DA ITAD BIR Ruling No. 071-06

June 16, 2006 DA ITAD BIR RULING NO. 071-06 Article 5&7, Philippines-Japan tax treaty; BIR Ruling No. 068-88 Punongbayan & Araullo Unit 807, 8th, Floor Ayala Life-FGU Center Mindanao Avenue Corner Biliran Road, Cebu Business Park 6000 Cebu City, Philippines Attention: Ms. Marivic C. Espao Partner, Tax Advisory and Compliance Gentlemen : This refers to your letter dated June 1, 2005, on behalf of your client, KT Sakurai Corporation (KTSC), requesting confirmation of your opinion that the service fees paid by KTSC to Kenko Co., Ltd. (KCL) under their Management Agreement are not subject to Philippine income tax and value-added tax (VAT), pursuant to the provisions of the National Internal Revenue Code of 1997 and the Philippines-Japan tax treaty. It is represented that KCL is a nonresident foreign corporation with office address at 3-9-19 Nishiochiai, Shinjyuku-ku, Tokyo, Japan and is a taxable person in Japan with Tax Reference Number 165077 per Certification issued by the District Director of the Shinjuko Tax Office, Japan dated February 2, 2005; that it is not registered either as a corporation or a partnership in the Philippines per certification issued by the Securities and Exchange Commission dated May 27, 2005; that KTSC is a corporation organized and existing under the laws of the Philippines and registered with the Philippine Economic Zone Authority (PEZA) with office address at Mactan Export Processing Zone I, Lapu Lapu City, Cebu. It is further represented that KTSC and KCL entered into a Management Agreement (Agreement) which is effective for a twelve month-term commencing on May 1, 2004 until April 30, 2005 subject to automatic renewal for another twelve-month term unless one of the parties serves a written notice of non-renewal to the other party not later than one (1) month prior to the expiration of` the current term; that under the said Agreement, KCL shall provide KTSC they following services outside of the Philippines: (a) advertisement and promotion of sales of the products manufactured by KTSC in the Philippines to the customers in Japan and other foreign countries; (b) formulation and implementation of a business strategy for the customers outside the Philippines; (c) conducting of operating activities associated with sales promotion in foreign countries requested by KTSC; (d) ordering and purchasing of parts of the products manufactured by KTSC and making payments for KTSC; and (e) assisting the management and funding for KTSC; that pursuant to the Agreement, the employees and personnel of KCL shall exclusively perform the services for KTSC in Japan or in other countries outside the Philippines and that should it be necessary for KCL to send its employees to the Philippines, the stay of these individuals shall not in any case exceed six (6) months; that as compensation for the services performed by KCL, KTSC shall pay Nineteen Million One Hundred Fifty Four Thousand One Hundred Seventy Yen (Y19,154,170) per year to KCL and KCL shall send an invoice to KTSC on a monthly basis for the services rendered during the quarter covered and it shall be paid by KTSC thirty (30) days from the receipt of such invoice; and that an employee of KTSC came to the Philippines to render services pursuant to the Agreement on the following dates: May 4, 2004 to May 8, 2004; and January 16, 2005 to January 20, 2005. HAECID In reply, please be informed that Article 7(1) of the Philippines-Japan tax treaty provides, viz : "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 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." In relation thereto, 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. 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 , (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. xxx xxx xxx" Based on the aforementioned 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 the profits 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 services by such corporation, through its employees, continue within the Philippines for a period or periods aggregating more than six months in any taxable year. Considering that the furnishing of the services under the Management Agreement is to be generally performed by KCL for KTSC in Japan, and that should it be necessary for KCL to send its employees to the Philippines, the stay of these individuals shall not in any case exceed six (6) months, KCL may be deemed not to have a permanent establishment in the Philippines to which its business profits may be attributed to. Therefore, the income derived by KCL from services rendered to KTSC under the Management Agreement is not subject to Philippine income tax for as long as KCL does not have a permanent establishment in the Philippines and that in the course of its rendition of services, none of its employees will stay in the Philippines for a period or periods aggregating more than 6 months in any taxable year. (BIR Ruling No. 068-88 dated March 3, 1988) As regards the imposition of the VAT on the rendition of services of KCL, please be informed further that Section 108 of the Tax Code of 1997 1 provides as follows: "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%) 2 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, in general, the VAT is imposed on services rendered by KCL in the Philippines. On every payment of service fees, KTSC is 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 ]. CSIDTc However, in Commissioner of Internal Revenue vs. Seagate Technology (Philippines) (G.R. No. 153866, February 11, 2005), the Supreme Court held, viz : "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 purchase 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 manage 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 10(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. Such being the case, the payment of services fees by KTSC, being a PEZA-registered enterprise, to KCL under the above Agreement should be, as it is hereby confirmed to be, exempt from VAT. ASHICc 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. Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service Footnotes 1. 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. 2. Effective February 1, 2006, the rate shall be 12%. 3. Referring to the old Section 109 (q) of the Tax Code of 1997 [now Section 109(K), as amended by RA No. 9337].