DA ITAD BIR Ruling No. 099-07

October 17, 2007 DA ITAD BIR RULING NO. 099-07 Article 12 (Royalties) Philippines-Australia tax treaty; Sections 28 (B) (4) and 108 (A) National Internal Revenue Code of 1997; BIR Ruling Nos. DA-229-06 and DA-ITAD 39-04 Sycip Gorres Velayo & Co. 6760 Ayala Avenue 1226 Makati City Attention: Atty. W. U. Villanueva Principal, Tax Services Gentlemen : This refers to your letter dated April 11, 2007, requesting confirmation that rental payments to be made by the branch office in the Philippines of Aristocrat (Philippines) Pty. Limited (hereinafter, Aristocrat Philippines ) to Aristocrat (Asia) Pty. Limited (hereinafter, Aristocrat Asia ) for the lease of electronic gaming machines are subject to 7.5% Philippine income tax based on the gross amount thereof, pursuant to Article 12 the Agreement between the Government of the Republic of the Philippines and the Government of Australia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (Philippines-Australia tax treaty) 1 in relation to Section 28 (B) (4) of the National Internal Revenue Code of 1997 (Tax Code of 1997) . BASIC FACTS It is represented that Aristocrat Asia and Aristocrat Philippines are corporations both organized and existing under the laws of Australia, with the same address at 71 Longueville Road, Lane Cove, Sydney, New South Wales, 2006, Australia; that Aristocrat Asia is a registered company under the Corporations Act 2001 and is taken to be registered in New South Wales, as evidenced by a Certificate of Registration of a Company dated July 15, 2005, issued by the Australian Securities and Investments Commission; that Aristocrat Asia is not registered as a corporation or as a partnership in the Philippines, as evidenced by a Certificate of Non-Registration of Corporation/Partnership dated April 2, 2007, issued by the Securities and Exchange Commission; that, on the other hand, Aristocrat Philippines, is licensed to establish a branch office in the Philippines, under Company Registration No. FS200603712, to sell and/or lease various types of gaming machines and equipment, games, systems, and associated products and services in the Philippines, as evidenced by a License to Transact Business in the Philippines dated March 31, 2006, issued by the Securities and Exchange Commission; and that this branch office is Aristocrat (Philippines) Pty. Limited Philippine Branch (hereinafter, Aristocrat Philippines Philippine Branch ), with address at the 12th Floor, Net One Center, 26th Street corner 3rd Avenue, Crescent Park West, Bonifacio Global City, Taguig, Metro Manila, Philippines. HcISTE It is also represented that on February 21, 2007, Aristocrat Asia and Aristocrat Philippines , acting through Aristocrat Philippines Philippine Branch , entered into a Lease Agreement (Agreement) whereby Aristocrat Asia appointed Aristocrat Philippines Philippine Branch as its exclusive Intellectual Property Rights 2 licensee in connection with the lease and sub-lease, maintenance and support of the Products in the Territory 3 in respect of Recurring Revenue; 4 that the Products are the Gaming Machines, 5 the Systems, 6 the Conversion Kits, 7 and any components, Parts, 8 accessories, fixtures or fittings of materials pertaining thereto, and including main boards; that under the Agreement, Aristocrat Asia grants Aristocrat Philippines Philippine Branch an exclusive and non-transferable right in the Territory solely in connection with Recurring Revenue: a) to lease the Products from Aristocrat Asia; b) to enter into sub-lease agreements with Customers 9 in the Territory; c) to perform Maintenance and Support Services 10 within the Territory; and d) to perform such other services as are agreed from time to time between the parties; that in consideration of the foregoing, Aristocrat Asia will invoice Aristocrat Philippines Philippine Branch on a monthly basis for the lease of the Products and Aristocrat Philippines Philippine Branch will pay such invoices in full demand; that Aristocrat Asia will invoice Aristocrat Philippines under the following Recurring Revenue Model: 1. Aristocrat Philippines Philippine Branch will be liable to pay a Rental Fee to Aristocrat Asia for each financial year in relation to a recurring revenue transaction entered into by Aristocrat Philippines Philippine Branch with Aristocrat Asia. 2. The Rental Fee payable will be based on the Gross Revenue derived by Aristocrat Philippines Philippine Branch under a recurring revenue transaction. The Rental Fee is equal to 50% of the Gross Revenue, unless other percentage is agreed upon between the parties. 3. No payment of the Rental Fee is required if the Gross Revenue is zero or negative. 