CTA: List of allowable deductions for PEZA registered enterprises not exclusive

Republic Act 7916 (PEZA Law), otherwise known as the “The Special Economic Zone Act of 1995” was enacted as a means of attracting investors in the Philippines. Among its provisions is a tax incentive which grants to business establishments registered with the Philippine Economic Zone Authority (PEZA), a five-percent preferential gross income tax (GIT) rate imposed on gross income, in lieu of all national and local taxes. Gross Income is defined in the Implementing Rules and Regulations of the PEZA Law (PEZA Rules) as 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. In relation to this, the Implementing Rules and Regulations of the PEZA Law (PEZA Rules) have provided a list of allowable deductions for the purposes of computing gross income.

To clarify the list of direct costs included as allowable deductions under the PEZA Rules, the Bureau of Internal Revenue (BIR) had issued Revenue Regulations (RR) 11-05 which provides a list of direct costs which are as follows:

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; portion of the building owned or constructed used exclusively in the rendition of 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 amounts of which were not previously capitalized.

The BIR had opined in BIR Ruling No. 14-12 and subsequent rulings [BIR Ruling Nos. 92-13; 125-13; 194-13] that the enumeration contained in RR 11-05 is exclusive. Thus if an expense does not fall under any of the list of direct costs under RR 11-05, it cannot be claimed as a deduction by a PEZA enterprise.

This issue was again brought into the limelight in the recent Court of Tax Appeals case of East Asia Utilities Corporation vs the Commissioner of Internal Revenue (CTA Case No. 8179), promulgated May 21, 2014. In this case, the petitioner, East Asia Utilities Corporation (EAUC), a PEZA registered enterprise, operates a megawatt power plant. It had been assessed for deficiency taxes in the amount of P2,791,894.70 because of a disallowance by the BIR of various expenses amounting to P34,467,835.76 for the reason that these expenses do not fall under the list of direct costs expenses under RR 11-05.  EAUC contends however that the list of allowable deductions under RR 11-05 is not exclusive.  The list serves only as a guide in determining what items may be considered as direct costs or cost of sales.

The CTA ruled in favor of EAUC and declared that the list of direct costs under RR 11-05 is indeed not exclusive. It agreed with EAUC that when RR 11-05 amended the previous RR 02-05, the words “consists only” were deleted and the pertinent phrase restated to “the following direct costs are included in the allowable deductions x x x .”

It held that the list under RR 11-05 was not meant to be all-inclusive but merely enumerates the expenses that can be considered as direct costs and that PEZA-registered enterprises may be allowed to deduct expenses which are in the nature of direct costs even though the same are not included in the list. That the criteria in determining whether or not the item of cost or expense should be part of the direct cost is the direct relation of the expense in the rendition of the PEZA-registered services.  If the item of cost or expense can be directly attributed in providing the PEZA-registered services, then it should be treated as direct cost.  Since EAUC was able to present evidence that their costs of services such as employee benefits, and technical training of employees were directly related to their registered activity, the CTA ruled that these should be allowed as deductions.

Both EAUC and the CIR had filed their separate motions for reconsideration to this decision of the CTA.  It would therefore be interesting to see how this case would be decided if and when it reaches the Supreme Court. The Court’s final decision would be of great importance to PEZA registered enterprises that want to claim deductions, as well as to investors who plan to set up business in the Philippines and register with PEZA.

Mark Andrew M. Santiago is an Supervisor from the Tax Group of R.G. Manabat & Co. (RGM&Co.), the Philippine member firm of KPMG International.

This article is for general information purposes only and should not be considered as professional advice to a specific issue or entity.

The view and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG International or RGM&Co. For comments or inquiries, please email [email protected] or [email protected].

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