BIR Ruling [DA-348-06]

June 6, 2006 BIR RULING [DA-348-06] 037-04 Quiason Makalintal Barot Torres & Ibarra 21st Floor, Robinsons-Equitable Tower 4 ADB Avenue corner Pedro Poveda Street 1605 Ortigas Center, Pasig City Attention: Atty. Benedict R. Tugonon Gentlemen : This refers to your letter dated May 8, 2006 stating that your client, Gaming Advisory & Management Exponents Ltd., (GAMES), is a non-resident foreign corporation duly organized and existing under and by virtue of the laws of Hong Kong, Special Administrative Region, with address at 12/F China Merchants Tower, Shun Tak Centre, 168-200 Connaught Road, Central, Hong Kong, is not engaged in trade or business within the Philippines and has no permanent establishment in the Philippines; that it is not registered either as a corporation or as a partnership and has not been licensed to do business in the Philippines; that on the other hand, Philippine Gaming Management Corporation (PGMC) is a corporation duly organized and existing under the laws of the Philippines with principal office address at 6784 Ayala Avenue, Legaspi Village, Makati City; that GAMES entered into a Procurement Services Agreement (PSA) with the PGMC whereby GAMES will render the following services to PGMC outside the Philippines: "a. Identify Suppliers To provide Client with information such as the name of leading suppliers, available products, product reviews, manufacturer's profile, dealer's and distributor's profile, contacts, of leading online lottery equipment in the world, which the Client could use in replacement and upgrade of the online-lottery equipments it leased out to PCSO; b. Consultancy Services To advise the Client as to the best available online lottery equipments in the market and to propose to the Client the most suitable equipment that could be used to replace and upgrade its present equipment used in connection with the Online Lottery System of the PCSO; c. Contract Negotiation & Brokering To represent the Client in negotiating for the best price, the terms and conditions over its intended purchase of the Equipments with potential foreign suppliers in the US, Hong Kong or other countries; d. Coordination Services. To coordinate and communicate with the foreign suppliers, on behalf of the Client, on all other matters in connection with the procurement/purchase of the Equipments including the delivery dates of the equipments, the volume to be delivered, breakage or loss during transit, damaged equipments, return of equipments, warranty issues, and other matters in connection with the purchase of the Equipments; e. Work Flow Design/Process To review the existing work flow, system, and operational structure of the Client with the aim of rationalizing the existing work flow, system and structure, adopting best practices and solutions used by Contractor and other businesses abroad operating or leasing Online Lottery Equipments. To propose revisions in the system, plan and structure of the Client; f. Such other services that may be necessary to implement the foregoing undertakings of the Contractor and other services which are analogous to the foregoing." that in consideration of the performance by GAMES of the above-mentioned services, it will be paid service fees by PGMC as provided for in the PSA; that none of the services to be performed by GAMES requires performance thereof within the Philippines; and that information needed by GAMES in the performance of its services will be provided for by PGMC and will be communicated electronically or by telephone to the staffs of GAMES who will liaise with PGMC's staff in the course or the performance of the services. In connection therewith, you now request confirmation of your opinion that 1. The service fees are not in the nature of royalties; 2. The payment of the service fees to GAMES by the PGMC is not subject to Philippine income tax pursuant to the provisions of Section 28(B)(1) in relation to Section 42(C) of the National Internal Revenue Code of 1997, as amended; 3. The payment of the service fees are not subject to value-added tax (VAT) since the services are performed outside the Philippines, consequently the payments are not subject to withholding tax; and 4. The service fees paid by PGMC to GAMES for services performed by the latter constitute an ordinary and necessary business expense of PGMC which are allowed as a deduction from its gross income pursuant to Section 34(A)(1) of the Tax Code. In reply thereto, please be informed that your opinion is hereby confirmed as follows 1. The service fees payable by PGMC to GAMES are business profits and not royalties if GAMES carries on business in the Philippines through a permanent establishment (PE). If it carries on business as aforesaid, the profits of the enterprise may be taxed in the Philippines but only so much of them as are attributable to such PE. In other words, if the income is in the form of business profits, the same will only be subject to Philippine income tax if a PE is created in the Philippines. Conversely, if there is no PE, there will be no tax consequences in the Philippines. Thus, it is important to differentiate between business profits and royalties. One must inquire on whether the payee has proprietary interest in the property giving rise to the income. If the payee has no proprietary interest, then the payment is a compensation for personal services or business profits. ( Philippine Refining Co., Inc. vs. Commissioner of Internal Revenue , CTA Case No. 2872 dated January 15, 1986 citing Ingram vs. Bowers , 5 F 2d 65; and Oppenhein vs. Commissioner of Internal Revenue , 31 BTA 563). To be considered as royalties, there must be a transfer in the Philippines of scientific, technical, industrial or commercial knowledge or information or other property where the payee has proprietary interest. (BIR Ruling No. 036-90 dated March 27, 1990) HEDSIc In the instant case, the service fees payable by PGMC to GAMES are clearly business profits, since there is nothing in the PSA that would require the transfer into the Philippines of technology, equipment or other property where GAMES has proprietary interest or would otherwise permit GAMES to impart to PGMC its special knowledge and experience which remain unrevealed to the public. 