DA ITAD BIR Ruling No. 129-06

October 27, 2006 DA ITAD BIR RULING NO. 129-06 Arts. 5 & 7, Philippines-Singapore tax treaty; BIR Ruling No. DA-ITAD 91-06 Sycip Gorres Velayo & Co . 6760 Ayala Avenue 1226 Makati City Attention: Atty. Romulo S. Danao, Jr. Partner, Tax Services Gentlemen : This refers to your letter dated June 28, 2006 requesting confirmation on the following Philippine tax implications arising from the Service Level Agreement (Agreement) which your client, Sony Philippines, Inc. (SPI) entered into with Sony Electronics Asia Pacific Pte. Ltd. (SEAP): 1. The income payments to be made by SPI to SEAP in consideration for the services to be provided pursuant to the Agreement are service fees and not royalties as defined under Article 12 paragraph 3 of the Philippines-Singapore tax treaty; 2. Since SEAP does not carry on business in the Philippines through a permanent establishment as defined under Article 5 in relation to Article 7 of the Philippine-Singapore tax treaty, the income payments it receives from SPI are business profits of SEAP which should not be subject to Philippine income tax and consequently, to withholding tax; 3. The income payments are likewise not subject to value-added tax (VAT) since the services will be performed by SEAP outside the Philippines, pursuant to Section 108(A) of the 1997 Tax Code, as amended. It is represented that SEAP (formerly Sony Marketing Asia Pacific Pte. Ltd.) is a nonresident foreign corporation organized and existing under the laws of Singapore with principal office address at No. 2 International Business Park, #01-10 Tower One, The Strategy, Singapore 609930 as shown in the Memorandum and Articles of Association of SEAP; that SEAP is not registered either as a corporation or as a partnership in the Philippines as confirmed by the Certificate of Non-Registration of Corporation/Partnership issued by the Securities and Exchange Commission on April 10, 2006; that SPI, on the other hand, is a company organized and existing under the laws of the Philippines with principal office at 26th Floor, The Enterprise Center, Tower 1, 6766 Ayala Avenue corner Paseo de Roxas Street, Makati City. It is further represented that on April 3, 2006, SEAP and SPI entered into a Service Level Agreement (Agreement) whereby the former agreed to provide to the latter the following services: cSIADa 1. System Support Provide the SIMPLE system covering the following application modules SD, MM, FI & Co. 2. Business Operation Support Maintain and upkeep common business process and Process Definition Document (PDD); Maintain system user guide; Evaluate process and system change requests, co-ordinate process and system change control; 3. Application Support and Maintenance Troubleshooting and resolution of 'application problems'. Note that "application problems' refers to the failure of the application to provide correct output or correct results in accordance with its intended design. Troubleshooting and resolution of Customer's on-line screen errors, output printing errors and report errors; Troubleshoot data transmission and interface problems with EAI, local staging and other linked systems 4. Daily System Operation Support Provide monthly/weekly system offline backup and daily online backup for production server; Coordination with Customer and other sales companies on planned down-time to minimize system and operation impact; Coordination and scheduling of registered production jobs. Preparation and processing job parameter changes and Customer ad-hoc job requests for registered jobs; System load balancing and performance monitoring; Perform user ID registration and system authorization changes; 5. Provision of Helpdesk Services Helpdesk will be provided to the Customer as single point of contact. The Helpdesk will provide the following services: An assigned resolution engineer will respond within 1 hour of the initial incident logged. After Vendor official working hours, the response is within 4 hours; Vendor will apply established escalation processes and procedures to provide an increased level of technical and management resources to resolve the problem in an orderly and timely manner; Ensure all incidents are closed promptly; Monitoring, logging and management of all incidents raised; cTEICD Maintain knowledge database of frequent problems encountered. That the Agreement covers the system application, support and maintenance services of the SIMPLE system; that SIMPLE system is a shared SAP system that supports a few Sony sales companies in Pan Asia region; that the system will automate certain back-office business functions of SPI such as sales and distribution, materials management, financial management and controlling, so as to ensure the smooth running of the critical business operations of SPI; that in consideration for the foregoing services, SPI will pay SEAP service fees in accordance with the schedule provided in the Agreement; that the termination of the contract should be carried out in writing and informed to Vendor one (1) month in advance; that the services shall be performed outside the Philippines except in cases when it is necessary that SEAP shall provide onsite services to SPI provided that such onsite services or related activities in the Philippines shall not continue for a period or periods aggregating more than 183 days; 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. 