DA ITAD BIR Ruling No. 072-08

October 29, 2008 DA ITAD BIR RULING NO. 072-08 Articles 5, 7, 12, 13 and 22; Philippines-Japan tax treaty Sycip Gorres Velayo & Co. 6760 Ayala Avenue 1226 Makati City Attention: Atty. Maria Victoria A. Villaluz Tax Services Gentlemen : This refers to your letter dated July 31, 2006, requesting confirmation that payments to be made by Mikado Philippines Corporation (Mikado Philippines) to Mikado Propeller Company Ltd. (Mikado Japan) pursuant to a Deed of Transfer/Assignment of Business Operations and Distribution Rights are exempt from Philippine income tax under 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). 1 ACIDTE BASIC FACTS It is represented that Mikado Japan is a corporation organized and existing under the laws of Japan, with address at 1300-2 Yabata, Nabari, Mie, Japan, as confirmed by its Certificate of Status of Taxable Person dated May 1, 2006, issued by the Taxation Office in Ueno, Japan; that Mikado Japan is not registered as a corporation or as a partnership in the Philippines, as confirmed by the Certificate of Non-Registration of Corporation/Partnership dated December 9, 2005, issued by the Securities and Exchange Commission; that, on the other hand, Mikado Philippines is a corporation organized and existing under the laws of the Philippines, with address at the Cavite Economic Zone, Rosario, Cavite, Philippines; that Mikado Japan and Mikado Philippines are both engaged in the manufacture, sale, supply and distribution of marine propellers and stern equipment including casting parts in bronze for various types of machinery; and that Mikado Japan has existing contracts/agreements to sell/supply/distribute to customers in Japan and to customers outside of Japan (overseas customers). AcSEHT It is further represented that following Mikado Japan's streamlining of operations in Japan, Mikado Japan eventually entered into a Deed of Transfer/Assignment of Business Operations and Distribution Rights (Deed of Transfer/Assignment) with Mikado Philippines on December 20, 2005, whereby Mikado Japan transferred to Mikado Philippines the right to sell/supply/distribute to its (Mikado Japan) overseas customers (existing and prospective), and all other rights, interests, and privileges arising from all existing agreements/contracts to sell/supply/distribute which Mikado Japan has with the following Overseas Customers: Name of Customer Nature of Contract Agreement Date Other Terms 1. Michigan Wheel Exclusive Private September 7, 2005 Renewable Corporation Label Sales Agreement automatically (United States of America) 2. B.T. Marine Distribution December 14, 2004 Renewable Limited (United Agreement automatically Kingdom of Great Britain and Northern Ireland) 3. Indemar Marine Non Exclusive October 11, 2004 Renewable (Italy) Distributorship automatically Agreement 4. Elix s.r.l. (Italy) Agreement April 7, 2004 Renewable automatically 5. Teignbridge Sourcing Contract July 22, 2003 Renewable Propeller Ltd. automatically (United Kingdom) 6. M&J Engineering Non Exclusive November 11, 2001 Renewable & Marine Sales Ltd. Distributorship automatically (Australia) Agreement 7. Teignbridge Exclusive Sales May 18, 2000 (Renewable Propeller Inc. Agreement automatically (United States) 8. Teignbridge Exclusive September 17, 1999 Renewable Propeller & Marine Distributorship automatically Equipment Agreement Company (United Arab Emirates) and that in consideration for the transfer, Mikado Philippines will be paying Mikado Japan an amount of One Million Six Hundred Eighty Thousand United States dollars ($1,680,000.00), to be paid in sixty (60) equal monthly installment for five (5) years, and carrying an interest of 4% per annum for the outstanding balance of the amount. cSEDTC Moreover, it is represented that the object contemplated in the Deed of Transfer/Assignment is Mikado Japan's right to sell/supply/distribute to the Overseas Customers only, and as such, Mikado Japan will not transfer any other intangible assets to Mikado Philippines; that as a result of the transfer/assignment, Mikado Japan will not be competing with Mikado Philippines for twenty-five (25) years by way of Mikado Japan not entering into similar agreements/contracts to sell/supply/distribute with other overseas (non-Japanese) customers in the future, which will be in direct competition with the business operation acquired by Mikado Philippines from Mikado Japan; and that as Mikado Japan's other commitments, Mikado Japan will be providing Mikado Philippines all the necessary assistance in maintaining (and even increasing) the roster of the Overseas Customers, and will be assisting Mikado Philippines in securing the consent of the Overseas Customers on the transfer and, if necessary, in the execution of new contracts with them. HEDaTA RULING In reply please be informed as follows. A. On whether the payments are in the nature of business profits. It is your opinion that the payments for the sale of the right to sell/supply/distribute to the Overseas Customers to be made by Mikado Philippines to Mikado Japan are in the