BIR Ruling No. 005-06

March 8, 2006 BIR RULING NO. 005-06 Sec. 50 000-00 SGV & Co . 6760 Ayala Avenue Makati City Attention: Atty. Romulo S. Danao, Jr./Atty. Cirilo P. Noel Tax Services Gentlemen : This refers to your letter dated February 17, 2006 stating that your client, Wyeth Philippines, Inc. (Wyeth) , is a corporation duly organized and existing under and by virtue of the laws of the Philippines; that it is a subsidiary of the New Jersey-based global pharmaceutical and health-care firm which produces various pharmaceutical products, consumer health products, infant formula milk products, and performs research and marketing activities, among others; that in the Philippines, Wyeth produces infant milk formula products; that Wyeth is considering to further invest in the Philippines with the opening of a third dryer in its existing plant located in the Canlubang Industrial Estate in Bo. Pittland, Cabuyao, Laguna; that the third dryer will increase its production capacity for infant formula by approximately 48 million pounds, requiring a capital investment of approximately US$58 Million; that the increased volume in production will be primarily used to meet the growing market demand for infant formula in the Philippines; that the company is also expected to hire about 400 people to construct the new facility and about 150 regular employees to operate the third dryer; that the operation of the third dryer will ultimately help the government, in terms of economic benefits, as it will generate additional revenue estimated to be around P900 million per year; that on August 23, 2005, the Board of Investments (BOI) granted Wyeth pioneer status as a new producer of infant formula, making Wyeth eligible for incentives, including a six-year income tax holiday (ITH) on sales from its registered activities; that the BOI further authorized Wyeth to implement a cost allocation method during the ITH period whereby "only additional costs attributable to the operation of the new facility, the registered activity, shall be charged thereto, while indirect costs incurred even without the new facility and costs otherwise attributable to the existing facility shall be charged to such facility;" that you believe that the adoption of such cost allocation method is reasonable and justifiable because under this method, all additional costs, whether directly or indirectly attributable to the registered activity, shall be charged to such activity, while indirect costs incurred regardless of the existence of the new facility, shall remain charged to the existing facility as they are already incurred even without the new facility and they are not incurred because of the operation of the new facility; that the said cost allocation method is recognized under cost accounting principles; and that the BOI itself likewise supports this methodology and authorizes the use of the same in its letter to Wyeth dated February 9, 2006; that the production output of the existing facility and of the registered or new facility shall be distinguished by the product codes specific to the production output of each facility; that the BOI itself requires Wyeth to, among others, (1) observe the production volume and sales volume for the registered activity as prescribed in the BOI letter; (2) secure its permission before it can expand its capacity, with or without incentives; (3) maintain separate books of accounts for each activity, registered and unregistered with the BOI; (4) submit a list of direct costs attributable to each type of activity for purposes of determining the taxable income of each activity; and (5) submit a quarterly report of actual sales pertaining to the registered activity. Based on the foregoing, you are requesting for a ruling approving the above cost allocation method that Wyeth will adopt for its BOI-registered activity. In reply, please be informed that the Tax Code itself prescribes no hard and fast rule that would guide taxpayers in allocating expenses where the business involves distinct activities like that of Wyeth, i.e., the operation of its existing two spray dryers (which is subject to regular taxation) and the proposed third dryer (which is subject to ITH). It is recognized that no uniform method of accounting can be prescribed for all taxpayers, and the law contemplates that each taxpayer shall adopt such forms and systems as are in his judgment best suited to his purpose ( Section 167, Revenue Regulations No. 2 ). Allocation of costs is essentially an accounting issue, and given that the law does not expressly provide rules that will govern situations like that of Wyeth, the method of allocation adopted, should, at best, be one that is reasonable and justifiable, and is consistently used. Hence, a method of accounting which reflects the consistent application of generally accepted principles in a particular trade or business in accordance with accepted practices in that trade or business ordinarily is regarded as accurately reflecting income ( Mertens, Law of Federal Income Taxation, Volume 2, Chapter 12B.01 ). Moreover, it has been held that the allocation of expenses attributable to exempt and nonexempt income is to be based on all the facts and circumstances ( CCH, Standard Federal Tax Reporter, citing Rev. Reg. 63-27, 1963-1 CB 57 ). In the instant case, the adoption of a cost allocation method, whereby "only additional costs attributable to the operation of the new facility, the registered activity, shall be charged thereto, while indirect costs incurred even without the new facility and costs otherwise attributable to the existing facility shall be charged to such facility" is reasonable and justifiable. This is because under this method, all additional costs, whether directly or indirectly attributable to the registered activity, will be charged to such activity, while indirect costs incurred regardless of the existence of the new facility will remain charged to the existing facility as they are already incurred even without the new facility and they are not incurred because of the operation of the new facility. The use of this method should, however, be consistently used by Wyeth during the ITH period of its registered activity. cHCIEA Moreover, the use of the said cost allocation method is authorized by the BOI. It is noted that the BOI, a co-equal body, is mandated by law to grant fiscal and non-fiscal incentives to pursue the objectives of and implement the investments programs under the Omnibus Investments Code, and the BIR takes cognizance of such mandate ( BIR Ruling No. 064-00 dated November 27, 2000 ). In view thereof, this Office allows Wyeth to use the above cost allocation method during the ITH period of its registered activity. This ruling is issued on the basis of the facts as represented. However, if upon investigation it shall be disclosed that the facts are different, then this ruling shall be without force and effect insofar as the herein parties are concerned. Very truly yours, (SGD.) JOSE MARIO C. BUAG Commissioner of Internal Revenue