Sycip Gorres Velayo & Co.

January 21, 2022 ITAD BIR RULING NO. 001-22 Article 13 (2) (b) (i) and (iii) of the Philippines-United States of America Tax Treaty, in relation to Article 12 (2) (a) of the Philippines-Czech Republic Tax Treaty, Sections 28 (B) (1), 32 (B) (5), 105 and 108 of the Tax Code Sycip Gorres Velayo & Co. 6760 Ayala Avenue 1226 Makati City Gentlemen : This refers to your tax treaty relief application that was filed on January 13, 2012 requesting confirmation that the royalties paid by Mead Johnson Nutrition (Philippines),Inc. (MJ PH) to Mead Johnson & Company LLC (MJ US) are subject to the preferential income tax rate of 10% pursuant to the most favored nation (MFN) clause under Article 13 (2) (b) (iii) of the Convention between the Government of the Republic of the Philippines and the Government of the United States of America with Respect to Taxes on Income (PH-US Tax Treaty), in relation to Article 12 (2) (a) of the Convention between the Republic of the Philippines and the Czech Republic for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (PH-Czech Tax Treaty). MJ US is a foreign corporation duly organized and existing under the laws of the United States of America (US) based on its Limited Liability Company Agreement and a resident thereof based on the Certificate of Residence duly issued by the Internal Revenue Service of the US. It is engaged in the following industries: other food manufacturing, pharmaceutical and medicine manufacturing, fruit and vegetable preserving and specialty food manufacturing, food preparations, pharmaceutical preparations, and canned specialties. 1 It is not registered as a corporation in the Philippines nor licensed to do business in the Philippines per the Certification of Non-Registration of Company duly issued by the Securities and Exchange Commission. On the other hand, MJ PH is a domestic corporation engaged in providing nutritional and pediatric feeding solutions. 2 On January 1, 2011, MJ PH and MJ US entered into a Business Process and Operating Systems Design and Implementation Cost Recharge Agreement (Agreement) whereby MJ US shall, on an annual basis, recharge to MJ PH a portion of the total cost incurred by MJ US under the SAP License and Services Agreements and the Master Services Agreement (the SAP Cost),based on methodology that includes specific cost allocation keys, consideration for MJ PH's business model and valuation components. The allocated cost shall be evidenced by an invoice submitted by MJ US to MJ PH, which will be generated annually beginning December 2011, payable within sixty (60) days following the invoice date, and payable to MJ US's bank account in the US. The Agreement shall remain in force until the expiration of the cost allocation period. Under the SAP License and Services Agreements executed on March 31, 2009, SAP America, Inc. granted MJ US and its affiliates, including MJ PH, the right to use the following business process outsourcing software systems and components (hereinafter referred to as SAP system): 1. SAP Enterprise Core Component; 2. SAP Supply Chain Management; 3. SAP Global Trade Solution; 4. SAP Global Regulatory and Compliances; 5. SAP Process Integration; 6. SAP Supplier Relationship Management; 7. SAP Supplier Network Collaboration; 8. SAP Business Intelligence; 9. SAP Supplier Self Services; 10. SAP Business Planning and Consolidations; 11. SAP Solution Manager; 12. SAP Partner Applications, including Vertex (for sales and use taxes) and Vistex (for incentives, rebates and chargebacks). The SAP system provides benefit to the MJ Group of Companies across all business modules including manufacturing, order to cash, general ledger, BPC consolidation, and procure to pay. In order to determine an equitable allocation, each module was evaluated based on development complexity and business span. The following methodologies were used to segment SAP costs between MJ US and its affiliates: 1. estimate of total project cost (capital and expense) paid by MJ US for all the US-related SAP expenses, as well as for the costs incurred on behalf of all other affiliates; 2. breakdown of SAP services costs into operational business buckets or modules; 3. rational between splitting the total SAP costs between modules: a) Manufacturing 20% b) Order to Cash 20% c) General Ledger 20% d) BPC Consolidation 20% e) Procure to Pay 20%; 4. basis for further allocation of SAP costs associated with specific modules between affiliates: a) Manufacturing allocated based on cost of products sold b) Order to Cash allocated based on distribution and finance users c) General Ledger allocated based on finance users d) BPC Consolidation allocated to the US only e) Procure to Pay allocated based on all SAP users; and 5. validation of the allocation methodology. RULING In reply, please be informed that under Section 28 (B) (1) of the National Internal Revenue Code of 1997 (Tax Code), as amended, royalty income derived by a nonresident foreign corporation from sources within the Philippines is generally subject to income tax at the rate of 30%, except to the extent required by any treaty obligation binding upon the Government of the Philippines: SEC. 28. Rates of Income Tax on Foreign Corporations. xxx xxx xxx (B) Tax on Nonresident Foreign Corporation. (1) In General. Except as otherwise provided in this Code, a foreign corporation not engaged in trade or business in the Philippines shall pay a tax equal to thirty-five percent (35%) of the gross income received during each taxable year from all sources within the Philippines, such as interests, dividends, rents, royalties, salaries, premiums (except reinsurance premiums), annuities, emoluments or other fixed or determinable annual, periodic or casual gains, profits and income, and capital gains, except capital gains subject to tax under subparagraph 5(c) and (d) above: Provided, That effective 1, 2009, the rate of income tax shall be thirty percent (30%). 3 SEC. 32. Gross Income. xxx xxx xxx (B) Exclusions from Gross Income. The following items shall not be included in gross income and shall be exempt from taxation under this Title: xxx xxx xxx (5) Income Exempt under Treaty. Income of any kind, to the extent required by any treaty obligation binding upon the Government of the Philippines. xxx xxx xxx Relative thereto, Article 13 (2) (b) of the PH-US Tax Treaty states that royalties arising in the Philippines and paid to a US resident, except those paid by a corporation registered with the Philippine Board of Investments and engaged in preferred areas of activities, are subject to tax at 25% or at the lowest tax rate of Philippine tax that may be imposed on royalties of the same kind paid under similar circumstances to a resident of a third state, thus: Article 13 ROYALTIES 1. Royalties derived by a resident of one of the Contracting States from sources within the other Contracting State may be taxed by both Contracting States. 2. However, the tax imposed by that other Contracting State shall not exceed a) In the case of the United States, 15 percent of the gross amount of the royalties, and b) In the case of the Philippines, the least of: (i) 25 percent of the gross amount of the royalties, (ii) 15 percent of the gross amount of the royalties, where the royalties are paid by a corporation registered with the Philippine Board of Investments and engaged in preferred areas of activities, and (iii) the lowest rate of Philippine tax that may be imposed on royalties of the same kind paid under similar circumstances to a resident of a third State. 3. The term "royalties" as used in this Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literacy, artistic or scientific work ,including cinematographic films or films or tapes used for radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or other like right or property, or for information concerning industrial, commercial or scientific experience. The term "royalties" also includes gains derived from the sale, exchange or other disposition of any such right or property which are contingent on the productivity, use, or disposition thereof. (Emphasis supplied) xxx xxx xxx The most favored nation clause under Article 13 (2) (b) (iii) of the PH-US Tax Treaty speaks of the lowest rate of Philippine tax that may be imposed on royalties of the same kind paid under similar circumstances to a resident of a third State. As a basis for the MFN treatment, MJ US invoked Article 12 (2) (a) of the PH-Czech Tax Treaty, which provides that royalties arising from the use of, or the right to use, any copyright of literary, artistic or scientific work in the Philippines and paid to a resident of the Czech Republic may be taxed in the Philippines at a rate not exceeding ten percent (10%), viz. : Article 12 ROYALTIES 1. Royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State. 2. However, such royalties may also be taxed in the Contracting State in which they arise and according to the laws of that State, but if the beneficial owner of the royalties is a resident of the other Contracting State, the tax so charged shall not exceed: a) 10 per cent of the gross amount of the royalties arising from the use of, or the right to use, any copyright of literary, artistic or scientific work ,other than that mentioned in sub-paragraph (b),any patent, trade mark, design or model, plan, secret formula or process, or from the use of, or the right to use, industrial, commercial or scientific equipment, or for information concerning industrial, commercial or scientific experience; b) 15 per cent of the gross amount of the royalties arising from the use of, or the right to use, any copyright of cinematograph films, and films or tapes for