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May 31, 2019 ITAD BIR RULING NO. 008-19 Articles 5 (Permanent Establishment) and 7 (Business Profits) Philippines-Indonesia tax treaty AAA _______________ _______________ _______________ Madam : This refers to your tax treaty relief application filed on December 10, 2018 requesting confirmation that income payments made by Philippine National Railways (" PNR ") to PT Industri Kereta Api (Persero) (" PT Inka ") are exempt from income tax pursuant to the Convention between the Government of the Republic of the Philippines and the Government of the Republic of Indonesia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (" Philippines-Indonesia tax treaty "). FACTS PT Inka is a corporation organized and existing under the laws of Indonesia and a resident thereof based on its amended Articles of Association and Certificate of Taxpayer Residency issued by the Directorate General of Taxes of Indonesia. The business purpose of PT Inka is to implement and support the Indonesian government's programs and policies in the field of economics and national development, particularly in railways and the transportation industries, and to optimize utilization of resources to produce high quality goods and services. It is engaged in producing railway facilities such as carriages, passenger trains, locomotives, infrastructure equipment railways, and railway engineering parts. It is a state-owned enterprise established on May 18, 1981 by the Ministry of Transportation and the Ministry of Finance of Indonesia. It is supervised by the Ministry of State-Owned Enterprises of Indonesia. Based on its License to Transact Business in the Philippines, PT Inka is licensed by the Securities and Exchange Commission on August 31, 2018 to establish a representative office in the Philippines under the name PT Industri Kereta Api (Persero) (" PT Inka Representative Office "), which shall act as its liaison and shall disseminate information about its products and services. The representative office is located at 18V Legaspi Towers 300, Malate, Manila. PT Inka 's resident agent in the Philippines is BBB, who is authorized to accept summons and legal processes in all legal proceedings and notices affecting the company. On the other hand, PNR is a governmental instrumentality in the Philippines operating an extensive intra-island railway in Metro Manila and the Bicol Region. 1 In 2018, PNR and PT Inka entered into three (3) contracts for the purchase and delivery of trainsets as described below: First contract Contract date: January 8, 2018 Description: Purchase of diesel multiple unit Contract price: Php485,312,600 Expected completion and delivery by PT Inka : Within two (2) years from the issuance of notice to proceed by PNR or until January 12, 2020 Second contract Contract date: May 29, 2018 Description: Purchase of four (4) diesel-multiple unit trainset Contract price: Php1,071,112,296 Expected completion and delivery by PT Inka : Within twenty (20) months from the issuance of notice to proceed by PNR or until January 18, 2020. Third contract Contract date: May 29, 2018 Description: Purchase of three (3) diesel hydraulic locomotive trainset Contract price: Php1,306,051,922 Expected completion and delivery by PT Inka : Within twenty-four (24) months from the issuance of notice to proceed by PNR or until May 18, 2020 The contracts were all signed and notarized in the Philippines. CCC, General Manager of PNR , and Budi Noviantoro, President and Director of PT Inka , signed the contracts respectively on behalf of their principals. Based on a certification issued by PNR , the trains will be manufactured in Indonesia, and the employees of PT Inka will be in the Philippines only during the delivery and testing of the trainsets and not during the whole completion period. Based on a sworn statement issued by PNR , the income subject of this ruling is not under investigation, on-going audit, administrative protest, claim for refund or issuance of a tax credit certificate, collection proceedings, or judicial appeal. RULING In reply, please be informed that paragraph 1, Article 7 and paragraphs 1 and 2, Article 5 of the Philippines-Indonesia tax treaty provide: " 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 : a) that permanent establishment; or b) sales within that other Contracting State of goods or merchandise of the same or similar kind as those sold through that permanent establishment; or c) other business activities carried on in that other State of the same or similar kind as those effected through that permanent establishment." " Article 5 PERMANENT ESTABLISHMENT 1. For the purposes of this Agreement, the term 'permanent establishment' means a fixed place of business through which the business of the enterprise is wholly or partly carried on . 