ITAD BIR Ruling No. 013-09

April 15, 2009 ITAD BIR RULING NO. 013-09 Articles 12 (Interest), 13 (Royalties) and 23 (Relief from Double Taxation); Philippines-United States of America tax treaty Isla Lipana & Co. 29th Floor, Philamlife Tower 8767 Paseo de Roxas 1226 Makati City Attention: Atty. Malou P. Lim Partner, Tax Services Gentlemen : This refers to your letters both dated October 31, 2007, requesting confirmation that royalties to be paid by Casual Clothing Specialists, Inc. (Casual Clothing) to Banana Republic (ITM), Inc. (Banana Republic) and Gap (ITM), Inc. (Gap) are subject to income tax at the rate of ten percent based on the gross amount thereof pursuant to 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 (Philippines-United States tax treaty). 1 Basic Facts It is represented that Banana Republic and GAP are corporations organized and existing under the laws of the United States and both are residents of the United States for purposes of United States taxation, based on the relevant Certifications dated February 7, 2007, issued by the Internal Revenue Service of the United States; that Banana Republic and GAP are both situated at 2 Folsom Street, San Francisco, California 94105, United States, and both are issued Taxpayer Identification Numbers by the Internal Revenue Service (TIN 94-3259249 for Banana Republic and TIN 94-3259248 for GAP ); that GPS Strategic Alliances LLC (GPS) is a corporation organized and existing under the laws of the United States, situated at 675 6th Avenue, New York, New York 10011, United States; that Banana Republic, GAP and GPS are not registered as corporations or as partnerships in the Philippines based on the relevant Certifications of Non-Registration of Corporation/Partnership dated October 1, 2007, issued by the Securities and Exchange Commission; that, on the other hand, Casual Clothing is a corporation organized and existing under the laws of the Philippines, situated at the 6th Floor, Midland Buendia Building, 403 Senator Gil J. Puyat Avenue, 1200, Makati City, Philippines. The Banana Republic Franchise Agreement It is further represented that on May 4, 2007, GPS, Banana Republic and Casual Clothing entered into an International Area Franchise Agreement (Franchise Agreement) wherein GPS granted Casual Clothing the right and license to (a) develop, own and operate the Stores (either free standing or located within shopping malls) in the Philippines, (b) purchase the Authorized Products from GPS or its designated supplier and sell them through the Stores in the Philippines, and (c) market the Stores and the Authorized Products for retail sale in the Philippines; that under the Franchise Agreement, Banana Republic granted Casual Clothing the right and license to use the Marks and the Other Intellectual Property in the Philippines solely in connection with the foregoing and in compliance with the terms and conditions of the Franchise Agreement, the Brand Standards, the Operating Manual, the applicable legal requirements in the Philippines, and any other guidelines and procedures that GPS and Banana Republic may establish from time to time and communicate to Casual Clothing in writing. It is also represented that Stores means retail stores that are developed, owned and operated by Casual Clothing in the Philippines pursuant to the Franchise Agreement, that offers Authorized Products for sale, that meets the standards and specifications of GPS and Banana Republic, and that operates under the Brand and the Brand System and is either operated by GPS or its affiliates or pursuant to a valid license from GPS and Banana Republic or one or more of their affiliates; that Brand means the trademark and service mark bearing or suggesting the name "Banana Republic"; that Brand System means distinctive and uniform store designs, layouts, construction, color schemes, graphics, signage, visual merchandising, marketing and advertising standards and formats, equipment, systems, concepts, business formats and procedures which are featured in the Stores and which may be modified by GPS from time to time; that Brand Standards means the mandatory specifications, standards, practices, procedures and guidelines imposed by GPS in the use of the Marks, the Brand, and the Other Intellectual Property; that Authorized Products means the products that GPS authorizes Casual Clothing to offer or sell at the Stores from time to time including the Core Products and the Non-Core Products; that Core Products means apparel and core accessories (hats, bags, belts, scarves, socks, small leather goods, shoes, tights, ties, handbags, backpacks and gloves) which are identified by the Brand and sold to Casual Clothing by GPS or its designated supplier; that Non-Core Products means all types of Authorized Products other than the Core Products, including without limitation, jewelry; that Authorized Supplies