DA ITAD BIR Ruling No. 065-08

September 10, 2008 DA ITAD BIR RULING NO. 065-08 Article 12, Philippines-Japan tax treaty; BIR Ruling Nos. DA-ITAD 127-06 and 173-02 Aranas Consunji Barleta Unit 106, Ground Floor, Le Metropole Building 326 Tordesillas corner De La Costa Streets Salcedo Village, Makati City Attention: Atty. Maria Louella M. Aranas Gentlemen : This refers to your letter dated March 23, 2007 requesting confirmation that royalties to be paid by Air Water Philippines, Inc. (Air Water Philippines) to Air Water, Inc. (Air Water Japan) 1 are subject to Philippine income tax at the rate of 25%, based on the gross amount thereof, pursuant to the Convention between the Republic of the Philippines and Japan for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (Philippines-Japan tax treaty) . 2 TaHDAS BASIC FACTS It is represented that Air Water Japan is a corporation organized and existing under the laws of Japan, with address at 1-8 Nakahama-Cho, Amagasaki-Shi, Hyogo, 660-0091 Japan, as evidenced by its Articles of Association; that the purpose for which Air Water is created is, among others, the production and sale of (1) oxygen, nitrogen, argon, hydrogen, carbon dioxide gas, dissolved acetylene and other compressed gasses or liquefied gas, (2) liquefied petroleum gas, petroleum products, and organic petrochemical industrial products, (3) plastic products, raw and sub materials thereof and household goods, (4) household equipments such as bathrooms and environmental hygiene facilities and equipments, and (5) compressed air and processing service for purification of industrial water; that Air Water Japan is not registered as a corporation or partnership in the Philippines as confirmed by the Certificate of Non-Registration of Corporation/Partnership dated January 29, 2007 issued by the Securities and Exchange Commission; that, on the other hand, Air Water Philippines is a corporation organized and existing under the laws of the Philippines, with address at 119 East Main Avenue, Special Economic Zone Laguna Technopark, Bian, Laguna, Philippines: that Air Water Philippines is registered with the Philippine Economic Zone Authority (PEZA) as an Ecozone Export Enterprise under Certificate of Registration No. 02-055 dated October 23, 2002; and that among other incentives available to it and based on the Certification by PEZA dated January 3, 2007, Air Water Philippines, as a registered enterprise, is liable only to the payment of 5% gross income tax in lieu all national and local taxes. It is also represented that on October 25, 2006, Air Water Japan and Air Water Philippines entered into a Technology Supply Contract whereby Air Water Japan will supply to Air Water Philippines the Process and related technology; that Air Water Philippines will make use of the Process and related technology and engage in the business of commissioned nitriding treatment for its customers in the Philippines, which will make use of a specialized furnace to be installed at Air Water Philippines' plant in the Philippines; that the Process refers to the nitriding process developed and commercialized by Air Water Japan and related technology; that the Process is carried out by creating an active fluoride layer on a metal surface as a pre-treatment, and that it covers Patent Nos. 2501925 (Method of Pre-treating Metallic Works) and 2138825 (Method of Nitriding Steel), which are duly registered in the name of Air Water Japan, under the applicable intellectual property laws of Japan; that the Process and related technology will be suitable for the materials and form of the Products to be treated and the production volume to be produced by Air Water Philippines; that the Products refer to the parts and materials that have undergone treatment by the Process and are intended to be delivered to customers of Air Water Philippines; that Air Water Japan will supply Air Water Philippines the following: ATcaHS 1. The main information concerning treatment by the Process; 2. The method of operation of the Facility; 3 3. A new version of the Process and related equipment if there is any change in the production plan or to the materials and shape of the Products to be treated after the initial supply of the Process; 4. The main information concerning treatment by the Process when changed; 5. The method of operation of the Facility for a new version of the Process and related equipment; 6. The method of maintenance of the Facility; 7. Technology information relative to the implementation of any technological improvement when Air Water Japan implements such improvement after introducing them to the original Process; and 8. Other technology and information relating to the foregoing items. That Air Water Japan, will immediately inform Air Water Philippines of the implementation of any improvement concerning the Know-How, 4 Process and related technology, and Air Water Japan will supply the technology and information relating to such improvement to Air Water Philippines upon its request. It is further represented that as compensation, Air Water Philippines will pay Air Water Japan an amount equivalent to 5% of the total