DA ITAD BIR Ruling No. 069-06

June 14, 2006 DA ITAD BIR RULING NO. 069-06 Section 108, NIRC of 1997; Articles 5, 7 & 12, Philippines-Japan tax treaty; Sec. 108, NIRC of 1997; BIR Ruling No. 13-06 Sycip Gorres Velayo & Co . 6F Ayala Life-FGU Center Mindanao Avenue corner Biliran Road Cebu Business Park, Cebu City6000 Cebu Attention: Rita A.S. Fernandez Tax Services Gentlemen : This refers to your application for relief from double taxation dated September 15, 2004, on behalf of your client, Taiyo Yuden (Philippines), Inc. (TYPI), requesting confirmation of your opinion that the gross amount of service fee remittances made by TYPI to Taiyo Yuden Co., Ltd. (Japan) (TYCL) are not royalties as defined under Section 42(A)(4) of the National Internal Revenue Code (Tax Code) of 1997, but are fees which constitute compensation for services performed outside the Philippines and are not subject to Philippine income tax, pursuant to Articles 5 and 7 of the Philippines-Japan tax treaty; nor to the ten percent (10%) value-added tax (VAT). It is represented that TYCL is a nonresident foreign corporation organized and existing under the laws of Japan with principal address at 16-20, Ueno 6-chome, Taito-ku, Tokyo, Japan; that TYCL has registered a representative office in the Philippines located at Makati City; that the representative office is registered as such for the following purposes: (1) to act as a liaison office and deal directly with clients, (2) to undertake information dissemination and promotion of the company's products, (3) to study and investigate export feasibility, (4) to cope with customers complaints and coordinate after sales service, (5) to coordinate warranty claims, (6) to conduct market research for its production and market expansion, and (7) to act as a communication link between clients and the company's head office; that as a representative office, it has not derived income from sources within the Philippines as evidenced by its Annual Income Tax Return and Audited Financial Statements for the fiscal years ending March 31, 2004, 2003 and 2002; that as shown in its Statement of Income and Expenses, the only income it has derived are minimal income on interests from local bank deposits and gains from foreign exchange; that its operation is fully subsidized by its head office as shown in its Balance Sheet under the account " Advances from JTY "; 1 that it does not participate in any manner in the management of any subsidiary that TYCL has in the Philippines; that since TYCL has a registered representative office in the Philippines, a Securities and Exchange Commission Negative Certification could not be obtained; and that the registration of a representative office in the Philippines would not prejudice the application for tax treaty relief since the representative office does not create a permanent establishment because it does not derive any income from the Philippines other than the passive income of interests on bank deposits; that per certification of Registration No. 2005-101 dated March 17, 2005, TYPI is registered with the then Export Processing Zone Authority (EPZA), now Philippine Economic Zone Authority (PEZA), as a Zone Export Enterprise under Registration Certificate No. 89-04 dated January 12, 1989; that it is further certified that TYPI's registered activities (except for the manufacture of ferrite chip beads inductors, etc., and the manufacture of surface-mounted choke coil) are entitled to the 5% Special Tax on Gross income under Section 24 of Republic Act (RA) No. 7916, 2 as amended by R.A. 8748 3 and in accordance with Rules XXV, Section 4 of its Implementing Rules and Regulations, and such 5% Special Tax on Gross Income applies upon expiry of TYPI's Income Tax Holiday entitlement. It is further represented that on September 1, 2004, a Service Agreement (Agreement) was executed by and between TYPI and TYCL, whereby it is stated that the former desires and the latter agrees to render certain support services for various product lines, service assistance during "suppliers' audit" conducted by TYPI's major customers, and various other services to be performed by TYCL in connection with TYPI's operations which shall neither involve a grant of license for the use of TYCL's proprietary rights nor will involve transfer of technological know-how and other intellectual property rights; that the support services are specifically in the nature of the following: (1) consultation and advisory services on its general management and administration including business planning and coordination, (2) assistance in procurement of raw materials and components sourced in Japan as well as sourcing of other product requirements, (3) advice on sales and marketing policies, strategies, marketing development, packaging design including provision of sample box products, (4) consultation and advisory services on operations and preventive maintenance of various product lines machinery and equipment, (5) provision of specialist production support in circumstances where TYPI's own technical resources are inadequate and need supplementing, (6) provision of internal audit services covering full scope of TYPI's operation, and (7) assistance during suppliers' audit conduct by TYPI's major customers; that TYCL shall perform the above services in Japan except for occasional visits or consultations required by TYPI in the Philippines which visits shall only be for short durations and in no case shall exceed an aggregate period of three (3) months in any calendar year; that in consideration for the above support services, TYPI shall pay TYCL the actual cost of services incurred, which includes, among others, the labor cost of TYCL personnel and all other incidental expenses incurred by the latter in the performance of their designated duties including, but not limited to, transportation, hotel and accommodation, meals and allowances; and that the Agreement takes effect on April 1, 2004 and will be valid for five (5) years, to be automatically renewed each year, unless otherwise agreed upon by both parties thereto, 60 days prior to its expiration. In reply, please be informed that Article 12 of the Philippines-Japan tax treaty provides, viz: "Article 12 xxx xxx xxx 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. xxx xxx xxx" 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." CIHTac Applying the above discussions to the case at hand, it is clear in the subject Agreement that the service fees are not within the definition of " royalties " under Article 12 of the Philippines-Japan tax treaty. Specifically, nothing in the Agreement would require transfer into the Philippines of technology, equipment or other property where TYCL has proprietary interest ( BIR Ruling No. 093-89 ) or would otherwise permit TYCL to impart to TYPI its special knowledge and experience which remain unrevealed to the public. Inasmuch as TYCL shall render these services using only its 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. Thus, the service fees paid to TYCL shall not be considered as royalties but shall be considered as business profits. With respect to business profits, Article 7(1) of the Philippines-Japan tax treaty provides as follows: "Article 7 1. The profits of an enterprise of 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." Relative thereto, paragraphs (1), (2) and (6) of Article 5 of the said treaty provides, viz: "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. 