2. The term 'permanent establishment' includes especially : a) a place of management ; b) a branch ; c) an office ; d) a factory ; e) a workshop;" Under Article 7, 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 such, the profits of that enterprise may be taxed in the other State but only so much of them as are attributable to the permanent establishment, among others. Under Article 5, a permanent establishment means a fixed place through which the business of the enterprise is wholly or partly carried on, and includes especially, a place of management, a branch, an office, a factory and a workshop. The question of permanent establishment The following commentaries of the Organisation for Economic Cooperation and Development (OECD) Model Tax Convention on Income and on Capital (Condensed Version 21 November 2017) provide conditions for the existence of a permanent establishment, to wit: " Paragraph 1 6. Paragraph 1 gives a general definition of the term 'permanent establishment' which brings out its essential characteristics of a permanent establishment in the sense of the Convention, i.e., a distinct 'situs,'a 'fixed place of business.' The paragraph defines the term 'permanent establishment' as a fixed place of business, through which the business of an enterprise is wholly or partly carried on. This definition, therefore, contains the following conditions : 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 . 7. It could perhaps be argued that in the general definition some mention should also be made of the other characteristic of a permanent establishment to which some importance has sometimes been attached in the past, namely that the establishment must have a productive character, i.e., contribute to the profits of the enterprise. In the present definition this course has not been taken. Within the framework of a well-run business organisation it is surely axiomatic to assume that each part contributes to the productivity of the whole. It does not, of course, follow in every case that because in the wider context of the whole organisation a particular establishment has a 'productive character' it is consequently a permanent establishment to which profits can properly be attributed for the purpose of tax in a particular territory (see Commentary on paragraph 4)." (Pages 117-118) In summary, the conditions for the existence of a permanent establishment are as follows: a) There must be a place of business ( e.g. , facility); b) The place of business must be fixed or permanent; and c) The business of the enterprise must be carried through the fixed place of business. Surely, PT Inka Representative Office constitutes a permanent establishment because it is an office under paragraph 2 (c), Article 5 of the Philippines-Indonesia tax treaty, and more importantly, it possesses the three conditions laid down in the commentaries. The fact that the representative office's business purpose is limited solely to acting as liaison of PT Inka and disseminating information about PT Inka 's products and services does not make the representative office less or short of a permanent establishment because it is not a requirement that the office must have a 'productive' character to qualify as a permanent establishment (Item 7 of the commentaries). Therefore, this renders immaterial whether the PT Inka Representative Office 's resident agent has an authority to conclude sales contracts for PT Inka , or such agent's authority is limited to accepting summons and legal processes affecting the company. Paragraph 2 of Article 5 lists down certain fixed places of business, which can be regarded as constituting a permanent establishment ( e.g. , place of management, branch, office, factory, workshop) regardless whether or not actual sales contracts are conducted in these places of business. The importance of having an agent with authority to conclude sales contracts is given in paragraph 4 of Article 5, to wit: "4. A person acting in a Contracting State on behalf of an enterprise of the other Contracting State (other than an agent of an independent status to whom paragraph 6 applies) shall be deemed to be a permanent establishment in the first-mentioned State if : a) he has, and habitually exercises in that State, an authority to conclude contracts on behalf of the enterprise, unless his activities are limited to the purchase of goods or merchandise for that enterprise; or b) he has no such authority, but habitually maintains in the first-mentioned State a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the enterprise; or c) in so acting, he manufactures or processes in that State for the enterprise goods or merchandise belonging to the enterprise." Here, such an agent constitutes a permanent establishment if he habitually exercises such authority for his principal-enterprise. However, this alternative definition of a permanent establishment is resorted to only if the enterprise does not have a fixed place of business in the concerned territory. In the instant case, the need to determine whether or not PT Inka has a dependent agent with authority to conclude contracts on its behalf is set aside because it already has in the Philippines a fixed place of business which constitutes a permanent establishment. The question of preparatory or auxiliary activities Paragraph 3, Article 5 provides an exception where a fixed place of business does not constitute a permanent establishment if the activities carried out therein are merely of preparatory or auxiliary character, to wit: "3. Notwithstanding the preceding provisions of this Article, the term "permanent establishment" shall be deemed not to include : a) the use of facilities solely for the purpose of storage or