DA ITAD BIR Ruling No. 076-09

August 18, 2009 DA ITAD BIR RULING NO. 076-09 Article 7 in relation to Article 5 of the Philippines-Japan tax treaty; BIR Ruling No. 14-06; BIR Ruling No. DA-ITAD 30-08; BIR Ruling No. DA-ITAD 29-08; BIR Ruling No. DA-ITAD 94-06; BIR Ruling No. DA-ITAD 129-06; BIR Ruling No. DA-ITAD 17-08 Regalado Bautista & Menzon Law Offices Suite 710 City & Land Mega Plaza ADB Ave. corner Garnet Street Ortigas, Pasig City Attention: Atty. Edith Abana-Bautista Atty. Rhodora Corcuera-Menzon Gentlemen : This refers to your letter dated May 16, 2008 which was received by this Office on 17 June 2008 requesting a ruling on the tax implication of the supplement no. 4 on the purchase of software by Canon Information Technologies Philippines, Inc. (hereinafter referred to as "Canon-Philippines" ) from Canon Inc. (hereinafter referred to as "Canon-Japan" ) and applying for a tax treaty relief pursuant to the Philippines-Japan tax treaty. It is represented that Canon-Japan is a foreign corporation organized and existing under the laws of Japan with principal address at 30-2, Shimomaruko 3-Chome, Ohta-ku, Tokyo 146-8501, Japan; that Canon-Japan is not registered either as a corporation or as a partnership in the Philippines, as evidenced by the Certification of Non-Registration of Corporation/Partnership dated May 27, 2008 issued by the Securities and Exchange Commission (SEC); that Canon-Philippines is a domestic corporation with office address at Floor Techno Plaza One, 18 Orchard Road, Eastwood, Quezon City and is registered with the Board of Investments under Certificate of Registration No. 93-170; that it is a subsidiary company of Canon-Japan and is registered with the Board of Investments under Certificate of Registration No. 93-170; that it is engaged in the business of hardware design and software development involving imaging, communications and related technologies. It is further represented that pursuant to Supplement No. 4 , entered into on January 1, 2008 between Canon-Philippines and Canon-Japan as supplement to the existing Software License Base Agreement (Agreement) between the said parties which took effect on January 1, 2005, Canon-Philippines purchased the following software products from Canon-Japan in the amount of One Hundred Eighty-Two Million Seven Hundred Two Thousand Japanese Yen (JP182,702,000.00) TEAICc I. Mentor 1) HDL Designer Ap SW 2) ModelSim SE MixedHLD Ap SW 3) Seamless CVE Kernel Ap SW 4) ARM Family PSP Op SW 5) MIPS Family PSP Op SW 6) Questa AFV Option Op SW II. Denali 1) Memory Maker 2) MMAV2006 III. Cadence 1) Incisive Enterprise Simulator 2) Specman Elite Testbench 3) eVC AMBA AHB aDICET 4) eVC USB 5) eVC PCI Express End Point 6) eVC PCI 2.2/2.3 7) eVC Ethernet 8) eVC for AMBA AXI 9) Incisive Enterprise Manager IV. Atrenta 1) SpyGlass Mix Language 2) SpyGlass Custom Builder 3) IT: System; that Supplement No. 4 is subject to the terms and conditions provided under the terms and conditions of the Agreement, whereby Canon-Japan grants to Canon-Philippines a nonexclusive, nontransferable license, without the right to grant a sublicense to others: (a) to copy and use the Licensed Software in the computer, which is located at the facilities of Canon-Philippines and connected via a global area network to the License Server (Canon-Philippines Designated Computer) , for the purposes specified in the applicable Supplement (Purpose); provided that the number of its employees using the Licensed Software simultaneously shall not exceed the number of licenses set forth in the applicable Supplement (License Number); and IHcTDA (b) to access from the Canon-Philippines Designated Computer via a global area network, and use the Licensed Software retained in the License Server or the computer, which is located at the facilities of Canon-Japan and connected via a global area network to the License Server, for the Purpose; provided that the number of its employees using the Licensed Software simultaneously shall not exceed the License Number; that Canon-Philippines shall not disassemble, decompile, reverse engineer or otherwise reduce to a human perceivable form the Licensed Software; that Canon-Philippines is not authorized or permitted to use, copy and have copied, duplicate and have duplicated, rent, lease, sell, distribute, sublicense, assign or otherwise transfer the Licensed Software and the Manual, except as expressly provided; that Canon-Philippines shall not, nor shall it allow any third party to, change or remove any copyright notice which the Licensors place on their respective Licensed Software and/or the Manual; that except as expressly provided, no license or right, express or implied, is conveyed or granted for any invention, patent application, patent, copyright or other intellectual property rights of Canon-Japan and the Licensors; that the said Agreement and each supplement do not transfer to Canon-Philippines any title to or ownership of the Licensed Software and/or the Manual; that Canon-Philippines shall have no right to create derivative works of the Licensed Software and the Manual; that Canon-Philippines shall not modify the Licensed Software or the Manual in any way; that Canon-Japan shall provide Canon-Philippines (a) any updates and bug-fixes of the License Software and the