BIR Ruling No. 008-09

April 17, 2009 BIR RULING NO. 008-09 28 (B) (1); 32 (B) (7); 000-00 SGV & Co. 6760 Ayala Avenue 1226 Makati City Attention: Atty. Veronica A. Santos Principal, Tax Division Gentlemen : This refers to your letter dated November 15, 2006, requesting for confirmation of your opinion that the payment of royalties by Petroenergy Resources Corporation ("Petroenergy") to the Republic of Gabon is not subject to Philippine income tax and withholdiug tax. FACTUAL BACKGROUND Petroenergy is a corporation organized and existing under the laws of the Philippines. It is engaged in the exploration of petroleum, mineral and other natural resources. The Republic of Gabon (or the "State") is an independent state located in Africa. It is the owner of the natural resources, including hydrocarbons ( e.g., crude, petroleum, condensates and natural gas), located within its territory, or in offshore areas under its sovereignty or which are part of its economic zone. Petroenergy is a Contractor of the Republic of Gabon for the exploration, exploitation, transportation, storage and marketing of Hydrocarbon natural resources (collectively, "Petroleum Operations") located in the Republic of Gabon, Africa, pursuant to a Production Sharing Contract ("Contract"). The Contract was originally entered into on July 7, 1995 by the Republic of Gabon through its Minister of Mines, Energy and Petroleum, and Vaalco Gabon (Etame), Inc. ("Vaalco Gabon"), a company incorporated under the laws of the State of Delaware, U.S.A., and Vaalco Energy (Gabon), Inc. ("Vaalco Energy"), a company also incorporated under the laws of the State of Delaware, U.S.A. In 1995, Vaalco Gabon farmed out forty nine percent (49%) of its participating interest to Petrofields Exploration and Development Corporation ("Petrofields") pursuant to a Deed of Assignment and Assumption dated September 28, 1995, a copy of which is attached hereto as Annex "B". In 1999, Petrofields' assets were transferred to Petroenergy in an asset-for-share swap agreement. Through a series of farm-outs by Petroenergy and Vaalco Gabon, Petroenergy presently holds only 2.525% Participating Interest in the Contract. Under the Contract, the Contractor shall supply all the financial and technical means necessary for the performance of the Petroleum Operations. The proceeds of production are shared by the Contractor and the Republic of Gabon. acADIT In connection with the Petroleum Operations, Article 26 of the Contract subjects the Contractor to the payment of "royalties" and taxes to the Republic of Gabon. Under Article 26 (b), the Contractor is obliged to pay the State a proportional mining royalty during the production phase at specified percentages of the Total Available Production during a calendar month. The proportional mining royalty is paid either in kind or in cash, at the State's option. Payment in cash of the proportional mining royalty is made to the office of the tax collector not later than the 28th of each month, on the basis of the average monthly production of the preceding calendar quarter. Under Article 26 (c), the Contractor is also obliged to pay the State an annual surface royalty, which is included in the Petroleum Costs. aESICD In view thereof, you now request for confirmation of your opinion that the proportional mining royalty and the annual surface royalty (collectively, "Royalties") paid by Petroenergy to the Republic of Gabon are not subject to Philippine income tax and consequently, to withholding tax. We reply, as follows: 1. The "Royalties" represent economic rent derived from upstream activities of the Petroleum Operations The state, as the resource owner, has a valuable asset in the land which contains oil or natural gas deposit. To convert this asset into financial resources, the state enters into an agreement with oil and gas companies on terms that ensure adequate payment of economic rents for its natural resource. Thus, in the case of mineral resources, upstream activities ( i.e., exploration and production or extraction) could always happen in one's territorial jurisdiction, in this case, the Republic of Gabon. aSIHcT It is common for a state to tax the oil and gas industry through a combination of tax and royalty payments. This regime may involve three levels: (a) a royalty to secure a minimum payment; (b) a regular income tax; and (c) a resource rent tax to capture a large share of the profits of the most profitable project. 1 Thus, in the context of upstream activities in the Petroleum Operations, royalties are levied to ensure that oil and gas companies make a minimum payment for the oil and natural gas that they extract. Royalties are either specific levies (based on the volume of oil and gas extracted) or ad valorem levies (based on the value of oil and gas extracted). A reading of Article 26, particularly Article 26.3 of the Contract, shows that the "Royalties" are specific levies paid for the upstream activities of Petroleum Operations. The "Royalties" paid by Petroenergy to the Republic of Gabon are not for any service for technology, information, or knowledge transfers by the Republic of Gabon to Petroenergy as understood under Section 42 (A) (4) of the Tax Code because there is no transfer into the Philippines of "technology, equipment or other property, where the payee has proprietary interest" or of "scientific, technical, industrial or commercial knowledge or information" [ITAD Ruling No. 145-02 (August 21, 2002); BIR Ruling 93-89 (May 2, 1989)]. The Royalties actually represent economic rent for the privilege and the right of exploring, exploiting and developing the hydrocarbon natural resources which legally belong to the Republic of Gabon. 2. The "Royalties" are economic rent derived by a foreign state from sources outside the Philippines and thus, are not subject to Philippine income tax and consequently, to withholding tax. The Republic of Gabon is a foreign government and cannot be the subject of any taxing jurisdiction of any country on foreign income, including income derived on investments in the Philippines pursuant to Section 32 (B) (7) (a) of the Tax Code. If this is so, then there is more reason to exempt the Republic of Gabon from Philippine income tax on the income in the form of economic rent derived from the extraction of its own mineral resources within its own territory. DSHcTC For purposes of Philippine taxation, there is no economic activity being undertaken in the Philippines that requires the imposition of Philippine income tax and consequently, withholding tax. The source of the "Royalties" paid to the Republic of Gabon is the exploitation of the mineral rights located in Gabon, and not in the Philippines. The exploitation of the mineral rights, which is done in Gabon, is the activity that produced the income. All activity relating to the exploration of the hydrocarbon natural resources under the Contract are done exclusively in the Republic of Gabon. There is no property, activity or service rendered in the Philippines which relates to the exploration of the natural resources in the Republic of Gabon. The fact that the payor of the royalties is a resident of the Philippines does not change the source of income from Gabon to the Philippines. Thus, "Royalties" paid to the Republic of Gabon are not subject to Philippine income tax and consequently, to withholding tax [ Commissioner of Internal Revenue v. British Overseas Airways Corporation, G.R. Nos. L-65773-74, April 30, 1987]. 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. EHTIDA Very truly yours, (SGD.) SIXTO S. ESQUIVIAS IV Commissioner of Internal Revenue Footnotes 1. "Revenue from the Oil and Gas Sector: Issues and Country Experience", Emil Sunley, Thomas Baunsgaard and Dominique Simard (2002).