Whether Persons Contracted by Petroleum Service Contractors Are "Subcontractors" Under PD 1354

June 13, 2001 BIR RULING NO. 024-01 Baniqued and Baniqued Suite 803, 8/F Jollibee Centre San Miguel Avenue, Ortigas Center Pasig City Attention: Attys . Carlos G . Baniqued and Laura Victoria A . S . Yuson Gentlemen : This refers to your letter dated January 31, 2001 requesting for a confirmation of your opinion that persons or entities contracted by petroleum service contractors, such as Shell Philippines Exploration B.V. (SPEX), to locally supply goods and materials that are required by and in, or that are inherently necessary or incidental to the service contractor's exploration and development of petroleum mineral resources, fall within the meaning of the term "subcontractors" under Presidential Decree No. 1354 and, therefore, are entitled to the preferential 8% final withholding tax on their gross income derived from such contracts. It appears that SPEX is a company duly organized and existing under the laws of Netherlands; that it is licensed by the Securities and Exchange Commission (SEC) to engage in business in the Philippines through a branch office which is located at the 19th Floor, Asian Star Condominium Building, Asean Drive corner Singapura Lane, Filinvest Corporate City, Alabang, Muntinlupa City; that SPEX is a petroleum service contractor of the Philippine Government pursuant to Presidential Decree (PD No. 87), as amended, otherwise known as "The Oil Exploration and Development Act of 1972" and under Service Contract No. 38 (SC 38); that in its capacity as a petroleum service contractor of the Philippine Government, SPEX and its co-venturers in SC 38 perform petroleum operations for the exploration and development of the Malampaya natural gas field located in offshore Palawan (Project); that SPEX implements the Project under the supervision and control of the Philippine Government through the Department of Energy (DOE); that the major components of the Project include: (1) the installation of five development wells and a subsea manifold to bring gas to a shallow water platform; (2) the construction of a shallow water platform to process the gas, and to separate and store condensate; (3) the installation of a bouy that will be used by tankers to lift condensate from the platform; (4) the installation of a 504 kilometer pipeline on the seabed to connect the platform to the gas landfall site in Batangas City; (5) the construction of an onshore gas plant to treat and process dry gas prior to sale; that in the course of developing the Malampaya natural gas field, SPEX enters into contracts or subcontracts with other persons or entities for the local supply not only of labor relating to certain portions of the work described in the immediately preceding paragraph but also of goods and materials that are required by and in, or that are inherently necessary or incidental to, SPEX's exploration and development of the Malampaya natural gas field; that such goods and materials locally supplied by its contractors which are required by and in, and that are inherently necessary to the petroleum operations of SPEX in the Malampaya natural gas field include, among others, the local supply of rocks, to be laid and imbedded throughout the route of the 504 kilometer offshore gas pipelines along the Malampaya natural gas field; that the laying of these rocks along the route of the offshore pipelines is necessary to ensure span protection to prevent loss of integrity of the pipelines through time and to avoid possibility of over-stressing fatigue damage which may be caused by several factors; and that the local supply of these rocks from its contractors is necessary in the petroleum operations of SPEX and is likewise an indispensable compliance requirement to also carry out environmental obligations imposed upon SPEX by the Government, through its political agencies, as indicated in the environmental compliance certificates issued to SPEX. EDIaSH In reply, please be informed that PD No. 87 was enacted to promote the discovery and development of the country's indigenous petroleum resources by providing meaningful incentives to service contractors. The Whereas Clauses of the said decree reveal this intention: "WHEREAS, Presidential Decree No. 8 dated October 2, 1972 was issued to promote the discovery and development of the country's indigenous petroleum resources and adopting therefore as part of the law of the land the provisions of Senate Bill No. 531 (An Act to Promote the Discovery, Production of Indigenous Petroleum and Appropriate Funds Therefor); "WHEREAS, it was found necessary for the national interest to amend Senate Bill No. 531 among other things to provide more meaningful incentives to prospective service contractors." Subsequently, PD No. 1354 was issued to provide an additional incentive for petroleum service contractors by subjecting subcontractors thereof to a preferential eight percent (8%) final tax. Section I of PD No. 1354 reads: "SEC. 1. Tax on subcontractors . Every subcontractor, whether domestic or foreign, entering into a contract with a service contractor engaged in petroleum operation in the Philippines shall be subject to a final income tax equivalent to eight percent (8%) of its gross income derived from such contracts, such tax to be in lieu of any and all taxes, whether national or local . Provided, however , that any income received from all other sources within and without the Philippines in the case of domestic subcontractors and within the Philippines in the case of foreign subcontractors shall be subject to regular income tax imposed under the National Internal Revenue Code. The term "gross income" means all income earned or received as a result of the contract entered into by the subcontractor with a service contractor engaged in petroleum operation in the Philippines under Presidential Decree No. 87." (Emphasis supplied) P.D. No. 1354 is explicit that any person or entity, whether domestic or foreign, that enters into a contract with a service contractor engaged in petroleum operation in the Philippines is considered a subcontractor . The decree, however, clarifies that the gross income entitled to the 8% preferential tax rate refers to the income earned or received