BIR Ruling [DA-368-06]

June 13, 2006 BIR RULING [DA-368-06] 57 (B); DA-249-01; DA-187-02 Ramon F. Garcia & Company 30/F Burgundy Corporate Tower 252 Sen. Gil Puyat Avenue Makati City Attention: Mr. Ramon F. Garcia Gentlemen : This refers to your letter dated May 16 and 30, 2006 requesting for a ruling to the effect that: 1. the royalty fees being collected by Max's Franchising, Inc. (MFI, formerly Max's, Inc.) be treated as active income subject to 15% creditable withholding tax instead of 20% final tax on franchises; 2. as a consequence of the change in the royalty treatment, the net operating loss carryover be deducted from the net income of the company; and 3. in transitioning from passive income to active income, is the income received by MFI from its franchisees which was subjected to 20% final tax be treated as royalty income(passive) and has not to be excluded from the taxable net income subject to the regular rate in its 2006 annual income tax return? It is represented that MFI is a 100% Filipino corporation duly organized and existing under the laws of the Republic of the Philippines; that its was incorporated on March 19, 1998 primarily to engage in the business of granting franchise for Max's Restaurant; that MFI derived its right to grant franchise by virtue of a Memorandum of Agreement signed by the co-owners of Max's tradename on April 17, 1998; that the co-owners are also the shareholders of MFI; that the salient terms and conditions of this MOA are as follows: 1. Co-owners grant MFI a master license for the right to franchise to others the use of service mark "Max's"; 2. Co-owners delegate their right to collect royalty fees from franchises as well as other charges and fees that may be imposed by MFI in accordance with the Franchise agreement except for existing family owned stores; 3. Since they are also stockholders of MFI, co-owners will not collect fees (royalty fees and others) from MFI. that on the basis of this MOA, MFI started franchising the tradename "Max's" and Max's plus the design," annotated logos, commercial symbols and such other tradenames, service marks and trademarks to other independent entities; that in exchange for these, it collected 5% royalty fees, franchise and other fees; that the royalty fees are subjected by the franchisees to 20% final withholding tax on total royalty fees paid to MFI and 15% creditable withholding taxes (before 10%) on all other fees and services performed by MFI; and that since MFI is subjected to 20% withholding taxes, it incurred an accumulated net operating loss carry-over in the amount of P2,426,881 for the year 2003, P10,539,280 for 2004 and P6,952,371 for 2005 or a total of P28,180,893 and tax overpayment in the amount of P6,952,371 as of December 31, 2005. ACETID In reply, please be informed that Section 27(D)(1) of the 1997 Tax Code pertinent portion of which is quoted hereunder, provides, to wit: "(D) Rates of Tax on Certain Passive Income. (1) Interest from Deposits and Yield or any other Monetary Benefit from Deposit Substitutes and from Trust Funds and Similar Arrangements, and Royalties. A final tax at the rate of twenty percent (20%) is hereby imposed upon the amount of interest on currency bank deposit and yield or any other monetary benefits from deposits substitutes and from trust funds and similar arrangements received by domestic corporations, and royalties, derived from sources within the Philippines; provided, however, that interest income derived by a domestic or a resident foreign corporation from a depository bank under the expanded foreign currency deposit system shall be subject to a final tax at the rate of seven and one-half percent (7 1/2%) of such interest income, . . ." As expressly denoted in the caption, to be subject to the 20% final withholding tax, the royalties must be in the nature of passive income. On the other hand, the royalties and other fees received by MFI are in the nature of active income arising from the active pursuit of its business. These activities are in accordance with its primary purpose, which is the distribution of licensed materials to its Philippine clients and the performance of support services as provided in its primary purpose in its Articles of Incorporation, which pertinently reads: "Primarily, to engage in, conduct, carry on and deal in the business of acquiring, developing, managing and utilizing any and all tradenames, trademarks, service marks, brand names, copyrights, patents, charters, goodwills, master franchises and licenses, including other intellectual property rights, necessary to commence and operate business enterprises, as well as to grant, issue, allow, permit, authorize, sanction and accredit the use, employment, exploitation and availment of such tradenames, trademarks service marks, brand names, copyrights, patents, charters, goodwill, master franchises and licenses and other intellectual property rights, for and in consideration of the payment of fees, dividends, royalties, charges, dues, commissions and remunerations, and in connection therewith, to set up, create and establish management services, systems, techniques, technologies and networks for the expansion of the business enterprises." Accordingly, the fees received by MFI are in the nature of active income rising from the active pursuit of its business subject to the normal corporate income tax. Consequently, since said payments are not considered passive income then these are not subject to the 20% final withholding tax. Moreover, the same are subject to 15% creditable withholding tax as required under Section 57(B) of the Tax Code of 1997, as implemented by Revenue Regulations No. 2-98, as amended. (BIR Ruling Nos. DA-249-01 dated December 3, 2001 and DA-187-02 dated October 16, 2002) In addition, Section 34(D)(3) of the Tax Code of 1997 provides that: "(3) Net Operating Carry-Over. The net operating loss of the business or enterprise for any taxable year immediately preceding the current taxable year, which had not been previously offset as deduction from gross income shall be carried over as a deduction from gross income for the next three (3) consecutive taxable years immediately following the year of such loss . . ." Thus, the P28,180,893 net operative loss as of December 31, 2005, after the change in the royalty treatment, can be deducted from the gross income of the company for the next three (3) consecutive taxable years immediately following the year of such loss, provided the same has not been a subject or a previous deduction from gross income. Moreover, in transitioning from passive income to active income, the amounts of royalty income received by MFI from its franchisees which were subjected to 20% final tax shall be treated as passive income and therefore, shall be excluded from the taxable net income subject to the regular rate in its 2006 annual income tax return. 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. cDCaTS Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service