This is a publication about developments in Philippine taxation. The contents usually include latest Republic Acts, Bureau of Internal Revenue issuances, Customs regulations, Court decisions, BSP circulars, SEC circulars, Department of Justice opinions and Executive Orders relevant to Tax practice.
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PFRS/IFRS 16, ‘Leases’, will impact the accounting and financial reporting for companies in the pharmaceutical and life sciences (PLS) industry in many areas. This article highlights key considerations regarding the evaluation of contract manufacturing arrangements for potential embedded leases. The new leases standard requires lessees to record an asset and a liability on the balance sheet for nearly all leases. This requirement also applies to any leases embedded in other arrangements. To identify embedded leases, companies will need to consider arrangements not typically thought of as leases, including supply contracts, data center agreements, outsourcing contracts and contract manufacturing arrangements. This publication focuses on the latter as an example of an arrangement that might contain an embedded lease. Determining whether an arrangement contains an embedded lease often requires a detailed analysis that involves significant judgement.
Contract manufacturing agreements can take many different forms. Generally, these agreements are structured such that a pharmaceutical company (Pharma) outsources the manufacturing of product to a contract manufacturing organization (CMO).The general rule under the new leases standard is that an arrangement contains a lease if (1) there is an explicitly or implicitly identified asset in the contract, and (2) the customer controls the identified asset over the period of use.
1. Identified asset
Contract manufacturing agreements could contain tangible assets that are explicitly specified in the contract. Examples might include machinery, production lines, and/or dedicated space in a facility. Even where no asset is explicitly specified in the contract, a tangible asset might be implicitly specified at the time when the asset (such as a machine or production line) is made available for use, provided that no alternative assets exist for the supplier to fulfil its obligations under the contract.
If an asset is explicitly or implicitly identified, the existence of substitution rights by the supplier will need to be evaluated. Where such rights are substantive, despite the existence of a specified asset, the customer would not have the right to use an identified asset, and thus a lease would not exist. A supplier’s right to substitute an asset is considered substantive only if both of the following conditions exist: (1) the supplier has the practical ability to substitute alternative assets throughout the period of use; and (2) the supplier would benefit economically from the exercise of its right to substitute the asset. This assessment is completed at inception of the arrangement based on facts and circumstances that exist as of that date.
The following factors are examples that might indicate that an arrangement does not contain a substantive substitution right and therefore includes the use of an identified asset:
Where Pharma is unable to readily determine if there is a substantive substitution right, it is presumed that no substitution right exists.
2. Right to control the use of an identified asset over the period of use
If Pharma concludes that the arrangement implicitly or explicitly identifies an asset, it must then evaluate whether it controls the use of that asset throughout the period of use. Pharma should assess whether, throughout the period of use, it has (1) the right to obtain substantially all of the economic benefits from use of the identified assets, and (2) the right to direct the use of the identified asset. Both criteria must be met for the arrangement to contain a lease. The following are among the factors that should be considered to determine whether Pharma controls the asset:
Example #1:
Facts: Customer A enters into an arrangement with a CMO to produce medical equipment and disposables (‘the Products’) that customer A then sells to outside customers. The CMO has multiple production lines that it uses to fulfil orders for multiple customers. The arrangement allows the CMO to choose the production line used to fulfil customer A’s orders. Even after the production of the Products commences on a product line, CMO can easily change to a different production line, with minimal transfer costs, because other production lines are available. Customer A submits legally binding purchase orders quarterly to the CMO, and it is contractually required to provide an annual non-binding production forecast. The Products are generic, and can easily be stored, and the CMO has full discretion over the operating process, including the selection of materials to use in production.
Question: Does this arrangement contain a lease?
Discussion: This arrangement is not likely to contain a lease under PFRS/IFRS 16. While the use of an asset (that is, the production line) is implicit in the contract, there is likely no identified asset, because substantive substitution rights exist (assuming that the CMO can benefit from substitution). Even if there was no substantive substitution, there is likely not a lease, because the CMO has the right to change the operating process and decide when the output is produced.
Example #2:
Facts: Assume the same facts as in Example#1, except that there is a dedicated production line for the Products, the CMO is contractually unable to use any other production line, the Products are highly specialized, and purchase orders are very frequent and effectively determine whether, when and how much output is produced. In addition, key operating decisions are standardized, and any changes in operating procedures are subject to approval by customer A.
