Tax Consequences of Cost-Sharing Reimbursement by a Branch to Its US Affiliate

October 21, 1999 BIR RULING NO. 165-99 165-99 Punongbayan & Araullo 6th Floor, Vernida Building Alfaro Street, Salcedo Village Makati City Attention: Atty . V . C . Mamalateo Gentlemen : This refers to your letter dated March 8, 1999 stating that your client, American Power Conversion (Phils.), Inc. (APCP) is a domestic corporation duly registered with the Securities and Exchange Commission (SEC) with office address at the Cavite Ecozone, Rosario, Cavite; that APCP is a wholly-owned subsidiary of American Power Conversion BV (APBV), a holding company based in Netherlands, which in turn is owned by American Power Conversion Corporation (APCC) of the United States; that APCP is primarily organized to engage in, operate, conduct and maintain the business of manufacturing, processing, importing, exporting, buying, selling and/or dealing in, on a wholesale basis, electronic equipment, power goods of similar nature and their accessories of whatever nature and character, and any and all equipment, materials, supplies used or employed in or related to the manufacture of such finished products; that APCP is also registered with the Philippine Economic Zone Authority (PEZA) as an Ecozone Export Enterprise having been issued PEZA Certificate of Registration No. 96-060 dated May 15, 1996; that under its Certificate of Registration, APCP has been authorized to engage in the manufacture, assembly and export of uninterrupted power supply (UPS) equipment such as power converters and voltage regulators at the Cavite Zone, as such, it enjoys a four (4)-year income tax holiday (ITH) incentive effective May 1996; that in addition to its Cavite Ecozone operations, APCP has been authorized by the PEZA to expand its operations in the manufacture of UPS equipment such as high-end converters and voltage regulators at the Carmelray Industrial Park, Special Economic Processing Zone located in Laguna; that APCP's Laguna operations is covered by a Supplemental Agreement executed between the PEZA and APCP dated February 5, 1997; that pursuant to said agreement, APCP's expansion project shall enjoy a three (3) year ITH incentive effective April 1997; that APCP is presently a contract manufacturer for APCC (i.e., APCP uses APCC's technology without charge, and APCP has no inventory risk) and sells to APCC for cost plus 15%; that the products that APCP manufactures for APCC are principally sold in the United States; that pursuant to ''APCC's worldwide restructuring, APCP will be converted from a subsidiary into a branch; that the Philippine operation will be converted from a contract manufacturer to a full-line manufacturer that holds its own technology; that the branch would obtain the rights to exploit intangible-assets (primarily technology) via royalty and cost sharing arrangements with APCC; that in connection with the conversion of the subsidiary into a branch, the assets of the subsidiary shall be transferred to the branch; that these assets consist of inventories of taxable goods and manufacturing equipment and other properties; that the branch will enter into a Cost-Sharing Agreement (Agreement) with another foreign affiliate; that under the said Agreement, the parties shall pool their respective resources and shall combine their research and development efforts in order to develop new intellectual property rights, technology, and other intangible property rights relating to certain products and the manufacturing processes therefor; that the parties shall share the costs and risks of research and development based on the benefits anticipated to be derived by each from the developed product; that the parties shall also exploit in their respective businesses the intellectual property rights, technology, and other intangible property rights developed; that each party shall have the right to use the developed product within its territory as described under the Agreement; that the parties shall share the costs and risks of research and development based on the benefits anticipated to be derived by each from the developed product; that the cost-sharing reimbursements to be made by the branch to another foreign affiliate under the Agreement are the branch's share of costs and expenses in the joint effort to develop new products and technology; that such payments shall represent compensation for the underlying research and development services to be rendered by foreign persons resident in the United States; that the costs shall first be advanced by the branch's US-based affiliate as they are incurred; that no mark-up whatsoever shall be realized by the US affiliate; and that as mere reimbursements, the cost-sharing payments shall reduce the costs and expenses to be advanced by the US affiliate, but shall in no case result into income to said US affiliate. In connection therewith, you now request confirmation of your opinion that "1. The cost-sharing reimbursement to be made by the branch to its US affiliate, being compensation for services rendered in the United States, shall be considered as foreign-source income, and shall not be taxable in the Philippines to the foreign persons who shall render the services; "2. The cost-sharing reimbursements made by the branch, being foreign source income payable to foreign persons who are residents of the United States, shall not be subject to Philippine withholding tax; "3. The transfer of assets of the subsidiary to the branch other than inventories of taxable goods, being not in the ordinary course of trade or business, shall not be subject to the value-added tax; "4. The transfer of inventories of taxable goods of the subsidiary to the branch shall be subject to 10% value-added tax if the Philippine subsidiary at the time of its liquidation is still enjoying the