DA ITAD BIR Ruling No. 068-06

June 9, 2006 DA ITAD BIR RULING NO. 068-06 Article 5 & 7, Philippine-Japan Tax Treaty; BIR Ruling No. DA-316-99; BIR Ruling No. 036-90 Aranas Consunji Barleta Unit 106 G/F Le Metropole Building 326 Dela Costa cor. Tordesilla St. Salcedo Village, Makati City Attention: Atty. Jesus Clint O. Aranas Gentlemen : This refers to your letter dated November 3, 2004, received by this Office on June 8, 2005, requesting confirmation of your opinion that the service fees paid by Philippine Iris Co., Inc. (IRIS-Phils) to Iris Company Limited (IRIS-Japan) under a Management Support Service Agreement are: (a) not royalty payments subject to tax on royalties under the Philippines-Japan tax treaty; and (b) exempt from income and withholding taxes, pursuant to Article 7 of the same treaty. It is represented that IRIS-Japan is a corporation organized and existing under the laws of Japan with head office at 1933, Iizuka-cho, Ota City, Gunma Prefecture, Japan as evidenced by the certified copy of Corporate Registration issued by the Minato Office, Tokyo Regional Legal Affair Bureau, Register of Deeds; that it is not registered either as a corporation or as a partnership in the Philippines as evidenced by the Certification of Non-Registration of Corporation or Partnership issued by the Securities and Exchange Commission dated May 17, 2005; that IRIS-Phils is a corporation duly organized and existing under the laws of the Philippines. It is further represented that on November 6, 1998, IRIS-Japan and IRIS-Phils entered into a Management Support Service Agreement (Agreement) whereby IRIS-Japan agreed to provide offsite and onsite services (management services) to IRIS-Phils; that the offsite services to be rendered by IRIS-Japan to IRIS-Phils include the following: a) review of IRIS-Phils' monthly financial reports and other management reports to identify the points to be improved, b) assistance to IRIS-Phils in developing its organization and creating its annual business plan, and c) provision of such other incidental advise as may be requested by IRIS-Phils to improve the latter's management in general; that all the above services shall be performed outside the Philippines, primarily in Japan, and shall not involve any transfer of technology, know-how or other intellectual property rights other than that related to the management of the company; that the Onsite Services shall be provided by IRIS-Japan to IRIS-Phils upon the written request of the latter and based on the terms mutually agreed upon by both parties; that in connection with the Onsite Services, IRIS-Japan shall send to IRIS-Phils, subject to availability of personnel, qualified administration professionals to render assistance and services to IRIS-Phils in connection with the management of IRIS-Phils for a reasonable period to be agreed upon by the parties hereto but not exceeding an aggregate period of 6 months in a given taxable year; that in consideration of the said Management Services, IRIS-Phils shall pay IRIS-Japan a monthly service fee of Four Hundred Thousand Yen in Japanese Currency (JP 400,000) payable semi-annually, which fee shall be reviewed by the parties on a periodic basis and which may be revised subject to the mutual agreement of the parties; and that the Agreement shall be effective for a period of one (1) year starting from the 1st day of October 1998 and renewable for like periods unless sooner terminated pursuant to the provisions of the Agreement. In reply, please be informed that Article 12 of the Philippines-Japan tax treaty provides: Article 12 (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." The above tax treaty-defines " royalties " to include " payments of any kind received as a consideration for information concerning industrial, commercial or scientific experience ." According to the commentaries of the ORGANISATION FOR ECONOMIC COOPERATION AND DEVELOPMENT (OECD) Committee on Fiscal Affairs on the Model Tax Convention [par. 11, Commentary on Article 12 (Royalties), 2005, p. 181], such information alludes to the concept of " know-how ". The definition of " know-how " adopted by the said Committee is " all the undivulged technical information, whether capable of being patented or not, that is necessary for the industrial reproduction of a product or process, directly and under the same conditions; inasmuch as it is derived from experience, know-how represents what a manufacturer cannot know from mere examination of the product and mere knowledge of the progress of technique ." In the know-how contract, one of the parties agrees to impart to the other, so that he can use them for his own account, his special knowledge and experience which remain unrevealed to the public. Further, in the case of Philippine Refining Company vs. CIR , CTA Case No. 2872 dated January 15, 1986, the Court of Tax Appeals had an occasion to rule on the distinction of service fees from royalties, to wit: "To distinguish between compensation for service and royalty payments, one must inquire on whether the payee has proprietary interest in the property giving rise to the income. If the payee has none, then the payment is a compensation for personal services, if the payee has proprietary interest then the payment is royalty. HIaTDS