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K. SPECIAL INCENTIVES

1. Board of Investments (BOI)

Article 39 of ExecutiveOrder (EO) No. 226 otherwise known as the Omnibus

Investments Code of 1987 provides the fiscal incentives for Board of Investments
(BOI)-registered enterprises. However, at the outset, the Group should check first the
specific terms and conditions of its BOI registration.

1.1 Income Tax Holiday:

(1) For six (6) years from commercial operation for pioneer firms and four (4)
years for non-pioneer firms, new registered firms shall be fully exempt from
income taxes levied by the national government. Subject to such guidelines
as may be prescribed by the Board, the income tax exemption will be
extended for another year in each of the following cases:

(i) The project meets the prescribed ratio of capital equipment to number of
workers set by the Board;
(ii) Utilization of indigenous raw materials at rates set by the Board;
(iii) The net foreign exchange savings or earnings amount to at least
US$500,000 annually during the first three (3) years of operation.

The preceding paragraph notwithstanding, no registered pioneer firm may

avail of this incentive for a period exceeding eight (8) years.

(2) For a period of three (3) years from commercial operation, registered
expanding firms shall be entitled to an exemption from income taxes levied
by the national government proportionate to their expansion under such
terms and conditions as the Board may determine: Provided, however, That
during the period within which this incentive is availed of by the expanding
firm it shall not be entitled to additional deduction for incremental labor
expense.

(3) The registered firms shall not be entitled to any extension of this incentive.

Expanding firms shall be entitled to the income tax holiday incentive only to the
extent of their actual increase in production. The rate of exemption from income
tax shall be computed as follows:

Incremental Sales
of the registered
product
Rate of
Exemption = ————————
Total Sales of
the Registered

The term “sales” as indicated in the above formula shall be expressed in volume
in cases of homogeneous products and value in case of heterogeneous products.
In general, modernization or rehabilitation shall not be entitled to income tax

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holiday if indicated in the IPP.

Where the start of commercial operation does not coincide with the first month of
the registered enterprise’s taxable year, the rate of exemption from income tax
shall be computed in the following manner:

(a) Get the total sales for the whole taxable year.
(b) Deduct the base figure from total sales (a) to get the incremental sales.
(c) The rate of exemption is determined by dividing the incremental sales
(b) by total sales (a).
(d) The rate of exemption shall apply only on the total income tax due
arising from sales of the registered product.

The rate of exemption for the last taxable year of availment in the above-
mentioned case shall be computed in the same manner as above except that the
rate of tax exemption shall be applied on the income tax due on the sales during
the months that the enterprise is still entitled to income tax holiday.

For new registered firms, the income tax holiday incentive may be extended for an
extra year for each of the following cases, but in no case to exceed the total
period of eight (8) years for pioneer registered enterprises.

1. If the ratio of the total imported and domestic capital equipment to the
number of workers for the project does not exceed US$10,000 to one (1)
worker.
2. If the average cost of indigenous raw materials used in the manufacture of
the registered product is at least fifty per cent (50%) of the total cost of raw
materials for the preceding years prior to the extension unless the Board
prescribes a higher percentage.
3. If the net foreign exchange savings or earnings amount to at least
US$500,000 annually during the first three (3) years of operation to be
determined by the Board at the end of such three-year period: Provided,
That the foreign exchange savings criterion shall apply as a general rule,
to registered firms whose products are totally imported into the country at
the time of registration and duly indicated as imports substituting in the
firm's certificate of registration.

For purposes of availment of this incentive, the registered firm shall file a letter-
request to the Board applying for the additional period and shall submit proofs of
compliance of the criteria above-indicated.

1.2 Additional Deduction for Labor Expense

For the first five (5) years from registration, a registered enterprise shall be
allowed an additional deduction from the taxable income of fifty percent (50%) of
the wages corresponding to the increment in the number of direct labor for skilled
and unskilled workers if the project meets the prescribed ratio of capital
equipment to number of workers set by the Board: Provided, That this additional
deduction shall be doubled if the activity is located in less developed areas.

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1.3 Tax and Duty Exemption on Imported Capital Equipment and its
Accompanying Spare Parts

New, expanding/modernizing enterprise which have been registered with the BOI
on or before December 31, 1994 shall be exempt to the extent of one hundred
percent (100%) of national internal revenue taxes and customs duties on
importations of machinery, equipment and accompanying spare parts within the
prescribed period under its law of registration or until December 31, 1997,
whichever comes first: Provided, however, That the enterprise which shall
register after December 31, 1994 shall be subject to the provisions of Republic
Act (RA) No. 7716, and three percent (3%) customs duties up to December 31,
1997: Provided, finally, That the importation of machinery, equipment and
accompanying spare parts shall comply with the following conditions:

(1) They are not manufactured domestically in sufficient quantity, or

comparable quality, and at reasonable prices;
(2) They are reasonably needed and will be used exclusively by the registered
enterprise in its registered activity, unless prior approval of the Board is
secured for the part-time utilization of said equipment in a non-registered
activity to maximize usage thereof or the proportionate taxes and duties
are paid on specific equipment and machinery being permanently used for
non-registered activities; and
(3) The approval of the Board was obtained by the registered enterprise for
the importation of such machinery, equipment and accompanying spare
parts.
(4) Subject to reasonable allowance, the rated capacity of the machinery or
equipment to be imported is within the registered capacity of the registered
enterprise.

In granting the approval of the importations under this paragraph, the Board
may require international canvassing but if the total cost of the capital
equipment or industrial plant exceeds US$5,000,000, the Board shall apply or
adopt the provisions of Presidential Decree No. 1764 on international
competitive bidding.

If the registered enterprise sells, transfers or disposes of these machinery,

equipment and spare parts without prior approval of the Board within five (5)
years from date of acquisition, the registered enterprise and the vendee,
transferee, or assignee shall be solidarily liable to pay twice the amount of the
tax exemptions given it. The Board shall allow and approve the sale, transfer
or disposition of the said items until December 31, 1997 or December 31,
1999 as the case may be if made:

(a) To another registered enterprise or registered domestic producer enjoying

similar activities;
(b) For reasons of proven technical obsolescence; or
(c) For purpose of replacement to improve and/or expand the operations of
the registered enterprise

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1.4 Tax Credit on Domestic Capital Equipment

A tax credit equivalent to one hundred percent (100%) of the value of the national
internal revenue taxes and customs duties that would have been waived on the
machinery, equipment and spare parts, had these items been imported shall be
given to the new and expanding enterprise registered with the BOI as of
December 31, 1994 which purchases machinery, equipment and spare parts from
a domestic manufacturer: Provided, (1) That the said equipment, machinery and
spare parts are reasonably needed and will be used exclusively by the registered
enterprise in its registered activity, unless prior approval of the Board is secured
for the part-time utilization of said equipment in a non-registered activity to
maximize usage thereof; (2) That the equipment would have qualified for tax and
duty exemption under paragraph (c) hereof; (3) That the approval of the Board
was obtained by the registered enterprise; and (4) That the purchase is made on
or before December 31, 1997 or December 31,1999 as the case may be. If the
registered enterprise sells, transfers, or disposes of these machinery, equipment
and spare parts, the provision in the preceding paragraph for such disposition
shall apply.

1.5 Tax Credit for Taxes and Duties on Raw Materials

Every registered enterprise shall enjoy a tax credit equivalent to the national
internal revenue taxes and customs duties paid on the supplies, raw materials and
semi-manufactured products used in the manufacture, processing or production of
its export products and forming part thereof: Provided, however, That the taxes
on the supplies, raw materials and semi-manufactured products domestically
purchased are indicated as a separate item in the sales invoice.

Nothing herein shall be construed as to preclude the Board from setting a fixed
percentage of exports sales as the approximate tax credit for taxes and duties of
raw materials based on an average or standard usage for such materials in the
industry.

1.6 Exemption from Taxes and Duties on Imported Spare Parts

Importation of required supplies and spare parts for consigned equipment or those
imported tax and duty-free by a registered enterprise with a bonded
manufacturing warehouse shall be exempt from customs duties and national
internal revenue taxes payable thereon: Provided, however, That such spare
parts and supplies are not locally available at reasonable prices, sufficient quantity
and comparable quality: Provided, finally, That all such spare parts and supplies
shall be used only in the bonded manufacturing warehouse of the registered
enterprise under such requirements as the Bureau of Customs may impose.

1.7 Exemption from Wharfage Dues and Export Tax, Duty, Imposts and Fee

The provision of law to the contrary notwithstanding, exports by a registered

enterprise of its non-traditional export products shall be exempted from any
wharfage dues, and any export tax, duty impost and fee.

Moreover, Article 40 of the E.O 226 provides incentives to Less-Developed-Area

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Registered Enterprises. A registered enterprise regardless of nationality located

in a less-developed-area included in the list prepared by the Board of Investments
after consultation with the National Economic & Development Authority and other
appropriate government agencies, taking into consideration the following criteria:
low per capita gross domestic product; low level of investments; high rate of
unemployment and/or underemployment; and low level of infrastructure
development including its accessibility to developed urban centers, shall be
entitled to the following incentives in addition to those provided in the preceding
article:

1.8 Pioneer Incentives

An enterprise in a less-developed-area registered with the Board, whether

proposed, or an expansion of an existing venture, shall be entitled to the
incentives provided for a pioneer registered enterprise under its law of
registration.

1.9 Incentives for Necessary and Major Infrastructure and Public Utilities

Registered enterprises establishing their production, processing or manufacturing

plants in an area that the Board designates as necessary for the proper dispersal
of industry or in an area which the Board finds deficient in infrastructure, public
utilities, and other facilities, such as irrigation, drainage or other similar
waterworks infrastructure may deduct from taxable income an amount equivalent
to one hundred percent (100%) of necessary and major infrastructure works it
may have undertaken with the prior approval of the Board in consultation with
other government agencies concerned; Provided, That the title to all such
infrastructure works shall upon completion, be transferred to the Philippine
Government: Provided, further, That any amount not deducted for a particular
year may be carried over for deduction for subsequent years not exceeding ten
(10) years from commercial operation.

1.10 Rules and Regulations in the Availment of ITH

For the revised guidelines in the availment of ITH, please see Annex L.

1.11 Conditions for the Availment of Incentives in General

a. Compliance with Obligations. — The enterprise shall observe and abide by the
provisions of the Code and its implementing rules and regulations, and take
adequate measures to ensure that its obligations thereunder as well as those
of its officers, employees, and stockholders are faithfully discharged.

b. Compliance with Directives. — The enterprise shall comply with the directives
and instructions which the Board may issue from time to time in pursuance of
its authority under the law.

c. Visitorial Powers. — The enterprise shall allow the duly authorized

representatives of the Board to inspect and examine its books of accounts and
other pertinent records and documents to ascertain compliance with the Code
and its implementing rules and regulations, and the terms and conditions of its

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registration.

d. Taxes and Duties Waived. — Registered enterprises shall submit to the Board
of Investments certified true copies or xerox copies of all papers or documents
evidencing their availment of incentives such as taxes, duties, charges, fees or
dues as determined and computed by the Bureau of Internal Revenue, Bureau
of Customs, or government agency concerned, of which said enterprises are
exempt from payment thereof under the Code. Said papers or documents
should be submitted within fifteen (15) days after official action thereon by the
government agency concerned has been completed.

e. Delinquent Enterprises. — No availment of incentives may be allowed an

enterprise delinquent in compliance with any of the terms and conditions of
registration, including such reports and statistical data which may be required
by the Board.

1.12 Submission of Reports and other Documents

Every registered enterprise shall, for each preferred area of investment, submit to
the Board the following reports and/or documents within the time herein
prescribed:

(a) Amendment of articles of incorporation or by-laws – within thirty (30) calendar

days from the date of registration of said amendments with the Securities and
Exchange Commission;

(b) Replacement of any director or other principal officers, with an indication of the
nationality of each new officer, and accompanied by a copy of his certificate of
citizenship, if a naturalized Filipino – within thirty (30) calendar days after said
replacement;

(c) List of alien officers and employees, their nationalities and positions, together
with a copy of its plantilla – within the month of January every year;

(d) If the enterprise has alien employees discharging supervisory, technical or

advisory functions, its programs for training Filipinos in said functions – within
thirty (30) calendar days from registration of the enterprise; otherwise, within
thirty (30) calendar days from the date the alien employee was employed;

(e) Report on the implementation of the above training program – within the
month of June every year;

(f) Change of address or principal place of business – within ten (10) calendar
days after such change;

(g) Change of its authorized representative to the Board – within ten (10) calendar
days after such change;

(h) Notice of the date the enterprise began operation – within ten (10) calendar
days from said date;

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(i) Notice of projected investment abroad – not later than thirty (30) calendar
days before any such investment is made;

(j) Income tax returns – thirty (30) calendar days from the filing thereof;

(k) Audited annual financial statements, viz.: (1) profit and loss statement; and (2)
balance sheets – one (1) month from date of filing with the Bureau of Internal
Revenue of the annual income tax return for the preceding calendar/fiscal
year;

(l) Quarterly production and sales report – one (1) month after the end of each
quarter;

(m) Form S-1 – January 31 of each year;

(n) Chart of Accounts – Three (3) months after issuance of certificate of

registration;

(o) Statement of the total peso value of incentives availed of under the Code
during the previous calendar year – not later than January 31 of the current
year;

(p) The enterprise shall submit to the BOI an environmental compliance certificate
(ECC) from the E.I.A. System from time to time, as may be required by the
BOI after sufficient notice.

1.13 Non-Registered Activities

An enterprise engaged or proposing to engage in non-registered activities shall

install an adequate accounting system segregating the investments, revenues,
sales, receipts, purchases, payrolls, costs, expenses and profits and losses of its
registered operations from those of its non-registered domestic and export
operations; or the Board may, in appropriate cases, require the establishment of a
separate entity for the registered activity in order to facilitate the proper
implementation of the Omnibus Investment Code.

