BIR Ruling [DA-010-05]

January 17, 2005 BIR RULING [DA-010-05] Income VAT 008-03; DA-578-04; 042-03 SGV & Co . 6760 Ayala Avenue 1226 Makati City Attention: Attys. C.P. Noel & W. U. Villanueva Gentlemen : This refers to your letter dated December 3, 2004 requesting on behalf of your clients, Mitsubishi Corporation ("Mitsubishi") and Mirant Global Corporation ("Mirant") , for confirmation of your opinion that: (1) Payments made by the Mirant Project Company to Mitsubishi for the performance of the construction, installation and related civil works specified in the Onshore Portion of the engineering, procurement and construction contract (the " EPC Contract ") between Mirant and Mitsubishi are subject to a creditable withholding tax at a rate of 2%. (2) The importation by the Project Company into the Philippines of the materials, machinery and equipment to be supplied by Mitsubishi under the Offshore Portion of the EPC Contract is subject to 10% Value-Added Tax ("VAT"); (3) The attribution formula prescribed under Revenue Audit Memorandum Order No. 1-95 ("RAMO 1-95") will apply in determining the taxable income of Mitsubishi on the payments arising from the Offshore Portion of said EPC contract, and said payments will not be subject to the 2% creditable withholding tax and the 10% VAT. The facts, as you represented, are as follows: Mitsubishi is a corporation duly organized and existing under and by virtue of the laws of Japan, with main office address at 6-3, Marunouchi, 2-chome, Chiyoda-Ku, Tokyo, Japan. Mitsubishi is one of the so-called Sogo Shoshas and is engaged in the business of general import and export trading, financing and the construction business. It is duly authorized by the Securities and Exchange Commission ("SEC") to operate a branch in the Philippines under the name "Mitsubishi Corporation (Manila Branch)." TDCAIS Mirant is a domestic corporation engaged in the generation and sale of energy. Mirant is considering the possibility of expanding the capacity of the power plants located at Barangay Ibabang Pulo, Pagbilao, Quezon and operated by Mirant Pagbilao Corporation (a [wholly-owned subsidiary of Mirant]; hereinafter, "MPC") pursuant to an Energy Conversion Agreement between MPC and national Power Corporation dated November 9, 1991. To help address the growing demand for electricity in Luzon, Mirant is contemplating the establishment of a domestic corporation (the " Project Company ") to operate and maintain a thermal unit with a capacity of approximately [364] megawatts, in addition to the existing thermal units currently operated by MPC with an aggregate capacity of approximately 750 megawatts, and is looking to invest about US$300 Million for the said expansion. Mirant (through the Project Company) and Mitsubishi propose to enter into an EPC Contract for the design, manufacture, supply, construction, execution, commissioning and completion of the additional 364 megawatt thermal unit referred to above, including the procurement and supply of all materials, machinery and equipment (the " Equipment "), and the performance of all acts required in connection therewith. The project will be finance through a loan granted by the Japan Bank for International Cooperation ("JBIC"). Mitsubishi's scope of work under the EPC Contract will be divided into two portions, as follows: (a) The design, fabrication, engineering, manufacture, supply and delivery of Equipment, all of which will be performed outside the Philippines, including offshore transportation thereof (the " Offshore Portion "); and acHTIC (b) The construction and installation of certain facilities, and the performance of related civil works for the project, which works will be performed in the Philippines, including transportation for the delivery of Equipment within the Philippines (the " Onshore Portion "). The scope of the Offshore and Onshore Portions of the EPC Contract will be clearly identified in the EPC Contract. Similarly, the fees payable to Mitsubishi for the Offshore and the Onshore Portions shall be clearly separated and specified. All the Equipment necessary under the Offshore Portion, as well as the engineering and design services related thereto, will be manufactured, fabricated, completed and performed in Japan and other overseas countries. Mitsubishi shall deliver such materials, machinery and equipment to the Project Company on an F.O.B. basis. The Project Company shall take title to and ownership of such materials, machinery and equipment outside the Philippines, shall be the importer of record and consignee thereof, and shall be responsible for importing the same into the Philippines. Mitsubishi shall perform the construction, installation and related civil works specified in the Onshore Portion in the Philippines. In reply, please be informed as follows: 1. Creditable Withholding Tax Section 2.57.2 (E) of Revenue Regulations ("RR") No. 2-98, as amended by RR No. 6-2001, provides that income payments made to contractors shall be subject to the 2% creditable withholding tax. Under the creditable withholding tax system, taxes withheld on certain income payments are intended to equal or at least approximate the tax due of the payee on said income [ Section 2.57 (B), RR No. 2-98 ]. Needless to state, the withholding of income/creditable withholding tax on a certain income payment presupposes that said income payment is considered taxable income to the payee. Therefore, reference must necessarily be made to the income source rules under our tax system. Specifically, if an income payment is considered non-Philippine sourced, the same should not be subject to creditable withholding tax when paid to a foreign corporation, like Mitsubishi, which is taxed only on Philippine-source income ( BIR Ruling DA-024-03 dated January 30, 2003 ). Section 42 of the Tax Code provides: "SEC. 42. Income from Sources Within the Philippines . (A) Gross Income From Sources Within the Philippines. The following items of gross income shall be treated as