display of goods or merchandise belonging to the enterprise; b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage or display; c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise; e) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character; f) the maintenance of a fixed place of business solely for any combination of activities mentioned in sub-paragraphs (a) to (e), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character." The question then arises if PT Inka Representative Office , by reason of its representation that it merely acts as liaison of PT Inka and disseminates information about the latter's products and services, is performing preparatory or auxiliary activities. In relation thereto, the following commentaries of the OECD Model Convention mention: "59. It is often difficult to distinguish between activities which have a preparatory or auxiliary character and those which have not. The decisive criterion is whether or not the activity of the fixed place of business in itself forms an essential and significant part of the activity of the enterprise as a whole. Each individual case will have to be examined on its own merits. In any case, a fixed place of business whose general purpose is one which is identical to the general purpose of the whole enterprise does not exercise a preparatory or auxiliary activity . 60. As a general rule, an activity that has a preparatory character is one that is carried on in contemplation of the carrying on of what constitutes the essential and significant part of the activity of the enterprise as a whole. Since a preparatory activity precedes another activity, it will often be carried on during a relatively short period, the duration of that period being determined by the nature of the core activities of the enterprise. This, however, will not always be the case as it is possible to carry on an activity at a given place for a substantial period of time in preparation for activities that take place somewhere else. Where, for example, a construction enterprise trains its employees at one place before these employees are sent to work at remote work sites located in other countries, the training that takes place at the first location constitutes a preparatory activity for that enterprise. An activity that has an auxiliary character, on the other hand, generally corresponds to an activity that is carried on to support, without being part of, the essential and significant part of the activity of the enterprise as a whole. It is unlikely that an activity that requires a significant proportion of the assets or employees of the enterprise could be considered as having an auxiliary character." The commentaries proceed that the decisive criterion whether or not the activity of the fixed place of business is preparatory or auxiliary is that such activity in itself forms an essential and significant part of the activity of the whole enterprise, and each individual case will have to be examined on its own merits. Moreover, as a general rule, an activity that has a preparatory character is one that is carried on in contemplation of the carrying on of what constitutes the essential and significant part of the activity of the whole enterprise. Since a preparatory activity precedes another activity , it will often be carried on during a relatively short period, the duration of which is determined by the nature of the core activities of the enterprise. On the other hand, an activity that has an auxiliary character corresponds to an activity that is carried on to support, without being part of, the essential and significant part of the activity of the whole enterprise as a whole. Accordingly, considering that PT Inka Representative Office is established a few months after PT Inka has concluded sales contracts with PNR for the purchase and delivery of the trainsets, whereby PT Inka has committed to manufacture the trainsets in Indonesia and deliver them to the Philippines within a period of two years, any activity performed and that will be performed by PT Inka Representative Office cannot be regarded as preparatory . Moreover, since the License to Transact Business issued to PT Inka is not time-bound, PT Inka Representative Office will not carry on activities in the Philippines during a relatively short period of time, thereby making those activities not preparatory . Similarly, those activities are not auxiliary . As defined, an activity is auxiliary if carried on to support, without being part of , the essential and significant part of the activity. Considering the long period of time to manufacture the trainsets and the need for PT Inka to have a representation in the Philippines pursuant to existing government procurement laws, the representative office's function of acting as liaison of PT Inka to PNR while the trainsets are being manufactured cannot be disregarded and be deemed as not forming part of PT Inka 's contractual obligations to PNR to deliver the trainsets in due time. Moreover, in determining whether a foreign corporation's activity in the Philippines is auxiliary or not, we must take into account that a foreign corporation which does not derive income in the Philippines, and which does not have an office or an agent in the Philippines is not doing business