DA ITAD BIR Ruling No. 076-06

June 23, 2006 DA ITAD BIR RULING NO. 076-06 Article 13 (Royalties) Philippines-United States of America tax treaty; BIR Ruling No. DA-ITAD 111-03 Punongbayan & Araullo 20th Floor, Tower 1 The Enterprise Center 6766 Ayala Avenue 1200 Makati City Attention: Atty. Benedicta Du-Baladad Tax Partner Gentlemen : This refers to your letter dated November 18, 2005 requesting confirmation that royalties to be paid by Warner Music Philippines, Inc . ( Warner Philippines ) to WEA International, Inc . ( WEA International ) pursuant to a License Agreement are subject to fifteen percent (15%) income tax under Article 13 (Royalties) of the Convention between the Government of the Republic of the Philippines and the Government of the United States of America with Respect to Taxes on Income (Philippines-United States of America tax treaty). It is represented that WEA International is a corporation organized and existing under the laws of the United States of America, with address at 1 Commerce Center, Suite 714, 12th and Orange Street, Wilmington, Delaware 19801, United States of America, as confirmed by its Certificate of Incorporation filed at the Office of the Secretary of State of the State of Delaware on February 21, 1975 and by the subject License Agreement; that WEA International 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 April 11, 2005 issued by the Securities and Exchange Commission; and that, on the other hand, Warner Philippines is a corporation organized and existing under the laws of the Philippines, with address at 4th Floor, Ma. Daniel Building, 470 M.H. del Pilar corner San Andres Streets, Malate, Manila, Philippines, as confirmed by its Articles of Incorporation and By-Laws filed at the Securities and Exchange Commission on October 29, 1999 and be the subject License Agreement. It is further represented that WEA International has the right to license the right to sell and/or to manufacture and sell in countries other than the United States, records 1 containing the sound performances embodied upon or in recording devices such as metal masters and/or master recording tapes (herein called "Masters" within the Licensed Catalogues; 2 that, on the other hand, Warner Philippines is engaged and will continue during the term of the License Agreement to be actively engaged in the manufacture and sale of records in the Philippines (herein called the "Licensed Territory"), and desires to obtain certain rights to sell and/or manufacture and sell records in the Licensed Territory reproducing the sound performances embodied upon or in the Masters within the Licensed Catalogues; that on December 1, 1992, WEA International and Warner Philippines entered into a License Agreement whereby WEA International granted Warner Philippines the following rights subject to certain restrictions, terms and conditions of the License Agreement: (a) the right to use in the Licensed Territory each and every master recording in the Licensed Catalogues (such Masters being thereinafter referred to as the "available Masters") except such master recordings as are committed or restricted with respect to the Licensed Territory at the time of their acquisition and except such master recordings as are subject to contractual commitments in the Licensed Territory prior to the effective date of the License Agreement (for so long as such commitments remain in effect) for the purpose of manufacturing and selling records therefrom during the term of the License Agreement in the Licensed Territory only; ADHCSE (b) the right (to the extent WEA International has such right) to use in the Licensed Territory the name, likeness and biography of each artist whose performance is embodied in the said master recording only for advertising and trade purposes in connection with the sales of records thereunder; it being expressly understood and agreed that no such use shall be in the nature of an endorsement, commercial tie-in or association other than with reference to records by such artist manufactured and/or sold by Warner Philippines thereunder. Warner Philippines shall abide by any restrictions imposed upon WEA International with respect to such use of which WEA International has notified Warner Philippines ; (c) the right to grant licenses for the public performance and/or broadcasting in the Licensed Territory of recordings in the Licensed Catalogue, subject to the right of copyright proprietors; and (d) during the term of the License Agreement, WEA International shall not grant rights to third parties which derogate from or are inconsistent with the rights therein granted to Warner Philippines . that in consideration of the foregoing, Warner Philippines shall pay WEA International royalties (in United States dollars) computed as follows: (a) Master Use Royalty . In consideration of the rights granted to manufacture and sell records derived from available Masters, Warner Philippines shall pay WEA International a Master use royalty in respect of one hundred percent (100%) of all records sold thereunder, calculated at the rate of twenty-six percent (26%) of the Royalty Base ("retail list price" or "suggested retail price" per record in the country of sale); and (b) Performance Royalties . To the extent permitted by applicable law, Warner Philippines shall pay WEA International an amount equal to fifty percent (50%) of the fees, if any, received or credited to Warner Philippines by reason of the public performance and/or broadcasting of the records in the Licensed Catalogues. and that the License Agreement, which became effective on December 1, 1992 for an initial period of one (1) year, shall be renewed automatically thereafter indefinitely unless otherwise terminated. In reply, please be informed that as regards income tax, the royalties for the musical copyrights to be paid by Warner Philippines to WEA International are subject to the preferential tax rate under Article 13 of the Philippines-United States tax treaty, to wit.: "Article 13 ROYALTIES 1. Royalties derived by a resident of one of the Contracting States from sources within the other Contracting State may be taxed by both Contracting States. 2. However, the tax imposed by that other Contracting State shall not exceed a) In the case of the United States, 15 percent of the gross amount of the royalties, and b) In the case of the Philippines, the least of: (i) 25 percent of the gross amount of the royalties, (ii) 15 percent of the gross amount of the royalties, where the royalties are paid by a corporation registered with the Philippine Board of Investments and engaged in preferred areas of activities, and (iii) the lowest rate of Philippine tax that may be imposed on royalties of the same kind paid under similar circumstances to a resident of a third State. 3. 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 cinematographic films or films or tapes used for radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or other like right or property, or for information concerning industrial, commercial or scientific experience. The term "royalties" also includes gains derived from the sale, exchange or other disposition of any such right or property which are contingent on the productivity, use, or disposition thereof. aEDCSI xxx xxx xxx" Paragraph 2(b)(iii) above provides that royalties arising in the Philippines and derived by a resident of the United States shall be subject to the lowest rate of Philippine income tax that may be imposed on royalties of the same kind paid under similar circumstances to a resident of a third State (commonly known as the most-favored-nation tax treatment of royalties). In relation thereto, the Supreme Court, in Commissioner of Internal Revenue vs. S.C. Johnson and Son, Inc. and Court of Appeals (G.R. No. 127105 dated June 25, 1999), has cited two conditions for royalties arising in the Philippines and derived by a resident of another country (in this case, the United States) to be subject to a most-favored-nation tax treatment. First, the royalties in question derived by a resident of the other country (the United States) must be of the same kind as those derived by a resident of the third country which are subject to the most-favored-nation tax treatment under the existing tax treaty between the Philippines and the third country. Second, the mechanism employed by the other country (the United States) in mitigating the effects of double taxation of foreign-sounded income derived by its residents must be the same with that employed by the third country, which can be determined by taking into account and comparing the respective articles on Elimination of Double Taxation of the other country (the United States) and the third country under their respective tax treaties with the Philippines. In looking for a third country which grants a most-favored-nation tax treatment on royalties, you cited the Netherlands and, accordingly, the Convention between the Kingdom of the Netherlands and the Republic of the Philippines for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (Philippines-Netherlands tax treaty), which entered into force on September 20, 1991 and whose provisions on taxes apply on income derived or which accrued beginning January 1, 1992. As to the first condition for the most-favored-nation tax treatment, it is noteworthy that payments for copyright of literary, artistic or scientific work (to which royalties for the musical copyrights to be paid by Warner Philippines to WEA International are assimilated), which are considered royalties under paragraph 3, Article 13 of the Philippines-United States tax treaty, are likewise considered as such under paragraph 4, Article 12 of the Philippines-Netherlands tax treaty, to wit: "Article 12 ROYALTIES 1. Royalties arising in one of the States and paid to a resident of the other State may be taxed in that other State. 2. However, such royalties may also be taxed in the State in which they arise, and according to the laws of that State, but if the recipient is the beneficial owner of the royalties the tax so charged shall not exceed: a) 10 per cent of the gross amount of the royalties where the royalties are paid by an enterprise registered, and engaged in preferred areas of activities in that State; and b) 15 per cent of the gross amount of the royalties in all other cases. 