4. Gross Revenue means those items relating to the recurring revenue model as characterized in Aristocrat Philippines Philippine Branch's financial statements using its accounting standards for a particular financial year. HEIcDT 5. Forecasted numbers will be used to calculate the Rental Fee payable throughout the financial year. 6. Aristocrat Philippines Philippine Branch will receive an arm's-length return for a financial year where its operating margin in relation to a recurring revenue for that financial year is between the Low Rate and the High Rate. If this is not the case, a Compensating Adjustment will be calculated. 7. The Rental fee is exclusive of value added tax (VAT). It is finally represented that the Agreement becomes effective on April 1, 2006, for an initial period of one year, unless earlier terminated; that after this initial period, the Agreement will be automatically renewed for a one-year period, unless either party gives notice of non-renewal at least sixty (60) days prior to any renewal date. RULING A. On income tax In reply, please be informed that the Rental Fee to be paid by Aristocrat Philippines Philippine Branch to Aristocrat Asia for the lease of the Products, generally comprising of gaming machines and other tangible objects associated therewith, are considered royalties as the same are "payments for the use of, or the right to use, any individual, commercial or scientific equipment" under paragraph 3 (b), Article 12 of the Philippines-Australia tax treaty, which provides: "Article 12 ROYALTIES 1. Royalties arising in one of the Contracting States, being royalties to which a resident of the other Contracting State is beneficially entitled, may be taxed in that other State. 2. Such royalties may also be taxed in the Contracting State in which they arise, and according to the law of that State. However, the tax so charged shall not exceed a) 15 per cent of the gross amount of the royalties where the royalties are paid by an enterprise registered with the Philippine Board of Investments and engaged in preferred areas of activities; and b) in all other cases, 25 per cent of the gross amount of the royalties. 3. Then term 'royalties' in this Article means payments or credits, whether periodical or not, and however described or computed, to the extent to which they are made as consideration for a) the use of, or the right to use, any copyright, patent, design or model, plan, secret formula or process, trademark, or other like property or right; b) the use of, or the right to use, any individual, commercial or scientific equipment; CIScaA c) the supply of scientific, technical, industrial or commercial knowledge or information; d) the supply of any assistance that is ancillary and subsidiary to, and is furnished as a means of enabling the application or enjoyment of, any such property or right as is mentioned in paragraph (a), any such equipment as is mentioned in paragraph (b) or any such knowledge or information as is mentioned in paragraph (c); e) the use of, or the right to use (i) motion picture films; (ii) films or video tapes for use in connection with television; or (iii) tapes for use in connection with radio broadcasting; or f) total or partial forbearance in respect of the use of a property or right referred to in this paragraph." With respect to taxation of royalties, paragraph 2 above states that royalties arising in the Philippines and derived by a resident of Australia are subject to Philippine income tax at the rate not exceeding (a) 15% of the gross amount of the royalties where they are paid by an enterprise registered with the Philippine Board of Investments and engaged in preferred areas of activities, or (b) 25% of the gross amount of the royalties, in all other cases. Accordingly, the Rental Fee to be paid by Aristocrat Philippines Philippine Branch to Aristocrat Asia is subject to Philippine income tax at a rate not exceeding 25% of the gross amount thereof. The Rental Fee cannot be subject to the lower rate not exceeding 15% because Aristocrat Philippines (Philippine Branch), the enterprise paying the royalties in this case, is not registered with the Philippine Board of Investments and engaged in preferred areas of activities. However, because the rates mentioned in paragraph 2 are the maximum rates which the country of source can impose on royalties, the Philippines, being the country of source in this case, provides under its domestic law for an even lower rate of income tax of 7 1/2% on rentals of equipment including rentals, charters and other fees of aircraft and machineries, based on the gross amount thereof. Section 28 (B) (4) of the Tax Code of 