means those supplies and other materials approved by GPS to be used in the operation of the Stores, including, without limitation, shopping bags, boxes, packaging, hangers and related items; that Marks means all trademarks, service marks, trade names, domain names and registrations and applications for registration thereof, which Banana Republic authorizes Casual Clothing to use to identify the Stores in the Philippines and the products and services offered by the Stores, including the trademarks, service marks, trade names and domain names and any common law rights pertaining thereto, including the registered and applied trademarks and service marks for the Brand as used in the following products Products Status Application Number or Registration Number Clothing (25) Registered 64051 Bags (18) Registered 64051 Retail Services (35) Registered 4-2000-010371 Retail Services (42) Registered 64078 Jewelry (14) Pending 4-2006-002131 Clothing (25) Registered 4-2005-08014 Bags (18) Registered 4-2005-08014 Retail Services (35) Registered 4-2005-08014 That Other Intellectual Property means all intellectual, proprietary, intangible and/or industrial properties other than the Marks constituting, embodied in, pertaining to, used in, or with respect to, the Stores, the Authorized Products and or the Authorized Supplies, and that Banana Republic or GPS authorizes Casual Clothing to use in the development and operation of the Stores pursuant to the Franchise Agreement, and all tangible embodiments thereof, wherever located, including but not limited to (i) all trade dress, (ii) all copyrights, moral rights, and other rights in works of authorship including all registrations and applications therefor, (iii) all know-how, patents and trade secrets, and (iv) all confidential and proprietary information related to the Stores, the Authorized Products and/or the Authorized Supplies or any of (i) through (ii) above; that Operating Manual means written materials, audio tapes, video tapes, electronic documents, and computer software, and other materials that GPS uses for the development and operation of the Stores. CHcTIA It is further represented that in consideration for the right and license granted, Casual Clothing will pay royalties to Banana Republic equivalent to 5 percent of the aggregate purchase price of all Core Products purchased by Casual Clothing for resale at the Stores, excluding freight, insurance and handling; that the royalties will be due and payable within 30 days from the receipt of such invoice from Banana Republic and will be remitted to the latter through electronic transfer or deposit; that a separate, additional royalty structure would apply to the aggregate purchase price of all Non-Core Products purchased by Casual Clothing for resale at the Stores, excluding freight, insurance and handling; that all outstanding payments of Casual Clothing to Banana Republic, GPS or their affiliates will bear interest after the due date of such payments at a rate equal to the lesser of: (i) 10 percent per annum, or (ii) the highest legal rate permitted by law. It is further represented that the Franchise Agreement may be terminated by either Casual Clothing or GPS upon the occurrence of specific event or events including acts of material breach by one party to the other party; that for Casual Clothing, the termination will take effect after a period of 180 days from the date of delivery of such written notice of termination to GPS; that for GPS, the termination will take effect either (i) immediately if such termination is attributed to a specific event or events which has no cure period or to the failure of Casual Clothing to make payments to GPS within a period of 10 days after delivery of such written notice of failure to Casual Clothing , or (ii) within a period of 60 days if the termination is attributed to material breach by Casual Clothing and it does not correct the failure within a period of 30 days after delivery of such written notice of failure to it by GPS. It is further represented that the Franchise Agreement is registered with the Intellectual Property Office of the Philippines under Certificate of Registration No. 5-2007-00079 dated July 25, 2007, valid from May 4, 2007, to September 29, 2012; and that based on this Certificate, the Franchise Agreement has been granted exemption from the provision of Section 88.4 of the Intellectual Property Code (Republic Act No. 8293) on Voluntary Licensing with regard solely to value-added tax on royalty payment, on the ground of Rule 12, Part 2 of the Rules and Regulations on Voluntary Licensing. The GAP Franchise Agreement It is further represented that on May 4, 2007, GPS, Gap and Casual Clothing entered into an International Area Franchise Agreement (Franchise Agreement) wherein GPS granted Casual Clothing the right and license to (a) develop, own and operate the Stores (either free standing or located within shopping malls) in the Philippines, (b) purchase the Authorized Products from GPS or its designated supplier and sell them through the Stores in the Philippines, and (c) market the Stores and the Authorized Products for retail sale in the Philippines; that under the Franchise Agreement, Gap granted Casual Clothing the right and license to use the Marks and the Other Intellectual Property in the Philippines solely in connection with the foregoing and in compliance with the terms and conditions of the Franchise Agreement, the Brand Standards, the Operating Manual, the applicable legal requirements in the Philippines, and any other guidelines and procedures that GPS and Gap may establish from time to time and communicate to Casual Clothing in writing. It is also represented that Stores means retail stores that are developed, owned and operated by Casual Clothing in the Philippines pursuant to the Franchise Agreement, that offers Authorized Products for sale, that meets the standards and specifications of GPS and Gap, and that operates under the Brand and the Brand System and is either operated by GPS or its affiliates or pursuant to a valid license from GPS and Gap or one or more of their affiliates; that Brand means the trademark and service mark bearing or suggesting the names "Gap", "Gap Kids" and "Baby Gap"; that Brand System means distinctive and uniform store designs, layouts, construction, color schemes, graphics, signage, visual merchandising, marketing and advertising standards and formats, equipment, systems, concepts, business formats and procedures which are featured in the Stores and which may be modified by GPS from time to time; that Brand Standards means the mandatory specifications, standards, practices, procedures and guidelines imposed by GPS in the use of the Marks, the Brand, and the Other Intellectual Property; that Authorized Products means the products that GPS authorizes Casual Clothing to offer or sell at the Stores from time to time including the Core Products and the Non-Core Products; that Core Products means apparel and core accessories (hats, bags, belts, scarves, socks, tights, ties, handbags, backpacks and gloves, and for babyGap Stores, plush toys, baby rattles, bibs and baby blankets) which are identified by the Brand and sold to Casual Clothing by GPS or its designated supplier; that Non-Core Products means all types of Authorized Products other than the Core Products; that Authorized Supplies means those supplies and other materials approved by GPS to be used in the operation of the Stores, including, without limitation, shopping bags, boxes, packaging, hangers and related items; that Marks means all trademarks, service marks, trade names, domain names and registrations and applications for registration thereof, which Gap authorizes Casual Clothing to use to identify the Stores in the Philippines and the products and services offered by the Stores, including the trademarks, service marks, trade names and domain names and any common law rights pertaining thereto, including the registered and applied trademarks and service marks for the Brand as used in the following products Products Status Application Number or Registration Number Gap Clothing (25) Registered 4-1998-000562 Bags (18) Registered 4-1998-000562 Retail Services (42) Registered 4-2000-006857 Clothing (25) Registered 4-2000-006856 Bags (18) Pending 4-2006-02129 Retail Services (42) Registered 4-2000-006856 Retail Services (42) Registered 61434 Gap Kids Clothing (25) Pending 4-2005-006303 Bags (18) Pending 4-2005-006303 Retail Services (35) Pending 4-2005-006303 Baby Gap Clothing (25) Pending 4-2005-006304 Bags (18) Pending 4-2005-006304 Retail Services (35) Pending 4-2005-006304 Blankets (24) Pending 4-2006-02132 Toys (28) Pending 4-2006-02132 Clothing (25) Pending 4-2006-02133 That Other Intellectual Property means all intellectual, proprietary, intangible and/or industrial properties other than the Marks constituting, embodied in, pertaining to, used in, or with respect to, the Stores, the Authorized Products and or the Authorized Supplies, and that Gap or GPS authorizes Casual Clothing to use in the development and operation of the Stores pursuant to the Franchise Agreement, and all tangible embodiments thereof, wherever located, including but not limited to (i) all trade dress, (ii) all copyrights, moral rights, and other rights in works of authorship including all registrations and applications therefor, (iii) all know-how, patents and trade secrets, and (iv) all confidential and proprietary information related to the Stores, the Authorized Products and/or the Authorized Supplies or any of (i) through (ii) above; that Operating Manual means written materials, audio tapes, video tapes, electronic documents, and computer software, and other materials that GPS uses for the