1.14 LBT Exemption under the Local Government Code (LGC)

LBT Exemption

Pursuant to Section 133 (g) of the LGC in relation to Local Finance Circular (LFC) No. 5-
931, BOI-registered enterprises are entitled to LBT exemption, as follows:

 Pioneer firms - Six (6) years from date of registration

with BOI
 Non-pioneer firms - Four (4) years from date of registration
with BOI
1 LFC No. 5-93 prescribes the limitations, manner, and procedures for the imposition of LBT on BOI-registered
enterprises as provided under Section 133 (g) of the LGC.

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The foregoing incentives shall apply both for new registered activity and expansion. For
purposes of these incentives, LFC No. 5-93 adopted the definitions of “pioneer
enterprise”, “non-pioneer enterprise”, and “expansion” under Article 17, 18 and 19,
respectively, of EO 226.

Availment of Exemption

To avail of the foregoing incentives under Section 133 (g) of the LGC and LFC No. 5-93,
the registered firm must submit within sixty (60) days from the receipt of the Certificate of
Registration from the BOI a certified-true copy of such Registration Certificate to the local
treasurer concerned, together with the request for a Certificate of Exemption for the
appropriate period.

Moreover, LBT exemption shall commence from the date of the Group’s registration with
the BOI and not from the start of commercial operations (SCO). [G.R. Nos. 152675 and
152771 dated April 28, 2004]

2. Philippine Economic Zone Authority (PEZA)

2.1 Income Tax Holiday (ITH)

Upon registration with the Philippine Economic Zone Authority (PEZA), the Group is entitled
to Income Tax Holiday pursuant to Section 6 (A)(1) Rule XV of the PEZA IRR which
provides, viz:

“SECTION 6. Other Incentives under the Code

A. Income Tax Holiday

1. Period of Availment - New ECOZONE Export or Free Trade Enterprises shall

be fully exempt from income taxes levied by the National Government for the
period as follows:

(a.) New Registered Pioneer Firms - Six (6) years from commercial
operations.
(b.) New Registered Non-Pioneer Firms - four (4) years from commercial
operations.
(c.) Expanding Firms - Three (3) years from commercial operation of the
expansion.”

Moreover, the same IRR provides that the income tax holiday incentive may be extended for
an extra year in each of the of the following cases but not to exceed a total of eight (8) years
for pioneer registered enterprises:

a. If the ratio of the total imported and domestic capital equipment to the number of
workers for the project does not exceed US$10,000 to one worker, or as prescribed
by the Board;
b. If the average cost of indigenous raw materials used in the manufacture of the
registered product is at least fifty percent (50%) of the total cost of raw materials for
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the preceding years prior to the extension unless the Board prescribes a higher
percentage;
c. If the net foreign exchange savings or earnings amount to at least US$500,000
average annually during the first three (3) years of operations to be determined by
the Board at the end of such three-year period: Provided, That the foregoing foreign
exchange savings criterion shall apply, as a general rule, to ECOZONE Export or
Free Trade Enterprises whose products are totally imported into the country at the
time of registration and duly indicated as imports substation in firm’s approved project
proposal.

For the purpose of availment of this incentive, the ECOZONE Export or Free Trade
Enterprise shall apply in writing to PEZA for the additional period and shall submit proof of
compliance with the criteria above-mentioned.

2.2 5% Gross Income Tax (GIT)

Upon the expiration of the Group’s ITH incentive on its PEZA-registered activities, the Group
shall be subject to 5% GIT, in lieu of the payment of national and local taxes as provided in
Section 4 of RA No. 8748, amending Section 24 of the RA No. 7916 (also known as “The
Special Economic Zone Act of 1995”) and Rule XX of the Rules and Regulations to
Implement RA 7916.

Section 24 of the RA No. 7916 (as amended by RA No. 8748):

“SECTION 24. Exemption from National and Local Taxes. — Except for real property
taxes on land owned by developers, no taxes, local and national, shall be imposed on
business establishments operating within the ECOZONE. In lieu thereof, five percent
(5%) of the gross income earned by all business enterprises within the ECOZONE shall
be paid and remitted xxx”

In addition, PEZA Memorandum Circular No. 2004-024 dated September 24, 2004 also
provides as follows:

“xxx 3. PEZA-registered economic zone enterprises availing of the 5% GIT Incentive are
exempted from payment of all national and local taxes, except real property tax on land
owned by developers.

Legal Basis:

Republic Act No. 7916: “The Special Economic Zone Act of 1995”, as amended by R.A.
No. 8748

Section 24. Exemption from National and Local Taxes. Except for real property taxes
owned by developers, no taxes, local and national, shall be imposed on business
establishments operating within the ECOZONE. In lieu thereof, five percent (5%) of the
gross income earned by all business enterprise within the ECOZONE shall be paid and
remitted. . .x x x. . .

Bureau of Internal Revenue’s Revenue Regulations No. 12-97: “Regulations

Implementing Section 24 of RA 7916 defines “local taxes”

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i. “Local Taxes” – shall refer to all local taxes, business taxes, real estate taxes, and
other taxes, fees and charges imposed by local government units pursuant to the Local
Government Code of 1991, as amended.”

PEZA issues Certificates of Incentives upon the request of registered economic zone
enterprises.

For the information and guidance of all concerned.”

Accordingly, once under the 5% GIT regime, the Group may be exempt from the following
taxes:

a. Value Added Tax (VAT)

b. Documentary Stamp Tax (DST)
c. Local Business Tax (LBT)
d. Other taxes, fees charges imposed by local government units
e. Real Property Tax (RPT) (Except on land owned by developers)

Please see detailed discussion on exemption from other taxes on pages K-44 to K-
48.

With respect to the venue for payment of the 5% GIT due, Section 24 of RA No. 7916 (as
amended by Section 4 of RA No. 8748) provides that the 5% GIT shall be paid and remitted
as follows:

(a) Three percent (3%) to the National Government;

(b) Two percent (2%) which shall be directly remitted by the business establishments to
the treasurer's office of the municipality or city where the enterprise is located.

Moreover, Section 3 of RR No. 1-00 dated November 12, 1999 provides that in case the
Special Economic Zone (ECOZONE) is situated and encompasses the territorial jurisdiction
of more than one (1) city or municipality, the share of each city or municipality from the 2%
special tax paid by ECOZONE enterprises shall be determined in accordance with the
implementing PEZA regulations on the subject.

Rule XX, Section 1 (c) of the PEZA IRR provides:

“SECTION 1. Special Tax Rate. — Pursuant to Section 24 of the Act, ECOZONE

Enterprises, except ECOZONE Service Enterprises, shall, in lieu of payment of
national and local taxes, be liable to the payment of a five per cent (5%) final tax on
gross income earned which shall be distributed as follows:

(a) 3% to the National Government;

(b) 1% to the Local Government Units affected by the declaration of the ECOZONE
to be distributed in proportion to their population, land area, and equal sharing
factors; and

(c) 1% for the establishment of a development fund to be utilized for the

development of municipalities outside and contiguous to each ECOZONE:

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Provided, That the respective share of the affected local government unit shall be
determined on the basis of the following formula:

Population - 50%
Land area - 25%
Equal sharing - 25%”

In addition, RR No. 1-00 dated November 12, 1990 provides:

“SECTION 3. Rules of Apportionment. — In case the Special Economic Zone

(ECOZONE) is situated and encompasses the territorial jurisdiction of more than one
(1) city or municipality, the share of each city or municipality from the 2% special tax
paid by ECOZONE enterprises shall be determined in accordance with the
implementing PEZA regulations on the subject. The Philippine Economic Zone
Authority (PEZA) shall issue certification as to the exact share of the concerned cities
or from the 2% tax as allocated under the implementing rules of PEZA.”

a. “Gross Income” defined

Rule 1, Section 2 (nn) of the PEZA IRR defines gross income as follows:

“Gross income” for purposes of computing the special tax due under Section
24 of the Act refers 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 expenses or incidental losses during a given taxable
period. The allowable deductions from 'gross income' are specifically
enumerated under Section 2, Rule XX of these Rules.”

Moreover, RR No. 11-2005 defines “Gross Income Earned” and provides for the following
allowable deductions:

“SECTION 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 cost of sales or directs costs but
before any deduction is made for administrative, marketing, selling and/or operating
expenses or incidental losses during a given taxable period.”

b. Gross Sales or Revenues

There is an issue on whether the term “gross sales/revenues” should only include
sales of the products/services specifically covered by the Group’s registered activities
or whether the term is broad enough to include income items which may not be
directly attributable to the registered activities of the Group (i.e. realized forex gains,
scrap sales, interest income, etc.). The following views may be considered in the
interpretation of the term gross sales or revenues for 5% GIT purposes:

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First View

The term gross sales or revenues may be limited only to those items that are directly
derived from the Group’s PEZA registered activities.

Rule XIII, Section 5 of the PEZA IRR provides that the incentives granted by the
PEZA shall only apply to the registered operations of the ECOZONE enterprise.
Thus, the term “gross sales/revenues” may only be limited to the income items
derived from the Group’s registered activities. In this regard, all other income (net of
allowable deduction), not covered by the Group’s PEZA registered activities (e.g.,
income from sale of scraps) may be subject to the 30% RCIT/2% MCIT or some other
applicable tax regime.

However, Section 1 of RR No. 20-02 dated October 14, 2002 provides as follows:

“SECTION 1. Tax Treatment. – Income derived by an enterprise registered with

the Subic Bay Metropolitan Authority (SBMA), the Clark Development Authority
(CDA), or the Philippine Economic Zone Authority (PEZA) from its registered
activity/ies shall be subject to such tax treatment as may be specified in its
terms of registration (i.e., the 5% preferential tax rate, the income tax holiday, or
the regular income tax rate, as the case may be). Nonetheless, whatever the
tax treatment of said enterprise with respect to its registered activity/ies, income
realized by such registered enterprise that is not related to its registered
activity/ies shall be subject to the regular internal revenue taxes, such as the
20% final income tax on interest from Philippine Currency bank deposits and
yield or any other monetary benefit from deposit substitutes, and from trust
funds and similar arrangements, the 7.5% tax on foreign currency deposits and
the 5%/10% capital gains tax or ½ % stock transaction tax, as the case may be,
on the sale of shares of stock.”

Note that based on this provision, income derived by a PEZA enterprise from
activities not related to the registered activities shall be subject to the regular internal
revenue taxes. Accordingly, it can be inferred that the 5% GIT shall apply to income
derived from registered activities as well as to income derived from activities related
to such registered activities.

Black’s Law Dictionary defines the term “related” as standing in relation; connected;
allied; akin. The term “incident” on the other hand, when used as a noun, denotes
anything which is usually connected with another, or connected for some purposes,
though not inseparably.

From the foregoing definitions, it may be argued that when an activity results as an
incident to the main activity, said activity is also related to the registered activity.
Accordingly, the 5% GIT may arguably cover also income arising from activities
related to or incidental to the registered activity of the Group.

This construction is consistent with several decisions of the Court wherein it was
consistently held that when an activity is related to or incidental to the main activity, it
is not ordinarily taxed as an independent business itself.

The Supreme Court in the case entitled Standard Vacuum Oil Co. vs. Antigua, et al.,

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No. L-6931, April 30, 1955 (96 Phil. 909), ruled:

“In conclusion, we hold that when a person or company is already taxed on its
main business, it may not be further taxed for doing something or engaging in
an activity or work which is merely a part of, incidental to and is necessary to its
main business.”

In the cases of Insular Life Assurance Co., Ltd., vs. Commissioner of Internal
Revenue, CTA Case No. 2336, and Filipinas Life Assurance Company vs.
Commissioner of Internal Revenue, CTA Case No. 2337, both dated November 12,
1973, the Court of Tax Appeals had the occasion to rule:

“We have had occasion to express the same view. . . . Where the law taxes a
business, it is presumed to be the legislative intent not to separately tax every
activity which is merely incidental or necessary to the conduct of said business.”

Moreover, in Atlas Consolidated Mining and Development Corporation v.

Commissioner of Internal Revenue (CTA Case No. 2778), dated February 16, 1988,
the Court held as follows:

“Where a person or corporation is engaged in a distinct business and, as a

feature thereof, in an activity merely incidental which serves no other person or
business, the incidental and restricted activity is not to be considered as
intended to be separately or additionally taxed.” (Standard-Vacuum Oil, Co. vs.
Antigua, 96 Phil. 909, citing Craig vs. Ballard & Ballard Co., 196 Sc. 238.)
Accordingly, we hold that since petitioner Atlas Consolidated Mining &
Development Corporation has already been taxed on its copper mining
operation, it may not be further taxed for doing something or engaging in an
activity or work of digging out limestone and processing it into lime which merely
a part is of and incidental to the production of copper concentrates.”

Foregoing considered, it may be argued that the 5% GIT may arguably also cover
income derived from activities incidental and/or related to the registered operations of
the Group.

What is incidental?

The term “incidental” means something necessary, appertaining to, or depending

upon another, which is termed the principal, something incidental to the main
purpose. (Davis v. Pine Mountain Lumber Co., 273 C.A.2d 218, 77 Cal. Rptr. 825).
Moreover, as cited in the case of Magsaysay Lines, Inc., et. al. vs. Commissioner of
Internal Revenue (CTA Case No. 4353 dated April 27, 1992), the term “incidental”
means depending upon or appertaining to something else as primary; something
necessary, appertaining to, or dependent upon another which is termed the principal.
[The Robin Goodfellow, D.C. Wash., 20 F2d 924, 925T; cited in Words and Phrases,
Vol. 20, p. 419 (1940)].

In the case of De la Rama Steamship Co. vs. Comm. of Internal Revenue, CTA Case
No. 1499, dated March 5, 1967, an incidental transaction is characterized to be as
“where something is done as mere incident to, or as a necessary consequence of the
principal business, it is not ordinarily taxed as an independent business itself. What is

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usually taken as essential is the main activity in which the taxpayer is engaged. All
the various transactions tending to better accomplish the principal end in view must
be treated as merely incidental.”

The case of Atlas Consolidated Mining and Development Corporation vs.

