ITAD BIR Ruling No. 011-09

April 1, 2009 ITAD BIR RULING NO. 011-09 Articles 7 and 5, Philippines-Australia tax treaty; Sections 28 (B) (4) and 108, Tax Code of 1997, as amended; BIR Ruling Nos. DA-ITAD-039-04 and DA-ITAD 198-00 Punongbayan & Araullo Certified Public Accountants 20th Floor, Tower 1, The Enterprise Center 6766 Ayala Avenue, 1200 Makati City Attention: Atty. Benedicta Du-Baladad Tax Partner Gentlemen : This refers to your letter dated 24 August 2006 on behalf of your client, Philippine AXA Life Insurance Corporation ( 'AXA-Philippines' for brevity), requesting confirmation that the payments for the lease of office equipment, furniture and fixtures by AXA-Philippines to AXA Asia Pacific Holdings Limited ( 'AXA-Australia' for brevity) are not subject to Philippine income tax, pursuant to the provisions of the Philippines-Australia tax treaty. TAcDHS It is represented that AXA-Australia is a corporation duly organized and existing under the laws of Australia as evidenced by its Articles of Association, with principal office address at Level 9, 447 Collins St., Melbourne Victoria, Australia; that AXA-Australia is incorporated with the purpose of providing financial products and services that are fundamental to the well-being and advancement of individuals, businesses and communities, to help people design and implement financial plans to make the most of life's choices; that in financial protection, AXA-Australia's products allow people to make important commitments confidently from buying their homes, to having children, to building careers, people can protect themselves, their families and their businesses from the financial consequences of personal injury or death, savings, investments and superannuation, AXA-Australia helps people to save for important needs from educating children, to travel and leisure, to retirement, AXA-Australia helps people achieve the lifestyles they desire; that it is responsible for the Global AXA Group's life insurance and wealth management businesses in the Asia-Pacific region; that AXA-Australia has operations in Hong Kong SAR, China, Singapore, Indonesia, Philippines, Thailand, India, Malaysia, Australia and New Zealand; that AXA-Australia is not registered either as a corporation or as a partnership in the Philippines as evidenced by the Certification of Non-Registration of Corporation/Partnership dated 17 August 2006, issued by the Philippine Securities and Exchange Commission; that on the other hand, AXA-Philippines is a domestic corporation with principal office located at 6/F Philippine AXA Life Centre, Sen. Gil Puyat Avenue, Makati City. It is further represented that on 01 January 2003 a Lease Agreement was entered into by and between AXA-Philippines and AXA-Australia whereby AXA-Australia (Lessor) agrees to lease to AXA-Philippines (Lessee) the properties described in the Schedule of Furniture and Fixtures as of December 31, 2002 of the Lease Schedule, (the 'Property') and such other property(ies) as the Lessor may lease to the Lessee from time to time as described in a similar Lease Schedule(s); that such additional Lease Schedule(s) which may be executed from time to time hereafter shall likewise constitute a part or parts of the Lease Agreement as if set forth in full therein; that the term "Lease Schedule" shall include such other schedule(s) as the parties may agree from time to time; that for purposes of the Lease Agreement, The Property shall include all original items, parts, accessories and additions thereto as well as replacements thereof, as well as any other chattels/movables which the Lessor and the Lessee may from time to time include in the Lease Agreement; that the rental payment is One Million Four Hundred and Sixty Thousand Nine Hundred and Twenty Pesos (P1,460,920.00), payable and due quarterly in advance until the termination or expiration of the Lease Agreement; that the term of this Agreement shall be Twenty (20) quarters, from the delivery and acceptance date specified, unless sooner terminated as set forth in the Lease Agreement; that the term of this Agreement shall have an obligatory, non-cancellable period which in no case shall be less than 5 years; 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 that the Section 28 (B) (1) of the National Internal Revenue Code (Tax Code) of 1997, as amended by Republic Act No. 9337 , applies in general to income received by a nonresident foreign corporation from all sources within the Philippines. It provides: "Section 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): Provided, That effective January 1, 2009, at the rate of income tax shall be thirty percent (30%). xxx xxx xxx However, Section 32 (B) (5) of the Tax Code of 1997, provides: "Section 32. Gross Income. xxx xxx xxx (B) Exclusions from Gross Income. The following items shall not be included in gross 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. DHSCTI xxx xxx xxx" Since AXA-Australia is a resident of Australia