Taxability of Net Margin from Operation of Business During Transition Period

February 11, 2004 BIR RULING NO. 004-04 27 (A) 108 (A) 000 SGV & Co . 6760 Ayala Avenue 1226 Makati City Attention: Atty. J.A. Osana Tax Division Gentlemen : This refers to your letter dated February 19, 2003 requesting on behalf of your client, Bayer Philippines, Inc. (BPI for brevity), a confirmation of your opinion that the net margin derived by BPI from the operation of the Flora Business during the Transition Period is not taxable to it on the basis of the circumstances set forth in your letter. The facts, as you represented, are as follows: BPI is a domestic corporation, which is a 100%-owned subsidiary of Bayer Aktiengesellschaft ("Bayer AG"), a corporation organized and existing under the laws of Germany. SCJ-Phils. is also a domestic corporation, which is a 100%-owned subsidiary of S.C. Johnson & Son, Inc. (SCJ-US), a corporation organized and existing under the laws of Wisconsin, U.S.A. On November 20, 2002, Bayer AG and SCJ-US entered into a Master Agreement relative to the sale and purchase, on a worldwide basis, of the Flora Business of the Bayer group of companies, including that of BPI, to the SCJ group of companies, including SCJ-Phils. The Flora Business consists of developing, producing, manufacturing, marketing, distributing or selling insecticides for household use as well as after-bite products, household cleaner products and air fresheners, and the distribution of other products by the household business unit of Bayer's Consumer Care division. The products of the Flora Business carry the brand names "Baygon;" "Bayfresh" and "Autan" (Flora Products). On its part, BPI will report as income the service fees received for Sales Cycle Transition Services and Inventory Management Services and pay income tax thereon. It is also represented that pursuant to the TSA, BPI provided the services to SCJ-Phils. from January 1, 2003 to March 31, 2003. Based on the foregoing, you now request for confirmation that: 1. The Net Economic Benefit, inclusive of the net margin, as described above shall form part of the taxable income of SCJ Phils. that will be subject to the regular income tax of 32%. Conversely, since BPI operates the Flora Business during the Transition Period only for the benefit of SCJ-Phils., BPI shall not be subject to income tax on the results of the operations (net margin) of the Flora Business, turned over to SCJ-Phils. 2. BPI shall be subject to income tax (and 10% VAT) on the Service Fee received from SCJ-Phils. on account of the Sales Cycle Transition Services and Inventory Management Services rendered during the Transition Period. However, the Service Fee paid by SCJ-Phils. to BPI shall not be subject to expanded withholding tax (EWT). In reply, please be informed as follows: 1. As of December 31, 2002, any income arising from the result of the operations of the Flora Business belongs to SCJ-Phils., its new owner. The income from the conduct of business is generated by the owner of the business, SCJ-Phils., notwithstanding that the importation, manufacture and sale of the Flora Business products will be made by and recorded in the books of BPI. Said activities are made by BPI for and on behalf of the real owner of the business, SCJ-Phils, in its capacity as agent or manager, for a fee. It bears stressing that the parties were only compelled to enter into the said arrangement to ensure that the Flora Business products will continue to be available in the market to avoid loss in market share during the period that SCJ-Phils. and BPI are working on the transfer of the BFAD Certificate of Product Registration to SCJ Phils. Without such certificate, SCJ-Phils. could not import raw materials or sell products to its customers and issue its own invoices without facing sanction from BFAD. cACTaI Moreover, to ensure that the results of the operations of the Flora Business during the Transition Period will be properly accounted for, all sales and purchases for the Flora Business shall still be reported by BPI in its books, and at the same time, BPI shall maintain separate subsidiary records for the same. Furthermore, during said period, BPI shall account for the result of the operations of the Flora Business on a monthly basis and turn over the net margin to SCJ Phils. as a component part of the Net Economic Benefit computed based on the pre-agreed formula embodied in the Master Agreement. This net margin turned over to SCJ Phils. shall be shown in the books of BPI as deduction for income tax purposes. On the other hand, SCJ-Phils. shall report as income the margin turned over by BPI and pay the 32% regular income tax thereon. In addition, as BPI will be issuing its own official receipts and sales invoices for the sales of Flora Products during the Transition period, BPI shall be liable for the 10% VAT on the said sales pursuant to Section 106 (A) of the Tax Code of 1997 and shall file the corresponding VAT returns. However, BPI, as the importer and purchaser of record, is allowed to claim as input tax credits the VAT paid by it on the importation of raw materials used in the manufacture of the Flora Products, as well as the VAT passed on to it for purchases of goods and services for the account of the Flora Business, in accordance with Section 110 of the Tax Code of 1997, viz. : SEC. 110. Tax Credits . (A) Creditable Input Tax. (1) Any input tax evidenced by a VAT invoice or official receipt issued in accordance with Section 113 hereof on the following transactions shall be creditable