sales of the commissioned finishing work implemented by Air Water Philippines; that the payments will be made quarterly on the last day of June, September, December and March, and they will be made in Japanese yen equivalent to the compensation amount using prevailing foreign exchange rate; and that for each of the quarterly payments, Air Water Philippines will be allowed to make the payment within sixty days from date they respectively fall due. AaCEDS It is finally represented that the Technology Supply Contract will be in force and effect for a period of ten years from the date it was signed on October 25, 2006, unless earlier terminated by the parties; and that if neither party expresses in writing its intent to terminate the Contract within three months before the end of the period of ten years, the Contract will automatically remain in effect for one more year and this procedure will apply to succeeding extension of the Contract. RULING A. On income tax In reply, please be informed that royalties arising in the Philippines and derived by a resident of Japan are subject to Philippine income tax in accordance with paragraphs 1, 2 and 3, Article 12 of the Philippines-Japan tax treaty which provides: "Article 12 1. Royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other Contracting State. 2. However, such royalties may also be taxed in the Contracting State in which they arise, and according to the laws of that Contracting State, but if the recipient is the beneficial owner of the royalties the tax so charged shall not exceed: a) 15 per cent of the gross amount of the royalties if the royalties are paid in respect of the use of or the right to use cinematograph films and films or tapes for radio or television broadcasting; b) 25 per cent of the gross amount of the royalties in all other cases. SIacTE 3. Notwithstanding the provisions of paragraph 2, the amount of tax imposed by the Philippines on the royalties paid by a company, being a resident of the Philippines, registered with the Board of Investments and engaged in preferred pioneer areas of investment under the investment incentives laws of the Philippines to a resident of Japan, who is the beneficial owner of the royalties, shall not exceed 10 per cent of the gross amount of the royalties. 4. The term 'royalties' as used in this Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films and films or tapes for radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or for the use of, or the right to use, industrial, commercial or scientific equipment, or for information concerning industrial, commercial or scientific experience." According to paragraphs 2 and 3 above, such royalties are subject to Philippine income tax at the rate not to exceed (a) 10% of the gross amount of the royalties if the company paying the royalties is registered with the Board of Investments and engaged in preferred pioneer areas of investment under the investment incentives laws of the Philippines, (b) 15% of the gross amount of the royalties if the royalties are paid in respect of the use of or the right to use cinematograph films and films or tapes for radio or television broadcasting, or (c) 25% of the gross amount of the royalties in all other cases. Considering that the compensation to be paid by Air Water Philippines to Air Water Japan for the supply of the Process and related technology and the Know-How are payments for the use of, or the right to use, of process, information concerning industrial, commercial or scientific experience, and copyright of literary, artistic or scientific work, respectively, and as such are royalties under paragraph 4 of Article 12, such compensation is subject to the applicable tax rate mentioned in paragraphs 2 and 3, Article 12 of the tax treaty. EIDaAH Accordingly, since Air Water Philippines is not registered with the Board of Investments and since payments to be made by Air Water Philippines to Air Water Japan are not paid in respect of the use of or the right to use cinematograph films and films or tapes for radio or television broadcasting, the compensation to be paid by Air Water Philippines to Air Water Japan for the supply of the Process and related technology and the Know-How is subject to Philippine income tax at the rate of 25%, based on the gross amount thereof. (BIR Ruling No. DA-ITAD 173-02 dated October 3, 2002.) B. On value-added tax Under Section 108 (A) (1) of the National Internal Revenue Code of 1997 (Tax Code), as amended by Republic Act No. 9337, 5 the use or the right to use by Air Water Philippines of the Process and related technology and the Know-How in the Philippines is subject to value-added tax (VAT). It 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 selling price or gross value in money of the goods or properties sold, bartered or exchanged, such tax to be paid by the seller or transferor: 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: HSDCTA (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' shall likewise include: (1) The lease or the use of or the right or privilege to use any copyright, patent, design or model, plan, secret formula or process, goodwill, trademark, trade brand or other like property or right; xxx xxx xxx (3) The supply of scientific, technical, industrial or commercial knowledge or information: " (emphasis added) Under Section 105, 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 nonresident foreign persons shall be considered as being rendered in the course of trade or business. It 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. 