television or radio broadcasting. The competent authorities of the Contracting States shall by mutual agreement settle the mode of application of these limitations. (Emphasis supplied) Based on the foregoing treaty provisions, the tax treatment of the royalties paid to MJ US may be taken in relation to the PH-Czech Tax Treaty that provides a lower tax rate on the same type of income if the conditions set forth under the PH-US Tax Treaty have been fully satisfied. In Commissioner of Internal Revenue vs. S.C. Johnson and Son, Inc. , 4 the Supreme Court construed the phrase "paid under similar circumstances" under the most-favored-nation clause as referring to circumstances that are tax-related. In other words, the similarity in the circumstances of payment of taxes on the royalties derived from the Philippines is a condition for the enjoyment of the most favored nation treatment. Moreover, in the recent case of Cargill Philippines, Inc. vs. Commissioner of Internal Revenue (Cargill case) , 5 the Court laid down the two conditions that must be met for the most favored nation clause to apply: (1) similarity in subject matter, i.e. ,royalties derived from the Philippines by a resident of the US and of the third state must be of the same kind or class; and (2) similarity in circumstances in the payment of tax, i.e. ,the tax consequences of royalty payments under the two treaties must be under similar circumstances. This requires a showing that the method employed for eliminating or mitigating the effects of double taxation under the treaty with the US and the third state are the same. In this case, it is undisputed that the first condition was satisfied. Both Article 13 (3) of the PH-US Tax Treaty and Article 12 (2) (a) of the PH-Czech Tax Treaty cover royalties for the use of, or the right to use, any copyright of literary, artistic or scientific work. The Philippines recognizes that software is generally assimilated as a literary, artistic or scientific work protected by the copyright laws of various countries. Thus, payments in consideration for the use of, or right to use, a copyright relating to software are regarded as royalties in the Philippines. 6 Certainly, the royalty payments made by MJ PH to MJ US for the use of the SAP system are within the definition of royalties under the said treaty provisions. The Bureau does not agree, however, that the methods employed for eliminating or mitigating the effects of double taxation under the PH-US Tax Treaty and PH-Czech Tax Treaty are the same. The pertinent provisions of the said tax treaties are as follows: PH-US Tax Treaty PH-Czech Tax Treaty Article 23 RELIEF FROM DOUBLE TAXATION Double taxation of income shall be avoided in the following manner: 1. In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof),the United States shall allow to a citizen or resident of the United States as a credit against the United States tax the appropriate amount of taxes paid or accrued to the Philippines and, in the case of a United States corporation owning at least 10 percent of the voting stock of a Philippine corporation from which it receives dividends in any taxable year, shall allow credit for the appropriate amount of taxes paid or accrued to the Philippines by the Philippine corporation paying such dividends with respect to the profits out of which such dividends are paid. Such appropriate amount shall be based upon the amount of tax paid or accrued to the Philippines, but the credit shall not exceed the limitations (for the purpose of limiting the credit to the United States tax on income from sources within the Philippines or on income from sources outside the United States) provided by United States law for the taxable year .x x x (Emphases supplied) Article 22 ELIMINATION OF DOUBLE TAXATION xxx xxx xxx 2. In the case of a resident of the Czech Republic, double taxation shall be eliminated as follows: a) The Czech Republic, when imposing taxes on its residents, may include in the tax base upon which such taxes are imposed the items of income which according to the provisions of this Convention may also be taxed in the Philippines, but shall allow as a deduction from the amount of tax computed on such a base an amount equal to the tax paid in the Philippines. Such deduction shall not, however, exceed that part of the Czech tax, as computed before the deduction is given, which is appropriate to the income which, in accordance with the provisions of this Convention, may be taxed in the Philippines. b) Where in accordance with any provision of the Convention income derived by a resident of the Czech Republic is exempt from tax in the Czech Republic, the Czech Republic may nevertheless, in calculating the amount of tax on the remaining income of such resident, take into account the exempted income. (Emphasis supplied) In the Cargill case, which is squarely