development and operation of the Stores. SaAcHE It is further represented that in consideration for the right and license granted, Casual Clothing will pay royalties to Gap equivalent to 5 percent of the aggregate purchase price of all Core Products purchased by Casual Clothing for resale at the Stores, excluding freight, insurance and handling; that the royalties will be due and payable within 30 days from the receipt of such invoice from Gap and will be remitted to the latter through electronic transfer or deposit; that a separate, additional royalty structure would apply to the aggregate purchase price of all Non-Core Products purchased by Casual Clothing for resale at the Stores, excluding freight, insurance and handling; that all outstanding payments of Casual Clothing to Gap, GPS or their affiliates will bear interest after the due date of such payments at a rate equal to the lesser of: (i) 10 percent per annum, or (ii) the highest legal rate permitted by law. It is further represented that the Franchise Agreement may be terminated by either Casual Clothing or GPS upon the occurrence of specific event or events including acts of material breach by one party to the other party; that for Casual Clothing, the termination will take effect after a period of 180 days from the date of delivery of such written notice of termination to GPS; that for GPS, the termination will take effect either (i) immediately if such termination is attributed to a specific event or events which has no cure period or to the failure of Casual Clothing to make payments to GPS within a period of 10 days after delivery of such written notice of failure to Casual Clothing, or (ii) within a period of 60 days if the termination is attributed to material breach by Casual Clothing and it does not correct the failure within a period of 30 days after delivery of such written notice of failure to it by GPS. It is further represented that the Franchise Agreement is registered with the Intellectual Property Office of the Philippines under Certificate of Registration No. 5-2007-00080 dated July 25, 2007, valid from May 4, 2007, to September 29, 2012; and that based on this Certificate, the Franchise Agreement has been granted exemption from the provision of Section 88.4 of the Intellectual Property Code (Republic Act No. 8293) on Voluntary Licensing with regard solely to value-added tax on royalty payment, on the ground of Rule 12, Part 2 of the Rules and Regulations on Voluntary Licensing. Ruling A. On income tax In reply, please be informed that a foreign corporation like Banana Republic or Gap, whether or not engaged in trade or business in the Philippines, is taxable only on income derived in the Philippines. Section 23 (F) of the National Internal Revenue Code of 1997 (Tax Code of 1997), as amended, provides: "SEC. 23. General Principles of Income Taxation in the Philippines. Except when otherwise provided in this Code: xxx xxx xxx (F) A foreign corporation, whether engaged or not in trade or business in the Philippines, is taxable only on income derived from sources within the Philippines." ATHCac In this case, since Banana Republic and Gap are not engaged in trade or business in the Philippines, based on the Certifications of Non-Registration of Corporation/Partnership dated October 1, 2007, issued by the Securities and Exchange Commission, income derived by these foreign corporations in the Philippines are generally subject to income tax at the rate of 35 percent, and 30 percent (beginning January 1, 2009), based on the gross amount thereof, as Section 28 (B) (1) 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. (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 subparagraphs 5(c). Provided, That effective January 1, 2009, the rate of income tax shall be thirty percent (30%)." However, such income derived by Banana Republic and Gap in the Philippines may be exempt from income tax (or partially exempt if subject only to a reduced income tax rate) if the income is exempt (or partially exempt ) pursuant to a treaty obligation binding upon the Philippine government. Section 32 (B) (5) of the Tax Code of 1997, as amended, provides: "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." SaETCI With respect to a treaty that may be invoked by Banana Republic and by Gap and by all other residents of the United States, there is the Philippines-United States tax treaty. 