DA ITAD BIR Ruling No. 093-06

August 22, 2006 DA ITAD BIR RULING NO. 093-06 Articles 5 (Permanent Establishment), 7 (Business Profits) Philippines-United States of America tax treaty; BIR Ruling No. 14-06 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 Corcuera-Menzon Gentlemen : This refers to your letter dated June 29, 2006 requesting a ruling on the tax implication of the purchase of software by Canon Information Technologies Philippines, Inc. ( Canon-Philippines ) from Averant, Incorporated (Averant) pursuant to Article 8 in relation to Article 5 of the Philippines-United States of America (US) tax treaty. It is represented that Averant is a nonresident foreign corporation organized and existing under the laws of the United States of America with principal address at 1050 Marina Village Parkway #201 Alameda, CA 94501; that Averant 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 May 26, 2006 issued by the Securities and Exchange Commission (SEC); that Canon-Philippines is a corporation duly organized and existing under the laws of the Philippines with office address at 2nd Floor Techno 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. It is further represented that Canon-Philippines purchased a software product (Solidify-Maintenance) from Averant in the amount of $8,000.00 under Averant, Inc. Software License Agreement (Agreement); that Averant grants to Canon-Philippines a nonexclusive, non-transferable right to use the software on one computer system or on a network computer system, using only the number of nodes for which Canon-Philippines has a license and for which Canon-Philippines has the security key(s) or authorization code(s) provided by Averant or its agents; that all software must be used within the country for which the systems were licensed and must be located at a single site (within a one kilometer radius); that in addition, all authorized person(s) who access and use the software must be within the country for which the systems were licensed and must be located at a single site (within a three kilometer radius from the location of the software); that Canon-Philippines shall not copy the software, in whole or in part, except as necessary to archive such software in accordance with the terms and conditions contained herein; that all copies of the software will be subject to all of the terms and conditions of the Agreement; that whenever Canon-Philippines is permitted to copy all or any part of the software, all titles, trademark symbols, copyright symbols and legends and other proprietary markings must be reproduced; that Canon-Philippines may not copy any part of the documentation, nor modify, adopt, translate into any language, or create derivative works based on the documentation without the prior written consent of Averant ; that Canon-Philippines shall not sublicense, transfer or assign this Agreement or any of the rights or licenses granted under the Agreement without the prior written consent of Averant ; and that the term of the Agreement shall be for one year and shall be delivered through electronic keys. CSIcHA 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 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. 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. (emphasis supplied) 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 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 therefore are business income. "b. Transfer of copyrighted articles . (emphasis supplied) 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. 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. CSDTac "xxx xxx xxx" 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 royalties 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) 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 Averant, being business income (or business profits), is subject to income tax in the Philippines only if it is attributable to a permanent establishment which Averant has in the Philippines, under paragraph 1, Article 8 in relation to Article 5 of the Philippines-US 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 Averant 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) Since it appears, based on the SEC Certificate that Averant is not registered either as a corporation or as a partnership in the Philippines, that Averant 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, Averant is deemed as not having permanent establishment to which said business profit may be attributed. Thus, for as long as Averant 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. 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 Averant . With regard to the procedure for withholding and paying the VAT, pursuant to 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, Canon-Philippines shall be responsible for the withholding of the 10 percent/(12 percent effective February 1, 2006) VAT on the license fee before remitting it to Averant . 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 Averant 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 Averant and the fourth copy for Canon-Philippines as its file copy. acEHSI 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.