applicable to the present case, the Supreme Court ruled that for the MFN clause to apply, the party invoking it must prove the similarity in tax reliefs accorded by the United States and the Czech Republic under their respective treaties with the Philippines. Because of the petitioner's failure to present in evidence the pertinent provisions of the United States law, which provides details on how the credit is applied in the US and its limitations, and, therefore, to prove the similarity in circumstances in the payment of tax, the Court denied the application of the MFN clause, thus: Indeed, both the United States and the Czech Republic adopt the credit principle, where the taxes paid in the Philippines on royalty income are allowed to be credited against the United States tax or Czech tax, as the case may be. However, a closer look at the treaty provisions would show that while the RP-Czech Tax Treaty specifies how the tax crude is to be implemented and its limitations, the RP-US Tax Treaty does not . By looking at the RP-Czech Tax Treaty, we would already know how the credit is applied and what the maximum deduction allowed is: First ,the Czech tax is calculated based on the taxpayer's total income, including the income from the Philippines, but the tax paid in the Philippines is allowed as deduction from the Czech tax; and Second ,the tax paid in the Philippines should not exceed the Czech tax appropriate to the Philippine-sourced income. On the other hand, while the RP-US Tax Treaty does not provide details on how the credit is to be applied and its limitations, it expressly refers to the United States law in that the tax paid or accrued to the Philippines shall be allowed as a credit against United States tax in accordance with, and subject to the limitations of United States law .Furthermore, the tax credit shall not exceed the limitations provided by the United States law for the taxable year . Moreover, under the RP-Czech Tax Treaty, the limitation on credit is already specified that the Philippine tax should not exceed the Czech tax payable for the same income. Under the RP-US Tax Treaty, the limitation on credit is not determinable unless we look into the internal tax law of the United States. Therefore, the Court of Tax Appeals was correct in ruling that the relevant provisions of the United States law are necessary to determine for certain the similarity in circumstances in the payment of taxes on royalty in the United States and the Czech Republic. xxx xxx xxx Petitioner's claim on behalf of CAN Technologies for refund of "erroneously paid withholding tax on royalty income" is anchored on the 10% preferential tax rate under the RP-Czech Tax Treaty, in relation to the most favored nation clause of the RP-US Tax Treaty. Consequently, compliance with the conditions for the applicability of the most favored nation clause must be proven as a fact. It is necessary to show the similarity in tax reliefs accorded by the United States and the Czech Republic under their respective treaties with the Philippines. With regard to the RP-US Tax Treaty, a specific reference was made to the United States law for the limitation on allowable tax credit. This requires that the pertinent provisions of the United States law be presented in evidence. Whether the United States law imposes the same restrictions on tax credit as those imposed in the RP-Czech Tax Treaty is a question of fact that petitioner must prove. All told, the most favored nation clause cannot apply. Petitioner cannot avail of the lower 10% tax rate under the RP-Czech Tax Treaty for its failure to prove that the tax on royalties under the RP-US Tax Treaty was paid under circumstances similar to the tax on royalties under the RP-Czech Tax Treaty. Accordingly, there is no overpayment of tax on royalties from June 1, 2005 to April 30, 2007. The Court of Tax Appeals correctly denied petitioner's claim for refund of P8,771,270.71. Like Cargill, MJ US also failed to satisfy the second condition because it did not submit a copy of the internal tax law of the US to prove that the application of the tax credit in the US and its limitations are similar to the tax credit allowed in the Czech Republic. Accordingly, the royalty income derived by MJ US from the Philippines are subject to 25% pursuant to Article 13 (2) (b) (i) of the PH-US Tax Treaty and not to 10% under the MFN clause of the said treaty. Value-Added Tax (VAT) Finally, the gross receipts derived by MJ US from the sale of services to MJ PH are also subject to value-added tax (VAT) at the rate of 12% under Section 108 (A), in relation to Section 105, of the Tax Code, to wit: SEC. 105. Persons Liable. Any person who, in the course of trade or business, sells, barters, exchanges, leases goods or properties, renders services, and any person who imports goods shall be subject to the