3. The competent authorities of the States shall by mutual agreement settle the mode of application of paragraph 2. 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 or tapes for radio or television broadcasting, any patent, trademark, a sign or model, plan, secret formula or process, or for the use of, or the right to use, industrial, commercial or scientific equipment, or for the information concerning industrial, commercial or scientific experience. xxx xxx xxx" As to the second condition for the most-favored-nation tax treatment, it is also noteworthy that the United States and the Netherlands employ the same mechanism in mitigating the effects of double taxation of foreign-sourced income derived by their residents, that is, the ordinary credit method , as provided under their respective articles on Elimination of Double Taxation of their tax treaties with the Philippines, to wit: United States : "Article 23 RELIEF FROM DOUBLE TAXATION Double taxation of income shall be avoided in the following manner: 1. In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof), the United States shall allow to a citizen or resident of the United States as a credit against the United States tax the appropriate amount of taxes paid or accrued to the Philippines and, in the case of a United States corporation owning at least 10 percent of the voting stock of a Philippine corporation from which it receives dividends in any taxable year, shall allow credit for the appropriate amount of taxes paid or accrued to the Philippines by the Philippine corporation paying such dividends with respect to the profits out of which such dividends are paid. Such appropriate amount shall be based upon the amount of tax paid or accrued to the Philippines, but the credit shall not exceed the limitations (for the purpose of limiting the credit to time United States tax on income from sources within the Philippines or on income from sources outside United States) provided by United States law for the taxable year. For the purpose of applying the United States credit in relation to taxes paid or accrued to the Philippines, the rules set forth in Article 4 (Source of Income) shall be applied to determine the source of income. For purposes of applying the United States credit in relation to taxes paid or accrued to the Philippines, the taxes referred to in paragraphs 1(b) and 2 of Article 1 (Taxes Covered) shall be considered to be income taxes. HTAEIS xxx xxx xxx" Netherlands : "Article 22 ELIMINATION OF DOUBLE TAXATION xxx xxx xxx 1. The Netherlands, when imposing tax on its residents, may include in the basis upon which such taxes are imposed the items of income which, according to the provisions of this Convention, may be taxed in the Philippines. 2. Without prejudice to the application of the provisions concerning the compensation of losses in the unilateral regulations for the avoidance of double taxation, where a resident of the Netherlands derives items of income which according to Article 6, Article 7, paragraph 6 of Article 10, paragraph 6 of Article 11, paragraph 5 of Article 12, paragraphs 1 and 2 of Article 13, Article 14, paragraph 1 of Article 15, paragraphs 1 and 3 of Article 16, paragraph 2 of Article 18 and Article 19 of this Convention may be taxed in the Philippines and are included in the basis referred to in paragraph 1, the Netherlands shall exempt such items of income by allowing a proportionate reduction of its tax. This reduction shall not, however, exceed that part of the Netherlands tax as computed before the reduction is given, which is otherwise due on the said items of income. 3. Further, the Netherlands shall allow a deduction from the Netherlands tax so computed for the items of income which according to paragraph 2 of Article 8, paragraph 2 of Article 10, paragraph 2 of Article 11, paragraph 2 of Article 12 and Article 17 of this Convention may be taxed in the Philippines to the extent that these items are included in the basis referred to in paragraph 1. The amount of this deduction shall be equal to the tax paid in the Philippines on these items of income, but shall not exceed that part of the Netherlands tax which is otherwise due on the said items of income. 4. For the purposes of paragraph 3, where the Philippine tax actually paid on interest and royalties arising in the Philippines is lower than 15 per cent, then, the tax paid in the Philippines on these items of income shall be deemed to be 15 per cent. xxx xxx xxx" Under the ordinary credit method , the United States and the Netherlands (as countries of residence) would limit a taxpayer's allowable tax credit to that portion of the taxpayer's tax liability in their countries that is attributable to the income taxed in the Philippines (the country of source or country of situs). As a result of this limitation, if the Philippines has an effective tax rate that exceeds the effective tax rate of the United States and of the Netherlands on a particular income, the taxpayer would not receive full credit for the income tax imposed by the Philippines on such income. Under the article on Elimination