Commissioner of Internal Revenue (CTA Case No. 2778), dated February 16, 1988
may be helpful in interpreting the word incidental. In said case, Atlas is engaged in
the mining of copper ore from its mines property and concessions. In the process
thereof, it has to dig away and remove all the surface top materials consisting of
limestone, top soil and rocks to reach into the copper ore deposits found below. The
limestone is used as a flotation agent in the conversion of the copper rocks into
concentrates, which are then exported to Japan for processing into copper cathodes
and rods. Petitioners question whether or not limestone dug out and processed into
lime used in the production of copper concentrates is subject to ad valorem tax as a
mineral or mineral product.

The Court held that it seems clear beyond doubt that the utilization of waste limestone
by Atlas, which is engaged in mining copper ore, by converting such waste into lime
as a cleansing reagent in the conversion of copper ore into copper concentrate, was
merely incidental to its copper ore mining operation for which it is adequately taxed.
Petitioners therefore were not liable for ad valorem tax on said incidental activity.

In Manila Mandarin Hotels, Inc., petitioner, vs. Commissioner of Internal Revenue,

respondent, CTA Case No. 5046 dated March 24, 1997, the petitioner is engaged in
business as a hotel and restaurant operator. The respondent assessed petitioner for
deficiency VAT based on the gross selling price of transportation equipment sold by
petitioner in 1988. The transportation equipment was used by petitioner in its catering
business which business is already subject to the 4% caterer’s tax. In ruling for the
petitioner, the CTA, citing the cases earlier stated, held as follows:

“xxx

Now with respect to the sale of transportation equipment it is noteworthy to

point that the asset sold has been fully depreciated and is connected with the
catering business of petitioner. Considering further, that the catering business is
already subject to the caterer's tax under the other percentage taxes in Title V
of the Tax Code, the same should not be subject to the VAT. xxx”

From the foregoing, it appears that incidental income may include those income
derived from activities conducted as an offshoot or consequence of the registered
activity, that is, in the absence of the principal activity, the transaction giving rise to an
income would not have taken place at all. Accordingly, it may be argued that income
derived by the Group as a mere incident to its registered activity may be covered by
the 5% GIT regime.

Second View

On the other hand, gross sales/revenues may be broadly viewed as all encompassing
to include all income items derived from the activities within the zone, regardless of
whether these are related or not to the registered activity. This view is based on the
literal interpretation of the definition of “Gross Income” in Rule 1, Section 2 (nn) of the

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IRR, which states as follows:

“nn. “Gross Income” for purposes of computing the special tax due under
Section 24 of the Act refers to gross sales or gross revenues derived from
business activity within the ECOZONE for 5% GIT purposes.”

Further, Section 2 of RMC No. 74-99 provides as follows:

“SECTION 2. Background. — In general, enterprises registered and

operating under the said Act, otherwise known as ECOZONE or PEZA-
registered enterprises, shall only be imposed with a 5% special tax, based on
“gross income earned” in lieu of all taxes, except the real property tax. However,
this tax incentive only applies in respect of the registered enterprise's operations
within the ECOZONE. The ECOZONES “are selected areas with highly
developed or which have the potential to be developed into agro-industrial,
industrial tourist/recreational, commercial, banking, investment and financial
centers. xxx”

Thus, it may be argued that all other income (net of allowable deduction), even if not
specifically covered by the Group’s PEZA registered activities, but which arise from its
operations within the ECOZONE may also be considered in the computation of the
5% GIT.

Moreover, as discussed in the first view, it may further be argued that income derived
from activities which are incidental to the Group’s operations within the ECOZONE
are likewise covered by the 5% GIT regime.

To date we are not aware of any BIR or PEZA regulation or ruling clarifying which of
the two views discussed earlier should be adopted.

The first view is adopted for purposes of determining what items of revenue could be
subject to the 5% GIT. This position may be supported by RR No. 20-2002 dated
October 12, 2002 as discussed on page D-12.

c. Evaluation of Other Income Items

The following discussion will be based on the first view, that is, only income derived
from the Group’s registered activity/ies, and those incidental or related thereto, are
subject to the 5% GIT. This view is more conservative than the second view. Should
the Group wish to adopt the second view, it may be prudent to secure a BIR ruling to
protect its position.

i. Scrap Materials

As a general rule, sale of scrap is not part of the registered activities of the PEZA-
registered enterprise. Hence, the Group’s sale of income (net of allowable deduction)
from the sale of scrap materials may be subject to 30% RCIT/2% MCIT (or any other
applicable tax regime)2 strictly construing to Rule XIII, Section 5 of the PEZA IRR on
the interpretation of “gross income”.
2 Unless the context requires otherwise, reference to 30% RCIT/2% MCIT also includes all other applicable tax
regimes (e.g., 20% final tax on certain passive income, etc.)
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In Nidec Copal Philippines Corporation (Nidec) vs. Commissioner of Internal

Revenue, CTA Case No. 6577 dated September 25, 2006, Nidec argued that the
scrap materials sold came from the manufacture of registered products; hence, the
income therefrom is incidental to and necessarily connected with its registered activity
subject to the preferential tax rate of 5%. However, the Court ruled that the income
from the sale of scrap of Nidec is subject to the normal income tax pursuant to
Section 8, Rule VIII, Part V of the PEZA Rules which provides that rejects, seconds
and recoverable wastes shall, when taken from the restricted areas of the
ECOZONES to the customs territory, or to the non-restricted areas of the ECOZONE,
be taxed in accordance with the applicable provisions of the customs and internal
revenue laws and regulations of the Philippines. The Court provided that “Scrap” is a
term used to describe manufactured articles or parts rejected or discarded and useful
only as material for reprocessing, especially waste and discarded metal (Webster’s
New Collegiate Dictionary, 1977 edition), in other words, these scrap materials are
recoverable wastes.

However, PEZA Memorandum Circular No. 2005-032 dated September 14, 2005
provides, viz:

“1. All local sales shall be subject to applicable duties and taxes (including
VAT) prior to withdrawal thereof from the Ecozone;

2. For purposes of entitlement to income tax incentives (Income Tax Holiday

or 5% Gross Income Tax), the following shall apply:

a. Sale of production “rejects” and “seconds” from the registered activity of the
Export Enterprise shall be considered covered by the registered activity of
said Enterprise. Thus, any income derived therefrom shall be covered by
the applicable income tax incentive, i.e., Income Tax Holiday or 5% Gross
Income Tax.

b. Sale of recovered waste/scrap generated from processing of raw materials,

including used packaging materials and other direct/indirect
materials/supplies that have undergone processing/which have been used
in production/processing activity registered with PEZA shall likewise be
considered covered by the registered activity of an Export Enterprise. Any
income derived therefrom shall likewise be covered by the applicable
income tax incentive.

c. Sale of unprocessed, unused, obsolete or “off-specs” production inputs

(direct/indirect materials/supplies) shall not be covered by the registered
activity of an Ecozone Enterprise. Thus, any income derived therefrom
shall be subject to normal corporate income tax, provided that the related
cost shall be deducted only once for purposes of computing income.”

In BIR Ruling DA-071-08 dated February 6, 2008, Co. T, a PEZA-registered

enterprise engaged in the business of manufacturing goods such as molds and
plastic products and to trade the same on wholesale, requested for an opinion as to
whether its sale of scrap molds and plastic products arising from the manufacture of
its products is subject to the 5% GIT. As represented, it is inevitable that

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occasionally, in the course of manufacturing the above-mentioned products, certain

molds and plastic products would not meet the specific quality and standard required
to be sold as finished goods, hence they are regarded as rejects or scraps and that
these scrap item sales represent an estimated three percent (3%) of Co. T’s
registered revenue.

The BIR opined that the process of manufacturing its product is a registered activity
for which Co. T was authorized to engage in. The reject or scrap items which
inevitably arise at a certain stage of its registered activity are incidental to such
activity. They are merely by-products of the same registered activity and do not arise
as a result of a separate manufacturing process. The reject or scrap items are part of
the same manufacturing process that arise given the physical and mechanical
limitations of the machines used in the registered manufacturing operations.
Therefore, these scraps are the by-products of one and the same manufacturing
process which produces the finished goods.

The same ruling defined the term “Rejects/Seconds” as finished or semi-finished

products or raw materials which are defective or inferior in quality, such that any
further processing or manipulation thereof is not technically or economically feasible
for the purpose for which they are originally intended. [Sec. II (bb), Rule I,
Implementing Rules]

Further, the BIR ruled that since the manufacturing of Co. T’s product is a registered
activity and the reject or scrap items only inevitably resulted at a certain stage, the
sale thereof will definitely fall under the registered activity. Accordingly, the sale of
these scrap or reject items constitutes acts connected with the registered activity for
which Co. T was given authority to do business by PEZA entitled to the 5%
preferential tax rate on the sale of reject or scrap items.

Thus, gains from the sale of scrap materials may arguably qualify as incidental to its
PEZA-registered products/services (i.e., inevitably arise at a certain stage of the
Group’s registered activity) subject to 5% GIT.

ii. Foreign Exchange (Forex) Gains/Losses

Taxability of forex gains and forex losses

Forex gains/losses can only be recognized for tax purposes when they are actually realized.
Please refer to detailed discussion on the taxability of forex gains and losses in General
Issues A-17.

Tax rate applicable to realized forex gains/losses

(1) Realized forex gains from activities directly related to the PEZA-registered
activities

PEZA Memorandum Circular No. 32-2005 dated September 15, 2005 clarified the
treatment of gains on foreign exchange transactions for PEZA registered enterprises
as follows:

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“The tax treatment of foreign exchange (forex) gains shall depend on the
activities from which these arise. Thus, if the forex gain is attributed to an
activity with income tax incentive (Income Tax Holiday or 5% Gross Income
Tax), said forex gain shall be covered by the same tax incentive. On the other
hand, if the forex gain is attributed to an activity without income tax incentive,
such gain shall likewise be without tax incentive, i.e., therefore subject to normal
corporate income tax.”

With respect to what may be considered attributable to registered activities, in BIR

Ruling DA-375-08 dated June 20, 2008, the BIR ruled that the following foreign
exchange gains realized by Co. S are directly attributable to its PEZA-registered
activity which is the design, manufacture and sale of electronic products, and
therefore subject to 5% GIT. In said ruling, Co. S requested clarification on the
income tax treatment of the following transactions:

1. Realized forex gains on Trade Payables and Receivables

Trade payables were described as those related to purchase of raw materials

used in production. On the other hand, trade receivables are those related to
the sales of Co. S’ products.

2. Realized forex gains from non-trade payables

a. Spot Cash Trading

This was described as the difference between the deal or agreed rate with the
banks and the rate in the SAP system at the time of the spot transaction. Co.
S buys or sells foreign currencies from the bank to meet the needs of Co. S for
payment of costs directly attributable to the PEZA-registered activity such as
purchase of production machineries.

b. Forward Cash Transactions

This results from the difference between the future agreed rate and the actual
system rate at time of settlement of the liability. Co. S covers all open
positions at month-end by entering into forward transactions.

c. Non-trade Payables

This relates to payment of non-trade payables like purchase of production

supplies, machineries and equipment, office supplies, utilities, janitorial and
security services, consultant fees, and all other purchases except purchase of
raw materials.

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In this regard, the BIR ruled thus:

 The difference in the foreign currency translation of costs and sales directly
attributable to the registered activity of Co. S shall be considered in the
computation of its gross income subject to the incentives provided under the
PEZA Law. Given that the business of Co. S is the design, manufacture and sale
of electronic products, it is quite apparent that realized gains arising from trade
payables and trade receivables are attributable to Co. S’ registered activity and
are thus covered by the 5% GIT incentive.

 With respect to the realized forex gains from spot cash transactions and forward
cash transactions, however, only those gains arising from liabilities related to
production (i.e. the purchase of production machineries), may be covered by the
preferential tax regime.

 In the same manner, the tax treatment of realized gains arising from non-trade
payables depends on the nature of the cost from which the gains arose. Thus, if it
is a cost related to production, the realized gain arising therefrom shall be covered
by the income tax incentive (i.e. income tax holiday and/or 5% gross income tax,
whichever is applicable) granted by PEZA to Co. S.

 In the case of Co. S, the foreign currency translation arose from the sale of their
electronic products and from liabilities incurred by the Company which are directly
attributable to the registered activity of the Company, such as those relating to,
among others, the procurement of raw materials, production equipment and
supplies. It is worthwhile to mention that Co. S’ situation is distinct from foreign
exchange gain or loss resulting from foreign denominated loans which was
consistently held as not forming part of the registered activity of the PEZA
company, considering that there was no nexus between the transaction giving rise
to the foreign exchange gain or loss and the PEZA entity's registered activity (BIR
Ruling DA-166-04 dated April 5, 2004; BIR Ruling DA-209-06 dated April 5, 2006).

 Accordingly, the realized gains arising the aforementioned transactions that are
directly attributable to the registered activity of Co. S shall be covered by the tax
incentives, provided that if the realized gain arises from settlement of Co. S
liabilities, such gain is attributable to expenses or costs directly connected to the
registered activity of Co. S.

In BIR Ruling No. DA-195-08 dated March 25, 2008, the BIR ruled that realized forex
gains for payment of payroll, rent and utilities are subject to ITH/5% GIT, as
applicable. We quote:

“In the instant case, the difference in the foreign currency translation of costs
directly attributable to the registered activity of Co.T shall be considered in the
computation of its gross income subject to the incentives provided under the
PEZA Law. Given that the business of Co. T covers voice-based customer
service, sales and technical support, its ability to meet its primary obligations to
its employees and lessors and service providers for communication, light and
water, are its most basic liabilities, without which Co. T will not be able to
operate. Therefore, the aforementioned difference resulting from the said
transactions should be regarded as subject to the preferential tax regime given
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by PEZA to Co. T.

xxx

xxx In the case of Co. T, the foreign currency translation arose from liabilities
incurred by the company which are directly attributable to the registered activity
of Co. T, such as those relating to, among others, the payment of employee
salaries, rentals, and utility payments.

