DA ITAD BIR Ruling No. 139-06

November 8, 2006 DA ITAD BIR RULING NO. 139-06 Articles 5 (Permanent Establishment), 7 (Business Profits) Philippines-Germany tax treaty; BIR Ruling No. DA-ITAD 93-06 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 August 10, 2006 on behalf of your client, Canon Information Technologies Philippines, Inc. ( Canon-Philippines ),requesting a ruling on the tax implication of the purchase of software by Canon-Philippines from Gentleware AG ( Gentleware-Germany ) pursuant to Article 7 of the Philippine Germany tax treaty. It is represented that Gentleware-Germany is a nonresident foreign corporation, organized and existing under the laws of Germany, with principal office at Ludwigstr. 12, 20357 Hamburg, Germany; that Gentleware-Germany 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 August 9, 2006 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 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 Poseidon for UML Standard Edition 4.x (software) from Gentleware-Germany ;that under the Gentleware Single User License Terms and Conditions (Agreement), Gentleware-Germany grants to Canon-Philippines a nonexclusive, nontransferable, perpetual, limited right and license to: a) permit Licensed Developers to install and use the Licensed Software, on per product or per module basis, for the sole purpose of creating Applications; b) copy or have copied the Licensed Software as necessary for the purpose of exercising the rights granted under this Section 2 for back-up or disaster recovery purposes, provided, that Gentleware's copyright notice and other proprietary rights notices are reproduced on each copy. That Canon-Philippines may not, nor may permit any other person or entity to use, copy, modify, or distribute the Licensed Software (electronically or otherwise),or any copy, adaptation, transcription, or merged portion thereof, or the Documentation except as expressly authorized by Gentleware-Germany ;that Canon-Philippines may not modify or port the Licensed Software to operate on platforms other than those for which it has paid the appropriate fees; that Canon-Philippines may not, nor may permit any other person or entity to, reverse assemble, reverse compile, or otherwise translate any binary forms of the licensed Software, except to the extent applicable laws specifically prohibit such restriction; that Canon-Philippines ' rights may not be transferred, leased, assigned, or sublicensed except for a transfer of the License Agreement in its entirety to (1) a successor in interest of Canon-Philippines ' entire business who assumes the obligations of this License Agreement or (2) any other party who is reasonably acceptable to Gentleware-Germany ,enters into a substitute version of this License Agreement, and pays an administrative fee intended to cover attendant costs; that no service bureau work, multiple-user license, or time-sharing arrangement is permitted, except as expressly authorized by Gentleware-Germany ;that if Canon-Philippines uses, copies, or modifies the Licensed Software or transfers possession of any copy, adaptation, transcription, or merged portion thereof to any other party in any way not expressly authorized by Gentleware-Germany ,all licenses under this License Agreement are automatically terminated; that Gentleware-Germany shall have the sole and exclusive ownership of all right, title, and interest in and to the Licensed Software and all modifications and enhancements thereof (including ownership of all trade secrets and copyrights pertaining thereto),subject only to the rights and privileges expressly granted to Canon-Philippines ;that this License Agreement does not provide Canon-Philippines with title or ownership of the Licensed Software, but only a right of limited use; that the consideration for the purchase of the software is $2,241.00; 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. DaHISE In reply please be informed as follows: Concerning software payments, the Human 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 .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 therefor are business income. "b. Transfer of copyrighted articles .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. "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 Gentleware-Germany ,being business income (or business profits),is subject to income tax in the Philippines only if it is attributable to a permanent establishment which Gentleware-Germany has in the Philippines, under paragraph 1, Article 7 in relation to Article 5 of the Philippines-Germany tax treaty, to wit: ScAHTI "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 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" "Article 5 PERMANENT ESTABLISHMENT 1. For the purposes of this Agreement, 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' shall include specially: a) a place of management; b) a branch; c) an office; d) a factory; e) a workshop; f) a warehouse, in relation to a person providing storage facilities for others; g) a mine, quarry or other place of extraction of natural resources; h) a building site or construction or assembly project or supervisory activities in connection therewith, where such site, project or activity continues for a period of more than six months; xxx xxx xxx" Based on the foregoing, in order for Gentleware-Germany 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 Gentleware-Germany is not registered either as a corporation or as a partnership in the Philippines, that Gentleware-Germany 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, Gentleware-Germany is deemed as not having permanent establishment to which said business profits may be attributed to. Thus, for as long as Gentleware-Germany 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. (BIR Ruling No. DA-ITAD 93-06 dated August 22, 2006) However, the electronic transfer of software from the nonresident supplier is importation of software and is subject to value-added tax (VAT) under Section 107 of the National Internal Revenue Code, 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 Gentleware-Germany . With regard to the procedures for withholding and paying the VAT, Canon-Philippines shall be responsible for the withholding of the 10 percent/(12 percent effective February 1, 2006) VAT on the license fee before making any payment to Gentleware-Germany .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 purchased software provided to it by Gentleware-Germany 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 Gentleware-Germany and the fourth copy for Canon-Philippines 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. DIESaC 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.