Tax Consequences of a Lease Agreement Between a Domestic Corporation and a U.S.-Based Company

September 10, 1987 BIR RULING NO. 283-87 24 (b) 000-00 283-87 Gentlemen : This refers to your letter dated May 7, 1987 requesting a ruling on whether the lease agreement between you as a lessee and a New York, U.S.A. based company not engaged in trade or business in the Philippines as lessor constitutes a lease for tax purposes and if so, the applicable tax treatment in the light of the RP-US Tax Treaty. The salient points of the lease agreement are: "1. The proposed Lessor is a New York, U.S.A.,company not engaged in business in the Philippines. It contracts Philippine Apparel, Inc.,a Philippine corporation, to process garment for sale in the U.S.A. "2. The proposed Lessee is a Philippine-registered corporation with U.S. citizens as majority stockholders. "3. The Lessor will buy the equipment as per selection made by the Lessee. "4. The lease shall be for a non-cancellable time of five years. "5. In case of equipment defect, the Lessee shall file a claim against the supplier, not against the Lessor. "6. The Lessee will insure the equipment with the Lessor as the party insured. "7. Loss or damage of equipment shall be against the account of the Lessee. "8. The equipment will remain unattached to any real property. "9. Taxes, except income taxes if any, shall be paid by the Lessee. "10. The Lessor may, without Lessee's consent, assign or transfer the lease contract. "11. The Lessee shall have the option to purchase the equipment at the end of the term at an amount equal to the fair market value of the equipment but not to exceed 10% of the Lessor's acquisition cost. "12. The estimated life of the equipment is five years." adc Pursuant to Sec. 5, Revenue Regulations, No. 19-86, the parties to a lease agreement may secure from this Office an advance ruling recognizing the fact that an agreement actually constitutes a lease for taxpayers. In reply, please be informed that, in general, whether an agreement which in form is a lease, is in substance a conditional sale, depends upon the intent of the parties as evidenced by the provision of the agreement. An agreement purporting to be a contract of lease is treated as a contract of conditional sale if one or more of the compelling persuasive factors are present, namely: (1) The lessee is given the option to purchase the asset at any time during the period of the lease; (2) the lessee acquires automatic ownership of the asset upon payment of the stated amount of "rentals";(3) portions of the periodic rental payments are credited to the purchase price; and (4) receipts of payment indicate that the payments made were partial or full payment of the asset. (par. 4.03/2, Ibid ) From the foregoing provisions of the lease contract, it appears that none of the compelling persuasive factors are present in order that the contract can be treated as conditional sale. In fact, it is stipulated by the parties that the contract shall be deemed to be a lease. Moreover, it has the attributes of a contract of lease, i.e., the lessor gives to the lessee the enjoyment or use of the property for a price certain and for a definite period. (Art. 1643, Civil Code) However, while the lessor retains ownership of the property, the lessee has the option to purchase at the end of the lease period at the nominal sum of not exceeding 10% of the lessor's acquisition cost. Accordingly, this Office believes, and so holds, that for tax purposes, the abovementioned contract is a lease agreement rather than a conditional sale. However, pursuant to Article 8, par. (1) of the RP-US Tax Treaty, 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. Considering that the lessor in the instant case will not have a permanent establishment in the Philippines within the purview of Article 5 of the RP-US Tax Treaty, it is not subject to business profits tax on income realized from the lease. However, the rentals derived by non-resident lessors of equipment shall be subject to the 7 % withholding tax prescribed by Section 25(b)(4) of the Tax Code, in relation to Sections 51 and 52 of the same Code. Finally, as the importer of the above equipment, you are subject to compensating tax, pursuant to Section 169 of the Tax Code, as amended. Very truly yours, (SGD.) EUFRACIO D. SANTOS Deputy Commissioner