of Double Taxation of the Philippines-Netherlands tax treaty, the Netherlands applies the ordinary credit method to profits from the operation of ships and aircraft in international traffic, and dividends, interest and royalties to the extent they are not effectively connected to a permanent establishment or a fixed base, and income of artistes and athletes (paragraph 3, Article 22 of the tax treaty). (In addition, if the Philippine income tax on interest and royalties is lower than 15%, for example, 10% for interest and royalties paid under special circumstances, the Netherlands shall deem that the income tax on such interest and royalties is paid at 15%, the difference between 15% and the lower rate being the allowable tax sparing credit (paragraph 4, Ibid .). The tax sparing credit provision does not apply to royalties for musical copyrights like the subject royalties to be paid by Warner Philippines to WEA International because such royalties are subject to the rate of 15% and not lower than that.) On the other hand, the Netherlands applies the exemption method to all other types of income whereby the Netherlands exempts such income from Netherlands income tax (paragraph 2, Ibid .) In fine, because the two conditions for the most-favored-nation tax treatment on royalties are both satisfied, this Office is of the opinion and so holds that the royalties for the musical copyrights to be paid by Warner Philippines to WEA International are subject to the preferential income tax rate of 15% based on the gross amount thereof, under paragraph 2(b)(iii), Article 13 of the Philippines-United States tax treaty in relation to paragraph 2(b), Article 12 of the Philippines-Netherlands tax treaty. (BIR Ruling No. DA-ITAD 111-03 dated July 29, 2003) The subject royalties cannot be subject to the lower rate of 10% under paragraph 2(a), Article 12 of the Philippines-Netherlands tax treaty because Warner Philippines , the company paying the royalties, is not a registered enterprise engaged in preferred areas of activities in the Philippines (for example, if the enterprise is registered with the Board of Investments). cDTACE Finally, as regards value-added tax (VAT), the royalties for the musical copyrights to be paid by Warner Philippines to WEA International are subject to VAT under Section 108(A) of the National Internal Revenue Code of 1997 (Tax Code), 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 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 With regard to the procedures for withholding and paying the VAT, Sections 4 and 6 of Revenue Regulations No. 4-2000, Section 3 of Revenue Regulations No. 8-2002, and Section 7 of Revenue Regulations No. 14-2002, provide that Warner Philippines shall be responsible for the withholding of the VAT on the royalties before remitting them to WEA International . In remitting the Bureau of Internal Revenue the VAT withheld on the royalties, Warner Philippines shall use BIR Form No. 1600 (Monthly Remittance Return of VAT and Other Percentage Taxes Withheld). If a VAT-registered taxpayer, Warner Philippines may use as documentary substantiation for its claim of input VAT the duly filed BIR Form No. 1600 and the proof of payment accompanying it. If a non-VAT-registered taxpayer, Warner Philippines may include as part of the cost of the musical copyrights licensed to it by WEA International the VAT consequently shifted or passed on to it and may treat such VAT either as expense or asset , whichever is applicable. In addition, Warner Philippines is required to issue in quadruplicate the Certificate of Final Tax Withheld at Source (BIR Form No. 2306), the first three copies for WEA International and the fourth copy for Warner Philippines as its file copy. 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. Records shall refer only to disc type phonegraph records of the type now in use in the Licensed Territory covered thereby, and analog prerecorded magnetic sound tapes in reel-to-reel, cartridge and cassette configurations and compact discs, but said term does not include any device combining sound and sight or any other form or type of sound recording whatsoever except as specifically set forth above. 2. Licensed Catalogues shall refer to cash and every Master which is presently owned, or which may hereafter be produced or otherwise acquired by (i) Warner Bros. Records, Inc., (ii) Elektra Entertainment, a division of Warner Communications, Inc., or (iii) Atlantic Recording corporation or their respective successors and or subsidiaries engaged in the record business in the United States of America, or (iv) WEA International with respect to which WEA International has the unilateral right or disposition in the Licensed Territory and which is released in the United States of America or the country of origin. 3. Republic Act No. 9337 (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, amended Section 108(A) to read as: "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: (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%). . . . 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" 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.