Where Author's Work is Essential or Material Component in the Publishing Business, Royalty Paid Could be Taken-Up as Part of Cost of Sales in Financial Statement

December 29, 1997 BIR RULING NO. 145-97 21 (f) 000-00 145-97 Saint Matthew's Publishing 235-Agcor Bldg., Katipunan Ave. Loyola Heights, Quezon City Attention: Mr . Raymund S . Catabijan Gentlemen : This refers to your letter dated February 17, 1997 stating that you are a publishing company whose nature of business is publication of pre-school books nationwide; that you have a very small organization with sales personnel who are all commission-based; that your personnel are given about 10-20% commission for every book sold and this is subject to 5% withholding tax; that likewise, the authors who made the manuscript of the books are given 10% royalty for every book sold and this is subjected to 20% final tax; that commissions and royalties are two of your ordinary and necessary expenses to carry on the business and can be supported by Sales Executive Contracts renewed annually and Royalty Agreements between you and your authors as required by the Copyright Law; that these are common expenses in the publishing industry; and that you are a sole proprietor covered by the Simplified Net Income Tax System (SNITS). Based on the foregoing representations, you are now requesting, in effect, for a ruling as to whether or not you can take up the said expenses in your Financial Statements as part either of your salary and wages or of supplies accounts, whose coverage include anything that enables an existing entity to function properly or as part of cost of sales (Direct Labor). In reply, please be informed that Section 29 of the Tax Code, as amended by R.A. No. 7833, states that in computing taxable income subject to tax under Section 21(f) in the case of individuals engaged in business or practice of profession, only the following costs shall be allowed as deductions: a) Raw materials, supplies and direct labor; b) Salaries of employees directly engaged in activity in the course of or pursuant to the business or practice of their profession; c) Telecommunications, electricity, fuel, light and water; d) Business rental; e) Depreciation; f) Contributions made to the Government and accredited relief organizations for the rehabilitation of calamity stricken areas declared by the President; and g) Interest paid or accrued within a taxable year on loans contracted from accredited financial institutions which must be proven to have been incurred in connection with the conduct of a taxpayer's profession, trade or business. From the foregoing provisions of Section 29 it is clear that in computing income subject to tax under Section 21(f), as in the instant case, only the above enumerated direct costs shall be allowed as deductions. Such being the case, the 10-20% commissions and the 10% royalties which you are paying respectively to your sales personnel and the authors of the books you are publishing could not be taken up in your financial statement as part of "salaries and wages" since only salaries of employees directly engaged in activities in the course of or pursuant to the business or practice of profession are deductible under Section 21(f) of the Tax Code, as amended which presupposes the existence of an employer-employee relationship. Moreover, as a publishing company you could not likewise take up such commissions and royalties (as part of your supplies) since "supplies" is an independent account by itself which can be inventoried and where the supplies used during the taxable period is an expense of the company, part of the overhead operating expense, and the remaining supplies not used during the taxable year form part of the current asset. Furthermore, the said commissions could not also be taken up in your financial statement as part of cost of sales since the same is not an essential component in bringing about your finished product, i.e., books. However in the case of royalties, the same could be taken up in your financial statement as part of cost of sales considering that your author's work is an essential or material component in the publishing business, without the author's work, there would be nothing to publish. Accordingly, since your author's work is essential or material component in the publishing business, the said royalty you are paying your author could thus be taken-up in your Financial Statement as part of cost of sales (direct labor). Very truly yours, LIWAYWAY VINZONS-CHATO Commissioner of Internal Revenue