Manual, which is provided by Canon-Japan or (b) access key which Canon-Philippines uses in order to download such updates and bug-fixes of the License Software and the Manual from the website of Canon-Japan ; that this Agreement shall become effective as of the effective date and continue in full force and effect for a period of one (1) year unless earlier terminated; and that the issue or transaction subject of the above application is not under investigation, on-going audit, administrative protest, claim for refund or issuance of a tax credit certificate, collection proceedings, or a judicial appeal. EAHcCT In reply, please be informed that concerning software payments, the Bureau of Internal Revenue has issued two Revenue Memorandum Circulars (RMC) that govern the taxation of software payments. The first Circular (RMC 77-2003) 1 covers software payments made as of November 18, 2003 and until the effectivity of the second Circular and generally treats software payments as royalties, thus: " Definition of Royalties Includes Payments for the Use of Software: The term 'royalties' as generally used means payment 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 films or tapes used 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 term 'use' as contained herein shall include the reselling or distribution of software. Software is generally assimilated as a literary, artistic or scientific work protected by the copyright laws of various countries including the Philippines; thus payments in consideration for the use of, or the right to use, a copy or a copyrighted article relating to software are generally royalties." On the other hand, the second Circular (RMC 44-2005) 2 covers payments made as of September 8, 2005 and onwards and substantially amends the first Circular by treating software payments either as business income, royalties, rental income, or capital gains, depending on the nature of the transaction out of which such payments are made. Software payments are treated as royalties only if the transaction does not constitute a sale or exchange and not all substantial rights in the software have been transferred, but are merely for the transfer of copyright rights in the software. It provides: AIaSTE "Section 5. Characterization of Transactions. The character of payments received in a transaction involving the transfer of computer software depends on the nature of the rights that the transferee acquires under the particular arrangement regarding the use and exploitation of the program. a. Transfer of copyright rights. A transfer of software is classified as a transfer of a copyright right if, as a result of the transaction, a person acquires any one or more of the rights described below: i. The right to make copies of the software for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease or lending; ii. The right to prepare derivative computer programs based upon the copyrighted software; iii. The right to make a public performance of the software; iv. The right to publicly display the computer program; or EAIaHD v. any other rights of the copyright owner, the exercise of which by another without his authority shall constitute infringement of said copyright. The determination of whether a transfer of a copyright right in a software is a sale or exchange of property is made on the basis of whether, taking into account all facts and circumstances, there has been a transfer of all substantial rights in the copyright. A transaction that does not constitute a sale or exchange because not all substantial rights have been transferred will be classified as a license generating royalty income. When only copyright rights are transferred, payments made in consideration therefor are royalties. On the other hand, when copyright ownership is transferred, payments made in consideration therefor are business income. b. Transfer of copyrighted articles. A copyrighted article incorporating a software includes a copy of the software from which the work can be perceived, reproduced, or otherwise communicated, either directly or with the aid of a machine or device. The copy of the software may be fixed in the magnetic medium of a floppy disk or a CD-ROM, or in the main memory or hard drive of a computer, or in any other medium. DSEIcT If a person acquires a copy of a software but does not acquire any of the rights described above (or only acquires a de minimis grant of such rights), and the transaction does not involve the provision of services or of know-how, the transfer of the copy of the software is classified solely as a transfer of a copyrighted article and payments for which constitute business income. xxx xxx xxx" (Emphasis supplied) The substantial difference between the two Circulars is their characterization of payment from the purchase of a copyrighted article incorporating a software, like the license fee for the Licensed Software where the licensee (Canon-Philippines) is merely granted access to and use of the Licensed Software and not readily the right to market or exploit the Licensed Software. Under the first Circular, the license fee is treated as royalty income and taxable as such, while under the second Circular, the license fee is treated as business income (or business profits) and taxable as such, as described