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 terms '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: EaHDcS 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 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) IASTDE 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 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. Thus, fees for the software and services made under the Agreement by SPI to SEAP are business profits which will be taxed in the Philippines in accordance with Article 7 of the Philippine-Singapore tax treaty, which provides: "Article 7 BUSINESS PROFITS 1. The 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 or has carried on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment. xxx xxx xxx." Based on the foregoing, the profits of a Singapore enterprise shall be taxable only in Singapore unless such enterprise carries on business in the Philippines through a permanent establishment situated therein. If the Singapore enterprise carries on business as aforesaid, the profits of such enterprise may be taxed in the Philippines but only so much of them as is attributable to that permanent establishment. Applying this to the instant case, the service fees received by SEAP for the services rendered in the Philippines under the Service Level Agreement shall be taxable in the Philippines in connection with the activities giving rise to such income only if it has a permanent establishment in the Philippines. In relation thereto, Article 5 of the Philippines-Singapore tax treaty provides: "Article 5 PERMANENT ESTABLISHMENT 1. For the purposes of this Convention, the term "permanent establishment" means a fixed place of business in which the business of the enterprise is wholly or partly carried on. 2. The term "permanent establishment" includes specially but is not limited to: a) A seat of management, b) A branch; c) An office; DSAEIT d) A store or other sales outlet; e) A factory; f) A workshop; g) A warehouse, in relation to a person providing storage facilities for others; h) A mine, quarry, or outer place of extraction of natural resources; i) A building site or construction or assembly project or installation project or supervisory activities in connection therewith, provided such site, project or activity continues for a period 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." Inasmuch as the Agreement does not expressly provide for a specific term, the whole of such Agreement, including any continuance and renewal thereof, shall be regarded as being part of the "same or connected project" for the purpose of counting the aggregate period of 183 days above. In other words, the 183 day period shall be counted based on the total number of days the services are rendered in the Philippines beginning the effectivity of the Agreement, including all periods resulting from its continuance and renewal. Accordingly, for as long as the employees or agents of SEAP do not stay in the Philippines for a period or periods aggregating more than 183 days in the course of their rendition of services to SPI for the "same or connected project", then SEAP is deemed not to have a permanent establishment in the Philippines to which payment of the service fees may be attributed to and therefore, exempt from Philippine income tax. (BIR Ruling No. DA-ITAD 91-06 dated August 14, 2006) Moreover, while the compensation for services rendered outside the Philippines is not subject to the 12% VAT, the fees paid for that portion of the services of SEAP which are rendered in the Philippines are, however, subject to 12% VAT pursuant to Section 108 of the Tax Code of 1997, as amended by Republic Act (RA) No. 9337. Accordingly, SPI, being the resident withholding agent and payor in control of payment shall be responsible for the withholding of the 12% final VAT on such fees before making any payment to SEAP. In remitting the VAT withheld, SEAP shall use the BIR Form No. 1600 (Monthly Remittance Return of Value-Added Tax & Other Percentage Taxes Withheld). The duly filed BIR Form No. 1600 and proof of payment thereof shall serve as documentary substantiation for the claim of input tax to be applied against the output tax that may be due from SPI if it is a VAT-registered taxpayer. In case SPI is a non-VAT registered taxpayer, the passed-on VAT withheld shall form part of the cost of the service purchased or treated as an "expense" or as an "asset", whichever is applicable. In addition, SPI is required to issue in quadruplicate the relevant Certificate of Final Tax Withheld at Source (BIR Form No. 2306), the first three copies for SEAP and the fourth copy for SPI as its file copy. [Section 4.110-3(b), Revenue Regulations (RR) No. 7-95, as amended by RR Nos. 4-02, 8-02, and 14-02 (now Section 4, 114-2(b), RR No. 16-05); Section 4.114(D), RR No. 2-98, as last amended by RR No. 28-03] 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. SHEIDC 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.