1. Royalties Paragraph 2 (b), Article 13 of the Philippines-United States tax treaty below provides the taxation of royalties arising in the Philippines and derived by a resident of the United States, 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." ICTcDA Under subparagraph (b) (iii), royalties arising in the Philippines and derived by a resident of the United States may be subject to the lowest rate of Philippine income tax that may be imposed on royalties of the same kind paid under similar circumstances to a resident of a third State, or simply to the most-favored-nation income tax rate. In relation thereto, it is noteworthy that in Commissioner of Internal Revenue vs. S.C. Johnson and Son, Inc. and Court of Appeals (the S.C. Johnson case ) (G.R. No. 127105 dated June 25, 1999), the Supreme Court has cited two conditions for the application of the most-favored-nation income tax rate to royalties arising in the Philippines and derived by a resident of another country (in this case, the United States). The Court noted that, first, the royalties in question, derived by a resident of the other country (the United States), must be of the same kind as those derived by a resident of the third country whose tax treaty with the Philippines permits the residents of the third country a most-favored-nation income tax rate on royalties arising in the Philippines. And, second, the method employed by the other country (the United States) in eliminating or mitigating the effects of double taxation of income or certain types of income derived by its residents from sources in the Philippines must be the same with that of the third country in question, which can be determined by taking into account and comparing the methods described in the article on elimination of double taxation in their (the other country and the third country) respective tax treaties with the Philippines. In looking for a tax treaty that grants the most-favored-nation income tax rate that may apply on royalties arising in the Philippines and derived by a resident of another country, the provisions of the Convention between the Czech Republic and the Republic of the Philippines for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (Philippines-Czech tax treaty) , effective January 1, 2004, may be considered. Concerning the first requirement in the S.C. Johnson case, Article 12 of the Philippines-Czech tax treaty provides: "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." Under the article on royalties of the Philippines-Czech tax treaty, the lowest or the most-favored-nation rate of Philippine income tax that may be imposed on royalties arising in the Philippines and derived by a resident of Czech is 10 percent of the gross amount of the royalties, which covers royalties for the use of, or the right to use, any copyright of literary, artistic or scientific work (except copyright on cinematograph films, and films or tapes for television or radio 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 (know-how). 2 Under the Franchise Agreements, Casual Clothing will pay royalties to Banana Republic and Gap for the right and license to use the Marks and the Other Intellectual Properties in connection with the Authorized Products to be sold by Casual Clothing through the Stores, the trademarks and service marks of such products bearing or suggesting the names "Banana Republic" and "Gap", "Gap Kids" and "Baby Gap". As defined, Marks means all trademarks, service marks, trade names, domain names and registrations and applications for registration thereof, which Banana Republic and Gap authorize Casual Clothing to use to identify the Stores in the Philippines and the products and services offered by the Stores, and Other Intellectual Property means all intellectual, proprietary, intangible and/or industrial properties other than the Marks constituting, embodied in, pertaining to, used in, or with respect to, the Stores, the Authorized Products and or the Authorized Supplies, and that Banana Republic and Gap authorize Casual Clothing to use in the development and operation of the Stores pursuant to the Franchise Agreement, and all tangible embodiments thereof, wherever located, including but not limited to (i) all trade dress, (ii) all copyrights, moral rights, and other rights in works of authorship including all registrations and applications therefor, (iii) all know-how, patents and trade secrets, and (iv) all confidential and proprietary information related to the Stores, the Authorized Products and/or the Authorized Supplies or any of (i) through (ii) above. Based on the above definitions, the Marks and the Other Intellectual Properties embody at least intangible properties in the form of copyrights, patents, trademarks, and information concerning industrial, commercial or scientific experience (know-how). Under paragraph 2 (a), Article 12 of the Philippines-Czech tax treaty, royalties for the use of, or the right to use, of these types of intangible properties are subject to income tax at the rate of 10 percent based on the gross amount thereof. Relative thereto, under paragraph 3, Article 13 (Royalties) of the Philippines-United States tax treaty below, the use of, or the right to use, copyrights, patents, trademarks, and information concerning industrial, commercial or scientific experience (know-how) are likewise treated