above. The fact that what is being transferred to Canon-Philippines is only a copyrighted article incorporated in a software and there was no transfer of ownership thereto including pertinent rights protected under relevant intellectual property laws, Revenue Memorandum Circular (RMC) No. 44-2005, Section 5b thereof, will apply in this case which states that "If a person acquires a copy of a software but does not acquire any of the rights described above (or only acquires a de minimis grant of such rights), and the transaction does not involve the provision of services or of know-how, the transfer of the copy of the software is classified solely as a transfer of a copyrighted article and payments for which constitute business income. Thus, payments made by Canon-Philippines to Canon-Japan, being business income (business profits), are subject to Philippine income tax only if such payments are attributable to a permanent establishment which Canon-Japan has in the Philippines, under paragraph 1, Article 7 in relation to Article 5 of the Philippines-Japan tax treaty, to wit: cDCaTS "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 on so much of them as is attributable to that permanent establishment. xxx xxx xxx" "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; DIETcH d) a factory; e) a workshop; f) a warehouse; g) a mine, an oil or gas well, a quarry or other place of extraction of natural resources. xxx xxx xxx." Based on the foregoing, in order for Canon-Japan to be considered to have a permanent establishment to which said business profit may be attributed, it must satisfy the following conditions: 3 the existence of a "place of business", i.e., a facility such as premises or, in certain instances, machinery or equipment; this place of business must be "fixed", i.e., it must be established at a distinct place with a certain degree of permanence; the carrying on of the business of the enterprise through this fixed place of business. This means usually that persons who, in one way or another, are dependent on the enterprise (personnel) conduct the business of the enterprise in the State in which the fixed place is situated." (Paragraph 2) CHDTEA Since it appears, based on the SEC Certificate that Canon-Japan is not registered either as a corporation or as a partnership in the Philippines, that Canon-Japan does not have a place of business at its disposal which is fixed or established at a distinct place with a certain degree of permanence in the Philippines through which it may use for carrying on its business, Canon-Japan is deemed as not having permanent establishment to which said business profit may be attributed to. Thus, for as long as Canon-Japan is deemed not to have a permanent establishment in the Philippines to which its profits may be attributable, income from its sale of software, such as that made to Canon-Philippines in the instant case, shall be exempt from income tax and consequently withholding tax. (BIR Ruling No. 14-06 dated February 24, 2006; BIR Ruling No. DA-ITAD 30-08 dated April 29, 2008; BIR Ruling No. DA-ITAD 29-08 dated April 29, 2008; BIR Ruling No. DA-ITAD 94-06 dated August 22, 2006; BIR Ruling No. DA-ITAD 129-06 dated October 27, 2006; BIR Ruling No. DA-ITAD 17-08 dated March 7, 2008; and BIR Ruling No. DA-ITAD 30-08 dated April 29, 2008) However, the importation of software is subject to value-added tax (VAT) at the rate of 12% 4 pursuant to Section 107 of the National Internal Revenue Code of 1997 (Tax Code of 1997), as amended by Republic Act No. 9337. Accordingly, Canon-Philippines being the direct importer of the downloadable software, is subject to 12% VAT from its payments before telegraphically transferring it to the account of Canon-Japan . Moreover, Canon-Philippines , being the resident withholding agent and payor in control of the payments, shall be responsible for the withholding of the final VAT before making any payment to Canon-Japan . In remitting the VAT withheld, Canon-Philippines shall use BIR Form No. 1600 (Monthly Remittance Return of Value-Added Tax and Other Percentage Taxes Withheld). The duly filed BIR Form 1600 and proof of payment thereof shall serve as documentary substantiation for the claim of input tax by Canon-Philippines upon filing its own VAT Return, if it is a VAT-registered taxpayer. In case Canon-Philippines is a non-VAT registered taxpayer, the passed-on VAT withheld shall form part of the cost of the service purchased which may be treated as "expense" or "asset", whichever is applicable. In addition, Canon-Philippines is required to issue the respective Certificate of Final Tax Withheld at Source (BIR Form No. 2306) in quadruplicate, the first three copies thereof shall be given to Canon-Japan and the fourth copy to be retained by Canon-Philippines as its file copy. [Section 4 & 6, Revenue Regulations (RR) No. 4-2002; Section 3 RR No. 8-2002; Section 7 of RR No. 14-2002] SEcTHA 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. Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service Footnotes 1. Classification of Payments for Software for Income Tax Purposes. 2. Taxation of Payments for Software. 3. Organization for Economic Cooperation and Development (OECD), 2005 edition, paragraph 2, pages 85-91. 4. Revenue Memorandum Circular No. 7-2006.