DA ITAD BIR Ruling No. 054-09

May 11, 2009 DA ITAD BIR RULING NO. 054-09 Articles 5 (Permanent Establishment), 7 (Business Profits) and 11 (Interest) Philippines-Netherlands tax treaty; BIR Ruling No. DA-ITAD 30-08 Isla Lipana & Co. 29th Floor, Philamlife Tower 8767 Paseo de Roxas 1226 Makati City Attention: Atty. Malou P. Lim Partner, Tax Services Gentlemen : This refers to your letter dated April 8, 2008, requesting confirmation that payments to be made by United Coconut Planters Bank (UCPB) to Silverlake Netherlands B.V. (Silverlake) under a License Agreement are exempt from Philippine income tax pursuant to the Convention between the Kingdom of the Netherlands and the Republic of the Philippines for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (Philippines-Netherlands tax treaty). 1 acHDTE BASIC FACTS It is represented that Silverlake is a corporation organized and existing under the laws of the Netherlands and is a resident of the Netherlands based on the Certification dated December 17, 2007, issued by the Tax and Customs Administration of the Netherlands; that Silverlake is not registered as a corporation or as a partnership in the Philippines based on the Certification of Non-Registration of Corporation/Partnership dated January 31, 2008, issued by the Securities and Exchange Commission; that, on the other hand, UCPB is a corporation organized and existing under the laws of the Philippines, situated at UCPB Building, Makati Avenue, Makati City, Philippines. It is further represented that on November 15, 2007, UCPB and Silverlake entered into a License Agreement wherein Silverlake granted UCPB (including the latter's subsidiary, UCPB Savings Bank ) a nonexclusive, nontransferable, and perpetual license to use the Branch Delivery System Application Software (or the Product ) including any part thereof or any modification 2 made thereon; that the license covers 178 branches, 12 cash centers, 1 clearing center, and 1 server for 11 head office units, of UCPB throughout the Philippines; It is further represented that the Product is developed and owned by and is a proprietary product of Silverlake and/or its suppliers; that the License Agreement deals only with the licensed use of the Product and not the transfer of ownership or other rights in or to the Product; that the Product, whether written or in machine readable form, including programs, diskettes, tapes, listings and documentation, had originated with and was prepared by Silverlake and/or its suppliers jointly and pursuant to the Functional Specifications Document, and that any extension, modification, derivative, customizations, or enhancements made by Silverlake on the Product will continue to belong to Silverlake and/or its suppliers; that UCPB will neither permit nor cause any third party to translate, adapt, vary, modify, disassemble, decompile, or reverse engineer the Product in whole or in part, except to the extent permitted under applicable laws granting such rights to UCPB as a lawful user of the Product and to the extent permitted under the License Agreement; that UCPB will supervise and control the use of the Product in accordance with the terms of the License Agreement and will reproduce and include the copyright notice of Silverlake and/or its suppliers on all copies of the Product including partial copies or modifications thereof; that UCPB will, within 14 calendar days after the termination of the License Agreement and as instructed by Silverlake in writing, return or destroy all electronic copies and printed documents of the Product including all updates, upgrades and modifications of the Product and all documentation relating thereto, and that UCPB will giver a written notice to Silverlake that it has complied with such instruction of Silverlake and that notwithstanding the foregoing, UCPB may, with the prior written authorization of Silverlake , retain one copy of the Product for archive purposes only or for other purposes authorized by Silverlake under certain conditions imposed on the continued retention of the Product. TESICD It is further represented that in consideration for the use of the Product, UCPB will pay Silverlake a license fee of US$890,000, in accordance with the following schedule: Milestones Description Percentage of Contract Price Payable First Upon delivery of the Product 25 percent Second Upon delivery of the Product for User 25 percent Acceptance Testing Third Upon completion of User 20 percent Acceptance Testing by UCPB Fourth Upon Live Date 3 20 percent Fifth Upon expiry of the Warranty Period 4 10 percent that an additional license fee of US$5,000 will be charged for every additional branch, cash center, clearing center or server of UCPB that will make use of the Product, except for any additional head office units that connected itself to the existing server to which the eleven other head office units as previously described are connected; and that all payments to be made under the License Agreement will be paid within 30 days from the date of the invoice of such payments, and that payments not made within that period will accrue interest at the rate of 12 percent per annum computed from the due date to the actual date such payments are made. It is finally represented that either party may, upon the occurrence of some event or events which has not been remedied by the other