Accordingly, the gain in the foreign currency translation of costs arising from the
settlement of its liabilities directly connected to the registered activity of Co. T as
well as the implementation of the foreign currency hedging program, which is
intended to address the adverse effects of foreign currency fluctuations, as well
that arising from the settlement of liabilities, shall be covered by the tax
incentives (i.e., income tax holiday and/or 5% gross income tax, whichever is
applicable) granted by PEZA to the said company, provided that such difference
is attributable to expenses directly connected to the registered activity of Co. T;
xxx”

Based on the foregoing, the Group’s realized forex gains may be covered by its 5%
GIT/ITH incentive if the related receivables and payables arose from activities that are
also covered by the 5% GIT/ITH incentive (i.e., costs incurred in relation to the
registered activity).

However, in BIR Ruling DA-166-04 dated April 5, 2004, the BIR held that the foreign
exchange gain derived by Co. A, a PEZA-registered enterprise enjoying ITH, which
arose from the sale of machineries and equipments and was due to the foreign
exchange translation of the US Dollar denominated book value in Pesos of the
machineries and equipment is subject to 32% (now 30%) RCIT.

Moreover, the BIR consistently held in BIR Ruling DA-209-06 dated April 5, 2006 to
the effect that gain resulting from the foreign exchange translation of the book value
of foreign currency denominated loan into Philippine Peso, which was realized upon
actual conversion of the loan receivable from an affiliate company into equity, is
subject to 32% (now 30%) RCIT. This ruling involved a PEZA-registered enterprise
enjoying ITH.

Note that BIR Rulings DA-166-04 and DA-209-06 were issued before BIR Rulings
DA-375-08 and DA-195-08 on pages K-17 and K-19, respectively. Nevertheless,
there is a risk that the forex gains from non-trade transactions (e.g., forex gains from
sale of machineries and equipment) may be subject to 30% RCIT.

(2) Realized forex gains not considered attributable to PEZA-registered activities

In BIR Ruling No. DA-375-08 dated June 20, 2008 and DA-195-08 dated March 25,
2008, the BIR stated that:

“xxx S's situation is distinct from foreign exchange gain or loss resulting from
foreign denominated loans which was consistently held as not forming part of
the registered activity of the PEZA company, considering that there was no
nexus between the transaction giving rise to the foreign exchange gain or loss

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and the PEZA entity's registered activity (BIR Ruling DA-166-04 dated April 5,
2004; BIR Ruling DA-209-06 dated April 5, 2006). xxx”

Hence, it is clear that realized forex gains from the settlement of foreign currency
denominated loans will not be covered by the 5% GIT/ITH, but will instead be covered
by 30% RCIT / 2% MCIT.

(3) Realized forex losses

From activities considered attributable to the Group’s PEZA-registered activities

Rule I, Section 2 (nn) of the PEZA IRR defines gross income as follows:

“Gross income’ for purposes of computing the special tax due under Section 24
of the Act refers 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 expenses or incidental losses during a given taxable period. The
allowable deductions from 'gross income' are specifically enumerated under
Section 2, Rule XX of these Rules.”

The above definition specifically states that incidental losses incurred during a given
taxable period may not be deducted for purposes of computing gross income subject
to the 5% GIT. In this regard, in light of PEZA Memorandum Circular No. 32-2005, it
may be argued that realized forex losses from receivables/payables in connection
with an activity subject to 5% GIT will be considered incidental to such activity. Thus,
the realized forex losses may be considered incidental losses, and may not be
allowed as a deduction for 5% GIT.

Moreover, in BIR Ruling Nos. DA-375-08 dated June 20, 2008 and DA-195-08 dated
March 25, 2008, the BIR held that any realized forex loss arising from other registered
activities, which are entitled to an income tax holiday incentive, shall not be allowed
as a deduction from gross income which may be subject to RCIT.

Thus, the Group’s realized forex losses from activities considered attributable to its
PEZA-registered activities, being related or incidental to its PEZA-registered activities,
cannot also be deducted for RCIT purposes.

Realized forex losses from transactions not considered attributable to the Group’s
PEZA-registered activities

In BIR Ruling No. DA-209-06 dated April 5, 2006, the BIR ruled that the realized forex
loss incurred by the taxpayer from the repayment of foreign currency denominated
loans is an ordinary and necessary business expense deductible from the taxpayer’s
ordinary income subject to RCIT. In this case, the taxpayer was a PEZA-registered
enterprise availing of the 5% preferential income tax rate. The same ruling also held
that the realized forex gain from the conversion of the debt of an affiliate into equity is
outside the taxpayer’s PEZA registration. Hence, such gain is subject to the 35%
(now 30%) RCIT.

Based on the foregoing, there is a risk that realized forex losses arising from

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transactions like the settlement of foreign currency loans may not be covered by the
Group’s registered activities, and thus also not covered by the 5% GIT/ITH incentive.
Accordingly, these may be subject to 30% RCIT / 2% MCIT, whichever is applicable.

iii. Interest income from bank deposits

Section 1 of RR No. 20-2002 provides that whatever the tax treatment of a PEZA enterprise
with respect to its registered activity/ies, income realized by such registered enterprise that is
not related to its registered activity/ies shall be subject to the regular internal revenue taxes,
such as the 20% final income tax on interest from Philippine Currency bank deposits and
yield or any other monetary benefit from deposit substitutes, and from trust funds and similar
arrangement, the 7.5% tax on foreign currency deposits and the 5%/10% capital gains tax or
½ % stock transaction tax, as the case may be, on the sale of shares of stock.

However, in RMC 32-2005 dated June 17, 2005, the BIR stated that:

“For the information and guidance of all banks and others concerned, quoted hereunder
is the full text of BIR Ruling No. 001-2005 dated June 16, 2005 subjecting the income
realized by enterprises registered under the Bases Conversion and Development Act of
1992 and the Philippine Economic Zone Act of 1995 that is not related to its registered
activity/ies, particularly interest income from foreign currency deposits, to the regular
internal revenue taxes:”

BIR Ruling No. 001-2005 dated June 16, 2005 involves interest income from foreign
currency deposits maintained in a Subic bank by a PEZA-registered/SBMA locator. In this
ruling, the BIR held that:

“It may be gleaned from the aforecited provision of RR No. 20-2002 that the incentives
granted under Bases Conversion and Development Act of 1992 and the Philippine
Economic Zone Act of 1995 shall apply only to the registered operations of the
ECOZONE enterprises. (Section 5, Rules and Regulations to Implement R.A. No. 7916)

Therefore, the income earned from unregistered activities by enterprises registered

under the Bases Conversion and Development Act of 1992 and the Philippine Economic
Zone Act of 1995, such as the interest income from foreign currency deposits shall be
subject to the final income tax at the rate of 7.5% of such interest income. (Section 27
(D)(1) of the Tax Code of 1997)”

Based on the foregoing, interest income from bank deposits, regardless of whether the bank
is located within or outside the Zone, may not be covered by the 5% GIT.

iv. Sale of fixed assets, if applicable

The gain realized by a PEZA-registered company from the sale of fixed assets may
be subject to income tax. However, there may be an issue on whether or not the gain
may be considered as part of the Group’s registered activity subject to 5% GIT.
In the following rulings, the BIR opined that the sale of assets by PEZA-registered
enterprises is subject to 5% GIT:

 In VAT Ruling No. 089-02 dated December 17, 2002, the BIR held that Co. P’s
sale of its fixed assets to its parent company, which the latter consigned back
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to Co. P for its continued use in its PEZA-registered operations, must be

embraced by the said special tax regime under Section 24 of RA No. 7916, as
amended. Consequently, this sale transaction is embraced by the 5% special
tax, based on gross income earned therefrom by Co. P, in lieu of all taxes.

 In BIR Ruling DA-348-03 dated October 9, 2003, Co. K, a PEZA-registered

company engaged in the manufacture, design, mounting, and assembly of
electronic parts and components such as, but not limited to, circuit boards
transistors, coils and switches, sold its used and replaced equipment and
machineries to its non-resident affiliates abroad and to a PEZA registered firm.
In this regard, the BIR held viz:

“xxx gains from the sale by Co. K of its replaced equipment and
machineries to its non-resident affiliates abroad and to a PEZA-registered
firm is governed by the provisions of R.A. No. 7916, as amended,
otherwise known as "The Special Economic Zone Act of 1995". Co. K's
gross income earned therefrom shall be subject to the 5% special tax, in
lieu of all taxes, pursuant to Section 24, R.A. 7916, as amended, as held
in VAT Ruling No. 089-2002, dated December 17, 2002, citing BIR Ruling
No. 008-99 dated January 19, 1999. xxx”

 In BIR Ruling DA-027-05 dated January 24, 2005, the management of Co. F,
due to the country’s economic difficulties which adversely affected the
company’s operations, had decided to sell its building being occupied for the
business, to recover somehow the cost of construction. The BIR held that the
gain from the sale by Co. F of its building is governed by the provisions of RA
No. 7916, as amended. Thus, Co. F’s gross income earned therefrom shall
be subject to the 5% special tax, in lieu of all taxes.

 In BIR Ruling DA-135-06 dated March 17, 2006, the BIR held that the sale of
various office and telecommunications equipment that formed part of Co. R’s
data center assets from Co. R to IP Converge was still covered by Co. R’s
5%GIT incentive. In this ruling, Co. R was a PEZA-registered enterprise
engaged in the provision of wholesale data and bandwidth services to
customers. The BIR stated that the 5% GIT incentive of Co. R applied to
“business activities within the Ecozone.”

Thus, there may be a basis to argue that the gain on sale of fixed assets is covered
by the Group’s registered activity subject to 5% GIT.

However, in BIR Ruling DA-023-2003 dated January 28, 2003, Co. S, a PEZA-
registered company, has not commenced commercial operations in the Philippines
due to a worldwide decrease in the demand presently experienced by the disk drive
industry. Its Board of Directors approved the closure of the operations in Cebu and
eventual disposal of its manufacturing plant and equipment such as generator sets
and others. The BIR held, viz:

“ xxx Section 28(A)(1) of the Tax Code of 1997 provides that a corporation
organized, authorized, or existing under the laws of any foreign country,
engaged in trade or business within the Philippines, shall be subject to an
income tax equivalent to thirty three (33%) effective January 1, 1999; and
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effective January 1, 2000 and thereafter, the rate shall be thirty-two percent
(32%).

Ordinarily, Co. S as a PEZA-registered enterprise is entitled to an income tax

holiday of four (4) years. However, inasmuch as the sale of the above-
mentioned properties is not within the registered activity of Co.S, the sale
thereof is subject to an ordinary corporate income tax at the rate of 33% or 32%
(now 30%), as the case may be, based on its net taxable income (i.e., gross
income less allowable deductions). xxx”

Although the above ruling was issued to a corporation which has not commenced
operations and eventually liquidated, there is a risk that the BIR may apply this ruling
to the Group’s sale of fixed assets, if any, and consider the said sale as outside of the
registered activity of the Group subject to the 30% RCIT.

However, notwithstanding the possibility of taxing the gain at 5% GIT instead of 30%
RCIT / 2% MCIT, the loss from disposal of assets may not be deducted for purposes
of the 5% GIT. As to whether the loss can be deducted for purposes of the 30%
RCIT / 2% MCIT will depend on whether the sale itself will be considered covered by
the activity subject to 5% GIT. If the sale is part of the said activity, then the loss may
not be deducted for purposes of the 5% GIT and 30% RCIT / 2% MCIT.

d. Allowable Deductions

Rule XX, Section 2 of the PEZA IRR enumerates the following allowable deductions for
Ecozone Export Enterprises:

“SECTION 2. Gross Income Earned; Allowable Deductions. – For purposes of these

Rules, Gross Income earned shall be defined in Section 2(nn), Rule I of these Rules
subject to the following allowable deductions 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
- Goods in process (intermediate goods)
- Finished goods
- Supplies and fuels used in production
- Depreciation of machinery and equipment used in production and buildings
owned or constructed by an ECOZONE Enterprise
- Rent and utility charges associated with building, equipment and warehouses, or
handling goods
- Financing charges associated with fixed assets

xxx”

On the other hand, the PEZA IRR (Rule XX, Section 2) provides the following as allowable
deductions for Developer/Operator, Facilities, Utilities and Tourism:

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“2. ECOZONE Developer/Operator, Facilities, Utilities and Tourism Enterprises

a. Direct salaries, wages or labor expense

b. Service supervision salaries
c. Direct materials, supplies used or resold to another ECOZONE Enterprise
d. Depreciation of machinery, equipment and buildings owned and/or constructed
e. Financing charges associated with fixed assets
f. Rent and utility charges for buildings and capital equipment.”

Moreover, RR No. 11-2005 dated April 25, 2005, which took effect on March 5, 2005,
defines “gross income earned”, and provides the following allowable deductions for 5% GIT
purposes:

“SECTION 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 cost of sales or directs costs but before any
deduction is made for administrative, marketing, selling and/or operating expenses or
incidental losses during a given taxable period.

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

2. ECOZONE Developer/Operator, Facilities, Utilities and Tourism Enterprises:

 Direct salaries, wages or labor expense

 Service supervision salaries
 Direct materials, supplies used
 Depreciation of machineries and equipment used in the rendition of registered
services, and of that portion of the building owned or constructed that is used
exclusively in the rendition of registered service

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 Rent and utility charges for buildings and capital equipment used in the rendition
of registered services
 Financing charges associated with fixed assets used in the registered service
business the amount of which were not previously capitalized.

xxx"

From the definition of gross income and the enumeration of allowable deductions in the
PEZA IRR and RR No. 11-2005 above, there is an issue on whether the deductions allowed
for purposes of computing the 5% GIT include only the allowable deductions mentioned (i.e.,
“first view”), or whether the enumerated items are merely examples of direct costs that are
deductible for purposes of the 5% GIT (i.e., “second view”).

We discuss below two possible views.

