DA ITAD BIR Ruling No. 091-06

August 14, 2006 DA ITAD BIR RULING NO. 091-06 Articles 5 (Permanent Establishment), 8 (Business Profits) Philippines-United States of America tax treaty; Revenue Memorandum Circular No. 44-05; BIR Ruling No. 14-06; BIR Ruling No. DA-ITAD 05-06 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 J. Corcuera-Menzon Gentlemen : This refers to your letter dated April 20, 2006 requesting a ruling on the tax implication on the purchase of Canon Information Technologies Philippines, Inc . ( Canon-Philippines ) from Atrenta, Inc . ( Atrenta ) of the following software products namely: 1. SpyGlass Builder-Custom rule creation for VHDL/Verilog using Objects and C/C++); 2. SpyGlass Builder Maintenance; and 3. SpyGlass Predictive Analyzer Maintenance-VHDL specified in a written purchase order (PO). It is represented that Atrenta is a nonresident foreign corporation, organized and existing under the laws of Delaware, with principal office at 2001 Gateway Place, Suite 440W, San Jose, California 95510 as shown in the Certificate of Status Foreign Corporation issued by Mr. Bruce Mepherson, Secretary of State of California on March 30, 2006; that Atrenta is not registered either as a corporation or as a partnership in the Philippines, as confirmed by the Certification of Non-Registration of Corporation/Partnership dated November 23, 2005 issued by the Securities and Exchange Commission; that Canon-Philippines is a corporation duly organized and existing under the laws of the Philippines with office address at 2nd Floor Plaza One, 18 Orchard Road, Eastwood, Quezon City; that it is engaged in the business of hardware design and software development involving imaging, communications and related technologies; that Canon-Philippines develops hardware designs for consumers and office products and in doing so it uses RTL (register transfer logic); that to write RTL source code, a hardware description language (HDL) is used; that one HDL used is Very High Speed Integrated Circuit (VHSIC) Hardware Description Language or VHDL; that one of the key processes of the hardware design is lint-checking; that lint-checking is used to analyze and debug RTL code syntax synthesizability, unsupported constructs, and port mismatches. It is further represented that Canon-Philippines purchased a SpyGlass Builder-Custom rule creation for VHDL/Verilog using Objects and C/C++, SpyGlass Builder Maintenance and the SpyGlass Predictive Analyzer Maintenance VHDL under a Software License Agreement (Agreement); that these software programs are sophisticated integrated circuit design solutions which identify critical design issues; that the Spyglass Predictive Analyzer is a powerful extendible tool for analyzing HDL; that the SpyGlass Predictive analyzer works with SpyGlass Builder; that the SpyGlass Builder allows user to develop their own set of register transfer logic (RTL) rules for lint-checking; that Canon-Philippines had already acquired a perpetual license for SpyGlass Predictive Analyzer; that under the Agreement between Atrenta and Canon-Philippines , the former grants to the latter a non-exclusive, non-transferable limited license, without right to sublicense, to: (a) copy and install software on the designated server (s) at the designated location and use such installed software and the software keys, including use on licensee's local or wide area network; to develop the licensee products, provided that the number of seats using the software is no greater than the total number granted under the Agreement; (b) make a reasonable number of copies of the documentation solely for licensee's internal development purposes; and (c) authorize the use of the software for the licensee's business activities by licensee's subsidiaries and affiliates; that under such Agreement, Canon-Philippines will not permit any third party to: install or use the Software on computer systems, servers or at locations not authorized in accordance with this Agreement; use the Software other than as authorized under this Agreement; resell, lease, sublicense, assign, transfer, distribute or otherwise grant any rights in the Software to any other party, including for any commercial time-sharing, rental, outsourcing or service-bureau use; copy the Software except as authorized in this Agreement; or disclose to any other party, the capabilities, performance, capacity or any deficiencies in the software; modify, adapt, translate, reverse engineer, disassemble, decompile or otherwise attempt to derive source code from any of the materials provided by Atrenta to Licensee hereunder. That ownership of all the right, title and interest in and to the Atrenta trademarks and service marks and the software, documentation, in whole and in part, shall remain the exclusive property of Atrenta and its licensor; that Atrenta shall provide Canon-Philippines with: 1. basic technical support in accordance with Atrenta's support policy set forth in Exhibit C; 2. error verification, analysis and correction to the extent possible by telephone; and 3. any Updates and Upgrades to the Software. That under the Agreement, Atrenta