CTA: List of Allowable Deductions for PEZA Registered Enterprises not Exclusive

By: Mark Andrew M. Santiago
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] several rulings 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, then 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 21 May 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
Comment [g1]: “Several” refers to how many
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 which includes, among others,such as
employee benefits, and technical training of employees were directly related to their registered
activity, whose work is directly related to the 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.
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