gross income from sources within the Philippines: xxx xxx xxx (3) Services. Compensation for labor or personal services performed in the Philippines ." caCTHI xxx xxx xxx (C) Gross Income From Sources Without the Philippines. The following items of gross income shall be treated as income from sources without the Philippines; xxx xxx xxx (3) Compensation for labor or personal services performed without the Philippines . . . ." (Emphasis supplied) Based on the foregoing, payments received for services performed in the Philippines are considered Philippine-source income and therefore subject to income and withholding tax. Conversely, if the services are rendered outside the Philippines, the service income will be considered as foreign source income ( BIR Ruling No. DA-223-04 dated April 29, 2004 .) Accordingly, since you represented that the Onshore Portion of the EPC Contract will involve the rendering of services in the Philippines (consisting of construction, installation and related civil works) by Mitsubishi in favor of the Project Company, the portion of the service fee to be paid by the Project Company to Mitsubishi for said services shall be considered income derived from Philippine sources subject to income tax and consequently to the 2% creditable withholding tax under Section 2.57.2 of RR No. 2-98, as amended. On the other hand, the Offshore Portion of the EPC contract, involving the supply of equipment and related design, engineering and other services rendered outside the Philippines, is not subject to creditable withholding tax. In the case of Commissioner of Internal Revenue vs. Marubeni Corporation [372 SCRA 576 (G.R. No. 137377, December 18, 2001)] , where the contracts under consideration were contracts for the design, engineering, supply and delivery, construction, erection and installation, supervision, direction and control of testing and commissioning of a wharf/port complex and an ammonia storage complex, the Supreme Court affirmed and recognized that where the scope of work contemplated by a contract is divided into works to be performed by a foreign corporation outside the Philippines and within the Philippines ( e.g. , into an Offshore Portion and an Onshore Portion), payments received by such foreign corporation for the works performed outside the Philippines are not subject to Philippine taxes. The Supreme Court ruled as follows: "Clearly, the service of 'design and engineering, supply and delivery, construction, erection and installation, supervision, direction and control of testing and commissioning, coordination . . .' of the two projects involved two taxing jurisdictions. These acts occurred in two countries Japan and the Philippines. While the construction and installation work were completed within the Philippines, the evidence is clear that some pieces of equipment and supplies were completely designed and engineered in Japan. The two sets of ship unloader and loader, the boats and mobile equipment of the NDC project and ammonia storage tanks and refrigeration units were made and completed in Japan. They were already finished products when shipped to the Philippines. The other construction supplies listed under the Offshore Portion such as the steel sheets, pipes and structures, electrical and instrumental apparatus, these were not finished products when shipped to the Philippines. They, however, were likewise fabricated and manufactured by the sub-contractors in Japan. All services for the design, fabrication, engineering and manufacture of the materials and equipment under Japanese Yen Portion I were made and completed in Japan. These services were rendered outside the taxing jurisdiction of the Philippines and are therefore not subject to contractor's tax ." (372 SCRA at 601; emphasis supplied) ACSaHc Following the principle affirmed by the supreme Court in Marubeni , only payments connected with or arising from the Onshore Portion are subject to Philippine creditable withholding taxes and VAT. On the foregoing basis, we confirm your opinion that the payments to be made by the Mirant Project Company to Mitsubishi for the performance of the construction, installation and related civil works specified in the Onshore Portion of the EPC Contract will be subject to the 2% creditable withholding tax. On the other hand, payments arising from the Offshore Portion of the same contract will not be subject to the creditable withholding tax. 2. Value-Added Tax In as much as the services contemplated under the Onshore Portion, i.e. construction and installation of certain facilities, and the performance of related civil works, will be performed in the Philippines, the payments arising from the performance of said services in the Philippines will be subject to 10% VAT ( Section 108, Tax Code; Section 4.102-1, RR No. 7-95 ). Moreover, the importation into the Philippines from Japan of the Equipment contemplated by the Offshore Portion will be subject to the 10% VAT on importation ( Section 107, Tax Code; Section 4.100-1, RR No. 7-95; VAT Ruling No. 007-04 dated April 5, 2004; VAT Ruling No. 042-03 dated September 29, 2003 ). In Kanematsu Corporation vs. Commissioner of Internal Revenue, CTA Case No. 4875 February 12, 1997 , the Court of Tax Appeals ("CTA") ruled that the VAT is a liability of the seller of goods or services and the importer, and while there may be no sale subject to VAT since the sale was consummated in Japan, the importation of goods by local purchasers will be subject to the 10% VAT. Thus, the CTA held: " . . . Pursuant to Section 99, the purpose liable for VAT are the seller of goods or services and the importer. In the instant case, although the actual seller of goods is the Head Office in Japan, it cannot be made liable for VAT as the sale was consummated in Japan . acHITE Neither is the Branch (the herein petitioner) liable for VAT as it is not the actual seller. This was the Court's finding in an earlier case of petitioner decided on March 27, 1995. The decision in part states: " . . . Petitioner as a branch merely acted as an agent of the Head Office in promoting its sales, delivering the samples and the quotation to the possible buyers. The Head Office is the actual seller (shipper) of the goods as indicated in the commercial invoices presented in evidence by petitioner. The Head Office as a trading office buys the goods from manufacturers in Japan and then sells the same to local buyers in the Philippines . . ." (p. 7, Decision in CTA Case No. 4531, "Kanematsu-Gosho, Ltd.