party within 30 days from the date of their occurrence, terminate the License Agreement by giving a written notice of termination to the other party within 30 days before the date of such termination. RULING A. On income tax In reply, please be informed that under Section 23 (F) of the National Internal Revenue Code of 1997 (Tax Code of 1997), a foreign corporation like Silverlake , whether or not engaged in trade or business in the Philippines, is taxable only on income derived from sources in the Philippines. Section 23 (F) provides: "SEC. 23. General Principles of Income Taxation in the Philippines . Except when otherwise provided in this Code: DCISAE xxx xxx xxx (F) A foreign corporation, whether engaged or not in trade or business in the Philippines, is taxable only on income derived from sources within the Philippines." In this case, since Silverlake is not engaged in trade or business in the Philippines based on the Certification issued by the Securities and Exchange Commission, income derived by Silverlake from sources in the Philippines is generally subject to income tax at the rate of 35 percent based on the gross amount thereof under Section 28 (B) (5) (a) of the Tax Code of 1997, as amended by Republic Act No. 9337. 5 Section 28 (B) (5) (a) provides: "SEC. 28. Rates of Income Tax on Foreign Corporations. xxx xxx xxx (B) Tax on Nonresident Foreign Corporation. (1) In General. Except as otherwise provided in this Code, a foreign corporation not engaged in trade or business in the Philippines shall pay a tax equal to thirty-five percent (35%) of the gross income received during each taxable year from all sources within the Philippines, such as interests, dividends, rents, royalties, salaries, premiums (except reinsurance premiums), annuities, emoluments or other fixed or determinable annual, periodic or casual gains, profits and income, and capital gains, except capital gains subject to tax under subparagraphs 5(c). Provided, That effective January 1, 2009, the rate of income tax shall be thirty percent (30%)." However, under Section 32 (B) (5) of the Tax Code of 1997, such income derived by Silverlake in the Philippines may be exempt from income tax (or partially exempt from income tax if subject only to a reduced income tax rate) if the same is so exempt (or partially exempt ) pursuant to a treaty obligation binding upon the Philippine government. Section 32 (B) (5) provides: "SEC. 32. Gross Income . xxx xxx xxx (B) Exclusions from Gross Income. The following items shall not be included in gross income and shall be exempt from taxation under this Title: xxx xxx xxx (5) Income Exempt under Treaty. Income of any kind, to the extent required by any treaty obligation binding upon the Government of the Philippines." ISCTcH With respect to a treaty that may be invoked by Silverlake and other residents of the Netherlands, there is the Philippines-Netherlands tax treaty. Since tax treaties follow the principal method of classification and assignment in mitigating the effects of double taxation of income derived by a resident of a Contracting State from sources in the other Contracting State, it is important to know how income derived by Silverlake under the License Agreement is classified for purposes of the Philippines-Netherlands tax treaty. Because the License Agreement grants UCPB the right to use a software, namely, the Branch Delivery System Application Software, the characterization of payments involving the use of software is generally covered by Revenue Memorandum Circular No. 44-2005 (Taxation of Payments for Software), effective September 8, 2005. Section 5 of this Circular provides: "Section 5. Characterization of Transactions. The character of payments received in a transaction involving the transfer of computer software depends on the nature of the rights that the transferee acquires under the particular arrangement regarding the use and exploitation of the program. a. Transfer of copyright rights . A transfer of software is classified as a transfer of a copyright right if, as a result of the transaction, a person acquires any one or more of the rights described below: i. The right to make copies of the software for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease or lending; ii. The right to prepare derivative computer programs based upon the copyrighted software; iii. The right to make a public performance of the software; iv. The right to publicly display the computer program; or v. any other rights of the copyright owner, the exercise of which by another without his authority shall constitute infringement of said copyright. ICHcTD The determination of whether a transfer of a copyright right in a software is a sale or exchange of property is made on the basis of whether, taking into account all facts and circumstances, there has been a transfer of all substantial rights in the copyright. A transaction that does not constitute a sale or exchange because not all substantial rights have been transferred will be classified as a license generating royalty income. When only copyright rights are transferred, payments made in consideration therefor are royalties. On the other hand, when copyright ownership is transferred, payments made in consideration therefor are business income. b. Transfer of copyrighted articles . A copyrighted article incorporating a software includes