (Stages 1 and 2) which would qualify for treatment as capital expenditures are classified as "Toll Road Facilities Rights" in SIDC's balance sheet. The costs of Toll Road Facilities Rights represent the construction cost of the toll road facilities of Stage 1 and the accumulated costs of construction of Stage 2, both of the STAR Project. These construction costs classified as Toll Road Facilities Rights are amortized (depreciated) on a Straight Line Method over the term of the TCA which will expire on December 31, 2035. 8. Halcrow Group Ltd. (Halcrow), an independent traffic consultant, conducted an updated traffic study and submitted a report to SIDC, showing, among others, that numerous factors ranging from an increase in toll rates, petroleum prices, lower regional growth rates, and other infrastructure developments in the Southern Tagalog part of the country could considerably decrease traffic in SIDC's STAR Project. Halcrow is an international consulting firm engaged in planning, design, and management services for infrastructure development with government and private sector clients including international financing institutions like World Bank, International Finance Corporation and Asian Development Bank. Halcrow has also prepared updated traffic studies including the North Luzon Expressway and Manila Cavite Toll Expressway. 9. After consideration of the traffic volume and a review of the practice of some toll operators/concessionaires in Asia and Europe, SIDC is considering a change in the method of amortizing the Toll Road Facilities Rights from Straight Line to Output/Units of Production Method. The latter is considered a more reasonable method in determining the amount of the intangible asset (Toll Road Facilities Rights) which should be charged to current operations since road usage (in terms of actual traffic volume) is a better metric than the mere passage of time (which is the presumption under the Straight Line Method) in determining the reduction in value of the Toll Road Facilities Rights. 10. Based on the foregoing, SIDC has come to the conclusion that the Output/Units of Production Method is a more rational method of allocating acquisition costs of civil works (currently classified as Toll Road Facilities Rights) to the periods benefited by their use. Thus, SIDC would like to adopt the Output/Units of Production Method in computing the amortization of its Toll Road Facilities Rights over its STAR Project. You now request for a confirmation of opinion that SIDC's change of the method of amortizing/depreciating its Toll Road Facilities Rights from Straight Line to Output/Units of Production Method effective January 1, 2008 is allowable since the latter method is more reasonable and has due regard to the current and succeeding conditions of SIDC's business. In reply, please be informed that Sec. 34 (F) of the Tax Code of 1997 states that there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including reasonable allowance for obsolescence) of property used in trade or business. The term "reasonable allowance" shall include, but not be limited to, an allowance computed in accordance with rules and regulations prescribed by the Secretary of Finance, upon recommendation of the BIR Commissioner, under any of the following methods: TIESCA (a) Straight Line Method; (b) Declining Balance Method, using a rate not exceeding twice the rate which would have been used had the annual allowance been computed under the method described in Subsection (F) (1); (c) Sum-of-the-years-digit Method; and (d) Any other method which may be prescribed by the Secretary of Finance upon recommendation of the BIR Commissioner. In this connection, Sec. 109 of Regulations No. 2 provides: "Section 109. Method of computing depreciation allowance. The capital sum to be replaced should be charged off over the useful life of the property, either in equal annual installments or in accordance with any other recognized trade practice, such as an apportionment of the capital sum over units of production. Whatever plan or method of apportionment is adopted must be reasonable and must have due regard to operating conditions during the taxable period. While the burden of proof must rest upon the taxpayer to sustain the deductions taken by him, such deductions must not be disallowed unless shown by clear and convincing evidence to be unreasonable. The reasonableness of any claim for depreciation shall be determined upon the conditions known to exist at the end of the period for which the return is made. If it develops that the useful life of the property will be longer or shorter than the useful life as originally estimated under all the then known facts, the portion of the cost or other basis of the property not already provided for through depreciation allowances should be spread over the remaining useful life of the property as re-estimated in the light of the subsequent facts, and depreciation deductions taken accordingly." Moreover, Sec. 105 