shall provide Canon-Philippines with: (i) basic technical support in accordance with Atrenta's support policy, (ii) error verification, analysis and correction to the extent possible by telephone, and (iii) any Updates and Upgrades to the Software; that in order to be eligible for Support Services, Canon-Philippines must provide to Atrenta a technically qualified single point of contact for dealing with technical support; that in consideration of the licenses and rights granted in this Agreement for the initial term and any renewal term, and the support services provided thereunder, Canon-Philippines shall pay Atrenta the annual Subscription Fee. It is also represented that, in addition, Canon-Philippines availed of separate support and maintenance services of Atrenta under a Atrenta Support and Maintenance Agreement ; that under the said agreement, Atrenta will provide the following support and maintenance services: 1) Error Correction ; 2) Support . Atrenta will make a member of its SMS staff available, in accordance with the terms of the service plan; 3) Field Support . Upon request and subject to resource availability, Atrenta will provide field SMS at any Licensee field site(s) at Atrenta's then currently hourly field SMS rates, together with reimbursement of applicable travel, per diem and related expenditures, at Atrenta's cost. And that the fees for the initial term of the support and maintenance services are outlined in the purchase order. In reply please be informed as follows: 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 September 7, 2005 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 payments of any kind received as a consideration for the use of, or the right to use, any copyright of literacy, 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. It provides: "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 purpose 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 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 a 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. xxx xxx xxx c. After Sales Service . Contracts for the use of software are often accompanied with the provision of services (e.g., installation, maintenance, and customization of the software) by personnel of the relevant foreign licensor/owner or of the relevant local subsidiary, reseller, and distributor. Payments as consideration for after-sales service in a mixed contract are not royalties alone, but will include income from services. The appropriate course to take with such a contract is, in principle, to break down, on the basis of the information contained in the contract or by means of a reasonable apportionment, the whole amount of the stipulated payments according to the various parts of what is being provided under the contract, and then to apply to each part of it so determined the taxation treatment proper thereto. Thus, the part of the payments representing the use of the software will be treated as royalties and taxable as such and the other part of the payments representing the provision of services will be treated as income from services and taxable as such . (Emphasis supplied) If, however, one part of what is being provided constitutes by far the principal purpose of the contract and the other parts stipulated therein are only of an ancillary and largely unimportant character, then the treatment applicable to the principal part should generally be applied to the whole amount of the consideration. ( De minimis )" The substantial difference between the two Circulars is their characterization of payment from the purchase of a copyrighted article incorporating a software, like the 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 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. Since under the Agreement, Atrenta merely grants to Canon-Philippines a non-exclusive, non-transferable license to use the software but not to resell, lease, sublicense, assign, transfer, distribute or otherwise grant any rights in the Software to any other party, including for any commercial time-sharing, rental, outsourcing or service-bureau use, the software, the payments of Canon-Philippines for such non-exclusive, non-transferable license to use the software, to Atrenta shall be considered as business profits. In addition to the foregoing, it should be noted that under the same Software License Agreement, Atrenta will also provide Canon-Philippines the necessary maintenance services. Accordingly, based on the aforequoted Section 5(c) of the RMC No. 44-2005, the subject Software License Agreement should generally be characterized by breaking down the same into the portion which represents the use of the software and the portion which pertains to the provision of services. But if, as stated above, and as in this case, one part of what is being provided constitutes by far the principal purpose of the contract and the other parts stipulated therein are only of an ancillary and largely unimportant character, then the treatment applicable to the principal part should generally be applied to the whole amount of the consideration. Thus, the whole amount of the