DA ITAD BIR Ruling No. 094-06

August 22, 2006 DA ITAD BIR RULING NO. 094-06 Arts. 5 & 7, Philippines-India Tax Treaty; Revenue Memorandum Circular No. 44-2005; BIR Ruling No. DA-ITAD 42-06 Bank of Makati, Inc. 44 Sen. Gil Puyat Avenue Brgy. San Isidro, Makati City Attention: Ponciano S. Carreon, Jr. Controller Gentlemen : This refers to your letter dated April 10, 2006 applying for tax treaty relief for payments made by Bank of Makati, Inc. (BMI) to Nucleus Software Exports Limited (Nucleus) based on the provisions of the Philippines-India tax treaty and Revenue Memorandum Circular No. 44-2005. From the documents submitted, it is represented that Nucleus is a nonresident foreign corporation and a resident of India for tax purposes as certified by the Indian Income Tax Authorities; that Nucleus registered office is located at 33-35 Thyagraj Nagar Market, New Delhi, India; that Nucleus is not registered either as a corporation or as a partnership in the Philippines as confirmed by the Certification of Non-Registration issued by the Securities and Exchange Commission on March 14, 2006; that BMI is a domestic corporation with office address at 44 Sen. Gil Puyat Avenue, Makati City. It is further represented that on December 29, 2005, BMI and Nucleus entered into a License Agreement (Agreement) whereby Nucleus grants BMI a perpetual, non-exclusive, non-transferable license to use its proprietary computer programs and associated materials listed under Exhibit A of the Agreement, solely for BMI's own internal processing and computing needs and for no other purpose; that BMI shall be entitled to use the software product in a productive mode only at installed site; that the license is for the use of the object code (including updates provided or otherwise generally available to Nucleus customers at no additional cost) and all related documentation, commencing upon its delivery to BMI; that the Agreement also provides that BMI shall not use, copy, translate, print or display the software products, in whole or in part, other than as expressly authorized; that BMI agrees not to reverse engineer, assemble or recompile any software product or portion thereof, which Nucleus has not provided in human-readable source code form; that BMI also agrees not to use the software products to provide service bureau, time-sharing, or other computer services to third parties; that BMI shall use the software products solely on computers owned or leased by it and for processing of data only for itself; that BMI shall not directly or indirectly permit any other person or entity to have access or use of the software products; that the software products contain or are based at least in part on software that is the valuable property of Nucleus and contain copyright, patent and trade secrets of Nucleus; that Nucleus shall continue to retain all title, copyright, patent and other propriety rights to such software and all copies thereof and end user and that BMI agrees to include on any backup or archival copies notices of any interests that appear therein; that no title to the software, or any intellectual property therein, is transferred to the end user; that BMI agrees not to sell, assign or otherwise transfer the products or the license granted hereunder, or sublicense the products to any third party except as otherwise provided in the Agreement; and that BMI paid the amount of US$500,000 to Nucleus for the purchase of the software products; and that the Agreement shall commence as of the Effective date and continue thereafter unless terminated as provided under the Agreement. 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 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. Transfers 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; CDTSEI 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 . 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. 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 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 (BMI) 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. Since under the Agreement, Nucleus merely grants to BMI a non-exclusive, non-transferable license to use the software and Nucleus retains its title and ownership, 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 (license fees) by BMI to Nucleus, being business income (or business profits), will be subject to income tax in the Philippines only if it is attributable to a permanent establishment which Nucleus has in the Philippines, under paragraph 1, Article 7 in relation to Article 5, both of the Philippines-India tax treaty, to wit: CcEHaI "Article 7 BUSINESS PROFITS 1. Business profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is 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 the business of the enterprise is wholly or partly carried on. 2. The term 'permanent establishment' includes especially: a) a place of management; b) a branch; c) an office; d) a factory; e) a workshop; f) a mine, an oil or gas well, a quarry or any other place of extraction of natural resources; g) a place of exploration of natural resources; h) a building site or construction project or supervisory activities in connection therewith, where such site, project or activity continues for a period of more than six months; i) a warehouse, in relation to a person providing storage facilities for others. xxx xxx xxx" Based on the foregoing, in order for Nucleus 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 Nucleus, 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, Nucleus does not have a permanent establishment to which its business profits may be attributed to. CHDTEA This is further bolstered by the fact that it is neither registered as a corporation nor as a partnership in the Philippines. Accordingly, for as long as Nucleus is deemed not to have a permanent establishment in the Philippines to which it may attribute any profits it earned from the sale of the software to BMI, said profits are not subject to Philippine income tax at 35% of the gross amount thereof under Section 28(B)(1) of the National Internal Revenue Code (NIRC) of 1997, as amended. 4 (BIR Ruling No. DA ITAD 42-06 dated April 11, 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. Accordingly, BMI, being the direct importer of the downloadable software, is subject to VAT and is required to withhold VAT from its payments to BMI. 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 BMI shall be responsible for the withholding of the VAT on the license fee before remitting it to Nucleus. In remitting to the Bureau of Internal Revenue the VAT withheld on such fee, BMI shall use BIR Form No. 1600 (Monthly Remittance Return of VAT and Other Percentage Taxes Withheld). If a VAT-registered taxpayer, BMI 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, BMI may include as part of the cost of the services provided to it by Nucleus the VAT consequently shifted or passed on to it and may treat such VAT either as expense or asset , whichever is applicable. In addition, upon Nucleus request, BMI is required to issue in quadruplicate the relevant Certificate of Final Tax Withheld at Source (BIR Form No. 2306), the first three copies for Nucleus and the fourth copy for BMI 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 An Act Amending Sections 27, 28, 34, 106, 107, 108, 109, 110, 111, 112, 113, 114, 116, 117, 119, 121, 148, 151, 236, 237 and 288 of the National Internal Revenue Code of 1997, As Amended, And For Other Purposes.