2. Section 28(B)(1) of the Tax Code of 1997, as amended by Republic Act (R.A.) No. 9337, provides that "(1) In General. Except as otherwise provided in the Code, a foreign corporation not engaged in trade or business in the Philippines shall pay a tax equal to thirty-five (35%) 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): Provided. That effective January 1, 2009, the rate income tax shall be thirty percent (30%)." In defining what income payments are considered from sources without the Philippines, Section 42(C), supra , provides "(C) Gross income from sources without the Philippines . The following items of gross income shall be treated as income from sources without the Philippines: (1) Interest other than those derived from sources within the Philippines as provided in paragraph (1) of subsection (A) of this Section; (2) Dividends other than those derived from sources within the Philippines as provided in paragraph (2) of subsection (A) of this Section; (3) Compensation for labor or personal services performed without the Philippines; (4) Rentals or royalties from property located without the Philippines or from any interest in such property including rentals or royalties for the use of or for the privilege of using without the Philippines patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises and other like properties; and (5) Gains, profits and income from the sale of real property located without the Philippines." Thus Office had already occasion to rule on the matter, when it said in BIR Ruling No. 037-04 dated February 2, 2004 that "xxx xxx xxx 1. Based on Section 42(C)(3) in relation to Section 28(B)(1) both of the Tax Code of 1997, non-resident foreign corporations deriving income for services performed abroad are not subject to Philippine income tax since such services are considered income from sources without the Philippines. Accordingly, since the services are to be performed abroad by VSLHK, the service fees to be paid by VSLPH to VSLHK shall not be subject to Philippine income tax. Consequently, such payments are not also subject to final withholding tax pursuant to Section 2.57-1 (I)(1) in relation to Section 2.57(A), both of Revenue Regulatio ns N o. 2-98, as amended. Section 2.57-1(I)(1) of Revenue Regulati ons N o. 2-98 provides that non-resident foreign corporations are subject to final withholding tax only on their income derived from all sources within the Philippines. Thus, if the income is derived from sources outside the Philippines, the same is not subject to final withholding tax. VSLPH is, therefore, not required to withhold the 34% final income tax on its payments under the aforementioned Service Agreements to VSLHK. Considering that the above-cited ruling is in all fours similar to the instant case, the service fees payable to GAMES for services rendered outside the Philippines are not subject to Philippine income tax. 3. Section 108 of the Tax Code of 1997, as amended by R.A. No. 9 33 7, provides that "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, including those performed or rendered by construction and service contractors; . . . :" It is clear that the VAT applies only to services performed in the Philippines and not to services rendered outside the Philippines. Inasmuch as the services to be rendered by GAMES to PGMC will be performed outside the Philippines, it is axiomatic that the said services are not subject to VAT. DTAaCE Thus, in BIR Ruling No. DA037-04 dated February 2, 2004 , this Office ruled that "xxx xxx xxx "(2) Pursuant to Section 108(A) of the Tax Code of 1997 a VAT equivalent to ten percent (10%) of gross receipts is imposed on the sale or exchange of services, and 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. Conversely, services performed outside the Philippines are not subject to VAT. "Accordingly, VSLPH's payment of service fee to VSLHK pursuant to the aforementioned Services Agreement, shall not be subject to VAT. Consequently, no VAT may be passed on by VSLHK to VSLPH, as conversely suggested under Section 105 of the Tax Code of 1997." 4. Finally, in the same BIR Ruling No. DA037-04, this Office likewise ruled that "3. Pursuant to the aforementioned Section 34(A)(1) of the Tax Code all ordinary and necessary expenses paid or incurred during the taxable year in carrying on or which are directly attributable to the development, management, operation and/or conduct of the trade, business or exercise of profession are allowed as deduction from gross income. "It is noted that per VSLHK's representation, comparable companies usually avail of the above services in order to stay competitive, that the services that VSLHK will provide to VSLPH outside the Philippines will make the latter more efficient and effective in providing services to its customers; and that the engagement of VSLHK services outside the Philippines will improve VSLPH's net income. "Since the engagement of VSLHK by VSLPH to perform services covered under the Services Agreement is directly connected with and appropriate in the conduct of VSLPH's business the same may be considered as ordinary and necessary business expenses pursuant to aforementioned Section 34(A)(1) of the tax Code of 1997. "Accordingly, the service fees paid to VSLHK are deductible expenses from VSLPH's gross income pursuant to Section 34(A)(1) of the Tax Code of 1997." It is apparent from the above-cited ruling that the service fees payable to GAMES pursuant to the PSA are ordinary and necessary expenses incurred by PGMC in its business of leasing online lottery equipments. Such being the case, the said service fees are valid deductions of PGMC for income tax purposes. 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. aCcEHS Very truly yours, (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service