Applying the above discussions to the instant case, there is nothing in the subject Agreement that would require transfer into the Philippines of technology, equipment or other property where IRIS-Japan has proprietary interest or would otherwise permit IRIS-Japan to impart to IRIS-Phils their special knowledge and experience which remain unrevealed to the public. Likewise, inasmuch as IRIS-Japan shall render these services using their customary skills, then the compensation to be received therefor shall not constitute as consideration for the use of, or the right to use, any copyright, patent, trademark, design or model, plan, secret formula or process, or for the transfer of technology. ( BIR Ruling No. 036-90 dated March 27, 1990 ) Thus, service fees under the Agreement shall be subject to Article 7 and Article 5 of the Philippines-Japan tax treaty, which provide as follows: " Article 7 "1. The profits of an enterprise of a Contracting State shall be taxable only in that Contracting State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in that other Contracting State but only so much of them as is attributable to that permanent establishment." " Article 5 1. For the purposes of this Convention, the term 'permanent establishment' means a fixed place of business through which the business of an enterprise is wholly or partly carried on. xxx xxx xxx 6. An enterprise of a Contracting State shall be deemed to have a permanent establishment in the other Contracting State if it furnishes in that other Contracting State consultancy services, or supervisory services in connection with a contract for a building, construction or installation project through employees or other personnel other than an agent of an independent status to whom paragraph 7 applies , provided that such activities continue (for the same project or two or more connected projects) for a period or periods aggregating more than six months within any taxable year. . . . Based on the aforequoted provisions, it is clear that if a corporation which is a resident of Japan carries on business in the Philippines through a permanent establishment situated therein, the profits of the same shall be subject to Philippine income tax, but only so much of them as is attributable to that permanent establishment. For this purpose, a corporation which is a resident of Japan may be deemed to have a permanent establishment in the Philippines if, among others, the furnishing of consultancy or supervisory services by such corporation, through its employees or other personnel, in the same or connected project, continue within the Philippines for a period or periods aggregating more than six (6) months in any taxable year. Considering that under the subject Agreement, the furnishing of services is agreed to be performed by IRIS-Japan in Japan and that should it be necessary for IRIS-Japan to send its employees to the Philippines, as in the case of the onsite services, the length of stay of said employees shall not exceed an aggregate of six (6) months in a given taxable year, IRIS-Japan is deemed not to have a permanent establishment in the Philippines to which its business profits may be attributed to. Such being the case, the service, income derived by IRIS-Japan from services rendered to IRIS-Phils under the subject Agreement are not subject to Philippine income tax and consequently withholding tax pursuant to Article 7 in relation to Article 5 of the Philippines-Japan tax treaty. ( BIR Ruling No. 78-02 and 184-02 dated May 2, 2002 and October 17, 2002 ) However, the fees to be paid by IRIS-Phils to IRIS-Japan for the services actually rendered in the Philippines are subject to value-added tax (VAT) at the appropriate rate. 1 Accordingly, IRIS-Phils, being the resident withholding agent and payor in control of payment shall be responsible for the final VAT on such fees before making any payment to IRIS-Japan. In remitting the VAT withheld, IRIS-Phils shall use BIR Form No. 1600 (Monthly Remittance Return of Value-Added Tax & Other Percentage Taxes Withheld). The duly filed BIR Form No. 1600 and proof of payment thereof shall serve as documentary substantiation for the claim of input tax to be applied against the output tax that may be due from IRIS-Phils if it is a VAT-registered taxpayer. In case IRIS-Phils is non-VAT registered taxpayer, the passed-on VAT withheld shall form part of the cost of the service purchased or treated as an "expense" or an "asset", whichever is applicable. In addition, IRIS-Phils is required to issue the Certificate of Final Tax Withheld at Source (BIR Form No. 2306) in quadruplicate, the first three copies thereof be given to IRIS-Japan upon its request, and the fourth copy to be retained by IRIS-Phils. [ Section 4.110-3(b), Revenue Regulations (RR) No. 7-95, as amended by RR Nos. 4-02 and 8-02/ Section 4.114-2(b), RR No. 16-05; Section 4.114, RR No. 2-98, as last amended by RR No. 28-03 ]. DcSEHT This ruling is issued based on the facts as represented. However, if upon investigation it shall be disclosed that the 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.) JAMES H. ROLDAN Assistant Commissioner Legal Service Footnotes 1. The rate shall be 12% effective February 1, 2006 (Revenue Memorandum Circular No. 7-2006).