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. CHIaTc 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, 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." Accordingly, pursuant to Section 4.112-2 of Revenue Regulations No. 16-2005, 7 as amended by Revenue Regulations No. 4-2007, 8 Air Water Philippines, as a resident withholding agent, shall, in general, be liable to withhold VAT on the commissions and payments to be made to Air Water Japan, the nonresident recipient, at a rate of 12% 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. TIHDAa 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." SIcEHC However, under Section 109 (q) of the Tax Code of 1997, as amended and renumbered as 109 (1) (K) by Republic Act No. 9337, certain transactions are exempt from VAT if they are so exempt under international agreements to which the Philippines is a signatory or under special laws. It provides: "SEC. 109. Exempt Transactions . (1) Subject to the provisions of Subsection (2) hereof, the following transaction shall be exempt from the value-added tax: xxx xxx xxx (K) Transactions which are exempt under international agreements to which the Philippines is a signatory or under special laws, except those under Presidential Decree No. 529." With respect to special laws relevant to Air Water Philippines and other PEZA-registered enterprises, it is worth mentioning Republic Act No. 7916 [An Act Providing for the Legal Framework and Mechanism for the Creation, Operation, Administration, and Coordination of Special Economic Zones in the Philippines, Creating for this Purpose, the Philippine Economic Zone Authority (PEZA), and for Other Purposes], which became effective on February 24, 1995. Section 24 of Republic Act No. 7916 and Section 1, Rule XIV (Incentives to ECOZONE Developers/Operators) of the Implementing Rules and Regulations of this Act provide that PEZA-registered enterprises are liable only to the payment of 5% Gross Income Tax, in lieu of all national and local taxes like VAT, thus: "Section 24. Exemption from Taxes Under the National Internal Revenue Code . Any provision of existing laws, rules and regulations to the contrary notwithstanding, no taxes, local and national, shall be imposed on business establishments operating within the ECOZONE. In lieu of paying taxes, five percent of the gross income earned by all business and enterprises within the ECOZONE shall be remitted to the national government. . . " 9 "Section 1. ECOZONE Developers/Operators . ECOZONE Developers/Operators shall be entitled to the following incentives: A. Exemption from National and Local Taxes and Licenses. An ECOZONE Developer/Operator shall to the extent of its construction and operation, be exempt from payment of all national internal revenue taxes and local government impost, fees, licenses or taxes, including but not limited to the following: 1. Internal revenue taxes such as gross receipts tax, value-added tax, ad valorem and excise taxes; TIcEDC 2. Franchise, common carrier or value added taxes and other percentage taxes on public and service utilities and enterprises." Therefore, based on the Certification by PEZA dated January 3, 2007, Air Water Philippines is liable only to the payment of 5% gross income tax in lieu of all national and local taxes, including VAT, among other incentives available to it. Accordingly, the compensation to be paid by Air Water Philippines to Air Water Japan for the supply of the Process and related technology and the Know-How under the Technology Supply Contract is exempt from VAT. (BIR Ruling No. DA-ITAD 127-06 dated October 23, 2006.) In relation thereto, and pursuant to Section 4.109-1 of Revenue Regulations No. 16-2005, when a transaction is exempt, the supply of services by Air Water Japan to Air Water Philippines is not subject to VAT (output tax) and Air Water Japan is not allowed any tax credit of VAT (input tax) on its purchases, if any. Section 4.109-1 provides: "SEC. 4.109-1. VAT-Exempt Transactions . (A) In general. 