1997, as amended by Republic Act No. 9337, 11 provides: "SEC. 28. Rates of Income Tax on Foreign Corporations . xxx xxx xxx (B) Tax on Nonresident Foreign Corporation. xxx xxx xxx (4) Nonresident Owner or Lessor of Aircraft, Machineries and Other Equipment. Rentals, charters and other fees derived by a nonresident lessor of aircraft, machineries and other equipment shall be subject to a tax of seven and one-half percent (7 1/2%) of gross rentals or fees." SDITAC We note that the Rental Fee is a payment for the rental of the Products under the Agreement and for the use of, or the right to use, certain intangible properties resulting from Aristocrat Philippines Philippine Branch leasing and sub-leasing of and providing maintenance and support for such Products in the Territory. Under the Agreement, these intangible properties were referred to as patents, trade marks, copyright, design, domain name, circuit layout rights and other proprietary rights. Thus, the question arises whether the 7 1/2% tax rate under the Tax Code of 1997 or the 25% tax rate under the Philippines-Australia tax treaty shall be applied in the instant case. In this connection, the commentaries in the Model Tax Convention on Income and on Capital (Condensed Version, July 15, 2005), published by the Organisation for Economic Cooperation and Development, provides the following guide on the characterization of payments involved in mixed contracts, to wit: "11.6. In business practice, contracts are encountered which cover both know-how and the provision of technical assistance. One example, amongst others, of contracts of this kind is that of franchising, where the franchisor imparts his knowledge and experience to the franchisee and, in addition, provides him with varied technical assistance, which, in certain cases, is backed up with financial assistance and the supply of goods. The appropriate course to take with a mixed 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 consideration 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. 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." 12 Applying the above commentaries to the Rental Fee, there is no doubt that the use of, or the right to use, the Products (equipment) constitutes by far the principal purpose of the Agreement, and the use of, or the right to use, certain intangible properties involved in the Products are only of an ancillary and largely unimportant character so that the Rental Fee should be generally characterized as payments for the use of, or the right to use, any individual, commercial or scientific equipment. This being the case, the Rental Fee should therefore be subject to income tax at the rate of 7 1/2% based on the gross amount thereof pursuant to Section 28 (B) (4) of the Tax Code of 1997, as amended by Republic Act No. 9337. (BIR Ruling No. DA-ITAD 39-04 dated April 28, 2004 and DA-229-06 dated April 11, 2006.) B. On VAT Finally, the Rental Fee is subject to VAT under Section 108 (A) of the Tax Code of 1997, as amended by Republic Act No. 9337, which provides: "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: ESTcIA (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%). 13 . . . The phrase 'sale or exchange of services' shall likewise include: xxx xxx xxx (2) The lease or the use of, or the right to use of any industrial, commercial or scientific equipment;" (BIR Ruling No. DA-ITAD 39-04 dated April 28, 2004 and DA-229-06 dated April 11, 2006.) With regard to the procedures for withholding and paying the VAT, pursuant to Sections 4 and 6 of Revenue Regulations No. 4-2002, Section 3 of Revenue Regulations No. 8-2002, and Section 7 of Revenue Regulations No. 14-2002, Aristocrat Philippines Philippine Branch shall be responsible for the withholding of VAT on the Rental Fee before remitting it to Aristocrat Asia. In remitting to the Bureau of Internal Revenue the VAT withheld, Aristocrat Philippines Philippine Branch shall use BIR Form No. 1600 (Monthly Remittance Return of VAT and Other Percentage Taxes Withheld). If it is a VAT-registered taxpayer, Aristocrat Philippines Philippine Branch may use as documentary substantiation for its claim of input VAT the duly file BIR Form No. 1600 and the proof of payment accompanying such form. On the other hand; if it is a non-VAT-registered taxpayer, Aristocrat Philippines Philippine Branch may include as part of the cost of the Products (equipment) leased to it by Aristocrat Asia the VAT consequently shifted or passed on to it by Aristocrat Asia and may treat such VAT either as expense or asset, whichever is applicable. In addition, Aristocrat Philippines Philippine Branch is required to issue the Certificate of Final Tax Withheld at Source (BIR Form No. 2306) in quadruplicate, the first three copies for Aristocrat Asia and the fourth copy for Aristocrat Philippines Philippine Branch 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 actual facts are different, then this ruling shall be without force and effect insofar as the herein parities are concerned. Very truly yours, Commissioner of Internal Revenue By: (SGD.) GREGORIO V. CABANTAC Deputy Commissioner Legal and Inspection Group Footnotes 1. Signed on May 11, 1979, and became effective on January 1, 1980. 