BIR Ruling [DA-238-98]

June 15, 1998 BIR RULING [DA-238-98] Platon Martinez Flores San Pedro & Leao 6th Floor, Tuscan Building 114 Herrera Street Legaspi Village Makati City Attention: Atty . Hector A . Martinez Gentlemen : This refers to your letter dated July 4, 1997 stating that your client, McGeorge Food Industries, Inc. (McGeorge), a corporation organized and existing under Philippine laws, with principal office address at the 17th Floor, Citibank Building, 8741 Paseo de Roxas, Makati City, has entered into a License Agreement dated September 1, 1993 with McDonald's Corporation (McDonald USA), a corporation organized and existing under the laws of the State of Delaware, USA; that under the License Agreement, McDonald USA, as licensor, granted to McGeorge, as licensee, the right to adopt and use the McDonald System in developing and operating a restaurant system in the Philippines; that the McDonald's System is a comprehensive restaurant system for the retailing of a limited menu of uniform and quality food products, emphasizing prompt and courteous service in a clean, wholesome atmosphere which is intended to be attractive to children and families and includes proprietary rights in certain valuable trade-names, service-marks and trade-marks, including the trade-names "McDonald's" and "McDonald's Hamburgers"; that the License Agreement is duly registered with the Technology Transfer Registry of the Bureau of Patents, Trademarks and Technology Transfer under Certificate of Registration No. 1630 dated November 2, 1994; that the License Agreement grants to McGeorge the right, subject to the prior written consent and approval of McDonald USA, to sub-license to others the rights conferred on McGeorge by the said agreement; that in consideration for the rights granted by McDonald USA to McGeorge, the latter has agreed to pay to McDonald USA a royalty of 5% of Net Sales as defined in the License Agreement with an additional bonus royalty of 1% of Net Foreign Exchange Earnings as defined in the License Agreement (the royalty is reduced to 3% of Net Sales with respect to those restaurants which have been operated by McGeorge prior to 1993 as listed in Schedule A to the License Agreement); that the term "Net Sales" is defined in the License Agreement as "Gross Sales minus (i) trade, quantity or cash discounts and broker's or agent's commission, if any; (ii) return credits and allowances; (iii) tax, excise or other governmental charges not already deducted to arrive at Gross Sales; (iv) freight, insurance and packing costs;" that on the other hand, the term "Gross Sales" is defined in the License Agreement as follows: LLphil "Gross Sales". For the purpose of this Agreement, the term "Gross Sales" shall mean all revenues from sales of the Licensee based upon all business conducted upon or from all of the Restaurant, including those operated by sub-licensees (if any), whether such sales be evidenced by check cash, credit, charge account, exchange or otherwise, and shall include, but not limited to, the amounts received from the sale of goods, wares and merchandise, including sales of food, beverages and tangible property of every kind and nature, including, but not limited, to premium and promotional items, and for services performed from or at the Restaurants, together with the amount of all orders taken or received at the Restaurants, whether such orders be filled from the Restaurants or elsewhere. Gross Sales shall not include sales of merchandise for which cash has been refunded, provided that they shall have previously been included in Gross Sales. There shall be deducted from Gross Sales the price of merchandise returned by customers for exchange, provided that such returned merchandise shall have been previously included in Gross Sales, and provided that the sales price of merchandise delivered to the customer in exchange shall be included in Gross Sales. Sales shall not include the amount of any sales tax imposed by federal state, municipal or other governmental authority directly on sales and collected from customers, provided that the amount thereof is added to the selling price or absorbed therein, and actually paid by the Licensee to such governmental authority. Each charge or sale upon credit shall be treated as a sale for the full price in the month during which such charge or sale shall be made, irrespective of the time when the Licensee shall receive payment (whether full or partial) therefor." that since