nature of business profits, taxable under Article 7, paragraph 1, of the Philippines-Japan tax treaty, which provides: "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." ITEcAD Relative to the concept of an enterprise vis--vis the concept of business profits or profits of an enterprise, the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention on Income and on Capital (Condensed Version, July 2005 Edition) comments as follows: "4. The question whether an activity is performed within an enterprise is deemed to constitute in itself an enterprise has always been interpreted according to the provisions of the domestic laws of the Contracting States. No exhaustive definition of the term 'enterprise' has therefore been attempted in this articles. However, it is provided that the term 'enterprise' applies to the carrying on of any business . . ." 2 According to the commentaries, the subject payments are in the nature of business profits (or more appropriately, profits of an enterprise) if they are derived by Mikado Japan from an activity or activities performed within an enterprise or is deemed to constitute in itself an enterprise. Generally speaking, income from the supply of goods or merchandise, income from the supply of services, and income from the lease of personal properties, are treated as business profits if they are derived by Mikado Japan from carrying on its primary and regular business activities. To determine if such activities are primary and regular, it is important to consider those activities of Mikado Japan as expressly declared in its Articles of Incorporation, and those other activities of Mikado Japan which, although not expressly declared, are being undertaken by it on a regular or habitual basis. ICTHDE Inasmuch as the right to sell/supply/distribute to the Overseas Customers is not the type of goods or merchandise normally sold by Mikado Japan to other parties, but, in fact, can be considered as part of the assets forming part of the business property of Mikado Japan, payments for the sale of such right will not be normally treated as business profits. Also, the fact that there is nothing in the documents submitted that will show that Mikado Japan has been selling the same or similar rights to other parties makes the payments for the sale of the right to sell/supply/distribute to the Overseas Customers to Mikado Philippines not as business profits, especially since the activity of selling the same or similar rights is not expressly declared to be among the primary business activities of Mikado Japan. As represented, Mikado Japan (and Mikado Philippines ) are engaged in the manufacture, sale, supply and distribution of marine propellers and stern equipment including casting parts in bronze for various types of machinery. (BIR Ruling No. DA-ITAD 40-07 dated March 19, 2007) Under paragraph 7, Article 7 of the Philippines-Japan tax treaty, when items of income are dealt with separately in other articles of the tax treaty, the provisions of those articles, rather than those of Article 7, will primarily govern the taxation of such items of income, thus: "7. Where profits include items of income which are dealt with separately in other Articles of this Convention, then the provisions of those Articles shall not be affected by the provisions of this Article." CTAIDE Paragraph 7 provides that the taxing authority, before applying the provisions of the article on business profits to a specific class of income, shall initially consider if such income is or will be governed by the provisions of the other article or articles of the tax treaty. Thus, it should first be determined whether the payments for the sale of the right to sell/supply/distribute to the Overseas Customers, which right is in the nature of an intangible property and which right is not the type of goods or merchandise normally sold by Mikado Japan to other parties, is in the nature of royalties or capital gains. B. On whether the payments are in the nature of royalties. The term royalties is defined in Article 12, paragraph 4 of the Philippines-Japan tax treaty as follows: "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." AHCTEa On the meaning of royalties, the OECD Model Tax Convention comments as follows: "1. In principle, royalties in respect of licenses to use patents and similar property and similar payments are income to the recipient from a letting. The letting may be granted in connection with an enterprise ( e.g., the use of literary copyright granted by a publisher or the use of a patent granted by the inventor) or quite independently of any activity of the grantor ( e.g., the use of a patent granted by the inventor's heirs)." 