a copy of the software from which the work can be perceived, reproduced, or otherwise communicated, either directly or with the aid of a machine or device. The copy of the software may be fixed in the magnetic medium of a floppy disk or a CD-ROM, or in the main memory or hard drive of a computer, or in any other medium. If a person acquires a copy of a software but does not acquire any of the rights described above (or only acquires a de minimis grant of such rights), and the transaction does not involve the provision of services or of know-how, the transfer of the copy of the software is classified solely as a transfer of a copyrighted article and payments for which constitute business income." Under Section 5, payments for the use of software can give rise to either royalties or business profits . Payments for the use of software are royalties when the use permits the person concerned to make copies of the software for purposes of distribution to the public, to prepare derivative computer programs, to make a public performance of the software, to publicly display the computer program, or to exercise any other rights of the copyright owner of the software that will otherwise constitute infringement if done without the latter's authority. On the other hand, payments for the use of software are business profits when the person concerned merely acquired a copy of the software and/or merely acquired a de minimis right or rights for the use of the software. HcSETI Under the License Agreement, UCPB is permitted to use the Branch Delivery System Application Software in a specific number of its branches, cash centers, clearing center and server throughout the Philippines, but such use does not permit UCPB to translate, adapt, vary, modify, disassemble, decompile, or reverse engineer the software in whole or in part. However, UCPB may, with the prior written authorization of Silverlake , retain one copy of the software for archive purposes only or for other purposes authorized by Silverlake under certain conditions imposed on the continued retention of the software. Because of the limited rights that UCPB can exercise with respect to the use of the software, payments to be made by UCPB to Silverlake cannot give rise to royalties but should be characterized as business profits , in accordance with the guidelines laid down in Section 5 of Revenue Memorandum Circular No. 44-2005. That UCPB may retain one copy of the Branch Delivery System Application Software for archive purposes only or for other purposes authorized by Silverlake under certain conditions imposed on the continued retention of the software refers to a de minimis right which may be exercised with or without the authorization of Silverlake under Section 189 of the Intellectual Property Code of 1998 (Republic Act No. 8293). Section 189 provides: "Section 189. Reproduction of Computer Program . 189.1. Notwithstanding the provisions of Section 177, the reproduction in one (1) backup copy or adaptation of a computer program shall be permitted, without the authorization of the author of, or other owner of copyright in, a computer program, by the lawful owner of that computer program; Provided, That the copy or adaptation is necessary for : (a) The use of the computer program in conjunction with a computer for the purpose, and to the extent, for which the computer program has been obtained; and (b) Archival purposes, and, for the replacement of the lawfully owned copy of the computer program in the event that the lawfully obtained copy of the computer program is lost, destroyed or rendered unusable . 189.2. No copy or adaptation mentioned in this Section shall be used for any purpose other than the ones determined in this Section, and any such copy or adaptation shall be destroyed in the event that continued possession of the copy of the computer program ceases to be lawful. SDTcAH 189.3. This provision shall be without prejudice to the application of Section 185 whenever appropriate." (Emphasis supplied) As business profits, payments to be made by UCPB to Silverlake are subject to the provisions of paragraph 1, Article 7 of the Philippines-Netherlands tax treaty as follows: "Article 7 Business Profits 1. The profits of an enterprise of one of the States shall be taxable only in that State unless the enterprise carries on business in the other State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment." Under paragraph 1, such payments made to Silverlake may be taxed in the Philippines if the same are attributable to a permanent establishment which Silverlake has in the Philippines. Relative thereto, a permanent establishment is defined in paragraphs 1 and 2, Article 5 of the Philippines-Netherlands tax treaty as follows: "Article 5 Permanent Establishment 1. For the purposes of this Convention, the term 'permanent establishment' means a fixed place of business in which the business of the enterprise is wholly or partly carried on. 2. The term 'permanent establishment' includes especially: a) a place of management; b) a branch; c) an office; d) a factory; e) a workshop; f) a mine, quarry or other place of exploration or extraction of natural resources; TSaEcH g) a building site or construction or assembly project or supervisory activities in connection therewith, where such site, project or activity continues for a period of more than 