of said Regulations states that: "Section 105. Depreciation. A reasonable allowance for the exhaustion, wear and tear, and obsolescence of property used in the trade or business may be deducted from gross income. For convenience, such an allowance will usually be referred to as depreciation, excluding from the term any idea of a mere reduction in market value not resulting from exhaustion, wear and tear, or obsolescence. The proper allowance for such depreciation of any property used in the trade or business is that amount which should be set aside for the taxable year in accordance with a reasonable consistent plan whereby the aggregate of the amount so set aside, plus the salvage value, will, at the end of the useful life of the property in business, equal the basis of the property. Due regard must also be given to expenditures for current upkeep." [cited in BIR Ruling Nos. DA-183-07 dated March 27, 2007; DA-217-06 dated April 7, 2006; and DA-413-04 dated July 30, 2004]. In relation to the foregoing provision is Sec. 107 of the same Regulations, the pertinent portion of which reads: "Section 107. Depreciation of intangible property. Intangibles, the use of which in the trade or business is definitely limited in duration, may be the subject of a depreciation allowance. . . ." The depreciation charged against income using the Units of Production Method is determined by the actual output vis--vis the total expected output during the useful life of the asset. This method gives a more accurate estimate of usage of the asset in comparison to the other methods. It has often been applied in the field of transportation where miles of operation, ton-miles hauled, or hours of operation are used as the units of production. In the case of SIDC, it is a method of calculating depreciation where the Toll Road Facilities Rights are written off in proportion to the amount of vehicular traffic in a given year divided by the total anticipated traffic over the expected operating life of SIDC's STAR Project. In BIR Ruling No. DA-183-07, the facts of which fall all square with SIDC's request, wherein the Manila North Tollways Corporation (MNTC) requested for authority to change its method of computing depreciation of its North Luzon Expressway (NLEX) Project from the Straight-Line Method to Output/Units of Production. Initially, MNTC adopted the Straight Line Method in depreciating its property and equipment. For the civil works component of its property and equipment, MNTC made use of an estimated useful life of twenty-six (26) years from the start of commercial operations or until December 31, 2030 which constitutes the end of its fixed-term concession period. MNTC considered a change in depreciation method after reviewing the actual traffic volume in year 2005 vis--vis its original projections and after considering the numerous factors which could considerably decrease the expected traffic in the NLEX. Upon consideration of the updated traffic projections and the practice of toll road operators/concessionaires in other countries, MNTC considered a change in depreciation method from Straight Line Method to Output/Units of Production Method for the civil works portion of the NLEX. This Office granted MNTC's request for the change in its method of computing the depreciation allowance of the civil works component of its property and equipment considering that the existing conditions in the operation of NLEX does not maximize the use of the said assets and that the use of the Output/Units of Production Method best reflects the true value of the said assets and gives a more accurate estimation of their usage. DCcIaE In the same ruling above, the BIR granted MNTC's request for the change in accounting method to apply retroactively. MNTC is registered with the BOI and, thus, entitled to incentives including the (ITH). Under the ITH, MNTC will derive no tax benefit whatsoever even if the change in accounting method is retroactively applied. This finds support in BIR Ruling No. DA-119-03 dated April 14, 2003 [citing BIR Ruling No. DA-048-96 dated April 10, 1996] where the BIR approved the change in a company's depreciation method retroactive to the date of the acquisition of its assets, to wit: ". . . considering that DPI will, in essence be claiming increased depreciation charges during its ITH, the retroactive application thereof is hereby granted since no tax benefit therefrom accrues to DPI, and government collections will not be prejudiced because of such change." Given the existing conditions in the operation of SIDC's STAR Project, this Office hereby grants permission to SIDC to change its method of computing depreciation for the STAR Project from Straight Line to Output/Units of Production Method effective January 31, 2008. This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it will be ascertained that the facts are different, then this ruling shall be considered as null and void. Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service