-Manila Branch vs. CIR," prom. March 27, 1995; Emphasis supplied) In the case at bar, VAT is properly and legally due on the local buyers who are considered the importers. As earlier said, under Section 99 of the Tax Code, VAT is a liability of the seller of goods or services and the importer. Although it has been established that there was no sale subject to VAT as the said sale was consummated in Japan, there was definitely importation of goods by local purchasers who are liable for VAT . However, considering that such VAT on importation was already paid by the local buyers, it should not longer be imposed on the herein petitioner." (Italics supplied) However, payments by the Project Company to Mitsubishi arising from services under the Offshore Portion of the EPC Contract will not be subject to the 10% VAT. In VAT Ruling Nos. 007-03 and 008-03 both dated January 10, 2003 , both involving a project comprising of a 'service component' (local construction) and an 'imported component' (importation of materials and equipment), the BIR held that the contractors' taxable gross receipts shall not include the "imported component" and that the contractors are liable to pay the 10% VAT on the gross receipts only on the onshore portion, i.e. , net of importation. Accordingly, we confirm that while the 10% VAT is imposed on (1) the payments for services performed under the Onshore Portion and (2) the importation of the Equipment necessary for the Pagbilao expansion project, VAT shall not be imposed on Mitsubishi in respect of the payments by the Project Company to Mitsubishi for the goods supplied and services rendered outside the Philippines pursuant to the Offshore Portion of the EPC Contract. ECaSIT 3. Revenue Audit Memorandum Order No. 1-95 RAMO 1-95 provides special guidelines and audit procedures to determine the taxable income of the Japanese Sogo Shoshas as well as similarly situated foreign trading companies. RAMO 1-95 provides: "1. The Philippine income tax due from soliciting orders, purchaser, service contracts, trading, construction and other activities of the Philippine branches and liaison offices of MNEs will be ascertained using the following formula. For solicitation and trading activities Worldwide Operating Sales to the Philippines Attribution Tax Income X Worldwide Sales X Rate X Rate Plus For construction and other activities Net Income from construction and other activities X Tax Rate 2. In implementing the above formula, the following terms shall be construed to mean as follows: (a) . . . (b) . . . (c) Sales to the Philippines shall be defined as the aggregated amount of exports and offshore transactions to the Philippines by the Head Office, all branches and liaison offices and shall include the amount of indent transactions from which commissions are generated. These shall also include imported materials and equipment of construction projects undertaken in the Philippines , but shall exclude local service income from construction projects or onshore income from local construction. (d) . . . (e) . . . (f) . . . (g) Net income on construction shall consist of local service income from construction projects income from construction projects less the costs associated with local construction projects including the cost of locally purchased materials equipment, if any. . . ." (emphasis supplied) Despite the passage of Republic Act No. 8424, otherwise known as the Tax Code of 1997, the formula provided by RAMO 1-95 in computing the Philippine income tax of Sogo Shoshas and other similarly situated foreign trading companies, which is based on their worldwide trading activities, continues to apply in the computation of their normal income tax liability imposed under Section 28 (A) (1) of the Tax Code of 1997 on resident foreign corporations ( ITAD Ruling No. 004-01 dated January 18, 2001; BIR Ruling No. DA-578-2004 dated November 12, 2004 ). aHATDI Based on the foregoing formula, Mitsubishi (through its Manila Branch) shall report, for income tax purposes, its net onshore income from the project (i.e., net income from the Onshore Portion of the contract) and pay the 32% corporate income tax thereon, net of the 2% creditable withholding tax that will be withheld by MPC on its payments corresponding to the onshore portion of the contract. Mitsubishi Corporation's income from the offshore portion of the Pagbilao expansion project will form part of its reportable "Sales to the Philippines" as an integral component of the same attribution formula prescribed under RAMO 1-95. At the end of its taxable/fiscal year, and upon compliance with the documentary requirements under RAMO 1-95 that include submission of Mitsubishi Corporation's audited worldwide audited financial statements, Mitsubishi Manila Branch shall likewise compute and pay the 32% corporate income tax based on the resulting attributable income from Mitsubishi's solicitation and trading activities. Thus, your opinion that the attribution formula prescribed under RAMO 1-95 will apply in determining the taxable income of Mitsubishi on the payments arising from the Offshore Portion of said EPC contract is also confirmed. This ruling is being issued on the basis of the foregoing facts as represented. However, if upon investigation, it will be disclosed that the facts are different, then this ruling shall be considered null and void. Very truly yours, Commissioner of Internal Revenue By: (SGD.) JOSE MARIO C. BUAG Deputy Commissioner Legal and Inspection Group