183 days; h) the furnishing of services including consultancy services by an enterprise through an employee or other personnel where activities of that nature continue (for the same or a connected project) for a period or periods exceeding in the aggregate 183 days within any twelve-month period." Based on the Certification of Non-Registration of Corporation/Partnership dated January 31, 2008, issued by the Securities and Exchange Commission that Silverlake is not registered as a corporation or as a partnership in the Philippines, it is unlikely for Silverlake to have a branch or an office , and, consequently, a permanent establishment , in the Philippines at least as of the date of the Certification on January 31, 2008. This being the case, payments to be made by UCPB to Silverlake pursuant to the License Agreement, particularly, the initial license fee of US$890,000 and the additional license fee of US$5,000, if any, for the use by UCPB of the Branch Delivery System Application Software in its branches, cash centers, clearing centers, servers, and head office units, throughout the Philippines, are exempt from Philippine income tax. (BIR Ruling No. DA-ITAD 30-08 dated April 29, 2008) On the other hand, interest on overdue payments or penalty charges to be paid by UCPB to Silverlake at the rate of 12 percent, per annum cannot be treated as business profits because this is not primarily the kind of income that Silverlake may derive in the grant of license to use software to its clients and customers like UCPB. On whether such interest on overdue payments or penalty charges are covered by Article 11 (Interest) of the Philippines-Netherlands tax treaty, we take note that the same is not treated as interest under this article. Paragraph 5 of Article 11 defines the term interest as follows: "5. The term 'interest' as used in this Article means income from Government securities, bonds or debentures, whether or not secured by mortgage but not carrying a right to participate in profits, and debt-claims of every kind as well as all other income assimilated to income from money lent by the taxation law of the State in which the income arises. Penalty charges for late payment shall not be regarded as interest for the purpose of this Article ."(Emphasis supplied) Such interest on overdue payments or penalty charges cannot be covered either by a residual article on other income or an article on income not expressly covered by the preceding articles of a tax treaty as such article is not present in the Philippines-Netherlands tax treaty. Where such a residual article is lacking in the Philippines-Netherlands tax treaty, interest on overdue payments or penalty charges to be paid by UCPB to Silverlake under the License Agreement are taxable in accordance with the domestic tax laws of the Philippines. Particularly, and as previously mentioned, such income shall be subject to income tax at the rate of 35 percent based on the gross amount thereof under Section 28 (B) (5) (a) of the Tax Code of 1997, as amended. AECIaD B. On value-added tax Under Section 108 (A) (1) of the Tax Code of 1997, as amended by Republic Act No. 9337, the sale or exchange of services, including the use or lease of properties, in the Philippines is subject to value-added tax (VAT). Section 108 (A) (1) provides: "SEC. 108. Value-added Tax on Sale of Services and Use or Lease of Properties. (A) Rate and Base of Tax. There shall be levied, assessed and collected, a value-added tax equivalent to ten percent (10%) of gross receipts derived from the sale or exchange of services, including the use or lease of properties: Provided, that the President, upon the recommendation of the Secretary of Finance, shall, effective January 1, 2006, raise the rate of value-added tax to twelve percent (12%), after any of the following conditions has been satisfied: (i) Value-added tax collection as a percentage of Gross Domestic Product (GDP) of the previous year exceeds one and one-half percent (1 1/2%); or (ii) National government deficit as a percentage of GDP of the previous year exceeds one and one-half percent (1 1/2%). 6 The phrase 'sale or exchange of services' means the performance of all kinds of services in the Philippines for others for a fee, remuneration or consideration, . . ." Under Section 105 of the Tax Code of 1997, while the VAT is imposed on any person who sells, barters, exchanges, leases goods or properties, and renders services, generally in the course of its trade or business, this section likewise provides that services rendered in the Philippines by a nonresident foreign person like Silverlake is considered rendered in the course of trade or business and as such will be subject to VAT. Section 105 provides: "SEC. 105. Persons Liable . 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 Sections 106 to 108 of this Code. AEIcSa The value-added tax is an indirect tax and the amount of tax may be shifted or passed on to the buyer, transferee or lessee of the goods, properties or services. This rule shall likewise apply to existing contracts of sale or lease of goods, properties or services at the time of the effectivity of Republic Act No. 7716. The phrase 'in the course of trade or business' means the regular conduct of pursuit of a commercial or an economic activity, including transactions incidental thereto, by any person regardless of whether or not the person engaged therein is a non-stock, nonprofit private organization (irrespective of the disposition of its net income and whether or not it sells exclusively to members or their guests), or government entity. The rule of regularity, to the contrary notwithstanding, services as defined in this Code rendered in the Philippines by nonresident foreign persons shall be considered as being rendered in the course of trade or business ."