Question: Does this arrangement contain a lease?
Discussion: This arrangement is likely to contain a lease under PFRS/IFRS 16. An identified asset is explicit in the contract (that is, the production line), and there are no substitution rights. There is a dedicated production line, and customer A appears to effectively control the decision-making rights over the use of the production line, because customer A’s purchase orders effectively determine whether, when and how much output is produced by the dedicated production line. The CMO does not have the right to change the operating instructions, including types of materials/components, overall production process, and other decisions related to the output, without prior authorization by customer A. Customer A also has substantially all of the economic benefits from use of the production line.
Lease arrangements that contain variable payments
Once a lease has been identified (including embedded leases), the accounting is impacted by whether the payments are fixed or variable. Fixed payments required under the lease can come in many forms, such as fixed annual payments or fixed monthly payments to guarantee capacity (often described as ‘capacity fees’ in lease arrangements). Companies will need to carefully review their lease agreements to ensure that all fixed payments have been identified. Variable lease payments are payments made by a lessee to a lessor for the right to use an underlying asset that vary because of changes in facts or circumstances occurring after the commencement date, other than the passage of time. Any payments that vary based on an index or a rate should initially be measured using the index or rate at the commencement date. Other variable lease payments will not impact the initial accounting for a lease (unless those payments are in-substance fixed lease payments), meaning that they are not included in the value of the initial lease liability and right-of-use (ROU) asset recorded at inception of a lease.
Example #3
Facts: Pharma enters into a two-year contract manufacturing agreement with Supplier, a CMO, to manufacture drug product. Pharma has concluded that it has an embedded lease for the production line. Pharma pays Supplier a fee for each batch of drug product produced. The contract specifies the minimum monthly volume of the drug product that is contractually required to be purchased by Pharma. The specified volume cannot be changed by Pharma during the term of the arrangement.
Question: How should Pharma account for this embedded lease under PFRS/IFRS 16?
Discussion: Pharma is required to purchase minimum volumes throughout the two-year period of use. As a result, although the total consideration is variable, the minimum volumes establish a fixed minimum consideration. First (assuming that Pharma has not elected to account for non-lease components as part of the lease component), Pharma should allocate the fixed consideration between the leased production line (lease component) and drug product (non-lease component), based on their relative stand-alone price at lease commencement. Then, Pharma would record an ROU asset and a lease liability on its balance sheet at the present value of the amount allocated to the lease.
Example #4
Facts: Assume the same facts as in Example #3, except that the contract contains no minimum monthly volume.
Question: How should Pharma account for this embedded lease under PFRS/IFRS 16?
Discussion: While this contract manufacturing agreement contains an embedded lease, the consideration is 100% variable. Because variable consideration is excluded from the value of the initial ROU asset and lease liability, there would be no initial lease liability for this agreement. Instead, Pharma would record variable lease expense for the embedded lease component over the two-year period. Under the new leases standard, Pharma can elect not to separate lease components from non-lease components and, instead, to treat the entire drug product cost as lease expense as the drug is produced / delivered.
Willfulness may be proven by educational level and ability to understand
An individual taxpayer sold gold and silver to the BSP from 2005 to 2009. However, he did not declare these sales in his ITRs.
Accordingly, the BIR filed a criminal case against him for failing to supply correct and accurate information in his ITRs. The CTA found the taxpayer guilty, sentencing him to imprisonment and payment of fines, and ordering him to pay deficiency income taxes and penalties totaling approximately PHP12.2bn.
The conviction was based on the following:
(CTA Crim. Case Nos. O-287 to O-291, promulgated 17 January 2019)
Disallowance of expenses despite payment of deficiency withholding taxes
After receiving the FDDA on 23 September 2014, the taxpayer filed a request for reconsideration with the CIR. The latter’s decision was received by the taxpayer on
24 February 2015.
On 19 March 2015, the taxpayer paid the deficiency EWT assessment in the FDDA. In light of the EWT payment, the taxpayer sought the cancellation of the related deficiency income tax assessment, invoking Section 2.58.5(C) of RR No. 2-1998 which allows the deduction of expenses if the withholding tax is paid at the time of the investigation or reinvestigation/reconsideration.
The CTA upheld the income tax assessment because the EWT was paid on 19 March 2015, after the taxpayer received the CIR’s decision on the request for reconsideration of the FDDA. Therefore, the payment was not considered made during the investigation or reinvestigation/reconsideration.