value-added tax (VAT) imposed in Sections 106 to 108 of this Code. The value-added tax is an indirect tax and the amount of tax may be shifted or passed on to the buyer, transferee or lessee of the goods, properties or services. This rule shall likewise apply to existing contracts of sale or lease of goods, properties or services at the time of the effectivity of Republic Act No. 7716. The phrase 'in the course of trade or business' means the regular conduct or pursuit of a commercial or an economic activity, including transactions incidental thereto, by any person regardless of whether or not the person engaged therein is a non-stock, nonprofit private organization (irrespective of the disposition of its net income and whether or not it sells exclusively to members or their guests),or government entity. The rule of regularity, to the contrary notwithstanding, services as defined in this Code rendered in the Philippines by nonresident foreign persons shall be considered as being rendered in the course of trade or business." " 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: 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%) x x x" x x x The phrase " sale or exchange of services " shall likewise include: (1) The lease or the use of or the right or privilege to use any copyright, patent, design or model, plan, secret formula or process, goodwill, trademark, trade brand or other like property or right; xxx xxx xxx Lease of properties shall be subject to the tax herein imposed irrespective of the place where the contract of lease or licensing agreement was executed if the property is leased or used in the Philippines. The term "gross receipts" means the total amount of money or its equivalent representing the contract price, compensation, service fee, rental or royalty, including the amount charged for materials supplied with the services and deposits and advanced payments actually or constructively received during the taxable quarter for the services performed or to be performed for another person, excluding value-added tax. xxx xxx xxx Pursuant to Sections 105 and 108 of the Tax Code, as amended, any person who, in the course of trade or business, renders services are generally subject to 12% VAT. For VAT purposes, non-resident persons who perform services in the Philippines are deemed to be making sales in the course of trade or business even if the performance thereof is not regular. 7 Moreover, the phrase "sale or exchange of services" was defined to include the lease or the use of or the right or privilege to use any intellectual property right in the Philippines, such as copyright, patent, design or model plan, secret formula or process, goodwill, trademark, trade brand, among others. Thus, the gross receipts derived by MJ US from the lease or the use of or the right or privilege to use its SAP system in the Philippines are subject to 12% VAT. Based on Section 4.114-2 of Revenue Regulations No. 16-2005, 8 MJ PH shall, before making payment to MJ US, withhold the 12% VAT using BIR Form No. 1600 (Monthly Remittance Return of Value-Added Tax and Other Percentage Taxes Withheld) 9 and shall remit the same within ten (10) days following the end of the month the withholding was made. This ruling is issued on the basis of the facts as represented. However, if it will be disclosed upon investigation that the facts are different, then this ruling shall be without force and effect insofar as the herein parties are concerned. Very truly yours, (SGD.) CAESAR R. DULAY Commissioner of Internal Revenue Footnotes 1. Mead Johnson & Company, LLC Company Profile | Evansville, IN | Competitors, Financials & Contacts-Dun & Bradstreet (dnb.com). 2. Mead Johnson Nutrition Philippines, Inc. Company Profile-Philippines | Contacts & Key Executives | EMIS. 3. The income tax rate for nonresident foreign corporations was reduced to 25% effective January 1, 2021 pursuant to Republic Act (RA) No. 11534, otherwise known as an "Act Reforming the Corporate Income Tax and Incentives System, Amending for the Purpose Sections 20, 22, 25, 27, 28, 29, 34, 40, 57, 109, 116, 204 and 290 of the National Internal Revenue Code of 1997, as Amended, and Creating Therein New Title XIII, and for Other Purposes" or the CREATE Law. 4. G.R. No. 127105, June 25, 1999, 309 SCRA 87. 5. G.R. No. 203346, September 9, 2020. 6. Section 3 (b) of Revenue Memorandum Circular No. 44-2005. 7. Sec. 4.105-3, Revenue Regulations (RR) No. 16-2005, otherwise known as Consolidated Value-Added Tax Regulations of 2005. 8. Consolidated Value-Added Tax Regulations of 2005, as amended by Revenue Regulations No. 4-2007 (Amending Certain Provisions of Revenue Regulations No. 16-2005, as Amended, Otherwise Known as the Consolidated Value-Added Tax Regulations of 2005). 9. Now BIR Form No. 1600-VT (Monthly Remittance Return of Value-Added Tax Withheld).