pursuant to Article 4 of the Philippines-Australia tax treaty, the provisions of said treaty may be used to determine the taxability of its income in the Philippines. In this regard, Article 7, and in relation thereto, Article 5 of the Philippines-Australia tax treaty provide: "Article 7 BUSINESS PROFITS 1. The profits of an enterprise of one of the Contracting States 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 a) that permanent establishment; or b) sales within that other Contracting State of goods or merchandise of the same or a similar kind as those sold, or other business activities of the same or a similar kind as those carried on through that permanent establishment if the sale or the business activities had been made or carried on in that way with a view to avoiding taxation in that other State. xxx xxx xxx." "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 an enterprise is wholly or partly carried on. xxx xxx xxx 4. An enterprise shall be deemed to have a permanent establishment in one of the Contracting States and to carry on business through that permanent establishment if substantial equipment is being used in that State for more than six months by, for or under contract with the enterprise. (emphasis supplied) xxx xxx xxx" Based on the above provisions, the profits of an enterprise which is a resident of Australia shall be taxable only in Australia unless such enterprise carries on business in the Philippines through a permanent establishment situated therein. If the enterprise which is a resident of Australia carries on business as aforesaid, the profits of such enterprise may be taxed in the Philippines but only so much of such profits as is attributable to that permanent establishment. Applying this to the instant case, the rental fees received by AXA-Australia for the rental services rendered in the Philippines under the subject Agreement shall be taxable in the Philippines only if it has a permanent establishment in the Philippines in connection with the activities giving rise to such income. Peculiar in the Philippines-Australia tax treaty is paragraph 4 of its Article 5 where a taxpayer is deemed to have a permanent establishment in a contracting state if 'substantial equipment' is being used for more than 6 months by, for or under contract with an enterprise. Thus, an Australian enterprise shall be deemed to have a permanent establishment in the Philippines, and as such shall be subject to income tax in the Philippines, if substantial equipment is being used in the Philippines for more than six (6) months by, for or under contract with the Australian enterprise. ECcaDT With respect to the instant application for relief, the question now is whether or not the properties of AXA-Australia in the Philippines which are subject of the herein Lease Agreement constitute as 'substantial equipment' for the purposes of paragraph 4, Article 5 of the Philippines-Australia tax treaty. To understand the intention behind the said 'deemed permanent establishment provision' involving the use of substantial equipment, we are guided by the ATO Interpretative Decisions (ATO ID) which discuss how the term 'substantial equipment' is interpreted under other Australian tax treaties. In one of the interpretative decisions, ATO ID (2006/337), the ATO said that a 'computer system' which consists of approximately ten pieces hardware, including servers and routers, software market access and trading algorithms, collectively measuring 260cm x 398cm x 470cm, approximately weighing 164 kilograms, and valued at $200,000, is not substantial equipment. The reasons supporting this decision involving a computer system are discussed at length below. Since the terms 'equipment' and 'substantial equipment' are not defined in Australia's domestic tax laws, the discussions under Draft Taxation Ruling TR 2006/D8 were used to explain the meaning of 'equipment', as follows. "Paragraph 106 of TR 2006/D8 states that the relevant meanings of 'equipment' in the Macquarie Dictionary, 2001, 5th Edition are: 'anything used in or provided for equipping, a collection of necessary implements (such as tools)'. Paragraph 107 of TR 2006/D8, states that paragraphs 33 to 36 of Taxation Ruling TR 98/21 point to a number of cases and other references indicating that the meaning of 'equipment' is a wide one, and should be determined in the context in which it appears." From the ordinary meaning of the word 'equipment' the Commissioner considers the taxpayer's computer system includes a number of individual items of 'equipment' for the purposes of the definition of permanent establishment." Substantial "The relevant meanings of 'substantial' in the Macquarie Dictionary are: of ample of considerable amount, quantity, or size of real worth of or relating to the essence of a thing; essential, material, or important. Paragraph 112 of TR 2006/D8 states that whether the equipment in question is 'substantial' is a question of fact and degree