3 According to the commentaries, payments are in the nature of royalties if they are considered as income from a letting or a leasing, particularly, involving intangible properties (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, or for information concerning industrial, commercial or scientific experience), and even tangible properties like industrial, commercial or scientific equipment, as these types of property are expressly defined as royalties in paragraph 4, Article 12 of the tax treaty. aCATSI When an arrangement is one of a letting or leasing, the person who lets or leases a property does not extinguish or diminish his ownership and interest over the property when the same is let or leased to another person. As it appears, the sale of the right to sell/supply/distribute to the Overseas Customers does not constitute a letting or leasing by Mikado Japan as it will eventually extinguish its ownership and interest over such right in favor of Mikado Philippines, who will gain ownership and interest over such right. As such, the payments for the sale of this right cannot be in the nature of royalties. (BIR Ruling No. DA-ITAD 40-07 dated March 19, 2007) TcHCIS Moreover, considering that the tax treaty expressly describes those intangible properties that normally give rise to royalties, the right to sell/supply/distribute to the Overseas Customers, on the other hand, although an intangible property, does not assimilate to any of the intangible properties mentioned in the tax treaty. For example, under the Intellectual Property Code of the Philippines (Republic Act No. 8293), a patent particularly relates to an invention; 4 an industrial design to a special appearance of an industrial product; 5 a mark to any sign capable of distinguishing the goods (trademark) or services (service mark) of an enterprise; 6 a trade name to the name or designation identifying an enterprise ; 7 and a copyright to a literary or artistic work (original or derivative ). 8 None of these intangible properties can be considered as the appropriate category of the subject right sold by Mikado Japan to Mikado Philippines; hence, the payments for such right cannot be in the nature of royalties. C. On whether the payments are in the nature of capital gains. The payments for the sale of the right to sell/supply/distribute to the Overseas Customers are actually in the nature of capital gains because the transaction that gives rise to such payments involves the sale or transfer of assets. As such, Article 13 of the Philippines-Japan tax treaty below may govern the taxation of such payments, thus: "Article 13 1. Gains derived by a resident of a Contracting State from the alienation of immovable property as defined in paragraph 2 of Article 6 and situated in the other Contracting State may be taxed in that other Contracting State. IAETSC 2. Gains from the alienation of any property, other than immovable property, forming part of the business property of a permanent establishment which an enterprise of a Contracting State has in the other Contracting State or of any property, other than immovable property, pertaining to a fixed base available to a resident of a Contracting State in the other Contracting State for the purpose of performing independent personal services, including such gains from the alienation of such a permanent establishment (alone or together with the whole enterprise) or of such a fixed base, may be taxed in that other Contracting State. 3. Gains derived by a resident of a Contracting State from the alienation of ships or aircraft operated in international traffic and any property, other than immovable property, pertaining to the operation of such ships or aircraft shall be taxable only in that Contracting State. 4. Gains from the alienation of shares of a company, a partnership or a trust the property of which consists principally of immovable property situated in a Contracting State, may be taxed in that Contracting State. 5. Gains from the alienation of any property other than those referred to in paragraphs 1, 2, 3 and 4 shall be taxable only in the Contracting State of which the alienator is a resident." SEDICa Article 13 applies to capital gains derived by a resident of a Contracting State from the alienation or transfer of property situated in the other Contracting State. By this statement, the fact that payments for the alienation or transfer of a property are derived in a State by reason, for example, that the person making the payments is a resident of that State, will not make that State the source of income of the capital gains unless the property is situated also in that State. The abovementioned paragraphs of Article 13 confirm this point. (BIR Ruling No. DA-ITAD 40-07 dated March 19, 2007) In paragraph 1, gains from the alienation of real property may be taxed in the State where the real property is situated. In paragraph 2, gains from the alienation of movable property forming part of the business property of a permanent establishment or a fixed base, or from the alienation of the permanent establishment or the fixed base itself, may be taxed in the State where the movable property or the permanent establishment or the fixed base is situated. In paragraph 3, gains from the alienation of ships or aircraft operated in international traffic and of movable property pertaining thereto shall not be taxed in the State where the operation of the ship or aircraft takes place or where the movable