as royalties under this tax treaty, thus "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 literary, 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 added) This being the case, royalties to be paid by Casual Clothing to Banana Republic and Gap under the Franchise Agreements, being royalties for the use of copyrights, patents, trademarks, and information concerning industrial, commercial or scientific experience (know-how) under paragraph 3, Article 13 of the Philippines-United States tax treaty, are subject to the most-favored-nation tax rate of 10 percent based on the gross amount thereof pursuant to paragraph 2 (a), Article 12 of the Philippines-Czech tax treaty. CAScIH Concerning the second requirement in the S.C. Johnson case, the respective articles on elimination of double taxation of the Philippines-United States and the Philippines-Czech tax treaties provide as follows: United States: "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. For the purpose of applying the United States credit in relation to taxes paid or accrued to the Philippines, the rules set forth in Article 4 (Source of Income) shall be applied to determine the source of income. For purposes of applying the United States credit in relation to taxes paid or accrued to the Philippines, the taxes referred to in paragraphs 1(b) and 2 of Article 1 (Taxes Covered) shall be considered to be income taxes." aAcHCT Czech: "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." A perusal of the methods of relief or elimination of double taxation in both tax treaties reveal that the United States and Czech employ the ordinary credit method in eliminating double taxation of income or certain types of income derived by their residents from sources in the Philippines. Under this method, the United States and Czech (as countries of residence) would limit a taxpayer's allowable tax credit to that portion of the taxpayer's tax liability in the United States and in Czech which is attributable to the income that is taxed in the Philippines (the country of source or situs of the income). As a result of this limitation, if the Philippines has an effective tax rate that exceeds the effective income tax rate of the United States and Czech on an income or on certain types of income, the United States and Czech would not grant the taxpayer a full credit for the income tax imposed by the Philippines on such income or on such certain types of income. In the United States, this is described in the following statement: ". . . 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". And in Czech: ". . . 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". In subparagraph (b), Article 22 of the Philippines-Czech tax treaty, it is noteworthy that Czech (as a country of residence) would retain the right to take into account the amount of income exempted in Czech for the purpose of determining the tax to be imposed on the rest of the income of its taxpayers. This provision, which would apply only when a particular type of income is taxable or may be taxed only in the Philippines (the country of source or situs of the income) but not in Czech, is not relevant to income such as royalties which, as clearly provided in Article 12 of the Philippines-Czech tax treaty above, may be taxed in the Philippines and in Czech. DcCASI In fine, since the two requirements for the most-favored-nation income tax rate in the S.C. Johnson case are completely satisfied under the Philippines-Czech tax treaty in relation to royalties arising in the Philippines and derived by a resident of the United States, this Office is of the opinion and so holds that royalties to be paid by Casual Clothing to Banana Republic and Gap pursuant to the Franchise Agreements for the right and license to use the Marks and the Other Intellectual Properties in connection with the Authorized Products to be sold by Casual Clothing through the Stores are subject to the most-favored-nation income tax rate of 10 percent based on the gross amount thereof. 2. Interest On the other hand, with respect to interest on overdue payments to be paid by Casual Clothing to Banana Republic and Gap under the Franchise Agreements at a rate equal to the lesser of: (i) 10 percent per annum, or (ii) the highest legal rate permitted by law, such payment is treated as interest under paragraph 7, Article 12 (Interest) of the Philippines-United States tax treaty, which provides: "7. The term 'interest' as used in this Convention means income from debt-claims of every kind, whether or not secured by mortgage, and whether or not carrying a right to participate in the debtor's profits, and in particular, income from government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures, as well as income assimilated to income from money lent by the taxation law of the Contracting State in which the income arises, including interest