BIR Ruling [DA-223-04]

April 29, 2004 BIR RULING [DA-223-04] 27 (A); (E); 108 (B) (2) VAT 059-02; 013-03 SGV & Co. 6760 Ayala Avenue Makati City Attention: Atty. E.C. Alcantara Gentlemen : This refers to your letter dated March 9, 2004 stating that your client, Johnson & Johnson Philippines, Inc. (JJPI), is a corporation organized and existing under Philippine laws; that on the other hand, Johnson & Johnson US (JJUS), a company organized and existing under the laws of US, and its international affiliate companies (J&J Group), manufacture, market and distribute healthcare and consumer products; that J&J Group is divided into four main divisions (i) Pharmaceuticals (ii) MD&D (Medical Devices and Diagnostics) and Consumer Pharmaceuticals; (iii) Nutritional Products; and (iv) General Consumer Products; that the Consumer Products Division operates in four geographical areas: North America, Latin America, Europe and Middle East and Asia Pacific; that on a global basis, the group is organized on the principles of decentralized management; that in the Asia Pacific region, Johnson & Johnson Singapore (JJS), a corporation organized and existing under the laws of Singapore and a wholly owned subsidiary of JJUS, is currently the Johnson & Johnson Consumer Products Asia Pacific Supply Chain Center; that under a proposed new structure, it will act as the principal operating entity in the Asia Pacific Region for the Consumer Products business of the J&J Group; that in the Philippines, JJPI is a corporation organized and existing under Philippine laws with principal place of business at Edison Road, Barrio Ibayo, Paraaque City and a wholly owned subsidiary of JJUS; that under the present structure, JJPI directly purchases consumer products from suppliers in Thailand and Malaysia and other toll manufacturers in the Philippines and thereafter sells and distributes the said products to local consumers; that this structure results in JJPI taking title to the products purchased which, consequently, exposes it to the typical business risks such as the product liability risk, market, credit and collection; general business, foreign exchange and entrepreneurial risks; that in 1998, JJUS embarked on a plan to globally restructure and strengthen its sourcing strategies and operation capabilities; that since then, the group has begun implementing this restructuring in several regions of the world and has started reviewing its operating arrangements in the Asia Pacific Region; that the review is designed to: (1) improve cost efficiencies to deliver superior value to customers; (2) reduce introduction time for new or improved products; (3) integrate the sourcing strategies with research and development activities and, marketing strategies; (4) allow the local affiliates to concentrate on customers and consumers; (5) improve career development opportunities with the supply chain; (6) reduce the J&J Group's exposure to foreign exchange, market and inventory risk by centralizing risk management; and (7) reduce working capital costs by centralizing the management of inventory; that it is contemplated that JJPI will be converted into a commissionaire of JJS once the new inventory system is fully operational; that JJPI has filed a ruling request in 2002 with the BIR to effect this change; that however, the management information system and processes that can support the new business model envisioned by Johnson & Johnson will not be in place until mid to late 2005; that as a result, Johnson & Johnson will move into a transitional arrangement whereby JJPI will become a limited risk distributor (LRD), with a contingent service remuneration agreement of JJS; that specifically, the transitional arrangement will entail the following changes for the Philippine set-up: JJPI will now purchase the products from JJS which, in turn, will take over the sourcing of the products from suppliers in Thailand and Malaysia. This change notwithstanding, JJPI will continue to have local sources (approximately 40%); The products will continue to be delivered directly from Thailand and Malaysia to JJPI; JJPI and JJS will enter into a Limited Risk Distributor Agreement (LRDA) with a contingent service remuneration agreement which will include the payment of a Management Performance Fee (MPF); and The shift will result in JJS assuming/sharing (by around 80%20%) the following risks previously assumed entirely by JJPI: (a) market, (b) credit and collection, (c) general business, (d) foreign exchange, (e) entrepreneurial and (f) inventory. The LRDA provides that for the services to be rendered by JJPI and JJS to each other either party will be liable to pay the MPF depending on whether JJPI was able to realize on actual operating margin, as defined in the LRDA, of 5.5% of net trade sales. Specifically, should JJPI's actual Operating Margin be less than 4.5% ( i.e. , "Shortfall" scenario), there shall be a payment by JJS to JJPI of a management performance fee ("MPF") to bring the Operating Margin to 4.5%. On the other hand, should the Operating Margin be more than 5.5% ( i.e. , "Excess" scenario), there shall be an MPF payment by JJPI to JJS equivalent to the amount in excess of 5.5%. PriceWaterhouseCoopers (PWC) conducted a benchmarking analysis on Philippine distribution