property pertaining to such operation is situated; paragraph 3 provides that such gains shall be taxable only in the other State where the place of effective management of the enterprise operating the ships or aircraft is situated. In paragraph 4, gains from the alienation of shares of a company, a partnership, or a trust, the property of which consists principally of immovable property, may be taxed in the State where the immovable property is situated. cCTAIE In paragraph 5, gains from the alienation of any property, other than that mentioned in paragraphs 1, 2, 3 and 4, shall be taxable only in the State where the alienator is a resident. An examination of the provisions of paragraphs 1, 2, 3 and 4 reveals that the type of property covered by paragraph 5 must necessarily be situated also in the State concerned. (BIR Ruling No. DA-ITAD 40-07 dated March 19, 2007) Applying the provisions of the abovementioned paragraphs of Article 13 to the payments for the sale of the right to sell/supply/distribute to the Overseas Customers, such payments cannot be covered by paragraphs 1, 2, 3 and 4 because the property in question is not in the nature of real property (paragraph 1); nor of movable property forming part of the business property of a permanent establishment because Mikado Japan does not have a permanent establishment in the Philippines to begin with based on the Certificate of Non-Registration of Corporation/Partnership issued by the Securities and Exchange Commission (paragraph 2); nor of ships or aircraft (paragraph 3); nor of shares of a company, partnership, or trust (paragraph 4). Where paragraphs 1 to 4 cannot cover the payments for the sale of the right to sell/supply/distribute to the Overseas Customers, the residual paragraph 5 of Article 13 provides that the payments shall be taxable only in Japan, the State of residence of Mikado Japan (the alienator in this case). However, as mentioned above, in order for paragraph 5 to apply, it must be shown first that the Philippines is considered the State where the subject right is situated. For this purpose, inasmuch as the property involved is in the nature of an intangible property (although not the type that normally gives rise to royalties), we take into account the source of income rules set forth in Section 42 (A) (4) (a) of the National Internal Revenue Code of 1997 (Tax Code of 1997), which provides: DTISaH "Section 42. Income from Sources Within the Philippines. (A) Gross Income from Sources Within the Philippines. The following items of gross income shall be treated as gross income from sources within the Philippines: xxx xxx xxx (4) Rentals and Royalties. Rentals and royalties from property located in the Philippines or from any interest in such property, including rentals or royalties for (a) The use of or the right or privilege to use in the Philippines any copyright, patent, design or model, plan, secret formula or process, goodwill, trademark, trade brand or other like property or right;" In Section 42 (A) (4) (a), rentals and royalties are considered derived from sources within the Philippines if the property giving rise to the rentals and royalties is located in the Philippines, and/or, in the case of intangible properties (any copyright, patent, design or model, plan, secret formula or process, goodwill, trademark, trade brand or other like property or right), if the right or privilege to use the intangible property is exercised in the Philippines. By the same token, capital gains from the alienation of intangible properties are considered derived from sources within the Philippines if the intangible property, prior to its alienation or transfer, was located in the Philippines, and/or the right or privilege to use it was being exercised in the Philippines. (BIR Ruling No. DA-ITAD 40-07 dated March 19, 2007) aCITEH An intangible property constituting the right to sell/supply/distribute to the Overseas Customers cannot be considered situated in the Philippines because there is nothing in the documents submitted that will show that this property, prior to its sale to Mikado Philippines, was located in the Philippines and or the right or privilege to use it was being exercised in the Philippines. Considering that Mikado Japan and the Overseas Customers are not domiciled in Philippines but abroad (Japan for Mikado Japan, and Australia, Italy, the United Arab Emirates, the United Kingdom and the United States for the Overseas Customers), it follows that the right to sell/supply/distribute to the Overseas Customers was being exercised by Mikado Japan in these countries and not in the Philippines. This being the case where such right was not situated in the Philippines, the payments for the sale of such right, although appropriately in the category of capital gains, is, however, beyond the scope of Article 13 of the Philippines-Japan tax treaty. caHCSD D. The payments are in the nature of other income. Inasmuch as the payments for the sale of the right to sell/supply/distribute to the Overseas Customers are beyond the scope of the articles of the Philippines-Japan tax treaty on business profits (Article 7), royalties (Article 12), and capital gains (Article 13), the residual Article 22 of the tax treaty on other income below provides the taxation of such payments, thus: ScCIaA "Article 22 1. Items of income of a resident of a Contracting State, wherever arising, not dealt with in the foregoing Articles of this Convention shall be taxable only in that Contracting State. 