'VAT-exempt transactions' refer to the sale of goods or properties and/or services and the use or lease of properties that is not subject to VAT (output tax) and the seller is not allowed any tax credit of VAT (input tax) on purchases. The person making the exempt sale of goods, properties or services shall not bill any output tax to his customers because the said transaction is not subject to VAT." Furthermore, it is noteworthy that in VAT Ruling No. 100-99 dated September 16, 1999, this Bureau ruled that royalty payments made by a PEZA-registered export enterprise to a nonresident lessor of a property is exempt from VAT. The dispositive portion of this ruling provides: "In the case of payment for royalties to a non-resident owner, the responsibility for withholding the VAT and paying the same rests on the payor. However, since PEZA-registered export enterprise may not be passed on with nor claim input VAT, then payment of royalties to a non-resident lessor, . . . , should be as it is hereby confirmed to be, exempt from VAT." (BIR Ruling No. DA-ITAD 127-06 dated October 23, 2006.) ATcaID Likewise, in Commissioner of Internal Revenue versus Seagate Technology (Philippines) (G.R. No. 153866) dated February 11, 2005, the Supreme Court ruled that Seagate Technology (Philippines), a PEZA-registered enterprise and an exempt entity by virtue of Republic Act No. 7916, cannot be directly charged for the VAT on its sales nor indirectly made to bear, as an added cost to such sales, the equivalent VAT on its purchases. The dispositive portion of this ruling provides: Applying the special laws we have earlier discussed, respondent as an entity is exempt from internal revenue laws and regulations. This exemption covers both direct and indirect taxes, stemming from the very nature of the VAT as a tax on consumption, for which the direct liability is imposed on one person but the indirect burden is passed on to another. Respondent, as an exempt entity, can neither be directly charged for the VAT on its sales nor indirectly made to bear, as added cost to such sales, the equivalent VAT on its purchases. Ubi lex non distinguit, nec nos distinguere debemus . Where the law does not distinguish, we ought not to distinguish. Moreover, the exemption is both express and pervasive for the following reasons: First, R.A. 7916 states that 'no taxes, local and national shall be imposed on business establishments operating within the ecozone. Since this law does not exclude the VAT from the prohibition, it is deemed included. Exceptio firmat regulam in casibus non exceptis . An exception confirms the rule in cases not excepted; that is, a thing not being excepted must be regarded as coming within the purview of the general rule. DIECTc Moreover, even though the VAT is not imposed on the entity but on the transaction, it may still be passed on, therefore, indirectly imposed on the same entity a patent circumvention of the law. That no VAT shall be imposed directly upon business establishments operating within the ecozone under R.A. 7916 also means that no VAT may be passed on and imposed indirectly. Quando aliquid prohibetur ex directo prohibetur et per obliquum . When anything is prohibited directly, it is also prohibited indirectly. (BIR Ruling No. DA-ITAD 127-06 dated October 23, 2006.) In view thereof, since Air Water Philippines is not registered with the Board of Investments and since payments to be made by Air Water Philippines to Air Water Japan are not paid in respect of the use of or the right to use cinematograph films and films or tapes for radio or television broadcasting, the compensation to be paid by Air Water Philippines to Air Water Japan for the supply of the Process and related technology and the Know-How is subject to Philippine income tax at the rate of 25% based on the gross amount thereof, but such compensation is exempt from VAT. AICEDc 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. In Japanese, Air Water Kabushiki Kaisha . HDICSa 2. Signed on February 13, 1980, and effective on January 1, 1981. 3. Facility refers to the specialized furnace and peripheral equipment used for the Process employed in the business of commissioned nitriding treatment. 4. Know-How refers to all of the technical information, drawings, documents, calculations, knowledge, and materials supplied, offered, distributed, and informed by Air Water Japan to Air Water Philippines alongside the supplied Process and related technology, including, but not limited to the following: 1. The total content listed in the final documents; 2. The content of the related documentation revealed in the operational instruction, maintenance, work, technology instruction, and technology discussions; 3. The total content listed in all of the operational records, and maintenance records; 4. the content of technology information supplied or offered after conclusion of the Technology Supply Contract; 5. The information acquired related to the preceding items. 5. Entitled An Act Amending Sections 27, 28, 34, 106, 107, 108, 109, 110, 111, 112, 113, 114, 116, 117, 119, 121, 148, 151, 151, 236, 237 and 288 of the National Internal Revenue Code of 1997, as amended, and for Other Purposes, which was signed into law on May 24, 2005 and became effective on November 1, 2005. CDaSAE 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 which became 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 which became effective 15 days after its publication. 9. Republic Act 8748 entitled An Act Amending Republic Act No. 7916, Otherwise Known as the "Special Economic Zone Act of 1995", which became effective on June 1, 1999, provides that except for real property taxes on land owned by developers, business establishments operating within the ECOZONE continue to be subject to the 5% Special Tax on Gross Income in lieu of all national and local taxes.