against the output tax: (a) Purchase or importation of goods: (i) For sale; or (ii) For conversion into or intended to form part of a finished product for sale including packaging, materials; or (iii) For use as supplies in the course of business; or (iv) For use as materials supplied in the sale of service; or (v) For use in trade or business for which deduction for depreciation or amortization is allowed under this Code, except automobiles, aircraft and yachts. (b) Purchase of services on which a value-added tax has been actually paid. (2) The input tax on domestic purchase of goods or properties shall be creditable; (a) To the purchaser upon consummation of sale and on importation of goods or properties; and (b) To the importer upon payment of the value-added tax prior to the release of the goods from the custody of the Bureau of Customs. However, in the case of purchase of services, lease or use of properties, the input tax shall be creditable to the purchaser, lessee or licensee upon payment of the compensation, rental, royalty or fee. To implement the Master Agreement, BPI and SCJ-Phils. executed on December 19, 2002 a Local Asset Sale and Transfer Agreement and a Transition Services Agreement. Under the said agreement, BPI transferred to SCJ-Phils. as of the Closing Date (December 31, 2002) the Flora Business, including contracts with distributors, computer equipment, and employees. It is further represented however, that notwithstanding that SCJ-Phils. became the owner of the Flora Business of BPI as of December 31, 2002, SCJ-Phils. cannot immediately take over the said business in view of certain regulatory requirements. The Bureau of Food and Drug Administration is still in the process of reviewing the application for the transfer of the Certificate of Product Registration for the Flora Business products from BPI to SCJ-Phils. Without the Certificate of Products Registration in its name, SCJ-Phils. will have no authority to import, manufacture and sell the Flora Business products to the public. In view of this, BPI and SCJ-Phils. have agreed on a three-month Transition Period beginning January 1, 2003, and have executed Transition Services Agreement (TSA). It is embodied in the TSA that BPI shall continue running the Flora Business in behalf of SCJ-Phils. which is now the real owner and thus BPI will continue the importation, manufacture and sale of the Flora Business products. However, since the Certificate of Product Registration is still in the name of BPI, the latter will issue its own sales invoices during the Transition Period. Internally, BPI will create a separate environment for the Flora Business which will allow it to account for the transaction of the said business during the Transition Period separate from BPI's non-Flora Business. Accordingly, separate subsidiary records will be maintained. In addition, the TSA specifically provides that during the Transition Period, BPI will render Sale Cycle Transition Services and Inventory Management Services for a fee. Under the Sales Cycle Transition Services, BPI will basically solicit and accept customer orders for Flora Business products, process customer's orders, deliver related customer support, receive, manage and account for customer payments. Inventory Management Services encompass such services that will ensure that the inventory is available for continuous customer shipments in accordance with customers' orders and required delivery dates. Moreover, BPI will account for the result of operations of the Flora Business on a monthly basis and turn over the net margin to SCJ-Phils. also on monthly basis, as component part of the Net Economic Benefit computed based on a pre-agreed formula embodied in the Mastery Agreement. BPI, being merely the manager of the Flora Business, will not report as income and will not pay income tax, on the net margin derived during the Transition Period. SCJ-Phils. will, however, report as income the margin turned over by BPI as part of the Net Economic Benefit and pay the income tax thereon. Nevertheless if there is any excess input tax pertaining to the Flora Business at the end of the Transition Period, the same cannot be transferred to SCJ-Phils. considering that the receipts and sales invoices, which are the principal documents that support input taxes, are in the name of Bayer. aTADCE Furthermore, BPI shall withhold and remit to the BIR any expanded/creditable withholding taxes arising from income payments made by BPI to persons in connection with transactions subject to expanded withholding tax and creditable withholding tax pursuant to Revenue Regulations No. 2-98, as amended, pertaining to the operations of the Flora Business. 2. The service fees derived by BPI for its Sales Cycle Transition Services and Inventory Management Services performed for SCJ-Phils. during the Transition Period, are subject to the 32% income tax under Section 27(A) of the Tax Code of 1997 and also to the 10% Value Added Tax (VAT) imposed by Section 108(A), also of the same Code. Moreover, as BPI will be managing the Flora Business for the account of SCJ-Phils. during the Transition Period, the service fees derived by BPI for the Sales Cycle Transition Services and Inventory Management Services shall be subject to 10% expanded/creditable withholding tax pursuant to Section 2.57.2(B) in relation to (A)(6) of Revenue Regulations No. 2-98, as amended. 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 void. Very truly yours, (SGD.) GUILLERMO L. PARAYNO, JR. Commissioner of Internal Revenue