Subscription Fees to be paid by Canon-Philippines to Atrenta for the Software License Agreement, which includes support services, are to be considered as business profits. As business profits, the Subscription Fees paid by Canon-Philippines to Atrenta will be subject to income tax in the Philippines only if is attributable to a permanent establishment which Atrenta has in the Philippines, under paragraph 1, Article 8 in relation to Article 5 of the Philippines-United States tax treaty, to wit: "Article 8 BUSINESS PROFITS 1. Business profits of a resident of one of the Contracting States shall be taxable only in that State unless the resident has a permanent establishment in the other Contracting State. If the resident has a permanent establishment in that other Contracting State, tax may be imposed by that other Contracting State on the business profits of the resident but only on so much of them as are attributable to the permanent establishment. xxx xxx xxx" "Article 5 PERMANENT ESTABLISHMENT 1. For the purposes of this Convention, the term "permanent establishment" means a fixed place of business through which a resident of one of the Contracting States engages in a trade or business. 2. The term 'fixed place of business' includes but is not limited to: a) A seat of management; b) A branch; c) An office; d) A store or other sales outlet; e) A factory; f) A workshop; g) A warehouse; h) A mine, quarry. or other place of extraction of natural resources; i) A building site or construction or assembly project or supervisory activities in connection therewith, provided such site, project or activity continues for a period of more than 183 days; and j) The furnishing of services, including consultancy services, by a resident of one of the Contracting States through employees or other personnel, provided activities of that nature continue (for the same or a connected project) within the other Contracting State for a period or periods aggregating more than 183 days. xxx xxx xxx" Based on the foregoing, in order for Atrenta to be considered to have a permanent establishment to which said business profits 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) Since Atrenta , based on the documents submitted, 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, Atrenta does not have a permanent establishment to which its business profits may be attributed to. This is further bolstered by the fact that it is neither registered as a corporation nor as a partnership in the Philippines. Such being the case, since Atrenta does not have a permanent establishment to which it may attribute any profits earned from the sales of the software and services to Canon-Philippines , then said profits are not subject to Philippine income tax under Section 28(B)(1) of the National Internal Revenue Code (NIRC) of 1997. 4 Further, as regards the services to be rendered by Atrenta to Canon-Philippines under the Atrenta Support and Maintenance Agreement, it should be emphasized that Atrenta is deemed not to have a permanent establishment for as long as, in the course of the rendition of subject services, its employees do not stay in the Philippines for a period or periods aggregating more them 183 days for the same or connected project (and not in a given taxable year). Where the total number of days of stay in the Philippines by personnel rendering subject services do not exceed 183 days, the income derived by Atrenta from services rendered to Canon-Philippines shall not be subject to Philippine income tax and, consequently, to withholding tax. (BIR Ruling No. DA-ITAD 5-06 dated January 24, 2006) However, the electronic transfer of software from the non-resident supplier is importation of software and is subject to value-added tax (VAT) under Section 107 of the NIRC, as amended by Republic Act No. 9337 and Revenue Memorandum Circular No. 7-2006. Accordingly, Canon-Philippines being the direct importer of the downloadable software, is subject to 12% VAT and is required to withhold 12% VAT from its payments before it telegraphically transfers it to the account of the Atrenta . 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 Canon-Philippines shall be responsible for the withholding of the 10/12 percent VAT on the license fee before remitting it to Atrenta . In remitting to the Bureau of Internal Revenue the VAT withheld on such fee, Canon-Philippines shall use BIR Form No. 1600 (Monthly Remittance Return of VAT and Other Percentage Taxes Withheld). If a VAT-registered taxpayer, Canon-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. Canon-Philippines may include as part of the cost of the services provided to it by Atrenta the VAT consequently shifted or passed on to it and may treat such VAT either as expense or asset , whichever is applicable. In addition, Canon-Philippines is required to issue in quadruplicate the relevant Certificate of Final Tax Withheld at Source (BIR Form No. 2306), the first three copies for Atrenta and the fourth copy for Canon-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. 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. Republic Act No. 9337 new rate.