1. First (restrictive) view

Under this view, the Group may deduct from gross revenues, only those items of deduction
enumerated under Rule XX, Section 2 of the IRR, as further qualified by RR No. 11-2005.
The PEZA IRR states that “Gross Income earned shall be as defined in Section 2 (nn), Rule
1 of these Rules subject to the following allowable deductions for specific types of
enterprise.” Thus, it appears that this provision attempts to limit the deductions for 5% GIT
purposes to the allowable deductions specifically enumerated under Rule XX, Section 2 of
the PEZA IRR.

Some of these allowable deductions are further defined in the PEZA IRR as follows:

 Direct Labor Wage

Rule 1, Section 2 (vv) of the PEZA IRR states:

“Direct Labor Wage shall refer to compensation for labor directly used in the production
or manufacturing process up to and including the services of the production foreman, but
shall exclude labor for maintenance of production, machinery and equipment.
Compensation shall cover salaries and wages, including other payments such as
bonuses and cost of living allowances, which form part of the laborer’s or employee’s
taxable earnings.”

 Machinery and Equipment

Under Rule I, Section 2 (ff) of the IRR, “Machinery and Equipment” shall refer to capital
equipment, major components thereof, non-perishable tools, machines and other
mechanical, chemical and/or electrical apparatus, whether fixed or movable, needed in
the registered operations of the ECOZONE Enterprise.

Some of the items enumerated above would ordinarily also be included in the computation of
cost of sales/services or direct costs.

On February 8, 2005, the BIR issued RR No. 2-2005, which restricted the deductions for 5%
GIT to the items listed under Section 2, Rule XX of the PEZA IRR. This RR went beyond the

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PEZA IRR and qualified the listed deductions further. Section 7 of the said RR provides as
follows:

“SECTION 7. Gross income earned. — For purposes of the application of these

Regulations “gross income earned” shall refer to gross sales or gross revenue derived
from registered business activity within the Zone net of sales discounts, sales returns
and allowances minus cost of sales or direct costs but before any deductions for
administrative, marketing, selling, operating expenses or incidental losses during a given
taxable. For financial enterprises, gross income shall include interest income, gains from
sales, and other income.

For purposes of computing the total five percent (5%) tax rate imposed by Republic Act
No. 7227, Republic Act No. 7903, Republic Act No. 7922 and Republic Act No. 7916, the
cost of sales or direct cost shall consist only of the following cost or expense items which
shall be computed in accordance with Generally Accepted Accounting Principles
(GAAP):

xxx”

RR No. 2-2005 was temporarily suspended pending the review of concerns and issues on
the matter pursuant to DOF Memorandum CVP0333-DOF/2005 dated March 18, 2005 and
RMC No. 11-2005 dated March 30, 2005. However, RR No. 2-2005, above, uses the phrase
“shall consist only of” to restrict the allowable deductions for 5% GIT purposes to those
explicitly enumerated therein. Hence, it is clear that the intent of this RR was to limit the
deductions to those only enumerated in the said RR.

The foregoing Section 2 of RR No. 2-2005 was subsequently revoked on June 25, 2005,
when RR No. 11-2005 was published in The Philippine Star. This RR defined “Gross
Income Earned” to implement the tax incentive provision in Section 24 of RA No. 7916, and
retroactively took effect on March 5, 2005.

As discussed earlier on page K-24, Section 3 of the said RR 11-2005 provides as follows:

“SECTION 3. Gross Income Earned – xxx

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:

 xxx

2. ECOZONE Developer/Operator, Facilities, Utilities and Tourism Enterprises:

 xxx
xxx”

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Instead of using the phrase “shall consist only of” (as in the case of RR No. 2-2005), RR No.
11-2005 states that the costs enumerated therein “are included” in the allowable deductions
for 5% GIT purposes.

However, Hector S. De Leon, in his book The Fundamentals of Taxation, 13th edition,
defined deductions as “items or amounts which the law allows to be deducted under certain
conditions from the gross income of the taxpayer in order to arrive at the taxable income”.
The basic principles governing deductions are enumerated in the book, as follows:

“(1) The taxpayer seeking a deduction must point to some specific provisions of the
statute authorizing the deduction; and

(2) He must be able to prove that he is entitled to the deduction authorized or allowed.
(PH.Fed.Tax Course, par. 1801)

Deductions have generally been deemed to be a matter of legislative grace. They are
allowed only where there is a clear provision in the statute for the deduction claimed; and
where particular deductions are authorized by the statute, no others may be made.
(Basilan Estates, Inc. vs. Comm. & CTA, L-22492, Sept. 5, 1967; 61 C.J.S. 1563)

xxx”

Moreover, as clarified in Mertens Law of Federal Income Taxation § 3:09, which covers
Resolving Doubts in tax laws, doubts concerning tax code provisions on deductions,
exemptions and exclusions should generally be construed in favor of the government:

“It is the function and duty of courts to resolve doubts in the tax laws, a function which
should not be abdicated by the courts. Nevertheless, as a general rule, doubts on taxing
provisions should be resolved in favor of the taxpayer. On the other hand, Internal
Revenue Code provisions dealing with deductions, exemptions, and exclusions are
considered matters of legislative grace, and doubts concerning such provisions should
generally be construed in favor of the government. For example, exclusions to liability for
gross income are narrowly construed, and the taxpayer bears the burden of proving the
amount he or she is entitled to recover. (825 F.2d 1027; Stinson Estate v. U.S., 214 F.3d
846 (C.A.7 (Ind.),2000)).

This principle has thus been applied in various court rulings wherein the Court ruled income
tax deduction is a matter of legislative grace and the burden of clearly showing the right to
the claimed deduction is on the part of the taxpayer. [Berlimed Philippine Corporation vs.
CIR (C.T.A. Case No. 3159, dated April 28, 1989); ESSO Standard Eastern Inc. vs. CIR
(G.R. Nos. 28508-9, dated July 7, 1989); Fort Bonifacio Development Corporation vs. CIR
(CA-G.R. SP No. 76017 dated June 11, 2004)]

Thus, applying the above-discussed basic principles on deductions and the maxim of
expressio unius est exclusio alterius in interpreting the deductions allowed under RR No.
11-2005, there is a risk that the allowable deductions for 5% GIT purposes may be limited to
those specifically enumerated under Section 3 of RR No. 11-2005.

2. Second (expanded) view

Under the second view, we present the broader interpretation of allowable deductions based

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on the looser definition of gross income in the PEZA IRR and RR No. 11-2005.

Based on the definition of gross income in Rule I, Section 2 (nn), it appears that the items
enumerated as allowable deductions under Rule XX, Section 2 of the IRR, could be
additional deductions from gross income, which are distinct from what are considered cost of
services or direct costs deductible from gross revenues.

Moreover, the provision on allowable deductions under Section 3 of RR 11-2005 may be

interpreted to mean that the items specifically enumerated as allowable deductions under
the RR are mere examples of items that are considered direct costs deductible for purposes
of the 5% GIT. As previously mentioned, RR No. 11-2005 states that the deductions
enumerated therein “are included in” the allowable deductions for 5% GIT purposes (as
opposed to RR No. 2-2005, which clearly restricted the deductible expenses by stating that
direct costs for 5% GIT purposes “shall consist only of” those enumerated therein).

Thus, if the deductions enumerated under RR No. 11-2005 are not already included in the
Group’s direct costs, then it may be argued that these can be included as deductions.
However, the Group should also not be precluded from claiming as deductible direct costs,
those items that are not included in the enumeration in Section 3 of RR No. 11-2005.

Since there is no distinction made between “gross income” as defined in the first sentence of
Rule I, Section 2 (nn) of the IRR, and the term “gross income” used in the subsequent
sentence, it may be argued that the term “gross income” as used in the second sentence is
likewise already net of cost of sales. Thus, the allowable deductions from gross income
prescribed under Rule XX, Section 2 of the IRR may be deductible items in addition to other
costs comprising the cost of sales/services.

This was confirmed in BIR Rulings DA-280-05 dated June 23, 2005 and DA-057-06 dated
February 23, 2006, where the BIR held as follows:

“Gross income for purposes of computing the special tax due under Section 44 of the Act
refers to gross sales or gross revenues derived from business activity within the
ECOZONE, net of sales discounts, sales returns and allowances and minus cost of sales
or direct costs but before any deduction is made for administrative expenses or
incidental losses during a given taxable period. The allowable deductions from “gross
income” are specifically enumerated under Section 2, Rule XX of these Rules.

The above paragraph may be reduced to the following formula:

Gross ECOZONE Sales or Revenues

Less: Sales Discounts
Sales Returns
Direct Costs (Costs of Sales)
Gross Income
Less: Allowable Deductions (Sec. 2, Rule XX)
Taxable Gross Income (Subject to 5% final tax)

From the foregoing, direct costs (costs of sales) are deductible from gross sales/
revenues for purposes of computing a PEZA firm’s taxable gross income subject to the
5% final tax.”

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In addition, in CS Garments, Inc vs. CIR (CTA EB Case No. 287 dated January 14, 2008),
the CTA, based on the same Section 2, Rule XX of the PEZA Law IRR cited earlier, stated
that:

“xxx for purposes of computing the 5% preferential tax, gross sales/revenues may be
reduced only by sales discounts, sales returns and allowances, cost of sales or direct
costs or any of the enumerated allowable deductions under Section 2, Rule XX of the
PEZA Rules.”

In this particular case, however, the CTA held that “deductions for advertising,
representation and entertainment, transportation and travel, professional fee, export fees,
taxes and licenses should be disallowed because these expenses do not qualify as direct
costs, nor are they among the specified allowable deductions under the PEZA Rules.”

Moreover, in BIR Ruling DA-608-06 dated October 11, 2006, the BIR stated that:

“xxx Section 1 of RR 11-2005 includes cost of sales or direct costs, raw materials, direct
salaries, wages or labor expenses and production supervision salaries among the
allowable deductions for 5% GIT purposes. Although subcontracting expenses are not
among those specifically enumerated under the said regulations, the subject processing
fees directly related to the production of Co. S’ registered products partake the nature of
a direct cost. Accordingly, for as long as a cost or expense is determined to be in the
nature of a direct cost of a business, after taking into account its nature and the process
involved in the generation of its revenues, the same is allowed as deduction from gross
income. xxx”

Thus, to compute for the Group’s gross income, under the 2nd view, there is a need to
identify the cost of services or direct costs which may be deducted from revenues. After
computing for the gross income, the Group may claim the cost/expense items enumerated
under Section 2, Rule XX of the said IRR as additional deductions from the computed gross
income (if not already deducted as part of cost of services or direct cost), to arrive at the tax
base for purposes of the 5% GIT.

In any case, since the PEZA Law IRR does not provide a specific definition of direct costs or
cost of sales, there is an issue on what may be considered cost of sales or direct costs.

 RR No. 9-98, RMC No. 4-2003 and RMC No. 24-2008, in relation to Minimum Corporate
Income Tax (MCIT)

Section 2.27 (4)(a) of RR No. 9-98, provides that in the case of sales of services, the
term “gross income” means gross receipts less sales returns, allowances, discounts and
cost of services. Cost of goods manufactured and sold and cost of services is further
defined as follows:

“Cost of goods manufactured and sold” means all costs of production of finished
goods, such as raw materials used, direct labor and manufacturing overhead, freight
cost, insurance premiums and other costs incurred to bring the raw materials to the
factory or warehouse.

“Cost of services” means all direct costs and expenses necessarily incurred to
provide the services required by the customers and clients including (a) salaries and
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employee benefits of personnel, consultants and specialists directly rendering the

service, and (b) cost of facilities directly utilized in providing the service such as
depreciation or rental of equipment used and cost of supplies: Provided, however,
that “cost of services” shall not include interest expense except in the case of banks
and other financial institutions.

Revenue Memorandum Circular (RMC) No. 4-2003 dated January 15, 2003 further provides:

“The term ‘salaries, wages and other employee benefits’ as used herein shall include the
following employee benefits: bonuses, Pag-ibig, SSS, Medicare, and HDMF
contributions. If a cost or expenditure is incurred both directly to provide a service
required by a client, and indirectly for administration, operation, or sales-promotion
purposes, the taxpayer shall be allowed a ratable portion of such cost or expenditure to
form part of the “Cost of Service”.

In addition, RMC No. 24-2008 dated March 18, 2008 also provides:

“As provided for by Section 27 (E) and Section 28 (A) (2) of the 1997 Tax Code, as
amended, in computing the gross income subject to the 2% MCIT for sellers of services,
‘gross income’ means gross receipts less sales returns, allowances, discounts and cost
of services. ‘Cost of services’ shall mean all direct costs and expenses necessarily
incurred to provide the services required by the customers and clients including (A)
salaries and employee benefits of personnel, consultants and specialists directly
rendering the service and (B) cost of facilities directly utilized in providing the service
such as depreciation or rental of equipment used and cost of supplies: . . .”

“As can be gleaned from the above definition of “cost of services” of the sellers of
services, “direct costs and expenses” shall only pertain to those costs exclusively and
directly incurred in relation to the revenue realized by the sellers of services. In fine,
these refer to costs which are considered indispensable to the earning of the revenue
such that without such costs, no revenue can be generated. Thus, expenses and other
costs dispensed outside the ambit of what has been defined herein as “direct costs and
expenses” are not items allowed for inclusion to “cost of services”, for purposes of
computing the gross income subject to the 2% MCIT.”

The foregoing, however, were issued by the BIR to clarify the scope of the term “Direct
Costs and Expenses” that should comprise the “Cost of Services” for purposes of computing
the gross income subject to the 2% Minimum Corporate Income Tax (MCIT), and not direct
cost or cost of services for 5% GIT purposes.

Moreover, RR No. 12-2007 provides that “Cost of goods sold” shall include all business
expenses directly incurred to produce the merchandise to bring them to their present
location and use. Also, “Cost of Services or Direct Cost of Services” shall include business
expenses directly incurred or related to the gross revenue from rendition of services.

 Revenue Audit Memorandum Order (RAMO) No. 1-2000

Part XI (A) [Balance Sheet Approach to Examination] of RAMO No. 1-2000, dated November
12, 1999 gives the same exact definition of “cost of services” as provided in RR No. 9-98,
above.