comparables, which study showed that anticipated operating income of JJPI is at the higher end of the arm's length range. In sum, in an "Excess" scenario, what effectively takes place is that JJPI pays JJS for the services rendered under Article 5 of the LRDA. Conversely, in a "Shortfall" scenario, JJS pays JJPI for services rendered by the latter under Article 4 of the LRDA. In addition to the LRDA, JJPI will also enter into two other contracts an Information Management Services Cost-Sharing Agreement (IMSCSA) with JJS and a Contract Research and Development Agreement (CRDA) with JJUS; that the IMSCSA provides that JJS will render to JJPI regional Information Management (IM) services for the operations and maintenance of Asia Pacific information systems; that IM services to be rendered by JJS to JJPI as an independent contractor are necessary to carry on the latter's operations and would help to reduce the expenses that JJPI would otherwise have had to incur if it independently purchased its own IM system; that IMSCSA specifically provides that the services will be performed from outside the Philippines; that on the other hand, the CRDA will be entered into in order for JJUS to carry out and centralize under its supervision and direction all current and planned research and development activities worldwide for its consumer products that as provided for in the CRDA, JJPI will provide its services under the direction of JJUS (with coordination from the regional Vice President (R&D and Quality/Technical Assurance) located within JJS) which will be responsible for setting the R&D guidelines and budgets; that JJUS will be the legal and economic owner of all of the intellectual property developed through JJPI's R&D activities; that the CRDA directs that both parties should agree on a regular basis upon and to what extent the R&D services should be performed by JJPI; that examples of contracted activities could include product modification, including the making of appropriate modification to ensure customer acceptance, to bring the product into the region for regional production, to utilize regional raw materials for cost savings, to meet regulatory compliance, and so forth; that in consideration for the provision by JJPI of the R&D activities, JJUS will pay the amount of the Regional R&D expenses plus a mark-up calculated at a blended rate of 5% in respect of these expenses; and that the fees due to the R&D services shall be due quarterly and shall be remitted to JJPI in US dollars converted at every billing date or as otherwise agreed upon by JJUS. Based on the foregoing representations, you now request for an opinion on the tax consequences relative to the LRDA, IMSCSA and CRDA to be entered into by and among JJPI, JJS and JJUS. In reply thereto, please be informed that our opinion is based on the provisions of the Tax Code of 1997 and existing regulations and tax issuances applicable to the taxation of income arising from the above-mentioned transactions. LRDA A. In a Shortfall Scenario, the following shall be the tax consequences: 1. Income Tax Section 27(A) of the Tax Code of 1997 provides that an income tax of 32% is imposed upon the taxable income derived during each taxable year from all sources within and without the Philippines by every corporation organized and existing under the laws of the Philippines. Section 27(E) of the Tax Code of 1997, as amended by Revenue Regulations No. 9-98, as amplified in Revenue Memorandum Circular No. 4-2003, provides that a minimum corporate income tax of two percent (2%) of the gross income as of the end business operations, when the minimum income tax is greater than the tax computed under Subsection (A) of the said Section for the taxable year. In view of the foregoing provisions, the Management Performance Fee (MPF) to be paid by JJS to JJPI under the LRDA forms part of the gross income of JJPI and will be subject to the 32% regular corporate income tax or to the 2% minimum corporate income tax, as the case may be. This is so because JJPI being a domestic corporation is taxable on its income from all sources within and without the Philippines. 2. Value-Added Tax Section 108(B)(2) of the Tax Code of 1997 provides that services other than those mentioned in paragraph (1), the consideration for which is paid for in acceptable foreign currency and accounted for in accordance with the rules and regulations of the Bangko Sentral ng Pilipinas (BSP) shall be subject to zero percent (0%). The MPF to be paid by JJS for the provision of information services by JJPI, which is likely to be of use or benefit to JJS in connection with the marketing of the Products, to be paid for in foreign currency by JJS to JJPI, is subject to the VAT at zero-rate under Section 108(B)(2) of the Tax Code of 1997. In VAT Ruling No. 059-02 dated September 16, 2002, this Office ruled that ". . ., the research activity and consultancy service, which are both similar to a project study and an information service, that is paid for in US dollars inwardly remitted shall qualify as a zero-rated VAT transaction if rendered by your company to a non-resident foreign client. It must be noted that, to qualify as a zero-rated VAT transaction, the said services must not only be paid for in acceptable foreign