2. The provisions of the preceding paragraph shall not apply to income, other than income from immovable property as defined in paragraph 2 of Article 6, if the recipient of such income, being a resident of a Contracting State, carries on business in the other Contracting State through a permanent establishment situated therein, or performs in that other Contracting State independent personal services from a fixed base situated therein, and the right or property in respect of which the income is paid is effectively connected with such permanent establishment or fixed base. In such case the provisions of Article 7 or Article 14, as the case may be, shall apply." EaSCAH Paragraph 1 provides that items of income, wherever arising, which are not dealt with in the foregoing article of the tax treaty 9 shall be taxable only in the State where the recipient is a resident. Paragraph 2 provides an exception, that is, where such items of income are effectively connected with a permanent establishment or a fixed base which the recipient has in the other Contracting State where the income arises; in such a case, the other State is permitted to tax such items of income. The OECD Model Tax Convention comments on Article 22 as follows: "1. This Article provides a general rule relating to income not dealt with in the foregoing Articles of the Convention. The income concerned is not only income of a class not expressly dealt but also income from sources not expressly mentioned. The scope of the Article is not confined to income arising in a Contracting State; it extends also to income from third States." EAcIST The Income Tax Treaties of the United States, by Peter H. Blessing, comments that "the Other Income article is intended to act as a catchall provision for items of income not specifically provided for in other articles of the treaty. Such items of income may be either (1) of a class described in another treaty article but beyond the scope of such article, or (2) of a class not described in any other article of the particular treaty." 10 In the case of the payments for the sale of the right to sell/supply/distribute to the Overseas Customers, such payments, although considered in the nature of a capital gain, are, however, beyond the scope of Article 13 of the tax treaty on capital gains because the right that gives rise to such payments is not established to be situated in the Philippines before it was sold or alienated. ITSCED Pursuant to Article 22 of the Philippines-Japan tax treaty, inasmuch as Mikado Japan has no permanent establishment in the Philippines, the payments for the sale of the right to sell/supply/distribute to the Overseas Customers to be made to it by Mikado Philippines are exempt from Philippine income tax, as such payments are taxable only in Japan, the country of residence of Mikado Japan (the recipient in this case). Finally, Mikado Philippines, being a domestic corporation, is subject to tax on income derived from sources within and without the Philippines under Section 23 (E) 11 of the Tax Code of 1997. Upon the sale of such right to sell/supply/distribute to Mikado Philippines, the payments that the Overseas Customers will be making to Mikado Philippines for its sale/supply/distribution of raw materials to the Overseas Customers, being considered income derived by Mikado Philippines from sources without the Philippines, are accordingly subject to Philippine income tax. 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. CDTHSI Very truly yours, Commissioner of Internal Revenue By: (SGD.) GREGORIO V. CABANTAC Deputy Commissioner Footnotes 1. Signed in Tokyo, Japan, on February 13, 1980, and became effective on January 1, 1981. DcaECT 2. Ibid., Page 72. 3. Ibid., Page 178. 4. Section 21. 5. Section 112. 6. Section 121. 7. Section 121. 8. Section 172. 9. Income from real property (Article 6), business profits (7), profits from the operation of ships and aircraft in international traffic (8), income of associated enterprises (9), dividends (10), interest (11), royalties (12), capital gains (13), income from independent personal services (14), income from dependent personal services (15), directors' fees (16), income of artistes and athletes (17), pensions (18), income from government service (19), income of professors and teachers (20), and income of students and trainees (21). TIAEac 10. Copyright 1996. Chapter 17, page 5. 11. "SEC. 23. General Principles of Income Taxation in the Philippines. Except when otherwise provided in this Code: xxx xxx xxx (E) A domestic corporation is taxable on all income derived from sources within and without the Philippines; and" DTAIaH