DA ITAD BIR Ruling No. 156-06

December 13, 2006 DA ITAD BIR RULING NO. 156-06 Articles 5 (Permanent Establishment), 8 (Business Profits) Philippines-United States of America tax treaty; Revenue Memorandum Circular No. 44-05; BIR Ruling No. DA-ITAD 91-06 Regalado Bautista & Menzon Law Offices Suite 710 City & Land Mega Plaza ADB Ave. corner Garnet Street Ortigas, Pasig City Attention: Atty. Edith Abana-Bautista Gentlemen : This refers to your letter dated March 16, 2006 requesting a ruling on the tax implication on the purchase of a software (C++ Test Professional Edition-Windows Node Lock License) by Canon Information Technologies Philippines, Inc. (Canon-Philippines) from Parasoft Corporation (Parasoft) It is represented that Parasoft is a nonresident foreign corporation, organized and existing under the laws of the United States of America, with principal office at 101 E. Huntington Dr., 2nd Floor Monrovia, CA 91016 USA as shown in the Certificate of Status Domestic Corporation issued by Mr. Bill Jones, Secretary of State of California; that Parasoft 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 November 23, 2005 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 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. aEIADT It is further represented that Canon-Philippines purchased a software (C++ Test Professional Edition-Windows Node Lock License) from Parasoft under an End User Software License Agreement (Agreement) where Parasoft grants to Canon-Philippines a non-exclusive, non-transferable license to use the software but not to sell, transfer, or sublicense the software; that Canon-Philippines is authorized to install, use, display, and operate the software product for its own internal use, on the specific set of computer hardware and operating system on which the software is designed to run; that Canon-Philippines is authorized to make one (1) copy of the original recorded media provided by Parasoft for archival purposes or as part of Canon-Philippines normal system backup procedures; that each archival copy shall display the same program name, serial number, version number, copyright and trademark, notices as the original licensed copy provided by Parasoft ; that Parasoft shall retain title and ownership of the software and all portions thereof and all applicable rights in patents, copyrights and trade secrets in the software; that Parasoft will also provide Canon-Philippines the necessary maintenance services under Exhibit B (Software Maintenance Services and Updates) of the Agreement for a period of one year automatically renewable on a year to year basis unless terminated in writing; that the Software Maintenance Services includes the response to and resolution of encountered Errors in the Software by telephone, electronic mail, fax or delivery of Error Corrections, Enhancements, Updates and Releases; that the maintenance shall be within reasonable limits, as determined by Parasoft , and does not include requests for basic product training or technical consulting; that the provision of services shall be performed outside the Philippines as confirmed by the Certification issued by Canon-Philippines; and that as consideration for the purchase of software and for the maintenance services, Canon-Philippines will pay Parasoft $3,495.00 US Dollars and $700.00, respectively, inclusive of freight and other miscellaneous charges payable within 60 days from date of invoice. 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: aATHES "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. 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) cHaADC 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 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. If should be noted that under the same Agreement, Parasoft will also provide Canon-Philippines the necessary maintenance services. Thus, in accordance with the aforequoted Section 5c of the RMC No. 44-2005, the subject Agreement should be characterized by breaking down the same into the portion which represents the use of the software and the portion which pertains to the provision of services. As to the portion of the Agreement referring to the use of the software, it being clear that Parasoft merely grants to Canon-Philippines a non-exclusive, non-transferable license to use the software but not to sell, transfer, or sublicense the software, the payments of Canon-Philippines , being an end-user, to Parasoft shall be considered as business profits. Thus, payments (license fee) by Canon-Philippines to Parasoft that would be made 60 days from January 17, 2006, being business income (or business profits), will be subject to income tax in the Philippines only if they are attributable to a permanent establishment which Parasoft has in the Philippines, under paragraph 1, Article 8 in relation to Article 5 of the Philippines-United States 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." "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; DHESca 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 Parasoft 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 Parasoft , 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 carry on its business, Parasoft does not have a permanent establishment to which its business profits may be attributed to. This is further bolstered by the fact that it is neither registered as a corporation nor as a partnership in the Philippines. This being so, the business profits earned by Parasoft from its sale of the subject software to Canon-Philippines shall not be subject to Philippine income tax. On the other hand, as to the portion of the Agreement referring to the provision of services, the payments of Canon-Philippines shall be considered as income from sources without the Philippines under Section 42(C)(3) of the National Internal Revenue Code (Tax Code) of 1997. (BIR Ruling No. DA-ITAD 91-06 dated August 14, 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 Tax Code of 1997, 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 Parasoft . THDIaC 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 Canon-Philippines shall be responsible for the withholding of the 12 percent VAT on the license fee before remitting it to Parasoft . 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 Parasoft 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 Parasoft and the fourth Copy for Canon-Philippines 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.