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 Statements of Financial Accounting Standards (SFAS)

SFAS No. 1, Section F provides:

“S-6A. Costs of manufacturing products and providing services. Costs of manufacturing

products and providing services during a period include (1) costs of assets that are
completely used during the period in manufacturing products and providing services and
(2) allocated portions of the costs of assets or the revalued amounts of property, plant
and equipment which have been revalued that are partially used during the period in
manufacturing products and providing services, assigned in a systematic and rational
manner to those activities.

“S-6A(1). Product and service costs. Costs assigned to products and services provided
are those costs of manufacturing products and providing services that are considered
productive, including indirect costs (absorbed overhead). Costs of manufacturing
products and providing services for a period that are not assigned to product or service
costs are charged to expense for the period, for example, unabsorbed overhead.”

Moreover, with respect to manufacturing enterprises, in BIR Rulings DA-280-05 and DA-057-
06 dated June 23, 2005 and February 23, 2006, respectively, the BIR ruled that direct costs
(costs of sales) are deductible from gross sales/revenues for purposes of computing the 5%
GIT. These rulings were issued in response to a query on whether royalty payments by
PEZA-registered export enterprises are deductible in computing the 5% GIT. In the said
rulings, the BIR defined cost of inventories or finished goods based on SFAS no. 4 as
follows:

“xxx, the cost of inventories or finished goods is defined as follows in paragraph 4 of

Statement of Financial Accounting Standards (SFAS) No. 4, Summary of Generally
Accepted Accounting Principles on Inventories:

In general, cost is the price paid or consideration given to acquire an asset. As

applied to inventories, it represents the direct and indirect expenditures for items
purchased, produced or in the process of production including the cost of production
overhead. It constitutes the sum of the applicable expenditures and charges directly
or indirectly incurred in bringing the inventory items to their existing condition and
location.

Paragraph 5 of the same SFAS also states that:

Production overhead should be included as part of inventory cost; it is composed of

costs incurred for production other than direct materials and labor and includes both
variable and fixed expenses. Examples are indirect materials and indirect labor,
depreciation and maintenance of factory buildings and equipment, and the cost of
factory management and administration.

Recording of revenue from the sale of a product is accompanied by recording of an

expense for the cost of the product sold (SFAS No. 1, Sec. F.I.). Manufacturing costs for
a product include rationally and systematically assigned or allocated direct and indirect
productive costs of assets or property, plant, and equipment completely or partially
consumed in manufacturing the product [SFAS No. 1, Sec. F.II.A.S-6A; M-6A, S-6A(1),
M-6A(1)].
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In determining the aforesaid rational and systematic cost assignment or allocation,

Paragraph 6 of SFAS No. 4 provides as follows:

“The allocation of costs and charges to inventories requires the exercise of

judgment and involves a consideration of the adequacy of the procedures of the
cost accounting system in use, the soundness of the principles thereof, and their
consistent application. Generally, any allocation process should consider the
following principles:

a. Under some circumstances, items such as idle facility expense, excessive

spoilage, double freight, and rehandling costs may be so abnormal as to require
treatment as current period charges rather than as a portion of the inventory costs.

b. Also, general and administrative expenses should be included as period

charges, except for the portion of such expenses that may be clearly related to
production and thus constitute a part of inventory costs.

c. Selling expenses constitute no part of inventory costs.

Moreover, Paragraph 13 of International Accounting Standards (IAS) No. 2 on

Inventories further stipulates that ‘[o]ther 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
overhead, such as the costs of designing products for specific customers, in the cost of
inventories.”

Thus, the BIR held in the above ruling that the deductibility of royalty payments depends on
the consideration for which such fees were paid. When royalties relate to a system or
license, these are treated as general and administrative expenses, which are not
inventoriable costs. However, when royalties are connected with a product design, logo,
formula, or process, these are capitalized as part of inventories. Therefore, payments for
royalties related to the transfer of technical information and manufacturing know-how may be
considered as part of cost of manufacturing the products.

Based on the foregoing, a position may be taken that the Group can deduct the entire cost of
sales as defined earlier from its gross revenues to arrive at the gross income. From this
gross income, the Group may also claim the additional deductions enumerated in Rule XX,
Section 2 of the IRR, if not already deducted as cost of sales. However, if the Group will
adopt this second view, it may be prudent that the Group secure a BIR ruling duly confirming
this view, for proper protection.

 Philippine Accounting Standards (PAS) No. 2 - Inventories

Paragraph 19 of PAS No. 2 provide as follows:

“Cost of inventories of a service provider

19. To the extent that service providers have inventories, they measure them at the costs
of their production. These costs consist primarily of the labour and other costs of
personnel directly engaged in providing the service, including supervisory personnel,
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and attributable overheads. Labour and other costs relating to sales and general
administrative personnel are not included but are recognized as expenses in the
period in which they are incurred. The cost of inventories of a service provider does
not include profit margins or non-attributable overheads that are often factored into
prices charged by service providers.”

As reiterated in RMC No. 44-2002, for tax purposes, the taxable income shall be computed
in accordance with the method of accounting regularly employed in keeping the books of the
taxpayer. But if no such method of accounting has been employed, or if the method
employed does not clearly reflect the income, the computation shall be made in accordance
with such method as in the opinion of the Commissioner clearly reflects the income (Section
43, Tax Code).

Also, on certain occasions, the tax authorities have shown an inclination to adopt GAAP in
matters involving tax issues. In BIR Ruling No. 009-01 dated March 6, 2001, the BIR held,
adopting the accounting principle under SFAS No. 1, Section 3 on proper matching of costs
and revenues, that costs to be associated with future revenue or otherwise be associated
with future accounting period are deferred to future periods as assets. The cost of an asset
that provides benefits for only one accounting period is recognized as an expense of that
period.

Further, in BIR Rulings DA-280-05 dated June 23, 2005 and DA-057-06 dated February 23,
2006 mentioned earlier, the BIR adopted the definition of cost of inventories or finished
goods under SFAS No. 4 and International Accounting Standards (IAS) No. 2 as the direct
and indirect expenditures for items purchased, produced or in the process of production
including the cost of production overhead. The cost of inventories constitutes the sum of the
applicable expenditures and charges directly or indirectly incurred in bringing the inventory
items to their existing condition and location.

Specifically, paragraphs 10, 11, 12 and 15 of IAS No. 2 provide as follows:

“10. 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.

Costs of Purchase

11. The costs of purchase of inventories comprise the purchase price, import duties and
other taxes (other than those subsequently recoverable by the entity from the taxing
authorities), and transport, handling and other costs directly attributable to the acquisition
of finished goods, materials and services. Trade discounts, rebates and other similar
items are deducted in determining the costs of purchase.

Costs of Conversion

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

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that vary directly, or nearly directly, with the volume of production, such as indirect
materials and indirect labour.

xxx

Other Costs

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.”

In this regard, it may be argued that unless the Tax Code or the rules and regulations
implementing the same provides otherwise, the phrase “cost of goods and services” under
the second view includes other direct costs not specifically enumerated in Rule XX, Section
2 of the IRR, such as the following:

Legal basis Description

RR No.9-98  cost of goods sold and manufactured and facilities
directly utilized in providing the service.
RMC No. 4-  a ratable portion of such cost or expenditure which
2003 are incurred both directly to provide a service
required by a client, and indirectly for administration,
operation, or sales-promotion purposes.
S-6A, Section F  a ratable portion of indirect costs (administration,
of SFAS No. 1 operation, or sales-promotion) that contributed to the
rendering of service or manufacturing of goods.
Paragraph 19 of  labor and other costs of personnel directly engaged
PAS No. 2 in providing the service, including supervisory
personnel, and attributable overheads

In addition, the adoption of the second view will require consultation with the Group’s External
Auditor, for the determination of what are acceptable as cost of sales or direct costs under
GAAP.

In any case, where GAAP and tax laws differ on what may be considered Cost of Sales or
Direct Costs, tax laws prevail. This is based on RMC No. 22-2004 dated April 12, 2004, which
provides:

“II. Provisions of Tax Code Shall Prevail.

All returns required to be filed by the Tax Code shall be prepared always in conformity
with the provisions of the Tax Code, and the rules and regulations issued implementing
said Tax Code. Taxability of income and deductibility of expenses shall be determined
strictly in accordance with the provisions of the Tax Code and the rules and regulations
issued implementing the said Tax Code. In case of difference between the provisions of
the Tax Code and the rules and regulations implementing the Tax Code, on one hand,
and the generally accepted accounting principles (GAAP) and the generally accepted
auditing standards (GAAS), on the other hand, the provisions of the Tax Code and the
rules and regulations issued implementing the said Tax Code shall prevail.”

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In the same manner, RR No. 11-2005, which revoked Section 7 of RR No. 2-2005, could
also be used to support the expanded view of the deductibility of expenses. RR No. 2-2005
stated that the allowable deductions for the 5% GIT purposes “shall consist only of the
following cost or expense items which shall be computed in accordance with Generally
Accepted Accounting Principles (GAAP)”. On the other hand, RR No. 11-2005, cited earlier,
enumerated direct costs included as allowable deductions for 5% GIT purposes.

Consequently, the limitation of the maxim expression unius est exclusion alterius could
also be applied according to the interpretation of Ruben E. Agpalo. He had provided that
“the maxim expressio unius est exclusio alterius, is no more than an auxiliary rule of
interpretation to be ignored where other circumstances indicate that the enumeration was
not intended to be exclusive [Escribano vs. Avila, G.R. No. 30375, Sept. 12, 1978, 85 SCRA
245 (1978)].”

In Mertens Law of Federal Income Taxation § 3:15 (Chapter 3, Section 2, Construction of

Specific Words and Phrases), the words “includes” and “including” are defined as follows:

“Include--Including. The terms “includes” and “including,” when used in the Internal
Revenue Code, are not to be used to “exclude other things within the meaning of the
term defined.” Income from an individual bankruptcy estate was held to be within the
meaning of taxable trust or estate income under Sections 641(a) and 1(e), where Section
1(e) applies to the taxable income of estates “including” and thereafter lists four types of
income from trusts or estates that are taxable. To hold differently would, in effect,
substitute the term “limited to” for “including”.” (Chickasaw Nation v. U.S., 208 F3d 871,
2000-1 U.S. Tax Cas. (CCH) 50350, 85 A.F.T.R.2d 2000-1301 (10th Cir. 2000))

In the Philippines, the meaning of the words “including” or “include” has also been clarified
by several Court decisions. For example, in CIR vs. Exquisite Pawnshop and Jewelry, Inc.
(CA-G.R. SP No. 70319 dated May 13, 2003), the parties sought to interpret Section 108 of
Tax Code in determining whether pawnshops are subject to VAT. Section 108 of the Tax
Code provides for the meaning of the phrase “sale or exchange of services” and used the
word “including” followed by a list of services. Since pawnshops are not among those
services enumerated, the petitioners argued that pawnshops are not subject to VAT.
However, the Court ruled otherwise, stating that the use of the term “including” in Section
108 of the Tax Code should be construed as a term of enlargement, and not of limitation.
We quote the pertinent portion of the decision as follows:

“From the wordings of Section 108(A) of the NIRC, the legislative intent is not to limit the
application of the law to those enumerated therein, nor, exclude other kinds of services
performed for a fee, remuneration or consideration, because the law speaks of “all kinds
of services”. To limit its application to the enumeration would contradict the very clear
meaning of the phrase “all kinds of services”. The word “including” used in the law should
be construed as a term of enlargement, and not of limitation.

“A term whose statutory definition declares what it ‘includes’ is more susceptible to

extension of meaning by construction than where the definition declares what a term
‘means’. Thus, it has been said that 'the word 'includes' is usually a term of
enlargement, and not of limitation. It, therefore, conveys the conclusion that there are
other items includable, though not specifically enumerated . . ." (Sutherland Statutory
Construction, 4th ed., Vol. 24, p. 82, Sec. 47.08)

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xxx”

In addition, in BIR Ruling DA-608-06 dated October 11, 2006, the BIR cited the
abovementioned list of direct costs deductible for GIT purposes enumerated in RR No. 11-
2005 and stated as follows:

“In interpreting the scope of the foregoing list, this Office 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.”

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.” Xxx”

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The BIR also reiterated this position in BIR Ruling DA-080-07 dated February 8, 2007 and
BIR Ruling DA-656-07 dated December 17, 2007.

From the foregoing, there is basis to argue that the word “included” in RR No. 11-2005 does
not limit the deductions for 5% GIT purposes to the specific allowable deductions
enumerated under Rule XX, Section 2 of the PEZA IRR, as amended by RR No. 11-2005.
Rather, the use of the word “included” and the deletion of the word “only” found in RR No. 2-
2005 may be interpreted to mean that the specific allowable deductions enumerated
constitute examples of direct costs. If these listed deductions are not already included in the
Group’s direct costs, then it may be argued that these can be included as deductions.
However, the Group should also not be precluded from claiming as deductible direct costs,
those items that are not included in the enumeration in Section 1 of RR 11-2005.

In any case, if the Group will adopt this second view, it should also consult its External
Auditors to properly determine what are acceptable as cost of services under the new
Philippine Accounting Standards (PAS) and Philippine Financial Reporting Standards
(PFRS).

Finally, the adoption of the PAS and PFRS may result in significant differences between
PAS/PFRS and tax. This study, however, is not meant to cover such differences between
PAS/PFRS and tax.

Thus, under the 2nd view, the Group will be able to compute Taxable Gross Income as
follows.

