SUBJECT : Income Taxation of Service Contractors Engaged in Petroleum

Operations in the Philippines

1980-12-08 | Revenue Regulation No. 01-81

January 1, 1979 (December 8, 1980)

TO : All Internal Revenue Officers and Others Concerned:

Pursuant to the provisions of Presidential Decree No. 1682 in relation to Sections 4 and 326 of the National
Internal Revenue Code of 1997, as amended, the following regulations are hereby promulgated:

SECTION 1. Scope. — These regulations shall govern the taxation of income derived by service contractors
from their petroleum operations in the Philippines. Income derived from all other activities shall be governed
by other provisions of the National Internal Revenue Code and the implementing regulations.

SECTION 2. Persons subject to these regulations. —

(a) In general. — All corporations authorized to engage in petroleum operations in the Philippines in
accordance with a service contract entered into by the said corporation and the Bureau of Energy
Development (BED), shall be subject to the provisions of Title II (Income Tax) of the National Internal
Revenue Code and implementing regulations. A partnership, consortium or joint venture which is a signatory
to a service contract shall be considered a "corporation" as defined in Section 20 (b) of the National Internal
Revenue Code: Provided, however, that for purpose of these regulations, the term "corporation" as defined in
Section 20 (b) of the National Internal Revenue Code shall not include a partnership, consortium or joint
venture undertaking joint operations under an Operating Agreement and such partnership, consortium or joint
venture shall not be treated as a separate taxable entity.

(b) Exceptions. — These regulations shall not apply to contractors covered by service contracts entered into
prior to the effective date of Presidential Decree No. 1682 unless such contracts are amended upon the
agreement of the parties concerned and with the approval of the Minister of Energy.

SECTION 3. Definitions of Terms. — For purposes of these regulations, the following terms shall have their
respective meanings:

(a) Service contract — means the production sharing agreement executed between the contractor and the
BED, in consideration for service, technology and/or financing provided by the contractor;

(b) Service contractor — means the contractor in a service contract, whether acting alone or in consortium
with other engaged in petroleum operations under Presidential Decree No. 87;

(c) Contract area — means the whole area as defined and specified in the service contract;

(d) Oil field — means any place within a contract area, where one or more pools or reservoirs of oil are found
in commercial quantity on the same structure/build-up or the area encompassed by the individual
structure/build-up containing such oil pools or reservoirs;

(e) Dry hole — means a drilled well that is unable to produce oil or gas commercial quantities;

(f) Petroleum — means any mineral oil or hydrocarbon gas, bitumen, asphalt, mineral gas and all other similar
or naturally associated substances, with the exception of coal, peat, bituminous shale and other stratified solid
mineral fuel deposits;

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(g) Petroleum in commercial quantities — means petroleum in such quantities which will permit its being
economically developed as determined by the contractor after consultation with the BED taking into
consideration the location of the reserves, the depths and number of wells required to be drilled and the
transport and terminal facilities needed to exploit the reserves which have been discovered;

(h) Petroleum operations — means searching for and obtaining petroleum within the Philippines through
drilling and pressure or suction or the like, and all other operations incidental or related thereto. It includes the
transportation, storage, handling and the sale for export or for domestic consumption of the petroleum
obtained but does not include the transportation of petroleum outside the Philippines or the processing or
refining at a refinery; cda

(i) Market price — means the consideration which would be realized for petroleum under a service contract if
sold in a transaction between independent persons dealing at arm's length in a free market;

(j) Tangible cost — mean the expenditures for physical assets that have a salvage value and an expected
useful life of over one year based on its intended usage;

(k) Intangible exploration, drilling and development expenses — mean any expenditures which have no
salvage value and are incidental to and necessary for the drilling of wells and the preparation of wells for the
production of petroleum, including the following:

(1) Intangible exploration and drilling expenses — are those expenditures incurred to ascertain the existence
of petroleum deposits including geological, geophysical and other survey costs as well as expenditures made
for the preparation of drillsites, drilling and testing of wells or amounts paid to drilling contractors, wages, fuel,
supplies and similar activities pertaining to the search for such petroleum deposits;

(2) Intangible development and drilling expenses — are those expenditures incurred to determine the extent,
quantity or quality of petroleum deposits and to make them accessible for production, including the
preparation of drillsites, drilling and testing of wells, or amounts paid to drilling contractors, wages, fuel,
supplies and similar items, including delineation and development drilling, deepening of wells, injection of
wells, redrilling or workover of wells and other similar activities such as the transportation, on-site fabrication
and erection of platforms used in drilling operations: Provided, however, that expenditures described in this
sub-section (k) shall not pertain to the acquisition or improvement of property of a character subject to the
allowance for depreciation, but the allowance for depreciation of contractor's equipment used in exploration,
drilling and development shall be treated as a sub-section (k) expenditures.

