The sleepless nights of most accountants will end less than a month from now, as the last day of filing annual income tax returns (ITR) for corporations whose taxable year ended December 31, 2020 is on the 15^th of April. However, most of these companies are hoping that this due date will still be extended because, starting this week, the National Capital Region, along with other nearby provinces, will be observing a strict form of community quarantine. On top of this, some taxpayers are still struggling to comply with new requirements on transfer pricing (TP) and the impact of the Corporate Recovery and Tax Incentives (CREATE) Bill which is expected to be signed or lapse into law soon.

For enterprises registered with the Philippine Economic Zone Authority (PEZA) subject to 5% gross income tax (GIT), aside from issues on TP and the effects of the CREATE bill, one concern is determining expenses considered direct costs for purposes of computing GIT.

One focal issue that has hounded taxpayers is the determination of expenses considered by the Bureau of Internal Revenue (BIR) to be a direct cost that allowed for deduction or expense. The problem is that BIR examiners may assess taxpayers for disallowance or adoption of such deductions because there is no hard and fast rule that would determine if the nature of such deduction is a direct cost for purposes of computing the 5% special tax on gross income.

The provision laid down under Revenue Regulation (RR) 11-2005 may result in a vague interpretation as to whether the list of allowable deductions is exclusive or not. One reason behind the vagueness is the adoption of the lifeblood doctrine principle in taxation which construes the interpretation of tax provisions in favor of the government and against the taxpayer. However, the Supreme Court (SC) may have finally laid to rest this controversy.

On March 2, 2021, the Supreme Court handed down its decision on Commissioner of Internal Revenue vs. East Asia Utilities Corp. (G.R. 225266, Nov. 16, 2020). In its ruling, the SC confirmed the non-exclusivity of the list of allowable deductions for purposes of computing PEZA-registered enterprises’ 5% gross income tax. This issue of whether direct costs deductible as enumerated under RR No. 11 -2005 are exclusive or not exclusive has been the subject of various cases brought before the Court of Tax Appeals (CTA) and the BIR.

Under Sec. 24 of Republic Act No. 7916 or the PEZA Law, a PEZA-registered enterprise is entitled to a special tax of 5% on gross income earned within the ecozone in lieu of all national and local taxes. Gross income is composed of gross sales or revenue derived from business activity within the ecozone, net of sales discounts, sales returns, and allowances, minus cost of sales or direct cost but before any deductions for administrative, marketing, selling, operating expenses, or incidental losses.

This provision, as implemented under RR 2-2002, states that computation of gross income shall be subject to the 5% preferential tax rate. It is also further highlighted that the cost of sales or direct costs “shall consist only” of the enumerated costs or expense items, all computed in accordance with Generally Accepted Accounting Principles or GAAP. This phrase limits the allowable deductions from the gross income of a PEZA-registered enterprise. Subsequently, the BIR issued RR-11-2005 which revoked Sec. 7 of RR 2-2005 and removed the exclusive nature of the costs or expenses allowed as deductions from gross income. RR-11-2005 provides that “direct costs are included in the allowable deductions.” The SC, in its ruling, interpreted the word “include” to mean “to take in or comprise as part of a whole,” which can also mean a partial list. This phrase was taken to mean that the list or enumeration of direct costs under the RR 11-2005 is non-exclusive. RR 11-2005 likewise effectively deleted the phrase “consist only,” and used the word “included,” thereby stripping the enumeration of its exclusive character. In Moog Controls Corp.-Philippine Branch vs. CIR (CTA EB Case No. 1809. November 2019), the CTA ruled that RR 11-2005 does not point to exclusivity of the list of allowable deductions but instead serves as an instructive regulation or guide. It does not limit but merely enumerates allowable deductions.

However, some direct costs were affirmed by the CTA. In CIR vs. First Sumiden Circuits, Inc. (CTA E.B. case no. 1831, Feb. 12, 2020), the appellate court ruled that indirect labor welfare retirement is considered part of labor expenses because RR-11-2005 does not distinguish whether these expenses should be direct or indirect, or whether the term “office supplies” covers fees on photocopies of work orders and other forms used for production and planning purposes and control procedures of products and whether these charges are deductible. In the Moog case, the CTA found that costs for repair and maintenance of machinery and other equipment should form part of the cost of sales.

In addition to the list provided by revenue regulations, PEZA earlier issued Memorandum Circular (MC) 2020-053 which provides that expenses related to the COVID-19 pandemic are allowable deductions to gross income. This was confirmed by the BIR through a letter (Reference No. M. 076-2020). Subject to qualifications stated in the MC, these fees cover costs of providing temporary accommodation to operations and maintenance personnel during quarantine, shuttle services for employees, port charges in MCIP, Manila Ports, and NAIA arising from delays in the release of shipments at the said ports immediately after the implementation of the enhanced community quarantine in NCR. These are the direct costs that PEZA-registered enterprises may include as deductible expenses to their gross income.

According to the Moog case, the criteria to be used in determining whether expenses form part of direct cost are these costs’ direct relation to the business activities of PEZA-registered enterprises. If such an item of cost or expense can be directly attributed to the operations of PEZA-registered enterprises, then it should be considered direct cost. However, the principle that tax deductions, being in the nature of tax exemptions, are to be construed strictissimi juris against the taxpayer is well settled (H. Tambunting Pawnshop, Inc. vs. CIR, G.R. No. 173373, July 29, 2013). Taxpayers should be prepared and should be able to prove through related facts and laws that a deduction is authorized and that it is entitled to such deduction.

The Supreme Court has thus settled once and for all the issue at hand. The statutory list of direct costs under RR 11-2005 is not exclusive, nor does it limit allowable items for deduction to the items enumerated. PEZA-registered enterprises may avail of deductions by citing other direct costs not listed in the regulation as long as these expenses are related to the enterprises’ activities. This pronouncement by the Court is anticipated to further guide PEZA-registered taxpayers when they file their annual ITR before the BIR.

Mark Ebenezer A. Bernardo is an associate of the Tax Advisory and Compliance Division of P&A Grant Thornton.

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