Allowable deductions for PEZA IT enterprises

by: Arnold P. Supilanas 
(Published in BusinessWorld on September 26, 2006)



In today’s computer age, information technology (“IT”) has become the emerging industry in the global economy.  And with the country’s English-speaking and highly-skilled IT professionals, the Philippines has become a favorite investment destination for most IT and IT-enabled companies.

Due to this competitive advantage, the Philippines is now hosting a number of business process outsourcing (“BPO”) firms, contact centers (popularly known as “call centers”),  software research and development enterprises, medical and legal transcription firms, design engineering companies and other IT and IT-enabled firms.

Most of these IT and IT-enabled firms are registered with the Philippine Economic Zone Authority (“PEZA”) obviously for the availment of certain fiscal and non-fiscal incentives.  As in the case of any other PEZA-registered entity, the IT industry is also entitled to the 5% special tax regime based on the gross income earned. Under the existing PEZA rules, “gross income” refers to the 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. For export enterprises, the direct costs are enumerated in Section 2, Rule XX of the Implementing Rules and Regulations of Republic Act No. 7916, as follows:

1.   Direct salaries, wages or labor expenses
2.   Production supervision salaries
3.   Raw materials used in the manufacture of products
4.   Goods in process (intermediate goods)
5.   Finished goods
6.   Supplies and fuels used in production
7.   Depreciation of machinery and equipment used in production, and buildings owned or constructed by an ECOZONE Enterprise
8.   Rent and utility charges associated with building, equipment and warehouses, or handling of goods
9.   Financing charges associated with fixed assets

Notably, the list of allowable deductions for export enterprises is more applicable to manufacturing companies rather than to service, such as IT or IT-enabled companies. Are these deductions intended to be all-inclusive or are these merely enumeration of the typical expenses that can be considered as direct costs?  Should PEZA-registered IT enterprises be allowed to deduct direct costs and other expenses which are in the nature of direct costs, although not included in the list?

The Bureau of Internal Revenue (BIR) attempted to address this concern when it issued Revenue Regulations (“RR”) No. 2-2005 where it inserted the word “only” in the enumeration of the allowable deductions, thus, limiting the deductible costs to those listed. But the implementation of the said regulations was suspended. In trying to arrest the issue, the BIR subsequently issued RR No. 11-2005 which deleted the word “only” in the list.  Going through the content of RR No. 11-2005, it can be observed that the list of expenses provided under the BIR regulations and the PEZA implementing regulations are the same, except for the clarification that the depreciation and financing charges allowed as deductions shall be limited to those relating to fixed assets used in the production of goods and the deductible portion of goods in process and finished goods accounts.

On the other hand, the removal of the word “only” in the list was understood by most PEZA-registered companies, particularly the IT enterprises, that the BIR has conceded that the allowable deductions are not only limited to those listed in the regulation and, as such, other expenses that are in the nature of direct costs, depending on the nature of the business, can also be claimed as deduction. Consequently, PEZA IT Enterprises may deduct other expenses which are in the nature of direct cost for purposes of computing the gross income earned.

The justification of a specific cost as a direct cost could be an issue. Under the generally accepted accounting principles, the underlying principle in determining the item of cost or expense as part of direct cost is the direct relation of such item in the production of the product or service.  If such item of cost or expense is a prerequisite element in the production of the product or service, then it should be considered as direct cost.  Hence, it may be significant to understand the production processes of a certain company to properly determine which item of cost or expense is classifiable as direct cost.

In the absence of a specific regulations, it would be prudent for PEZA IT enterprises to secure a ruling from the BIR should they decide to claim expenses, other than those listed in the regulations, as deductions for purposes of computing the 5% special tax.

Our regulators, however, should consider that formulation of specific regulations on the allowable deductions for PEZA IT Enterprise would foster a uniform application of the PEZA incentives. With a well defined incentive system, the Philippines will not be far from being the number one investment destination in the IT industry.