income tax holiday (ITH) incentives; otherwise, it may claim exemption therefrom; and "5. The branch may utilize, for VAT reporting and payment purposes, the accumulated input VAT of the subsidiary company. In reply, please be informed that your opinion is hereby confirmed as follows: 1. Section 42(C)(3) of the Tax Code of 1997 provides that compensation for labor or personal services performed without the Philippines shall be treated as income from sources without the Philippines. For the source of income to be considered as coming from the Philippines, it is sufficient that the income is derived from an activity within the Philippines (Commissioner vs. British Overseas Airway Corporation and Court of Tax Appeals, G.R. Nos. 65773-74 dated April 30, 1987). Considering that the cost-sharing reimbursement to be made by the branch to its US affiliate is for actual services rendered in the United States by US residents, payments thereof should not be considered as income from within the Philippines and therefore not subject to Philippine income tax. prcd 2. Article 8(1) of the RP-US Tax Treaty provides that business profits of a resident of one of the Contracting States shall be taxable only in that State unless the resident has a permanent establishment in the other Contracting State. If the resident has a permanent establishment in that other Contracting State, tax may be imposed by that other Contracting State on the business profits of the resident but only on so much of them as are attributable to the permanent establishment. In relation thereto, Article 5(1) and (2) of the said treaty reads: "Article 5 "Permanent Establishment "1. For the purposes of this Convention, the term "permanent establishment" means a fixed place of business through which a resident of one of the Contracting States engages in a trade or business. "2. The term "fixed place of business" includes but is not limited to: a) A seat of management; b) A branch; c) An office; d) A store or other sales outlet; e) A factory; f) A workshop; g) A warehouse; h) A mine, quarry, or other place of extraction of natural resources; i) A building site or construction or assembly project or supervisory activities in connection therewith, provided such site, project or activity continues for a period of more than 183 days; and j) The furnishing of services, including consultancy services, by a resident of one of the Contracting States through employees or other personnel, provided activities of that nature continue (for the same or a connected project) within the other Contracting State for a period or periods aggregating more than 183 days." Since APCC does not have a permanent establishment in the Philippines to which its business profits/income is attributable, the cost-sharing reimbursements made by the branch to US residents for actual services rendered in the United States are not subject to Philippine income tax and consequently to withholding tax. LexLib 3. Section 105 of the Tax Code of 1997 provides that "any person who, in the course of trade or business, sells, barters, exchanges, leases goods or properties, renders services, and any person who imports goods shall be subject to the value-added tax (VAT) imposed in Section 106 to 108 of the said Code. "xxx xxx xxx The phrase "in the course of trade or business" means the regular conduct or pursuit of a commercial or an economic activity, including transactions incidental thereto. . . ." In the instant case, the intended transfer of assets of the subsidiary, other than inventories of taxable goods, to the proposed branch is not in the course of trade or business as contemplated in the above-mentioned section, neither is it incidental thereto since the same does not necessarily follow its primary function of manufacturing, processing, importing, exporting, buying, selling and/or dealing in electronic equipment, power goods of similar nature and their accessories. (Magsaysay Lines Inc. et. al v. Commissioner of Internal Revenue, CTA Case No. 4353, April 27. 1992). Such being the case, since the intended transfer of assets of the subsidiary to the proposed branch is just an isolated transaction, said transfer is not-subject to value-added tax. (BIR Ruling No. 113-98 dated July 23, 1998) 4. The transfer of inventories of taxable goods of the subsidiary to the branch shall be subject to 10% value-added tax imposed under Section 106(B)(1) of the Tax Code of 1997, if the Philippine subsidiary at the time of its liquidation is still enjoying an income tax holiday (ITH). However, if the subsidiary is no longer enjoying the ITH at the time of its liquidation, and is in fact already being taxed at the rate of 5% on gross income, then it may claim exemption from the 10% value-added tax since the 5% income tax on gross income applicable to PEZA registered enterprises is in lieu of all national and local taxes including the 10% VAT. 5 For VAT purposes, the branch may utilize the accumulated input VAT of the subsidiary, since the conversion of the subsidiary to a branch is akin to a merger. Where there is transfer of all the assets and the assumption of debts and liabilities of the absorbed corporation by the absorbing corporation and the legal personality of the absorbed corporation is extinguished but its interest subsists inasmuch as the transfer is in consideration for the shares of stock to be issued by the absorbing corporation. In the instant case, the conversion of the subsidiary into a branch, the stockholders' interest in the subsidiary also subsists since the shares of stock of the subsidiary are owned by the head office of the branch. With the conversion, from indirect ownership of the assets of the subsidiary, APCBV will now have direct ownership of the said assets. LLjur Very truly yours, (SGD.) BEETHOVEN L. RUALO Commissioner of Internal Revenue