Gross ECOZONE Sales or Revenues xxx

Less: Sales Discount xxx
Sales Returns xxx
Direct Costs (Costs of Sales/Services) xxx xxx
Gross Income xxx
Less: Allowable Deductions (Sec. 2, Rule XX of PEZA IRR*)
Direct salaries, wages or labor expenses
Production/Service supervision salaries
Raw materials used n the manufacture of
products/rendering registered services
Supplies and fuels used in production/rendering registered
services
Depreciation of machinery used in production/rendering
registered services and of that portion of the building
owned or constructed that is used exclusively in the
production of goods/rendering registered services
Rent and utility charges associated with building,
equipment and warehouses used in production/rendering
registered services
Financing charges associated with fixed assets used in
production/rendering registered services the amount of
which was not previously capitalized xxx
Taxable Gross Income (Subject to 5% Final Tax) xxx
* If not already included in cost of sales

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The Group should secure a confirmatory ruling if it will follow this view, for proper protection.
Note that as a rule, deductions are strictly construed against the taxpayer.

3. Third (Ipso Facto) View

In BIR Rulings DA-280-05 dated June 23, 2005 and DA-057-06 dated February 23, 2006,
the BIR quoted the definition of “gross income earned” as defined under Section 3 of RR No.
16-99 dated September 27, 1999 governing a Trading and Manufacturing Subic Bay
Regional Enterprise3 registered with the Subic Bay Metropolitan Authority (SBMA), as an
added argument for the deductibility of royalties of a PEZA-registered enterprise. We quote:

“Moreover, Section 3 of BIR Revenue Regulations No. 16-99 provides that firms
established under Republic Act No. 7227 are allowed to deduct royalty payments when
calculating gross income subject to the 5% final tax. Section 3 of Revenue Regulations
No. 16-99 governing enterprises registered with the Subic Bay Metropolitan Authority
(SBMA), modifies the definition of gross income earned to read as follows:

o. Gross Income Earned — refers to gross sales or gross revenues derived from the
business activity within the zone, net of sales discounts and sales returns and
allowances and minus costs of sales or direct costs but before any deduction for
administrative expenses or incidental losses during a given taxable period. For
financial enterprises, gross income shall include interest income, gains from sales, and
other income, net of allowable deductions. The following deductions shall be allowable
for the calculation of gross income earned for specific types of enterprises:

“1) Trading and manufacturing enterprises

Direct salaries
Production supervision salaries
Raw materials used in the manufacture of products
Goods in process (Intermediate goods)
Finished goods
Supplies and fuels used in production
Toll manufacturing fees
Commission expenses
Distribution expenses
Depreciation of machineries and equipment used in production and building
owned and/or constructed by SBMA-registered enterprise
Equipment lease payments
Rent and utility charges associated with building, equipment and warehouses, or

3 A Subic Bay Regional Enterprises (SBRE), as defined in Section 3 (p) of RR No. 16-99, is any multinational
company, whose purpose, as expressed in its organizational documents or by resolution of its Board of Directors
or its equivalent, is to engage in regional and/or international trade/services and in business activities such as,
but not limited to, manufacturing, including entering into toll and contract manufacturing arrangements, employing
commission agents and/or distributors; trading, marketing, financial services and treasury, services may establish
in the Subic Special Economic and Freeport Zone (SSEFZ) its seat of management and the situs of its business
transactions, including the recording of its income, from some or all countries in the Asia-Pacific region and or
other parts of the world, including the Philippines, by registering as a Subic Bay Regional Enterprise (SBRE) with
the Subic Bay Metropolitan Authority (SBMA).

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handling of goods
Financing charges associated with fixed assets
Corporate management salaries
Administrative salaries
Marketing and sales salaries
Advertising
Research and Development
Royalty fees
Travel expense
Communication Expenses
Outside Professional Services
Interest and financial charges on working capital
Loss on foreign exchange translation
Loss on disposal of merchandise inventory.

xxx

xxx. By virtue of R.A. 7916 (PEZA Law), these SBMA privileges are also extended to
PEZA firms as follows:

“51. Ipso-Facto Clause. — All privileges, benefits, advantages or exemptions granted

to special economic zones under Republic Act No. 7227, shall ipso-facto be
accorded to special economic zones already created or to be created under this Act.
The free port status shall not be vested upon the new special economic zones."
(Section 51 of the PEZA Law)”

Since the above-quoted provisions of RR 16-99 pertain to Trading and Manufacturing Subic
Bay Regional Enterprises, the counterpart provision can be referred in the same RR (RR 16-
99) on allowable deductions for Service Subic Bay Regional Enterprises. Note that under
the same RR 16-99, the allowable deductions for service enterprises are as follows:

 Direct salaries
 Service supervision salaries
 Direct Materials, supplies used or resold to another SBMA registered enterprise
 Depreciation of machineries, equipment and buildings owned and/or constructed
 Equipment lease payments
 Financing Charges associated with fixed assets
 Rent and utility charges for buildings and capital
 Equipment
 Corporate management salaries
 Administrative salaries
 Marketing and sales salaries
 Advertising
 Research & Development
 Royalty Fees
 Travel and Entertainment expenses
 Communication expenses
 Outside Professional Services
 Interest & financial charges on working capital
 Loss on foreign exchange translation
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Thus, based on BIR Rulings DA-280-05 and DA-057-06, above, and applying the PEZA
Law’s Ipso Facto clause, since the BIR allows incentives of SBMA enterprises to be
extended to PEZA registered enterprises, it may be argued that the costs and expenses
allowable to SBMA enterprises under RR 16-99 should also be allowed as deductions for
purposes of the 5% GIT incentive of PEZA-registered enterprises.

However, the above BIR rulings appear to have erroneously quoted Section 3 of RR 16-99.
Section 3 of RR 16-99 provides as follows:

“SECTION 3. Section 3 of Revenue Regulations No. 1-95 is hereby amended by adding

paragraph (4) under sub-section (o) thereof and by adding thereto a sub-section (p), to
read as follows:

"o. Gross Income Earned. — . . .

1) Trading and manufacturing enterprises . . .;

2) Service enterprises . . .;

3) Financial Institutions . . .;

4) Subic Bay Regional Enterprise. — For purposes of this paragraph, the term "Gross
income earned" refers to the gross sales or gross revenues derived from the
business activity within the zone, net of sales discounts and sales returns and
allowances and minus the costs of sales or direct costs and other costs that are
material in the operations of the business and involves a significant amount in
determining the profitability and viability of the business (but before any deduction
for administrative expenses or incidental losses during a given taxable period). For
financial enterprises, gross income shall include interest income, gains from sales,
and other income, net of allowable deductions. The following deductions shall be
allowable for the calculation of gross income earned for the following specific types
of enterprises:

(a) Trading and manufacturing enterprises

Direct salaries
Production supervision salaries
Raw materials used in the manufacture of products
Goods in process (Intermediate goods)
Finished goods
Supplier and fuels used in production
Toll manufacturing fees
Commission expenses
Distribution expenses
Depreciation of machineries and equipment used in production and building
owned and/or constructed by SBMA-registered enterprise
Equipment lease payments
Rent and utility charges associated with building, equipment and warehouses,
or handling of goods
Financing charges associated with fixed assets

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Corporate management salaries

Administrative salaries
Marketing and sales salaries
Advertising
Research & Development
Royalty Fees
Travel expense
Communication Expenses
Outside Professional Services
Interest & financial charges on working capital
Loss on foreign exchange translation
Loss on disposal of merchandise inventory

(b) Service enterprises

Direct salaries
Service supervision salaries
Direct Materials, supplies used or resold to
another SBMA registered enterprise
Depreciation of machineries, equipment and
buildings owned and/or constructed
Equipment lease payments
Financing Charges associated with fixed assets
Rent and utility charges for buildings and capital
Equipment
Corporate management salaries
Administrative salaries
Marketing and sales salaries
Advertising
Research & Development
Royalty Fees
Travel and Entertainment expenses
Communication expenses
Outside Professional Services
Interest & financial charges on working capital
Loss on foreign exchange translation

The deductions enumerated in these Rulings apply to Subic Bay Regional Enterprises. This
is a separate type of registered enterprise which may not be applicable to the Group. Please
note too, that RR No. 16-99 appears to have not amended the allowable deductions
provided for SBMA-registered Service enterprises under Section 3 of RR No. 1-95, as
follows:

“2) Service enterprises

Direct salaries, wages or labor expense

Service supervision salaries
Direct Materials, supplies used or resold to another SBMA registered enterprise
Depreciation of machineries, equipment and buildings owned and/or constructed
Financing Charges associated with fixed assets
Rent and utility charges for buildings and capital equipment”

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Hence, there is a risk that the additional deductions provided to Subic Bay Regional
Enterprises may not be applicable to the Group unless this ruling is saying that the said
deductions should also be extended to PEZA entities such as the Group under the Ipso
Facto clause.

As mentioned above, Sec. 51 of RA 7916 (PEZA Law) states as follows:

“51. Ipso-Facto Clause. — All privileges, benefits, advantages or exemptions granted to

special economic zones under Republic Act No. 7227, shall ipso-facto be accorded
to special economic zones already created or to be created under this Act. The free
port status shall not be vested upon the new special economic zones.”

In BIR Rulings DA-280-05 and DA-057-06, the BIR ruled that by virtue of the ipso facto
clause of RA 7916, the privileges granted to SBMA enterprises are also extended to PEZA
enterprises. If such is the case, then there is a risk that the provisions of RR No. 13-2005
retroacted to March 5, 2005 which amends the tax incentive provision under paragraph (c)
of Sec. 12 of R.A. 7227 (The Bases Conversion Development Act of 1992), shall also
extend to the PEZA enterprises, as follows:

“(o) Gross income earned – shall refer to gross sales or gross revenues derived from
business activity within the Zone, 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. For financial enterprises, gross income shall include interest
income, gains from sales, and other income, net of costs of funds. For purposes of
computing the final five percent (5%) tax rate imposed, the following deductions shall be
allowable for the calculation of gross income earned for specific types of enterprises:

1. Trading Enterprises:

- Cost of Sales

(Cost of Sales which is equal to inventory, beginning plus purchases minus

Inventory of goods, ending)

2. Manufacturing 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 by the registered enterprise 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

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3. Service Enterprises:

- Direct salaries, wages or labor expense

- Service supervision salaries
- Direct materials, supplies used
- Depreciation of machineries and equipment used in the rendition of registered
services, and of that portion of the building owned or constructed that is used
exclusively in the rendition of the registered service
- Rent and utility charges for buildings and capital equipment used in the rendition
of registered services
- Financing charges associated with fixed assets used in the registered service
business the amount of which were not previously capitalized.”

In more recent rulings, BIR Ruling DA-089-07 dated February 13, 2007 and BIR Ruling DA-
552-07 dated October 23, 2007, the BIR also held that royalties were deductible for 5% GIT
purposes under the Ipso Facto rule, which extends the privileges granted to SBMA
enterprises to PEZA enterprises:

“xxx In view of the foregoing, this Office holds that royalties arising from the Technical
Assistance Agreement relative to the product design, logo, formula or process, in the
manufacture of the company's products, the payment of which is capitalized as part of
inventories, should be deductible in computing the gross income subject to the 5%
preferential tax rate as defined under Section 2, Rule 1 of the PEZA Rules and as
extended to PEZA registered firms as mandated by Sec. 51 of R.A. No. 7916. xxx”

Moreover, in Nidec Copal Philippines Corporation vs. CIR (CTA Case No. 6577 dated
September 25, 2006), the CTA confirmed the applicability of the ipso facto clause as follows:

“xxx Indeed, by virtue of the ipso facto clause under Section 51 of RA 7916, the
privileges, benefits, advantages or exemptions granted to SSEFZ enterprises equally
apply to PEZA entities. xxx”

This was reiterated in CIR vs. Nidec Copal Philippines Corporation (CTA EB Case No. 250
dated October 1, 2007) as follows:

“xxx PEZA-registered enterprises are similar to SSEFZ-registered enterprises created

under RA 7227, which are also subject to the 5% preferential tax rate, in that the
privileges, benefits, advantages or exemptions granted to SSEFZ-registered enterprises
equally apply to PEZA-registered entities pursuant to Section 51 of RA 7916, xxx ”

Based on the foregoing, there is also an issue on whether RR No. 13-2005 limits the
allowable deductions for 5% GIT purposes to those specifically enumerated in the RR.
Moreover, it is not clear whether the deductions allowed to Subic Bay Regional Enterprises
have been deleted. Based on the wording of RR No. 13-2005, it appears that the deductions
allowed to Subic Bay Regional Enterprises were removed. However, BIR Ruling DA-057-06,
cited earlier, where the BIR held that privileges granted to SBMA enterprises are also
accorded to PEZA enterprises, is dated February 23, 2006, which is subsequent to the date
when RR No. 13-05 was issued.

Thus, the following expense items of the Group (which may not be deductible under the first

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view) may be deductible following the 3rd view (ipso-facto clause):

 Commission expenses
 Corporate management salaries
 Administrative salaries
 Marketing and sales salaries
 Advertising
 Research and Development
 Royalty fees
 Travel Expense
 Outside professional fees
 Interest and financial charges on working capital
 Loss on foreign exchange translation
 Loss on disposal of merchandise inventory
 Communication expense

If the Group will take the position that the additional deductions given to Subic Bay Regional
Enterprises (SBRE) are also applicable to the Group in light of BIR Rulings DA-280-05 and
DA-057-06, it should obtain its own ruling for proper protection. As it is, the additional
deductions given to SBREs are not applicable to NON-SBREs.

2.3 Value Added Tax

Input Tax

Section 4.106-5 (c) of RR No. 16-05 provides that sales of goods or property to
persons or entities that are tax-exempt under special laws, e.g. (PEZA) shall be
effectively subject to VAT at zero-rate. Moreover, Section 4.108-6 (3) of the same
Regulation provides that services rendered to persons or entities whose exemption
under special laws or international agreements to which the Philippines is a signatory
effectively subjects the supply of such services to zero percent (0%) rate.

The BIR has consistently held in numerous rulings that purchase of goods and services by
PEZA-registered enterprises are subject to zero-rated VAT. We cite the following:

 BIR Ruling [DA-(VAT-008) 019-09 dated January 15, 2009: The BIR confirmed that
sale of goods and/or services by Co. E, a VAT-registered entity, to its various PEZA-
registered customers are subject to value-added tax (VAT) at zero percent (0%) rate.
Moreover, in the case of sale of services, the service should be performed within the
Ecozone. Sale of services within the customs territory, hence, rendered outside the
Ecozone, is not qualified for VAT zero rating.