(CTA Case No. 9016, promulgated 8 January 2019)
30-day period to appeal is tolled by a request for reconsideration
When an administrative protest is denied by the duly authorized representative of the CIR, the taxpayer may, within 30 days from receipt of the denial, either file an appeal with the CTA or file a request for reconsideration with the CIR.
Accordingly, if the taxpayer received the FDDA on
12 November 2015, it generally has until 12 December 2015 to file an appeal with the CTA. However, if the taxpayer files a request for reconsideration of the FDDA with the CIR, it has 30 days from receipt of the denial of the CIR to file an appeal with the CTA.
(CTA Case No. 9301, promulgated 4 January 2019)
Proper service of assessment notices
The FAN/FLD should be served to the taxpayer either by registered mail or by personal delivery. Service through electronic mail (email) is not allowed and violates the right of the taxpayer to due process.
(CTA EB No. 1714, promulgated 4 January 2019)
Non-submission of supporting documents within 60 days from filing of protest
The Tax Code requires that all relevant supporting documents be submitted by the taxpayer within sixty (60) days from the filing of its administrative protest. Otherwise, the assessment becomes final.
However, if there is a showing that relevant supporting documents were attached to the administrative protest, the subsequent non-submission of supporting documents within the 60-day period will not render the assessment final. In this relation, the term ‘relevant supporting documents’ refer to those documents necessary to support the protest, as determined by the taxpayer and not by the BIR.
(CTA EB No. 1714, promulgated 4 January 2019)
When the 5-year prescriptive period for the right to collect taxes is tolled
The five-year prescriptive period for the BIR’s right to collect starts with the date of issuance of the FAN/FLD which is the date when the FAN/FLD is released, mailed or sent to the taxpayer. It is not the date of receipt by the taxpayer.
However, the above prescriptive period is tolled when the taxpayer files a request for reinvestigation of the FAN/FLD - not when a request for reconsideration is instead filed. In determining whether a protest letter is a request for reinvestigation or for reconsideration, the words used by the taxpayer, the tenor of its request, and the type of documents presented may be analyzed by the CTA.
Hence, if documents submitted with a protest letter partake the nature of additional evidence that could not have been passed upon by the BIR examiners during their investigation and re-examination of taxpayer records, the protest letter will be considered a request for reinvestigation. In such case, the prescriptive period to collect is tolled.
(CTA EB No. 1678 &1680, promulgated 3 January 2019)
Importations of alkylate are subject to excise taxes
The Tax Code imposes excise taxes on the importation of naphtha, regular gasoline and other similar products of distillation. According to the CTA, imported alkylate is a product of distillation, hence, subject to excise tax. Although alkylate is not directly produced through distillation (but by alkylation), the olefins and isobutane utilized during alkylation are products of distillation.
(CTA Case Nos. 8914 & 8981, promulgated 18 December 2018)
ADB’s Filipino employees are subject to income tax
According to the CTA, Filipino employees of the ADB are subject to income taxes for the following reasons:
(CTA EB No. 1674, promulgated 6 December 2018)
Applying the doctrine of apparent authority
A domestic corporation seeks to invalidate the FAN because it never issued a Secretary’s Certificate or Board Resolution authorizing a natural person to represent it before the BIR for purposes of the tax investigation.
The CTA upheld the validity of the FAN. Citing a Supreme Court decision, the CTA applied the doctrine of apparent authority whereby the board of directors may validly delegate authority to natural persons impliedly or by acquiescence in the general course of business. Thus, the authority of a corporate officer or agent may either be actual or apparent.
Based on the evidence presented, the internal accountants of the domestic corporation who represented the latter before the BIR were deemed to have apparent authority.
(CTA Case No. 9331, promulgated 11 December 2018)
Implementing the VAT exemption of certain drugs and medicines
The BIR issued regulations implementing the VAT exemption of sales of drugs and medicines prescribed for diabetes, high cholesterol and hypertension. Here are the salient features of these regulations:
(Revenue Regulations No. 25-2018, published 28 December 2018)
Excise tax exemption of purely electric or hybrid vehicles
Purely electric vehicles (EVs) are exempt from the excise tax on automobiles. On the other hand, hybrid electric vehicles (HEVs) are subject to fifty percent (50%) of applicable excise tax rates on automobiles.