(emphasis added) Accordingly, pursuant to Section 4.112-2 of Revenue Regulations No. 16-2005, 7 as amended by Revenue Regulations No. 4-2007, 8 UCPB, as the resident withholding agent, is liable to withhold VAT on all payments to be made by it to Silverlake , the nonresident recipient, pursuant to the License Agreement, at the rate of 12 percent beginning February 1, 2006, and onwards. Section 4.112-2 provides: "SEC. 4.114-2. Withholding of VAT on Government Money Payments and Payments to Non-Residents . xxx xxx xxx (b) The government or any of its political subdivisions, instrumentalities or agencies including GOCCs, as well as private corporation, individuals, estates and trust, whether large or non-large taxpayers, shall withhold twelve percent (12%) VAT, starting February 1, 2006, with respect to the following payments: (1) Lease or use of properties or property rights owned by non-residents; and (2) Other services rendered in the Philippines by non-residents. In remitting VAT withheld, the withholding agent shall use BIR Form No. 1600 Remittance Return of VAT and Other Percentage Taxes Withheld. IAETDc VAT withheld and paid for the non-resident recipient (remitted using BIR Form No. 1600), which VAT is passed on to the resident withholding agent by the non-resident recipient of the income, may be claimed as input tax by said VAT-registered withholding agent upon filing his own VAT Return, subject to the rule on allocation of input tax among taxable sales, zero-rated sales and exempt sales. The duly filed BIR Form No. 1600 is the proof or documentary substantiation for the claimed input tax or input VAT. Nonetheless, if the resident withholding agent is a non-VAT taxpayer, said passed-on VAT by the non-resident recipient of the income, evidenced by the duly filed BIR Form No. 1600, shall form part of the cost of purchased services, which may be treated either as an 'expense' or 'asset', whichever is applicable, of the resident withholding agent. VAT withheld under this Section shall be remitted within ten (10) days following the end of the month the withholding was made. This ruling is issued on the basis of the facts as represented. However, if upon investigation it shall be disclosed that the actual facts are different, then this ruling shall be without force and effect insofar as the herein parties are concerned. Very truly yours, Commissioner of Internal Revenue By: (SGD.) GREGORIO V. CABANTAC Deputy Commissioner Footnotes 1. Signed on March 9, 1989, and effective January 1, 1992. SEIDAC 2. Modification means the customization and/or enhancements developed by Silverlake at the request of UCPB as part of the Product. Customization means parameter setting of existing codes in accordance with the requirements under the Technical Specification Document (the technical requirements of the Product) and the Functional Specification Document (the functional requirements of the Product). Enhancement means the additional programming effort required to be made to the Product to meet the specifications of UCPB under the Technical Specification Document and the Functional Specification Document. 3. Live Date means the date that UCPB accepts the Product for live implementation in the first Pilot Branch, which should not be later than seven banking days following the live production of the first Pilot Branch. Pilot Branch means any of the first two branches of UCPB in Metro Manila and one branch of UCPB in the province that are selected for the implementation of the Product. 4. Warranty Period means a period of six months from Cutover Date. Cutover Date means the date that UCPB accepts the Product for live implementation in the third Pilot Branch, which should not be later than one month after the Live Date. 5. Entitled An Act Amending Sections 27, 28, 34, 106, 107, 108, 109, 110, 111, 112, 113, 114, 116, 117, 119, 121, 148, 151, 236, 237 and 288 of the National Internal Revenue Code of 1997, as amended, and for other purposes) , which was signed on May 24, 2005, and effective November 2005. 6. The VAT rate was increased to 12% on February 1, 2006, in accordance with the Memorandum of the Executive Secretary to the Secretary of Finance dated January 31, 2006, as circularized by Revenue Memorandum Circular No. 7-2006 (Publishing the Full Text of the Memorandum from Executive Secretary Eduardo R. Ermita dated January 31, 2006 Approving the Recommendation of the Secretary of Finance to increase the Value Added Tax Rate from Ten Percent to Twelve Percent) dated January 31, 2006. 7. Entitled Consolidated Value-Added Tax Regulations of 2005 , dated September 1, 2005, and effective 15 days after its publication. 8. Entitled Amending Certain Provisions of Revenue Regulations No. 16-2005, As Amended, Otherwise Known as the Consolidated Value-Added Tax Regulations of 2005 , dated February 7, 2007, and effective 15 days after its publication. CaHcET