in the country. In Cargill, Inc. vs. Intra Strata Assurance Corporation, G.R. No. 168266 dated March 15, 2010 , the Supreme Court held that: "The determination of whether a foreign corporation is doing business in the Philippines must be based on the facts of each case. In the case of Antam Consolidated, Inc. v. CA, in which a foreign corporation filed an action for collection of suns of money against petitioners therein for damages and loss sustained for the latter's failure to deliver coconut crude oil, the Court emphasized the importance of the element of continuity of commercial activities to constitute doing business in the Philippines. The Court held . . . xxx xxx xxx Most of these activities do not bring any direct receipts or profits to the foreign corporation, consistent with the ruling of this Court in National Sugar Trading Corp. v. CA that activities within Philippine jurisdiction that do not create earnings or profits to the foreign corporation do not constitute doing business in the Philippines . In that case, the Court held that it would be inequitable for the National Sugar Trading Corporation, a state-owned corporation, to evade payment of a legitimate indebtedness owing to the foreign corporation on the plea that the latter should have obtained a license first before perfecting a contract with the Philippine government. The Court emphasized that the foreign corporation did not sell sugar and derive income from the Philippines, but merely purchased sugar from the Philippine government and allegedly paid for it in full . In this case, the contract between petitioner and NMC involved the purchase of molasses by petitioner from NMC. It was NMC, the domestic corporation, which derived income from the transaction and not petitioner. To constitute doing business, the activity undertaken in the Philippines should involve profit-making . Besides, under Section 3(d) of RA 7042, soliciting purchases has been deleted from the enumeration of acts or activities which constitute doing business . Other factors which support the finding that petitioner is not doing business in the Philippines are: (1) petitioner does not have an office in the Philippines ; (2) petitioner imports products from the Philippines through its non-exclusive local broker, whose authority to act on behalf of petitioner is limited to soliciting purchases of productsfrom suppliers engaged in the sugar trade in the Philippines; and (3) the local broker is an independent contractor and not an agent of petitioner ." (Underscoring supplied) On the other hand, in Hutchison Ports Philippines Limited vs. Subic Bay Metropolitan Authority, International Container Terminal Services, Inc., Royal Port Services, Inc. and the Executive Secretary, G.R. No. 131367 dated August 31, 2000 , the Supreme Court held that a foreign corporation participating in any bidding process is already doing business in the Philippines, thus: "The maelstrom of this issue is whether participating in the bidding is a mere isolated transaction, or did it constitute engaging in or transacting business in the Philippines such that petitioner HPPL needed a license to do business in the Philippines before it could come to court . "There is no general rule or governing principle laid down as to what constitutes doing or engaging in or transacting business in the Philippines. Each case must be judged in the light of its peculiar circumstances. Thus, it has often been held that a single act or transaction may be considered as doing business when a corporation performs acts for which it was created or exercises some of the functions for which it was organized. The amount or volume of the business is of no moment, for even a singular act cannot be merely incidental or casual if it indicates the foreign corporations intention to do business . Participating in the bidding process constitutes doing business because it shows the foreign corporations intention to engage in business here. The bidding for the concession contract is but an exercise of the corporations reason for creation or existence . Thus, it has been held that a foreign company invited to bid for IBRD and ADB international projects in the Philippines will be considered as doing business in the Philippines for which a license is required. In this regard, it is the performance by a foreign corporation of the acts for which it was created, regardless of volume of business, that determines whether a foreign corporation needs a license or not." (Underscoring supplied) In the instant case, PT Inka has participated in a bidding process in the Philippines for the manufacture and delivery of trainsets to PNR , has secured a License to Transact Business in the Philippines, has an office in the Philippines, and has appointed an agent in the country. These circumstances lead to no other logical conclusion than that PT Inka is doing business in the Philippines . The question of attributable profits Under paragraph 1 of Article 7, the profits of an enterprise of a Contracting State may be taxed in the other Contracting State but only so much of them as are attributable to the permanent establishment situated in the other State. Article 7 proceeds on the basis that the other State as situs State has primary right to tax the profits