to be determined: on balance, according to the facts and circumstances of each particular case; and in an absolute sense, that is, when viewed independently; not in comparison with something else; or THDIaC in a relative sense; that is, by comparing it to something else. Therefore, based on the ordinary meaning of the term 'substantial', the relevant case law McDermott Industries (Aust) Pty. Ltd. v. Commissioner of Taxation [2005], and the guidance provided at paragraph 112 of TR 2006/D8 and paragraphs 1.61 to 1.64 of the Explanatory Memorandum (EM) to the International Tax Agreements Amendment Bill 2003, the Commissioner considers the following factors as relevant in determining whether equipment is 'substantial': size quantity where part of a unified process value importance in the sense of whether the equipment plays a core role in the income producing activity. The common characteristic of examples of substantial equipment in McDermott case and the EM is the size of the equipment. It is considered therefore that the size is the key factor and has greater weight in determining whether equipment is 'substantial'. If an item of equipment is sufficiently large in size, it will be 'substantial' in an absolute sense. In such instances, this factor alone will be decisive and further consideration of any other factors is not necessary. As the nature of the 'substantial equipment' test in paragraph 112 of TR 2006/D8 is one of fact and degree, determined on balance according to individual facts and circumstances, it was considered that the factors listed above, other than size, are not of themselves determinative. Each of these factors needs to be considered with the others, having regard to all facts and circumstances of the particular case. Where there are a number of items of equipment that are not large enough individually to be substantial in an absolute sense, it was considered that the size of the items collectively and the quantity can only be considered if the items of equipment are part of a unified process. This arises from the context in which the term 'substantial' appears in the provision; that is, it is part of the expression 'substantial equipment' as opposed to 'a substantial equipment'. TcHEaI Value is a relevant factor on two levels; firstly, in the sense of its cost (as per the ordinary meaning of the term) and, secondly, in the sense of its value creating potential. Equipment may be so valuable that it may be considered substantial in an absolute sense. For example, in one DTC, a tunneling equipment costing $600,000 was considered substantial equipment purely on the basis of its cost alone. However it is not possible to set a precise monetary threshold in relation to cost that will be determinative in all cases. As to importance , Case No. H106 (1957) 8 TBRD 484 stated that "the meaning of 'substantial' is relative, and in the case where the machinery required is not extensive and the whole is involved, it is 'substantial'. The above statement, the ordinary meaning of the term 'substantial', and the context in which the term is used, indicate that the sense in which importance is relevant is where the equipment is core to the enterprise conducting its income producing or value creating activity or to it creating its product in a particular country. Given the dimensions of the individual items of the taxpayer's computer system, it was considered that those individual items of equipment are each not large enough to be considered substantial in an absolute sense. Furthermore, the individual items of equipment are part of a unified process, but when the size of the individual items of equipment are viewed in aggregate, the dimensions of the entire computer system again indicate that the computer system is not substantial equipment by reason of its size. As there are only 10 individual items of equipment, it was considered that this factor (size) does not indicate that the computer system is substantial equipment. It was considered that the taxpayer's computer system, valued at $200,000, is not sufficiently high value for it to constitute substantial equipment on the basis of value. As only 50% of the taxpayer's business activities involve electronic trading through the computer system, it was considered that the computer system does not play a core role in the taxpayer's income-producing activities. On balance, there are insufficient grounds to conclude that the taxpayer's computer system is 'substantial equipment' for the purposes of the definition of permanent establishment." We adopt the foregoing criteria and discussions on size, quantity, value and importance relevant to the determination of whether or not the properties of AXA-Australia ( i.e. , office equipment, furniture and fixtures) in the Philippines subject of the herein Lease Agreement constitute as substantial equipment for the purposes of paragraph 4, Article 5 of the Philippines-Australia tax treaty. Hence, the office equipment, furniture