Prior to removal from the manufacturing plant or customs custody, the BIR, in determining qualification for excise tax exemption, shall require the manufacturer, assembler or importer to submit a certified true copy of the COC issued by the DENR-EMB (for HEVs) or a Certificate of Non-Coverage (for EVs).
(Revenue Regulations No. 24-2018, published 30 November 2018)
Amending the Exchange of Information Regulations
Taxpayers who are subjects of a foreign tax authority’s request for exchange of information held by financial institutions shall be duly notified in writing:
(Revenue Regulations No. 22-2018, published 19 October 2018)
Clarifying the start of the 90-day period to process VAT refund claims
The 90-day period for the processing of VAT refund applications, in relation to the VAT zero-rated sales of goods, property and services and for attributable input VAT, starts from the date when the application was filed up to the date when the refund is released.
For purposes of counting the 90-day period, the application is considered filed when the supporting official receipts or invoices have been submitted.
(Revenue Regulations No. 26-2018, published 1 January 2019)
Clarifying the payment of excise taxes on domestic coal
The excise tax on coal is a tax levied on the product. Generally, the coal producer is liable for the excise tax. However, if the excise tax is unpaid and possession of the coal has already been transferred to a buyer/possessor, the latter can be held liable for the unpaid excise tax.
Accordingly, when the coal is removed from the place of production without the payment of excise tax, the coal producer shall be a designated collecting agent of the excise tax due from the buyer-possessor and shall be required as follows:
The deadline for filing and payment of the excise tax is on or before the 10th day following the close of the month.
(Revenue Memorandum Circular Nos. 6-2019, issued 17 January 2019 & 105-2018, issued 19 December 2018)
List of VAT-exempt Diabetes, High Cholesterol and Hypertension Drugs
The BIR has disseminated the FDA-prepared List of VAT-exempt Diabetes, High Cholesterol and Hypertension Drugs updated as of 3 January 2018.
(Revenue Memorandum Circular No. 4-2019, issued 15 January 2019)
Implementing guidelines for the VAT-exempt sale of certain drugs
The DOH, DOF, FDA and BIR issued a Joint Administrative Order containing the implementing guidelines for the VAT exemption of the sale of diabetes, high cholesterol and hypertension drugs. Among others, the guidelines mandate the specific roles of the DOH, DOF, FDA and BIR.
The guidelines shall take effect on 1 January 2019 after complete publication in at least one newspaper of general circulation.
(Revenue Memorandum Circular No. 2-2019, issued 10 January 2019)
Further extending the deadline for processing VAT refund/credit claims
The concerned BIR offices have until 29 March 2019 to act on all VAT refund/credit claims that were filed before the effectivity of RMC No. 54-2014.
(Revenue Memorandum Circular No. 102-2018, issued 11 December 2018)
Setting aside a portion of VAT collections to cover VAT refunds
The BIR published the Joint Circular of the DOF, DBM, BTr, BIR, BOC and COA with respect to the payment of VAT refund claims.
The Joint Circular provides for the following:
The Joint Circular shall be published in the Official Gazette and in at least two (2) newspapers of general circulation prior to its effectivity on 1 January 2019.
(Revenue Memorandum Circular No. 3-2019, issued 10 January 2019)
Clarifying issues regarding the PERA Act of 2008
The BIR has issued clarificatory questions and answers (Q&As) in relation to the rules, guidelines and procedures in implementing the PERA Act of 2008. The Q&As touch on the following:
(Revenue Memorandum Circular No. 99-2018, issued 7 December 2018)
Certification of developers of filing and/or payment solutions
To encourage taxpayers to use the eBIRForms, the BIR allows the use of tax filing and/or payment solutions developed by tax software providers (TSPs). However, these solutions should be tested and certified by the BIR.
Accordingly, TSPs may access the Electronic Tax Software Provider Certification (eTSPCert) System in www.bir.gov.ph for the facilitation of the certifications of their tax filing and/or payment solutions.
(Revenue Memorandum Circular No. 98-2018, issued 5 December 2018)
Policies and guidelines in the re-accreditation of printers of receipts/invoices
The BIR issued guidelines, policies and procedures for the renewal of the accreditation of printers of principal/supplementary receipts/invoices. Among others, they provide for:
(Revenue Memorandum Order No. 6-2019, issued 15 January 2019)