Any intangible exploration, drilling and development expense allowed as a deduction in computing taxable
income during the year shall not be taken into consideration in computing the adjusted cost basis for the
purpose of computing allowable cost depletion.

(l) Pre-production expenditures — mean the intangible exploration, drilling development expenses, dry holes
and operating expenses, such as depreciation of tangible cost, overhead and administrative expenses paid or
incurred with respect to such contract area prior to the commencement of petroleum production in commercial
quantities from such contract area;

(m) Dry hole costs — mean the accumulated intangible drilling and development expenses and tangible costs
incurred in a well that fails to produce oil or gas in commercial quantities;

(n) Post-production expenditures — consist of ordinary and necessary expenses paid on incurred with respect
to a contract area after the commencement of commercial production in such contract area and which include:

(1) Operating costs — such as depreciation, depletion and other overhead and administrative expenses
relative to the current year production;

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(2) Intangible exploration drilling costs, including dry hole cost incurred; and
(3) Intangible development drilling costs.

SECTION 4. Computation of Net Income from Petroleum Operation. — The net income from petroleum
operations shall mean the gross income from petroleum operations as defined under Section 5, less the
deductions allowed by Section 6 hereof.

SECTION 5. Gross Income from Petroleum Operations. — Gross income from petroleum operations means
its total entitlement of the gross proceeds from the sale at market price during the taxable year of petroleum
produced under the service contract and such other income which is incidental to and arising from any one or
more of the petroleum operations of the contractor, Provided, that the amount of Filipino participation
incentive allowance received by a Philippine corporation pursuant to an operating agreement under a
petroleum service contract entered into between a service contractor and the Government under Presidential
Decree No. 87 shall not be included in the gross income of the Philippines corporation.

SECTION 6. Deductions. — In computing net income for the taxable year there shall be allowed as
deductions —

(a) Expenses in general — All ordinary and necessary expenses paid or incurred by the contractor during the
taxable year in carrying on the petroleum operations under a service contract;

(b) Interest — Interest expense paid or incurred within the taxable year will deductible in full for the purpose of
this section, except that loans or indebtedness incurred in finance exploration expenditures will be treated as
equity capital and no interest deductions will be allowed for such capital;

(c) Bonuses — All bonuses paid or incurred during the taxable year in accordance with the provisions of the
service contract, provided that bonuses paid prior to the date of commencement of production will be
amortized on a unit-of-production basis;

(d) Home-office charges — Duly substantiated and reasonable home-office charges, paid or incurred during
the taxable year, properly apportioned or allocated to petroleum operations in the Philippines;

(e) Depreciation — On all tangible assets initially placed in service in a taxable year and directly related to
production of petroleum, the service contractor is granted the option using the straight-line or double-declining
balance method of depreciation. The method elected for a particular taxable year shall be used for such
assets placed in service during the year.
In the event the double-declining balanced method is initially elected, the contractor may at any subsequent
date still elect to convert to the straight-line method of depreciation. The useful life of assets used in or related
to production of petroleum shall be 10 years or such shorter life as permitted by the Commissioner of Internal
Revenue. The useful life for automobiles, furniture, fixtures and general office equipment shall be five (5)
years. Only the straight-line method of depreciation shall be used for this latter category of investment.

(f) Depletion — In general. — A reasonable allowance for depletion or amortization, computed in accordance
with the cost depletion method of adjusted costs basis represented by pre-production expenditures and if
applicable cost capitalized in accordance with the provisions of Section 6(h), provided that the allowances
shall not exceed the capital invested.

(1) Cost depletion — The depletion unit shall be computed by dividing the adjusted cost basis as of the end of
the taxable year by the sum of (i) the remaining recoverable units of petroleum as of the end of the taxable
year; (ii) the units of petroleum sold and/or delivered by the contractor attributable to its share, and (iii) the
units of petroleum delivered by the Government and sold and/or delivered to purchaser (s) attributable to the
Government's share during the taxable year from the particular oil field involved. The cost depletion for the
taxable year shall thereafter be calculated by multiplying the depletion unit so determined by the total number

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of petroleum units sold and/or delivered under (ii) and (iii) above during such taxable year.

(2) Pre-production expenditures prior to January 1, 1979 — Depletion or amortization allowances relating to
pre-production expenditures incurred prior to January 1, 1979 shall be deductible only from income derived
from the same contract area on which such expenditures had been incurred.

(3) Pre-production expenditures on or after January 1, 1979 — Depletion or amortization or pre-production

expenditures incurred on or after January 1, 1979 shall be allowed as a deduction against income realized
from any source.

(g) Intangible exploration and drilling costs — Intangible exploration and drilling cost including cost of dry
holes incurred after the commencement of commercial production shall be deductible in the year paid or
incurred.