and fixtures leased by AXA-Phils from AXA-Australia are characterized in accordance with these criteria as follows. As to size The items involved in the instant case are not large enough individually to be substantial in an absolute sense. As to size and quantity Taken collectively, the size of the items being leased, which consist of office equipment, furniture and fixtures, may seem large enough to be considered substantial in an absolute sense. However, the size of the items collectively and the quantity can only be considered if the items of equipment are part of a unified process. aTcIAS Considering therefore that the subject items being leased do not operate or are not being used as part of a unified process, said individual items of equipment cannot be considered collectively to determine substantial equipment. As to value As to the cost of the equipment, no precise or exact monetary threshold was set in the foregoing ATO decisions which would be determinative in all cases. While tunneling equipment valued at US$600,000 is ruled as substantial equipment, a computer system valued at US$200,000, on the other hand, is ruled as not being substantial equipment. For purposes of determining whether the subject equipment if "substantial", we apply by analogy the standard set forth in Revenue Regulations No. (RR) 4-86 in defining what constitutes "principally". Under RR 4-86, "principally" means more than 50% of the entire assets in terms of value. (Sec. (a) and (b), Revenue Regulations No. 4-86) The equipment of AXA-Australia subject of lease by AXA-Philippines has a total net book value of PHP6,353,118.00 or US$115,333.00 based on the 2005 Financial Report of AXA-Australia. A verification of the said 2005 Financial Report discloses that the subject equipment being leased is approximately 5.76% in relation to the total property, plant and equipment of AXA-Australia which is US$2,000,000. Therefore, being less than 50% of the total property, plant and equipment of AXA-Australia, the equipment subject of the herein lease consisting of several office equipment, furniture and fixtures, valued at US$115,333, cannot be considered substantial equipment. As to importance Where the equipment is core to the enterprise conducting its income producing or value creating activity or to it creating its product in a particular country, it is substantial equipment. Should the equipment subject of the herein lease of AXA-Philippines from AXA-Australia be the heart of the latter's existence as a holding company, and if said equipment be so relevant to the very business purpose of AXA-Australia which is financial protection, then it could be substantial equipment for AXA-Australia. Otherwise, or if the subject leased equipment is not core to the income producing activities of AXA-Australia, it cannot be considered substantial equipment. ScHAIT In view of all of the foregoing, the 'equipment' which consist of office equipment, furniture and fixtures, subject of the herein Lease Agreement is not considered 'substantial equipment' of AXA-Australia in the Philippines under Article 5 (4) of the Philippines-Australia tax treaty so as to constitute a permanent establishment in the Philippines under the same Article. However, please be informed that income derived from lease of equipment by a resident of Australia is separately dealt with in Article 12 of the Philippines-Australia tax treaty. Said Article 12 provides: "Article 12 ROYALTIES 1. Royalties arising in one of the Contracting States, being royalties to which a resident of the other Contracting State is beneficially entitled, may be taxed in that other State. 2. Such royalties may also be taxed in the Contracting State in which they arise, and according to the law of that State. However, the tax so charged shall not exceed a) 15 per cent of the gross amount of the royalties where the royalties are paid by an enterprise registered with the Philippine Board of Investments and engaged in preferred areas of activities; and b) in all other cases, 25 per cent of the gross amount of the royalties. 3. The term "royalties" in this Article means payments or credits, whether periodical or not, and however described or computed, to the extent to which they are made as consideration for a) the use of, or the right to use, any copyright, patent, design or model, plan, secret formula or process, trademark, or other like property or right; b) the use of, or the right to use, any individual, commercial or scientific equipment; c) the supply of scientific, technical, industrial or commercial knowledge or information; d) the supply of any assistance that is ancillary and subsidiary to, and is furnished as a means of enabling the application or enjoyment of, any such property or right as is mentioned in paragraph (a), any such equipment as is mentioned in paragraph (b) or any such knowledge or information as is mentioned in paragraph (c); IcDCaT e) the use of, or the right to use i. motion