on deferred payment sales." Paragraph 7 defines two types of interest, (1) interest taking the form of income from debt-claims, including income from government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures, and (2) interest taking the form of income assimilated to income from money lent by the taxation law of the country of source of the income, which typically includes interest on deferred payment sales. The interest on overdue payments in question, which does not arise primarily from debt-claims but from unsettled or overdue obligations of Casual Clothing to Banana Republic and Gap relating to the right and license granted to Casual Clothing to use the Marks and the Other Intellectual Properties in connection with the Authorized Products, is classified as interest of the second category or income assimilated to income from money lent by the taxation law of the country of source of the income. On the taxation of interest, paragraphs 1, 2, 3 and 4 of Article 12, provide: "Article 12 INTEREST 1. Interest 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. Interest derived by a resident of one of the Contracting States from sources within the other Contracting State shall not be taxed by the other Contracting State at a rate in excess of 15 percent of the gross amount of such interest. 3. Interest derived by a resident of one of the Contracting States from sources within the other Contracting State with respect to public issues of bonded indebtedness shall not be taxed by the other Contracting State at a rate in excess of 10 percent of the gross amount of such interest. 4. Notwithstanding paragraphs 1, 2, and 3, interest derived by a) One of the Contracting States, or an instrumentality thereof (including the Central Bank of the Philippines, the Federal Reserve Banks of the United States, the Export-Import Bank of the United States, the Overseas Private Investment Corporation of the United States, and such other institutions of either Contracting State as the competent authorities of both Contracting States may determine by mutual agreement), or ECTSDa b) A resident of one of the Contracting States with respect to debt obligations guaranteed or insured by that Contracting State or an instrumentality thereof. shall be exempt from tax by the other Contracting State. Under paragraphs 2 and 3, interest arising in the Philippines and derived by a resident of the United States is subject to income tax at a rate not to exceed: (a) 10 percent of the gross amount of the interest if it arises from public issues of bonded indebtedness; or (b) 15 percent of the gross amount of the interest in all other cases. Under paragraph 4, such interest is exempt from income tax if it is derived by the Government of the United States, or an instrumentality of the United States such as the Federal Reserve Banks of the United States, the Export-Import Bank of the United States, the Overseas Private Investment Corporation of the United States, and other institutions of the United States that may be determined by mutual agreement, or by any other resident of the United States with respect to debt obligations guaranteed or insured by the Government of the United States or an instrumentality thereof. Accordingly, the subject interest on overdue payments to be paid by Casual Clothing to Banana Republic and Gap under the Franchise Agreements is subject to income tax at a rate of 15 percent of the gross amount thereof. The said interest cannot be subject to the lower rate of 10 percent under paragraph 3, nor be exempt under paragraph 4, because the conditions in availing either of these more preferential tax treatments are lacking in the case of the said interest payable to Banana Republic and Gap . B. On value-added tax Inasmuch as the Franchise Agreements between Casual Clothing and Banana Republic and between Casual Clothing and Gap involve the lease of intangible properties (copyrights, patents, trademarks, and information concerning industrial, commercial or scientific experience or know-how), such sale of services and use or lease of properties in the Philippines is generally subject to value-added tax (VAT) under Section 108 (A) (1) and (3) of the Tax Code of 1997, as amended, which provides: "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 one and one-half percent (1 1/2%); or (ii) National government deficit as a percentage of GDP of the previous year exceeds one and one-half percent (1 1/2%). 3 . . . 