there are no trade, quantity or cash discounts and broker's and agent's commission and no freight insurance and packing costs deductible against "Gross Sales", the amount of "Net Sales" and the amount of "Gross Sales" are practically the same; that in accordance with the right granted under the License Agreement, McGeorge has entered into sub-licensing agreements with various third parties pursuant to which McGeorge granted to said third parties a similar right granted to it by McDonald USA to adopt and use the McDonald's System in operating a McDonald's restaurant in the Philippines; that in consideration for said right, the sub-licensees have agreed to pay to McGeorge a royalty ranging from 3% to 7% of gross sales; that on November 19, 1995, a License Agreement was entered into by and between McGeorge and Valorie Joan Santos Cruz which is typical of the sub-license agreements entered into by McGeorge with various third parties; that under the said agreement, the sub-licensee has agreed to pay a royalty in an amount equal to five percent (5%) of the Gross Sales of the restaurant for the first five years, six percent (6%) of the Gross Sales of the Restaurant from sixth to the tenth year, and seven percent (7%) of the Gross Sales of the restaurant from the eleventh year onwards; that the term "Gross Sales" as used in the sub-license agreement has the same definition as the term "Gross Sales" in the License Agreement except that "Gross Sales" under the sub-license agreement does not include sales from restaurants operated by other sub-licensees, since the sub-licensee has no right to grant to third parties a further sub-licensing agreement; that the License Agreement expressly provides that Gross Sales includes not only sales from the restaurants operated by McGeorge but also sales from restaurants operated by the sub-licensee; that McGeorge, under the License Agreement, is obligated to remit to McDonald USA not only an amount equal to 5% of the Net Sales of the restaurants operated by McGeorge but also an amount equal to 5% of the Net Sales of the restaurants operated by its various sub-licensees; that the License Agreement inadvertently failed to expressly state the intention of the parties that the royalties to be received by McGeorge from the sub-licensees to the extent of 5% of Net Sales of the restaurants operated by the sub-licensees shall not belong to McGeorge but shall be held by McGeorge in trust for McDonald USA; that McGeorge and McDonald intend to amend the License Agreement to expressly provide that the amount of royalty to be received by McGeorge from the various sub-licensees to the extent of 5% of Net Sales of the restaurants operated by the sub-licensees shall not belong to McGeorge up to the time of remittance to McDonald USA, and shall be held by McGeorge in trust for McDonald USA. In connection therewith, you now request confirmation of your opinion that "(1) The amount of royalty to be received by McGeorge from its various sub-licensees to the extent of 5% of Net Sales of the restaurants to be operated by the sub-licensees shall not be subject to any withholding tax when paid by the various sub-licensees to McGeorge. When McGeorge in turn remits the said amount of royalty to McDonald USA, the same shall be subject to withholding tax of 10% in accordance with the most favored nation clause in Article 13(2)(b)(iii) of the Philippines-US Tax Treaty in relation to Article 12(2)(b) of the Philippines-West Germany Tax Treaty; "(2) The amount of royalty to be received by McGeorge from its various sub-licensees in excess of 5% of Net Sales of the restaurants operated by the sub-licensees shall, when paid by the various sub-licensees to McGeorge, be subject to 20% final withholding tax imposed under Section 24(e)(1) of the Tax Code [now Sec. 27(D)(1) of the Tax Code of 1997]; "(3) All the other amount of royalty to be paid by McGeorge to McDonald USA under the License Agreement shall be subject to 10% withholding tax under the aforementioned most favored-nation clause in Article 13(2)(b)(iii) of the Philippines-US Tax Treaty in relation to Article 12(2)(b) of the Philippines-West Germany Tax Treaty." In reply, please be informed that your opinion is hereby confirmed as follows: (1) The amount of royalty to be received by McGeorge from its various sub-licensees to the extent of 5% of Net Sales of the restaurants operated by the sub-licensees are merely held in trust for subsequent remittance by McGeorge to