(h) Intangible development and drilling expenses of producing wells — Intangible development and drilling
expenses of producing wells incurred after the commencement of commercial production may be allowed as
a deduction in the taxable year paid or incurred: Provided, however, that the contractor shall have the option
to capitalize and amortize the same on the basis of the recoverable units of reserves in the particular oil field
involved plus the units produced and sold during the same year from the said oil field, or over such shorter
amortization schedule, as the Commissioner of Internal Revenue may allow. The election in a taxable year to
capitalize or deduct shall apply to all similar costs incurred during said taxable year. Such election to
capitalize or deduct may, however, be availed of yearly.

(i) Intangible drilling expenses of uncompleted wells — If the contractor has elected to capitalize and amortize
intangible development and drilling expense of producing wells as provided in Section (h) including a well in
the process of being drilled at the end of the taxable year which is subsequently determined to be a well
which has failed to find petroleum in commercial quantities, all unamortized costs pertaining to such well may
be deducted in full in the year of such determination.

(j) Abandonment losses — (1) In the event a contract area is abandoned, the accumulated exploration and
development expenditures incurred therein prior to January 1, 1979 shall not be allowed as an abandonment
loss in the year abandon against the income from another contract area: Provided, however, that where such
expenditures were incurred on or after January 1, 1979, the said accumulated expenditures may be deducted
as abandonment loss, from income derived from any other activity. Contractor will furnish to the Bureau of
Internal Revenue a copy of all notices of abandonment submitted to the Bureau of Energy and Development
in accordance with the service contract.

(2) The unamortized costs of a previously producing well and undepreciated costs of equipment shall be
allowed as a deduction in the year such well, equipment or facilities are abandoned by the contractor. In the
event that such abandoned well is re-entered and production is initiated or restored, or such equipment or
facility is restored into service, the said abandonment loss shall be considered as income in the taxable year
of initiation or restoration, and such recaptured costs shall be amortized or depreciated in accordance with
Section 6(h) or 6(e).

SECTION 7. Combination of Income and Losses. — Net income or losses from petroleum operations under a
service contract shall be consolidated with the contractor's net income or losses from all other activities in
accordance with the provisions of the National Internal Revenue Code.

SECTION 8. Income and Deductions Pertaining to Materials, Equipment and Facilities Assigned to the
Government. — In the event contractor assigns title to materials, equipment and facilities erected or placed
within a contract area to the Republic of the Philippines, and retains the right to use such materials,
equipment or facilities in the conduct of petroleum operations free of charges as provided in the service
contract, no income of any source, nature or kind, will be deemed, imputed or otherwise attributed to the

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contractor under the National Internal Revenue Code due to the transfer or use by contractor of such
materials, equipment and facilities within the contract area, shall continue to maintain, repair or replace
materials, equipment and facilities as deemed necessary by contractor, and shall be permitted to deduct in
accordance with Section 6 hereof (i) all operating costs pertaining to the use or operation of such materials,
equipment and facilities; (ii) all costs pertaining to the relocation, maintenance, repair and replacement of
such materials, equipment and facilities; (iii) depreciation in respect to any undepreciated costs of such
materials, equipment and facilities normally subject to depreciation including any capital improvements
introduced thereon. Provided, however, that any remaining undepreciated costs of such transferred materials,
equipment and facilities shall be allowed as a deduction by the contractor in accordance with Section 6 (j) in
the year such materials, equipment and facilities are abandoned.

SECTION 9. Tax Rates on Corporations Engaged in Petroleum Operations. — The corporate income tax
rates imposed on domestic or resident foreign corporations under Section 24 of the National Internal Revenue
Code shall apply to corporation engaged in petroleum operations in the Philippines under a service contract.

SECTION 10. Filing of Corporate Return and Payment of Taxes. — A corporation subject to income tax under
these regulations shall be subject to the pertinent provisions of the National Internal Revenue Code as
regards the filing of the quarterly and final corporate returns and the payment of income tax.

SECTION 11. Penalties. — A corporation subject to income tax under these regulations shall be subject to
surcharges, interest and penalties in accordance with the pertinent provisions of the National Internal
Revenue Code in cases of failure to file an income tax return and to pay income tax on time, in cases of willful
neglect to file the return or when a false or fraudulent return to file the return or when a false or fraudulent
return is filed. An officer of the corporation required by law to make, render, sign or verify any return or to
supply any information, who makes any false or fraudulent return or statement shall likewise be subject to the
penalties prescribed in the National Internal Revenue Code.

SECTION 12. Repealing Clause. — All regulations, rulings, orders, or portions thereof, which are inconsistent
with the provisions of these regulations are hereby revoked and/or amended.

SECTION 13. Effectivity. — These regulations shall take effect beginning January 1, 1979.

(SGD.) CESAR VIRATA

Minister of Finance

Recommended by:
(SGD.) RUBEN B. ANCHETA
Acting Commissioner

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