 BIR Ruling [DA-(VAT-040) 227-09] dated May 15, 2009: The BIR held that the sales
by VAT-registered local suppliers to Co. N, once confirmed as a PEZA-registered
enterprise operating within the Ecozone, shall be treated as qualified export sales and
thus, entitled to the benefit of the zero percent VAT without further need of any prior
application for a BIR permit to zero rate such transaction. However, pursuant to the
provisions of Section 4.113-1 (B)(2)(c) of RR No. 16-05, if the sale is subject to zero
percent VAT, the term “zero-rated sale” shall be written or printed prominently on the
invoice or receipt issued by the local suppliers.

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Otherwise, the same shall not be entitled to the benefit of a zero-rated VAT transaction.

Based on the foregoing, it shall be emphasized that for sale of services to PEZA-
registered enterprises to be subject to VAT zero-rating, the services must be
rendered within the Ecozone. Moreover, the purchase of goods/services should be
supported by a VAT zero-rated invoice/OR.

Withholding VAT

The BIR has also held in the following rulings that payments by a PEZA-registered
entity to foreign suppliers in relation to PEZA-registered activities are exempt from the
withholding VAT:

 BIR Ruling DA-108-07 dated February 19, 2007: Co. S, a PEZA-registered

enterprise, entered into service agreements with non-resident corporations.
The BIR held that since effective zero-rating is not available to non-resident
suppliers, the sale of services by such suppliers is considered exempt and the
provisions of Section 109 (K) apply accordingly.

 BIR ITAD Ruling No. 044-09 dated April 2, 2009: Co. E, a PEZA-registered
enterprise, entered into a marketing services contract with Co. A, a non-
resident corporation registered in Japan. The BIR held that transactions
exempt from VAT by reason of P.D. 66 and R.A. 7916 are effectively zero-
rated. However, instead of zero-rating which is not available to non-resident
suppliers, the provision for exempt transactions under Section 109 (q) [now
Section 109 (K)] of the Tax Code of 1997 which provides VAT exemption for
transactions that are exempt under specials laws, e.g., Republic Act No. 7916
or PEZA Law, is particularly applicable to the instant case.

2.4 Other National and Local Taxes

Section 24 of RA No. 7916 provides that no taxes, local and national, except real
property taxes, shall be imposed on business establishments operating within the
Ecozone. Hence, PEZA-registered enterprises are exempt from the following national
and local taxes:

 Documentary Stamp Tax (DST)

 Local Business Tax (LBT)
 Real Property Tax (RPT)
 Other taxes, fees and charges imposed by local government units (LGU)
 Taxes and duties on importation of merchandise

DST

The BIR held in the following rulings that PEZA-registered entities are exempt from
DST on transactions related to PEZA-registered activities:

 BIR Ruling DA-509-06 dated August 25, 2006: Co. L and Co. E, both
PEZA-registered entities, entered into a lease contract agreement. The BIR
ruled that since both parties to the lease contract are both duly registered
PEZA enterprises enjoying the 5% special tax rate on gross income earned,
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then the lease contract over the “Leased Premises” shall not be subject to the
DST imposed under Section 194 of Republic Act No. 9243 by virtue of the
exemption provided by Section 24 of RA 7916 and Section 173 of RA 9243
which provides that whenever one party to the taxable document enjoys
exemption from the tax herein imposed, the other party thereto who is not
exempt shall be the one directly liable for the tax. Since both Co. E and Co. L
are exempt from all national and local taxes in lieu of the 5% special tax rate
on gross income earned, then the lease contract between them is exempt
from the DST.

 BIR Ruling DA-570-04 dated November 10, 2004: The BIR held that
considering that Co. A, a PEZA-registered enterprise, is liable to the
preferential tax rate of 5% on its gross income earned, in lieu of all local and
national taxes (except real property tax on land), it is exempt from the
payment of all other national taxes including documentary stamp taxes (RR
No. 12-97; BIR Ruling No. 146-99 dated September 14, 1999). This includes
documentary stamp taxes on loan agreements.

LBT

PEZA Memorandum Circular (MC) No. 2004-24 dated September 24, 2004 provides
that PEZA-registered enterprises availing of the 5% GIT incentive are exempted from
payment of all national and local taxes, except real property tax on land owned by
developers.

Under RR No. 12-97, local taxes shall refer to local taxes, business taxes, real estate
taxes, fees and charges imposed by local government units pursuant to the Local
Government Code of 1991, as amended.

In BIR Ruling No. 049-99 dated April 13, 2009, the BIR held that businesses
operating within the ECOZONE are no longer subject to the internal revenue taxes
imposed under the National Internal Revenue Code and to the Local taxes imposed
under the Local Government Code but only to the preferential tax rate of 5% based
on the gross income earned. The 5% in lieu of all taxes is a commutation tax which
effectively accords the grantee exemption from all other taxes (Philippine Airlines vs.
CIR, CTA Case No. 5, dated February 8, 1956; PNRC vs. CIR G.R. 10045, 34 Phil.
401).

RPT

PEZA MC No. 2004-24 also provides that PEZA-registered enterprises availing of the
ITH incentive are exempted from payment of all local taxes, licenses, imposts and
fees, except real estate taxes; provided that these enterprises shall also be exempted
from real property taxes on machineries and equipment they acquire for use in their
production operations, during the first 3 years of such machinery and equipment.

PEZA-registered enterprises availing of the 5% GIT are exempt from RPT except on
RPT on land owned by developers.

Moreover, opinions released by the Bureau of Local Government Finance (BLGF)

under the Department of Finance (DOF) provides that PEZA-registered enterprises
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under 5% GIT shall be exempt from national and local taxes except real property tax
on land owned by developers. We cite the following DOF-BLGF opinions:

 DOF-BLGF Opinion dated April 3, 2003: The Bureau held that Co. S, a
PEZA-registered enterprise shall be exempt from national and local taxes
except real property tax on lands. Co. S cannot be simultaneously liable to
pay the 2% tax to the municipality and the real property tax on land. It can
only be liable to pay the real property tax on land in pursuance of Section 24
of R.A. No. 8748.

 DOF-BLGF Opinion dated March 7, 2003: The Bureau opined that that
except for the land, the buildings, machineries and equipment owned by Co.
C, a PEZA-registered enterprise, are exempt from real property tax effective
CY 2003, the year following its registration with PEZA, pursuant to Section 24
of R.A. No. 8748.

Other taxes, fees and charges imposed by local government units (LGU)

PEZA MC No. 2004-04 provides that all PEZA-registered economic zone locator enterprises,
which are entitled to any or all 3 fiscal incentives [ i.e., Income Tax Holiday Incentive; the
option to pay the special 5% Tax on Gross Income, in lieu of all national and local taxes
except real property taxes on land owned by developers (5% GIT incentive); and / or tax-and
duty-free importation of machinery and equipment, raw materials, supplies, spare parts and
other production inputs], including Logistics Facilities Enterprises, are exempted from having
to secure all LGU permits.

However, under DOF-BLGF opinion dated August 25, 1999, PEZA-registered companies are
required to pay business permits and license fees, as follows:

“Business permit or license fees are charges imposed under the government's exercise
of police power to cover the cost of regulating business activities or privileges. It should,
therefore, be differentiated from a tax which is an imposition primarily for revenue
purposes and regulation is merely incidental.

It is therefore, necessary to determine whether a particular imposition is a tax or a fee

considering that some limitations apply only to one and not to the other, and for this
reason, exemption from taxes may not necessarily include exemption from payment of
license fee. (The fundamental of Taxation, Hector de Leon, p. 17, 1993)

Section 24 of R.A. No. 7916 explicitly provides that business entities within the
ECOZONES shall not be subject to tax, national and local. It is our opinion, therefore,
that the term tax as used therein strictly pertains to taxes for revenue purposes and does
not include business permit or license fees which are charges and impositions of a
different nature.

Hence, based on the above premise, municipalities such as the Municipality of

Dasmariñas should still collect business or license permit fees from establishments
operating within the ECOZONES thereat.”

Hence, there is a risk that the local government unit may still impose the payment of
business permits, license fees and other similar charges. However, the above opinion was
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dated before the release of the PEZA MC 2004-024 cited above. Thus, it is possible for the
Company to argue that it is exempt from such permits and fees pursuant to the PEZA MC.
This should be clarified by the Company with the LGU concerned.

Tax and duty free importation of merchandise

Section 1 Rule XV of the PEZA IRR provides that merchandise, raw materials,
supplies, articles, equipment, machineries, spare parts and wares of every description
brought into the ECOZONE Restricted Area by an ECOZONE Export or Free Trade
Enterprise to be sold, stored, broken up, repacked, assembled, installed, sorted,
cleaned, graded or otherwise processed, manipulated, manufactured, mixed with
foreign or domestic merchandise whether directly or indirectly related in such activity,
shall not be subject to customs and internal revenue laws and regulations of the
Philippines nor to local tax ordinances subject to the following conditions:

a. Importations of Capital Equipment

1. The machinery and equipment are directly and actually needed and will be used
exclusively by the ECOZONE Export or Free Trade Enterprise in its registered
activity;

2. The importation of spare parts shall be restricted only to component spare parts for
the specific machinery and / or equipment authorized to be imported; and

3. Subject to reasonable allowances, the rated capacity of the capital equipment to be

imported must be within the registered capacity of the ECOZONE Export or Free
Trade Enterprise.

Any sale, transfer, assignment, donation or other form of disposition of originally imported
capital equipment / machinery including spare parts, brought into the ECOZONE duty and
tax-free, within five (5) years from date of acquisition shall require prior approval of the
Board. Such approval shall be granted only if the sale or other form of disposition is made:

1. To an ECOZONE Enterprise entitled to duty and tax free importation of machinery, to

a BOI-registered enterprise enjoying similar incentives under this Rule, to operators
of BMW’s / BMCTW’s and / or to an export enterprise with a certificate of export-
orientedness from the Bangko Sentral ng Pilipinas;

2. For reasons of technical obsolescence as determined by the Board;

3. For purposes of replacement to improve and / or expand the operations of the

ECOZONE Export or Free Trade Enterprise intending to sell, transfer, assign, donate
or otherwise dispose of such machinery or spare parts;
4. In cases of withdrawal or cessation from operations of the ECOZONE Export or Free
Trade Enterprise, subject to payment of applicable duties and taxes and such other
conditions as may be prescribed by the Board.

If the ECOZONE Export or Free Trade Enterprise sells, transfers or disposes of these
machinery, equipment and spare parts without prior approval of the Board within five (5)
years from date of acquisition, the ECOZONE Export or Free Trade Enterprise and the

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vendee, transferee, or assignee shall be solidarily liable to pay twice the amount of the tax
exemptions granted.

Any sale, transfer, assignment, donation or other form of disposition of capital equipment,
brought into the ECOZONE duty and tax-free, after five (5) years from date of acquisition
shall require prior approval of the PEZA-Director General.

b. Importation of Construction Materials

1. The factory, warehouse or office building shall be constructed at the expense

of the ECOZONE Export or Free Trade Enterprise;

2. The construction materials to be imported are not manufactured domestically

in sufficient quantity, not of comparable quality and not sold locally at
reasonable prices. Construction materials shall not be considered available in
sufficient quantity if they cannot be made available to the ECOZONE Export or
Free Trade Enterprise at the time of need or within a reasonable period. In
determining whether the quality is comparable, the test, among others, will be
whether or not it will conform to the plans and specifications of the ECOZONE
Export or Free Trade Enterprise as approved by PEZA. In determining
reasonableness of the prices quoted by the domestic manufacturers or
suppliers, PEZA may be guided by the acquisition cost of similar construction
materials imported into the Philippines, after all applicable duties and taxes
were paid thereon, plus fifteen percent (15%) mark-up;

3. The construction materials to be imported are reasonably needed and will be

used exclusively in the construction of the factory, warehouse or office building
to be used by the ECOZONE Export or Free Trade Enterprise solely for its
registered operations;

4. The approval of PEZA is obtained by the ECOZONE Export or Free Trade

Enterprise before the purchase order is made or before the corresponding
letters of credit are opened; and

5. The construction materials shall be brought directly and physically inside the
ECOZONE restricted area or such area as may be designated by PEZA for
this purpose and in no instance shall these be sold, transferred, assigned,
donated or be disposed of in any manner in the customs territory.

c. Importation of Specialized Office Equipment and Furniture

Specialized office equipment and furniture such as computers, antistatic chairs,

tables and others of similar nature may be imported by ECOZONE Export or Free
Trade Enterprise exempt from customs duties and taxes payable thereon, if the
said equipment is not manufactured domestically in sufficient quantity, not of
comparable quality and not sold at reasonable price. Otherwise, ordinary office
equipment and furniture, whenever applicable shall be procured locally.

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d. Importation of Specialized Vehicles and Other Transportation Equipment

Specialized vehicles and other specialized transportation equipment, including

necessary spare parts, directly related to the registered activity of the ECOZONE
Export or Free Trade Enterprise, may be imported exempt from customs duties
and taxes only upon prior approval of the Board and with proper clearance from
the appropriate government agency(ies). Otherwise, ordinary vehicles and other
transportation equipment, including necessary spare parts, whenever applicable
shall be procured locally.

e. Importation of Professional Instruments and Household Effects

The professional instruments and implements, tools of trade, occupation or

employment, wearing apparel and personal household effects of foreign nationals
who shall settle in the Philippines in connection with their registered activity, may
be imported exempt from the payment of import duties and taxes: Provided, (a)
That the foreign national is an executive or is employed in an ECOZONE Export
or Free Trade Enterprise; and (b) That the above-mentioned articles shall not be
in commercial quantities nor for hire (Section 105 (h) of the Tariff and Customs
Code); and (c) That the approval of PEZA is obtained by the ECOZONE Export
or Free Trade Enterprise before the purchase order is made or before the
corresponding letters of credit are opened.

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