McDonald USA pursuant to the License Agreement entered into by the parties are not includible in McGeorge's gross income. Hence, McGeorge receipt of the 5% of Net Sales is not subject to income tax and consequently to the 20% final withholding tax imposed under Section 27(D)(1) of the Tax Reform Act of 1997 [formerly Section 24(e)(1) of the Tax Code of 1977]. However, when McGeorge in turn remits the said amount of royalty to McDonald USA, the same shall be subject to 10% withholding tax under Article 13(2)(b)(iii) of the RP-US Tax Treaty in relation to Article 12(2)(b) of the RP-West Germany Tax Treaty. Hence, McGeorge shall be constituted as the withholding agent of McDonald's USA with respect to the 5% of net sales of the restaurants operated by the sub-licensees. Under the most favored nation clause of the RP-US Tax Treaty (Article 13(2)(b)(iii), the tax imposable on royalties derived by a resident of the United States from sources within the Philippines shall be the lowest rate of Philippine tax that may be imposed on royalties of the same kind paid under similar circumstances to a resident of a Third State. Article 12(2)(b) of the RP-West Germany Tax Treaty, which took effect on January 1, 1985, provides that royalties arising in the Philippines and paid to a resident of West Germany may also be taxed in the Philippines, but the tax so charged shall not exceed 10% of the gross amount of royalties arising from the use of or the right to use, any patent, trademark, design or model, plan, secret formula or process, or from the use of, or the right to use, industrial, commercial or scientific equipment or for information concerning industrial, commercial or scientific experience. The said Treaty also provides that for as long as the transfer of technology under Philippine law is subject to approval, the limitations of the tax rate mentioned under (b) shall, in the case of royalties arising in the Republic of the Philippines, only apply if the contract giving rise to such royalties has been approved by the Philippine competent authorities. (Smith Kline and French Overseas Co. vs. Commissioner of Internal Revenue, CTA Case No. 5048, January 30, 1996; CIR vs. General Electric Philippines Meter and Instrument Co., Inc., C.A. G.R. No. 30674, January 26, 1994; IBM Philippines, Inc. vs. CIR, CTA Case No. 4308, March 31, 1993) prcd Such being the case, and inasmuch as the License Agreement executed by McGeorge and McDonald USA has been approved by the Bureau of Patents, Trademarks and Technology transfer of the Department of Trade and Industry, royalties arising in the Philippines and payable to McDonald USA are subject to Philippine tax at the rate of 10% pursuant to Article 13(2)(b)(iii) of the RP-US Tax Treaty, in relation to Article 12(2)(b) of the RP-West Germany Tax Treaty. The said tax shall be withheld and paid in the same manner and subject to the same condition as provided in Section 57(B) of the Tax Reform Act of 1997 [formerly Section 50(b) of the Tax Code of 1977]. (BIR Ruling No. 002-90 dated January 4, 1990) (2) The amount of royalty to be received by McGeorge from its various sub-licensees in excess of 5% of Net Sales of the restaurant operated by the sub-licensees shall be subject to the 20% final withholding tax imposed under Section 27(D)(1) of the Tax Code of 1997 (formerly Section 24(e)(1) of the Tax Code of 1977]. (3) All the other amounts of royalty to be paid by McGeorge to McDonald USA under the License Agreement shall be subject to 10% withholding tax under the aforementioned most favored nation clause in Article 13(2)(b)(iii) of the RP-US Tax Treaty in relation to Article 12(2)(b) of the RP-West Germany Tax Treaty. However, the said royalty payments to be made by McGeorge to McDonald USA under the License Agreement are subject to the 10% value-added tax imposed under then Section 102(a)(1) of the Tax Code, as amended [now Section 108(A)(1) of the Tax Code of 1997], based on the contract price agreed upon by the parties. Your client, McGeorge being the licensee shall be responsible for the payment of VAT on such royalty payments in behalf of McDonalds USA by filing a separate VAT declaration/return. The said VAT declaration/return can be used by McGeorge as evidence in claiming input tax credit (Section 4.102-1(b), Revenue Regulations No. 7-95). 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. LexLib Very truly yours, (SGD.) SIXTO S. ESQUIVIAS IV Deputy Commissioner (Legal & Enforcement Group)