2. The term 'permanent establishment' includes especially: (a) a store or other sales outlet; (b) a branch; (c) an office ; 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 . However, if the furnishing of such Services is effected under an agreement between the Governments of the two Contracting States regarding economic or technical cooperation, that enterprise shall, notwithstanding any provisions of this Article, not be deemed to have a permanent establishment in that other Contracting State. (emphasis supplied) xxx xxx xxx" If based solely on the aforequoted paragraph 6, TYCL may initially be considered as not having a permanent establishment in the Philippines, since the above Service Agreement executed by and between TYPI and TYCL provides that the occasional visits or consultations in the Philippines " shall only be for short durations and in no case shall exceed an aggregate of 3 months in any given calendar year ." (BIR Ruling No. 116-96 dated November 4, 1996). On the other hand, taking into consideration the provision under paragraph 2(c), TYCL is considered as having a permanent establishment in the Philippines since it maintains therein a representative office. Such being the case, the income which are or may be derived by TYCL may be taxed in the Philippines but only so much thereof as is attributable to such representative office, pursuant to Article 7(1) of the Philippines-Japan tax treaty. ( BIR Ruling No. 171-00 ) However, inasmuch as the purposes for which such representative office was established do not include the rendition of the services mentioned in the Service Agreement and since it is represented that the representative office of TYCL " does not participate in any manner in the management of any subsidiary TYCL has in the Philippines ", no part of the income of TYCL derived from such services may be attributed to such representative office. Thus, the entire income of TYCL insofar as the rendition of the same services is concerned shall not be subject to income tax, pursuant to Article 7(1) of the Philippines-Japan tax treaty. aSTHDc As the regards the imposition of the VAT on the rendition of services of TYCL, please be informed further that Section 108 of the Tax Code of 1997 4 provides as follows, to wit: "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. 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, . . . ." (Emphasis supplied). Thus, the VAT should be imposed when TYCL provides the above services in the Philippines " for short durations and in no case shall exceed an aggregate of 3 months in any given calendar year ". TYPI shall then be required to withhold such VAT and treat the same as a " passed on " VAT, pursuant to Section 4.110-3(b) of Revenue Regulations No. 7-95 as amended [ now Section 4.114-2(b) of Revenue Regulations No. 16-05 ]. However, in Commissioner of Internal Revenue vs. Seagate Technology (Philippines ) (G.R. No. 153866, February 11, 2005), the Supreme Court held that: "Special laws may certainly exempt transactions from the VAT. 3 * However, the Tax Code provides that those falling under PD 66 are not. PD 66 is the precursor of RA 7916 the special law under which respondent was registered. The purchase transactions it entered into are, therefore, not VAT-exempt. These are subject to the VAT; respondent is required to register. xxx xxx xxx Since the purchases of respondent are not exempt from the VAT, the rate to be applied is zero. Its exemption under both PD 66 and RA 7916 effectively subjects such transactions to a zero rate, because the ecozone within which it is registered is managed and operated by the PEZA as a separate customs territory . This means that in such zone is created the legal fiction of foreign territory. Under the cross-border principle of the VAT system being enforced by the Bureau of Internal Revenue (BIR), no VAT shall be imposed to form part of the cost of goods destined for consumption outside of the territorial border of the taxing authority. If exports of goods and services from the Philippines to a foreign country are free of the VAT, then the same rule holds for such exports from the national territory except specifically declared areas to an ecozone. xxx xxx xxx 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: . . . , RA 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. Moreover, even though the VAT is not imposed on the entity but on the transaction, it may still be passed on and, 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 RA 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. xxx xxx xxx" Based on the foregoing, transactions exempt from VAT by reason of PD 66 and RA 7916 are effectively zero-rated. However, instead of zero-rating which is not available to non-resident suppliers, the provision for exempt transactions under Section 109(q) [now Section 109 (K)] of the Tax Code of 1997 which provides VAT exemption for transactions that are exempt under specials laws, e.g., Republic Act No. 7916 or PEZA Law, is particularly applicable to the instant case. ( BIR Ruling 13-06 dated February 20, 2006 ) Such being the case, the payment of services fees by TYPI, being an EPZA-registered (now a PEZA-registered) export enterprise to TYCL, under the above Agreement, should be as it is hereby confirmed to be exempt from VAT. This ruling is issued on the basis of 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. IETCAS Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service Footnotes 1. This account consists of expenses incurred by TYCL on behalf of its representative office in Manila for the fiscal years 1999 to 2004. 2. AN ACT PROVIDING FOR THE LEGAL FRAMEWORK AND MECHANISMS 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. 3. AN ACT AMENDING REPUBLIC ACT NO. 7916, OTHERWISE KNOWN AS THE "SPECIAL ECONOMIC ZONE ACT OF 1995." 4. Please note that this cited provision has been retained by Republic Act (RA) No. 9337, although with the modification as to the applicable rate when the circumstances so warrant. 3. Referring to the old Section 109 (q) of the Tax Code of 1997 [now Section 109(K), as amended by RA No. 9337] .