2. Intellectual Property Rights includes the Patents, the Trade Marks, the Copyright and (a) all other rights in the nature of patent, copyright design, domain name, trade mark, service mark, trade name, circuit layout rights and other proprietary rights; (b) applications and registrations thereof, all rights identified in Article 2 of the Convention Establishing the World Intellectual Property Organisation, as amended in September 28, 1979; and (c) all rights to the registration of such rights wherever such rights exist in the world, comprising or related to the Products. ECcDAH Patents means the granted patents and patent applications owned by Aristocrat Asia or its licensors and rights of a similar nature that relate to the Products, equipment to manufacture the Products or the process according to which the Products are made filed in the Territory, patents issuing from those patent applications, claims of all patent applications and of the resultant patents that are directed to the subject matter described in the patents and/or patent applications specified in this definition, and any re-issues, continuations, divisional applications, supplemental disclosures or extensions of any patents or patent applications specified in this definition. Trade Marks means the trade marks owned by Aristocrat Asia or its licensors in the Territory relating to the Products, components of the Products, or services relating to the Products. Copyright means all rights of copyright owned by Aristocrat Asia or its licensors in the Territory which relate to the Products, including but not limited to such rights in Software, artistic, musical and literary works, and cinematograph films comprising or related to the Products. Software means any program or series of programs, containing instructions for a computer required either for the operational processes of the computer itself or for the accomplishment of other tasks. 3. Territory means the Philippines or such other territory as may be agreed between the parties from time to time. 4. Recurring Revenue means a revenue model where a Product (e.g., a Gaming Machine), is leased or sub-leased to a Customer. Ownership of the leased Product at all times remains with Aristocrat Asia and title is never transferred to the Customer. 5. Gaming Machine means an electronic gaming machine or other electronic gaming device (including tables with software embedded within the machine to make this operational and includes the Game. Game means an electronic gaming machine or other electronic gaming device supplied under the Agreement consisting of the Software and firmware expressing the machine game and associated artwork. 6. System means a combination of hardware (including computer equipment) and Software (including third party software) which operates and maintains a network connection between gaming machines and other devices (including, for example, gaming machines and a table) and a central computer. System includes the system known as Dacom. 7. Conversion Kits means a kit consisting of components of electronic gaming machines, associated hardware, software and artwork sold, hired or otherwise provided for the purpose of enabling an existing electronic gaming machine to be used for the playing of new or updated Games. 8. Parts means any components, parts, accessories, fixtures or fittings of materials which are part of a Gaming Machine or Conversion Kits and includes main boards. 9. Customer means any person within the Territory to whom Aristocrat Philippines (Philippine Branch) has leased or intends to lease the Gaming Machines, and also includes such persons outside the Territory where the context requires this meaning. 10. Maintenance and Support Services means maintenance and support services including but not limited to account management, training, installation, product delivery and product maintenance and support. 11. Entitled 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, signed on May 24, 2005, and became effective on November 1, 2005. 12. Page 182. 13. The VAT rate was increase 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.