as a result of the contract entered into by the subcontractor with the service contractor . PD No. 1354, therefore, does not distinguish between a contract for supply of services and a contract for supply of goods or materials, or both. All that PD No. 1354 requires is that the contract be entered into with a service contractor engaged in petroleum operation in the Philippines. In other words, the contract, whether for supply of labor, or of goods and materials, or both, must provide the service contractor the means necessary to enable it to pursue its petroleum operations. In Zapata Marine Service Ltd., S.A. v. Commissioner of Internal Revenue, CTA Case No. 6384, March 30, 1987 (affirmed en banc by a Resolution of the Supreme Court in G.R. No. 80046 dated April 19, 1988), the Court of Tax Appeals declared that the nature and purpose of the contract entered into by a particular entity with a service contractor determines whether such entity may be considered a subcontractor. The Tax Court ruled that petitioner Zapata Marine is a subcontractor since the contract it had entered into with the petroleum service contractor somehow provided the means necessary for the service contractor to pursue its petroleum operations. The Tax Court said: . . . " Determinative of the sense and scope of the term "sub-contractor" is the nature and purpose of the particular contracts entered into with the service contractor . Thus, Section 1 of P. D. No. 13 54, supra, begins with the broad assertion that "Every sub-contractor whether domestic or foreign entering into a contract with a service contractor engaged in petroleum operations in the Philippines shall be liable to a final tax equivalent to eight percent (8%) of its gross income from such contract, such tax to be in lieu of any and all taxes, whether national or local." This seemed to be where petitioner stood with respect to its contracts with other service contractors, viz.: AMOCO, CITCO and PCSI. As stipulated, the undertaking required of petitioner somehow provides the means necessary in pursuing the subject petroleum operation of service contractors . . . . (Emphasis supplied) Consonant with the reason underlying the passage of PD No. 87 to promote the exploration and development of the country's indigenous petroleum resources, the Court of Tax Appeals and the Supreme Court recognized that the definition of the term "subcontractor" liable to the 8% preferential tax includes all entities undertaking to provide the means necessary in pursuing the petroleum operations of a service contractor. The Court of Tax Appeals in Cebu Maintenance Corporation v. Commissioner of Internal Revenue, CTA Case No. 3060 dated March 28, 1983, held that the term "contractor", or "subcontractor", for that matter, includes one who contracts or covenants, whether with a government or other public body or with private parties, to furnish supplies or articles at a certain price or rate. Moreover, Black's Law Dictionary defines a "contractor" as follows: " Contractor . This term is strictly applicable to any person who enters into a contract, but is commonly reserved to designate one who, for a fixed price, undertakes to procure the performance of works or services on a large scale, or the furnishing of goods in large quantities, whether for the public or a company or individual. Such are generally classified as general contractors (responsible for entire job) and subcontractors (responsible for only a portion of the job; e.g. plumber, carpenter). aHTDAc xxx xxx xxx" In BIR Ruling No. 180-81, dated September 17, 1981, the Commissioner of Internal Revenue even classified as a subcontractor an entity ( i.e. , secondary subcontractor) that entered into a contract with a subcontractor ( i.e. , principal subcontractor) of the service contractor engaged in petroleum operation. The Commissioner of Internal Revenue emphasized that what is essential is that the contract entered into is "inherently or necessarily incidental to the exploration and development of petroleum mineral resources by the service contractor." It thus stands to reason that persons or entities that enter into contracts with the service contractor or subcontractors thereof for supply of goods and materials that are inherently or necessarily incidental to the service contractor's exploration and development of petroleum mineral resources should likewise be considered as subcontractors under PD No. 1354 and, therefore, are subject to a final tax of 8% of their gross income derived from such contracts. Furthermore, Section 2(b) of Revenue Regulations No. 15-78 defines the term "subcontractor" as a "foreign or domestic entity engaged by a service contractor for a specific undertaking in a pursuance of a service contract" does not serve to disqualify as a subcontractor an entity engaged by a service contractor to supply the latter goods or materials that are required by and in, or that are inherently necessary or incidental to, the service contractor's exploration and development of petroleum mineral resources. It is obvious that the service contractor undertakes under the service contract with the Philippine Government to provide not only services but also such equipment, supplies, goods and materials as are required by and in, or that are inherently necessary or incidental to, the service contractor's exploration and development of petroleum mineral resources. By subcontracting to another person or entity its undertaking to supply goods and materials required by or for use in its petroleum operations, or any part of such undertaking, the service contractor constitutes such other person or entity as a subcontractor within the meaning of PD No. 1354. In view of the foregoing, this Office hereby confirms your opinion that persons or entities contracted by SPEX, to locally supply goods and materials that are required by and in, or that are inherently necessary or incidental to its exploration and development of petroleum mineral resources, fall within the meaning of the term subcontractors under PD No. 1354 and are therefore entitled to the preferential 8% final withholding tax on their gross income derived from such contracts. 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.) REN G. BAEZ Commissioner of Internal Revenue