than the first-mentioned State where the enterprise is a resident. In the instant case, the Philippines is considered the situs State by reason that the contracts for the trainsets were signed and notarized in the Philippines and the trainsets will be delivered and utilized in the Philippines. While the resident agent of PT Inka Representative Office or any representative thereof did not sign the sales contracts but the President and Director of PT Inka who travelled to the Philippines to personally sign the three contracts in two occasions, this does not imply that payments for the trainsets are not attributable to the representative office. First, as explained above, the representative office's activities are not preparatory or auxiliary, but essential and significant while the trainsets are being manufactured by PT Inka in Indonesia until they are delivered to the Philippines and accepted by PNR . Without this office, PT Inka will not effectively fulfill its contractual obligations to PNR . Second, since the contracts are done in the Philippines and not Indonesia, the latter is not deemed the primary situs State and cannot have primary taxing right on the income under paragraph 1, Article 7 of the tax treaty. As country of residence, Indonesia may tax PT Inka 's income after the same is taxed in the Philippines, but it shall allow relief on any income tax imposed in the Philippines. This being so, income payments made by PNR to PT Inka for the trainsets are attributable to PT Inka Representative Office and may be taxed in the Philippines under paragraph 1 of Article 7. Consequently, PT Inka (through PT Inka Representative Office ) shall be considered a resident foreign corporation subject to income tax rate of 30% on its taxable income under Section 28 (B) (1) of the National Internal Revenue Code of 1997, as amended (" Tax Code "), to wit: " SEC. 28. Rates of Income Tax on Foreign Corporations. (A) Tax on Resident Foreign Corporations . (1) In General. Except as otherwise provided in this C od e, a corporation organized, authorized, or existing under the laws of any foreign country, engaged in trade or business within the Philippines, shall be subject to an income tax equivalent to thirty-five percent (35%) of the taxable income derived in the preceding taxable year from all sources within the Philippines: Provided, That effective January 1, 2009, the rate of income tax shall be thirty percent (30%)." Under Section 31 of the Tax Code, the term taxable income means pertinent items of gross income less deductions authorized for such types of income by this Code or other special laws. In the instant case, PT Inka 's taxable income is computed by deducting from the gross payments made by PNR the pertinent costs in manufacturing the trainsets in Indonesia until they are delivered to the Philippines and accepted by PNR , including the operational cost in maintaining the representative office. Since taxable, PNR , as government-owned or controlled corporation, shall withhold a creditable income tax at the rate of 1% on all payments made to PT Inka Representative Office or PT Inka , pursuant to Section 2.57.2 (N) of Revenue Regulations No. 2-98, 2 as amended, thus: " (N) Income payments made by the government to its local/resident supplier of goods and local/resident supplier of services other than those covered by other rates of withholding tax. Income payments, except any single purchase which is P10,000 and below, which are made by a government office, national or local, including barangays, or their attached agencies or bodies, and government-owned or controlled corporations, on their purchases of goods and purchases of services from local/resident suppliers . Supplier of goods One percent (1%) Supplier of services Two percent (2%); A government-owned or controlled corporation shall withhold the tax in its capacity as a government-owned or controlled corporation rather than as a corporation stated in Subsection (M) hereof." (Underscoring supplied) Finally, the importation of the trainsets is subject to value-added tax at the rate of 12% under Section 107 (A) of the Tax Code, to wit: " SEC. 107. Value-Added Tax on Importation of Goods . (A) In General . There shall be levied, assessed and collected on every importation of goods a value-added tax equivalent to twelve percent (12%) based on the total value used by the Bureau of Customs in determining tariff and customs duties, plus customs duties, excise taxes, if any, and other charges, such tax to be paid by the importer prior to the release of such goods from customs custody: Provided, That where the customs duties are determined on the basis of the quantity or volume of the goods, the value-added tax shall be based on the landed cost plus excise taxes, if any." Please be guided accordingly. Very truly yours, (SGD.) CAESAR R. DULAY Commissioner of Internal Revenue Footnotes 1. http://pnr.gov.ph/about-contact-us/who-we-are/corporate-profile . 2. Implementing Republic Act No. 8424, "An Act Amending the National Internal Revenue Code, as Amended" Relative to the Withholding on Income Subject to the Expanded Withholding Tax and Final Withholding Tax, Withholding of Income Tax on Compensation, Withholding of Creditable Value-Added Tax and Other Percentage Taxes.