currency and accounted for in accordance with the rules and regulations of the BSP must also be rendered directly to a non-resident foreign client." Moreover, in VAT Ruling No. 013-03 dated January 20, 2003 citing VAT Ruling No. 010-01, it was also ruled that ". . ., this Office hereby confirms your opinion that the aforementioned sale of services by NTAP are likewise entitled to the benefit of the zero percent (0%) VAT, pursuant to Section 108(B)(2) of the Tax Code of 1997, as implemented by Section 4.102-2(b) of Revenue Regulations No. 7-95, as amended by Revenue Regulations No. 5-96." As earlier mentioned, in a "Shortfall" scenario, JJS pays JJPI for services rendered by the latter under Article 4 of the LRDA. In view of the fact that the services as enumerated in the LRDA to be rendered by JJPI to JJS, a non-resident foreign corporation, are similar to project study and information service, the MPF, which is paid for in foreign currency by JJS to JJPI, is subject to the VAT at zero-rate under Section 108(B)(2) of the Tax Code of 1997. B. In an Excess Scenario, the following shall be the tax consequences: 1. Tax on Nonresident Foreign Corporation Section 28(B)(1) of the Tax Code of 1997 provides that a foreign corporation not engaged in trade or business in the Philippines shall pay a tax equal to 32% effective January 1, 2000 of the gross income received during each taxable year from all sources within the Philippines, such as interests, dividends, rents, royalties, salaries, premiums (except reinsurance premiums) annuities emoluments or other fixed or determinable annual, periodic or casual gains, profits and income and capital gains, except capital gains subject to tax under subparagraphs (5)(c) and (4). The situs of tax for services is the place where the service is rendered. Under the Philippine source of income rules for income tax purposes, service income will be considered Philippine source income only if the services are rendered in the Philippines. Conversely, if the services are rendered outside the Philippines, the service income will be considered as foreign source income. Thus, 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 " 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 " The tax implications of services performed offshore by a nonresident foreign corporation has been confirmed several times by this Office (VAT Ruling No. 019-02 dated March 26, 2002; ITAD Ruling No. 093-02 dated May 16, 2002; ITAD Ruling No. 145-02 dated August 21, 2002; BIR Ruling DA 315-98 dated July 16, 1998; and BIR Ruling No. 074-94 dated March 9, 1994). Thus, service income from services rendered outside the Philippines will not be subject to Philippine income tax in the hands of a nonresident foreign corporation such as JJS. Accordingly, the MPF to be paid by JJPI, in case the Operating Margin exceeds 5.5%, is not subject to Philippine income tax and, consequently, to withholding tax inasmuch as it represents payments to a nonresident foreign corporation for services performed outside the Philippines. 2. Value-Added Tax Section 108(A) of the Tax Code of 1997 provides that a value-added tax equivalent to ten percent (10%) shall be imposed on the gross receipts derived from the sale or exchange of services, including the use or lease of properties. The phrase "sale or exchange of services" means the performance of all kinds of services in the Philippines for others for a fee, remuneration or consideration . . . . In an "Excess" scenario, what effectively takes place is that JJPI pays JJS for the services rendered by JJS under Article 5 of the LRDA, which as provided for in the LRDA, will be rendered by JJS outside of the Philippines. Accordingly, the MPF to be paid by JJPI to JJS under the LRDA for services to be rendered offshore is not subject to VAT inasmuch as it represents payments to a non-resident foreign corporation for services performed outside the Philippines. ( BIR Ruling No. 110-97 dated October 23, 1997 ) IMSCSA 1. Income Tax The payments to be made by JJPI to JJS, a non-resident foreign corporation, under the IMSCSA for regional IM services to be rendered by JJS outside the Philippines is not subject to Philippine income tax under Section 28(A)(1) of the Tax Code of 1997, since non-resident foreign corporation is taxable only on sources within the Philippines. Inasmuch as the services under the IMSCSA are to be rendered offshore, it is deemed sourced from outside the Philippines and therefore not subject to the 32% corporate income tax. 2. Value-Added Tax The IM services will be rendered by JJS outside of the Philippines, no VAT should be imposed on such services. CRDA 1. Income Tax The payments to be made by JJUS to JJPI under the CRDA for research and development will form part of the gross income of JJPI and, therefore, subject to the 32% corporate income tax or to the 2% MCIT, prescribed in Section 27(A) and (E) of the Tax Code of 1997. 2. Value-Added Tax Since JJPI renders research and development services to JJUS and the said services are paid for in foreign currency, it is subject to VAT at zero-rate as prescribed in Section 108(B)(2) of the said Code. CIaASH 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, (SGD.) JOSE MARIO C. BUAG Deputy Commissioner Legal & Inspection Group