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 (3) The supply of scientific, technical, industrial or commercial knowledge or information ;"(emphasis added) cDCEIA While VAT is generally imposed on any person who sells, barters, exchanges, leases goods or properties, and renders services, generally in the course of his or its trade or business, Section 105 of the Tax Code provides that services rendered in the Philippines by nonresident foreign persons like Banana Republic and Gap are likewise considered rendered in the course of trade or business and as such will be subject to VAT. Section 105 provides: "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. " (emphasis added) CSDTac Accordingly, Casual Clothing, as a resident withholding agent, is liable to withhold VAT on payments to be made by it pursuant to the Franchise Agreements before remitting them to Banana Republic and Gap, the nonresident recipients, at the rate of 12 percent. For this purpose, Casual Clothing will use BIR Form No. 1600 (Remittance Return of VAT and Other Percentage Taxes Withheld), and, assuming Casual Clothing is a VAT-registered taxpayer, such VAT withheld may be claimed by it as input tax upon filing its own VAT Return, subject to the rule on allocation of input tax among taxable sales, zero-rated sales and exempt sales. The duly filed BIR Form No. 1600 will be the proof or documentary substantiation for the claimed input tax or input VAT. On the other hand, assuming Casual Clothing is not a VAT-registered taxpayer, such VAT passed-on to it by Banana Republic and by Gap as evidenced by the duly filed BIR Form No. 1600, will form part of the cost of services purchased, which may be treated either as an expense or as an asset of Casual Clothing, whichever is applicable. The VAT withheld will be remitted by Casual Clothing within 10 days following the end of the month such withholding was made. Section 4.112-2 of Revenue Regulations No. 16-2005, 4 as amended by Revenue Regulations No. 4-2007, 5 provides: "SEC. 4.114-2. Withholding of VAT on Government Money Payments and Payments to Non-Residents. xxx xxx xxx (b) The government or any of its political subdivisions, instrumentalities or agencies including GOCCs, as well as private corporation, individuals, estates and trust, whether large or non-large taxpayers, shall withhold twelve percent (12%) VAT, starting February 1, 2006, with respect to the following payments: (1) Lease or use of properties or property rights owned by non-residents; and (2) Other services rendered in the Philippines by non-residents. In remitting VAT withheld, the withholding agent shall use BIR Form No. 1600 Remittance Return of VAT and Other Percentage Taxes Withheld. VAT withheld and paid for the non-resident recipient (remitted using BIR Form No. 1600), which VAT is passed on to the resident withholding agent by the non-resident recipient of the income, may be claimed as input tax by said VAT-registered withholding agent upon filing his own VAT Return, subject to the rule on allocation of input tax among taxable sales, zero-rated sales and exempt sales. The duly filed BIR Form No. 1600 is the proof or documentary substantiation for the claimed input tax or input VAT. Nonetheless, if the resident withholding agent is a non-VAT taxpayer, said passed-on VAT by the non-resident recipient of the income, evidenced by the duly filed BIR Form No. 1600, shall form part of the cost of purchased services, which may be treated either as an 'expense' or 'asset', whichever is applicable, of the resident withholding agent. DTEcSa VAT withheld under this Section shall be remitted 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 upon investigation it shall be disclosed that the actual facts are different, then this ruling shall be without force and effect insofar as the herein parties are concerned. Very truly yours, (SGD.) SIXTO S. ESQUIVIAS IV Commissioner of Internal Revenue Footnotes 1. Signed on October 1, 1976, and effective January 1, 1983. 2. Before the effectivity of the Philippines-Czech tax treaty, the most-favored-nation income tax rate on royalties is available under the Agreement between the Government of the Republic of the Philippines and the Government of the People's Republic of China for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (Philippines-China tax treaty) , effective January 1, 2002. However, unlike the Philippines-Czech tax treaty as described above, the 10 percent most-favored-nation income tax rate under the Philippines-China tax treaty would not apply to royalties for the use of, or the right to use, any copyright of literary, artistic or scientific work, and to contracts giving rise to the payment of royalties which are not approved by the Philippine competent authorities (particularly, the Intellectual Property Office). 3. The VAT rate was increased to 12 percent 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. 4. Entitled Consolidated Value-Added Tax Regulations of 2005, dated September 1, 2005, and effective fifteen days after its publication. 5. Entitled Amending Certain Provisions of Revenue Regulations No. 16-2005, As Amended, Otherwise Known as the Consolidated Value-Added Tax Regulations of 2005, dated February 7, 2007, and which is effective fifteen days after its publication.