picture films; ii. films or video tapes for use in connection with television; or iii. tapes for use in connection with radio broadcasting; or f) total or partial forbearance in respect of the use of a property or right referred to in this paragraph." (Emphasis supplied) Based on the aforequoted provisions, payments to a resident of Australia for the use of or the right to use any individual, commercial or scientific equipment constitute as royalties taxable at fifteen percent (15%) if the payor is a Board of Investments (BOI)-registered enterprise; or twenty-five percent (25%) in all other cases. Accordingly, payments made for the lease of the subject equipment which are royalty payments for the use of any individual, commercial or scientific equipment may be subject to a preferential tax rate not exceeding 25%. Since the 25% preferential tax treaty rate is a maximum rate imposed on royalties derived by a resident of Australia in the Philippines under the Philippines-Australia tax treaty, we refer to the Tax Code of 1997 which provides for a lower income tax rate of seven and one-half percent (7 1/2%) on rentals of equipment derived by nonresident foreign corporations which may apply to the instant case. Section 28 (B) (4) of the Tax Code of 1997, as amended provides: "SEC. 28. Rates of Income Tax on Foreign Corporations. xxx xxx xxx (B) Tax on Nonresident Foreign Corporation. xxx xxx xxx (4) Nonresident Owner or Lessor of Aircraft, Machineries and Other Equipment. Rentals, charter and other fees derived by a nonresident lessor of aircraft, machineries and other equipment shall be subject to a tax of seven and one-half percent (7 1/2%) of gross rentals or fees." (Emphasis supplied) DcSACE In view thereof, this Office is of the opinion and so holds that the income from lease of equipment derived by AXA-Australia from AXA-Philippines under the subject Lease Agreement is subject to tax at the rate of 7 1/2% based on gross rentals, the same not having exceeded the 25% rate imposed on the gross amount of royalties under the Philippines-Australia tax treaty, contrary to your opinion that the said lease payments are not subject to income tax pursuant to Article 7, in relation to Article 5 of the same tax treaty. (BIR Ruling No. DA-ITAD-198-00 dated 07 December 2000) Moreover, the lease payments of AXA-Philippines to AXA-Australia under the subject Lease Agreement made from January 1, 2003 to January 31, 2006, are subject to 10% value-added tax (VAT) 1 under Section 108 (A) (1) of the Tax Code of 1997. And, the payments from February 1, 2006 shall be subject to 12% VAT 2 under Section 108 (A) (1) of the Tax Code of 1997, as amended. As to the procedure 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 AXA-Philippines shall be responsible for the withholding of the VAT on the lease payments before remitting them to AXA-Australia. In remitting to the Bureau of Internal Revenue the VAT withheld on the lease payments, AXA-Philippines shall use BIR Form No. 1600 (Monthly Remittance Return of VAT and Other Percentage Taxes Withheld). If a VAT-registered taxpayer, AXA-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. In addition, AXA-Philippines is required to issue in quadruplicate the Certificate of Final Tax Withheld at Source (BIR Form No. 2306), the first three copies for AXA-Australia and the fourth copy for AXA-Philippines as its file copy. Very truly yours, (SGD.) SIXTO S. ESQUIVIAS IV Commissioner of Internal Revenue Footnotes 1. Republic Act No. 9337 (An Act Amending Sections 27, 28, 34, 106, 107, 108, 109, 110, 111, 112, 113, 114, 116, 117, 119, 121, 148, 151, 151, * 236, 237 and 288 of the National Internal Revenue Code of 1997, as Amended, and for Other Purposes), which was signed into law on May 24, 2005 and became effective on November 1, 2005, amended Section 108 (A) to read as: "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 selling price or gross value in money of the goods or properties sold, bartered or exchanged, such tax to be paid by the seller or transferor: 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%), after any of the following conditions has been satisfied: (i) Value-added tax collection as a percentage of Gross Domestic Product (GDP) of the previous year exceeds two and four-fifth percent (2 4/5%); or (ii) National government deficit as a percentage of GDP of the previous year exceeds one and one-half percent (1 1/2%). . . . 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" 2. The VAT rate was increased to 12% on February 1, 2006, in accordance with the Memorandum of the Executive Secretary to the Secretary of Finance dated January 31, 2006, as circularized by Revenue Memorandum Circular No. 7-2006 (Publishing the Full Text of the Memorandum from Executive Secretary Eduardo R. Ermita dated January 31, 2006 Approving the Recommendation of the Secretary of Finance to Increase the Value Added Tax Rate from Ten Percent to Twelve Percent) dated January 31, 2006.