ITAD BIR Ruling No. 013-10

July 1, 2010 ITAD BIR RULING NO. 013-10 Articles 5 (Permanent Establishment), 7 (Business Profits), and 12 (Royalties) Philippines-Netherlands 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 letter dated December 19, 2008, filed on behalf of your client, Silverlake (Netherlands) B.V. (Silverlake), requesting confirmation of your opinion on the following, with respect to the License Agreement entered into by Silverlake and United Coconut Planters Bank (UCPB) : ECcaDT 1. that payment made by UCPB to Silverlake pursuant to the said License Agreement are classified as business profits under Revenue Memorandum Circular No. 44-2005; 2. that Silverlake has no permanent establishment in the Philippines, pursuant to Article 5 of the Philippines-Netherlands tax treaty; and 3. that the subject payments are exempt from Philippine income/withholding tax, pursuant to Article 7 (1) of the Philippines-Netherlands tax treaty. It is represented that Silverlake is a corporation organized and existing under the laws of the Netherlands and is a resident of the Netherlands within the meaning of Article 4 of the Convention for the avoidance of double taxation between the Netherlands and the Republic of the Philippines, with address at Strawinskylaan 3105, 1077 ZX Amsterdam based on the Declaration of Residence dated January 21, 2009, issued by M. de Graaff, the Inspector of the Tax Administration, Rotterdam, the Netherlands; that Silverlake is not registered as a corporation or as a partnership in the Philippines based on the Certification of Non-Registration of Corporation/Partnership dated November 18, 2008, issued by the Securities and Exchange Commission; and that, on the other hand, UCPB is a corporation organized and existing under the laws of the Philippines, situated at UCPB Building, Makati Avenue, Makati City, Philippines. It is further represented that on April 30, 2008, UCPB and Silverlake entered into a License Agreement wherein Silverlake granted UCPB (including the latter's subsidiary, UCPB Savings Bank, UCPB Leasing and UCPB Securities ) a nonexclusive, nontransferable, and perpetual license to use the Core Banking System Software Package (or the Product); 1 and that the Product shall be used by UCPB at the Site 2 for their internal processing requirements in the Philippines only. It is further represented that the Product is developed and owned by and is a proprietary product of Silverlake and/or its suppliers; that the License Agreement deals only with the licensed use of the Product and not the transfer of ownership or other rights in or to the Product; that the Product, whether written or in machine readable form, including programs, diskettes, tapes, listings and documentation, had originated with and was prepared by Silverlake and/or its suppliers jointly and pursuant to the Functional Specifications Document, and that any extension, modification, derivative, customizations, or enhancements made by Silverlake on the Product will continue to belong to Silverlake and/or its suppliers; that UCPB will neither permit nor cause any third party to translate, adapt, vary, modify, disassemble, decompile, or reverse engineer the Product in whole or in part, except to the extent permitted under applicable laws granting such rights to UCPB as a lawful user of the Product and to the extent permitted under the Agreement; that UCPB will supervise and control the use of the Product in accordance with the terms of the Agreement and will reproduce and include the copyright notice of Silverlake and/or its suppliers on all copies of the Product including partial copies or modifications thereof; that UCPB will, within 14 calendar days after the termination of the Agreement and as instructed by Silverlake in writing, return or destroy all electronic copies and printed documents of the Product including all updates, upgrades and modifications of the Product and all documentation relating thereto, and that UCPB will give a written notice to Silverlake that it has complied with such instruction of Silverlake ; and that notwithstanding the foregoing, UCPB may, with the prior written authorization of Silverlake , retain one copy of the Product for archive purposes only or for other purposes authorized by Silverlake under certain conditions imposed on the continued retention of the Product; and that a copy of the Source Code of the Product, as well as all its upgrades and documentation may be accessed by UCPB through an escrow arrangement with UCPB's Trust Banking Division as the escrow agent, unless another Escrow Agent is mutually agreed upon between the parties and the corresponding escrow fees shall be shouldered entirely by UCPB unless another Escrow Agent is appointed per mutual agreement in which case the escrow fees to be charged shall be shared equally by UCPB and Silverlake . It is further represented that in consideration for the use of the Product, UCPB will pay Silverlake a license fee of US$3,156,900.00, in accordance with the following schedule: TcHEaI Milestones Description Percentage of Contract Price Payable First Upon confirmation to commence 25 percent Phase D pursuant to the Services Agreement Second Upon commencement of User 25 percent Acceptance Testing by UCPB Third Upon completion of User Acceptance 20 percent Testing and sign-off of User Acceptance Testing by UCPB Fourth Upon Cut-Over Date 20 percent Fifth Upon expiry of the Warranty Period 3 10 percent that all payments to be made under the License Agreement will be paid within 30 days from the payment due date, and that payments not made within that period will accrue interest at the rate of twelve percent (12%) per annum computed from the due date to the actual date such payments are made; and that the issue/s or transaction subject of the above request for ruling is not under investigation neither is it subject of an on-going audit, administrative protest, claim for refund or issuance of a tax credit certificate, collection proceedings nor a judicial appeal. In reply, please be informed that Section 28 (B) (1) of the National Internal Revenue Code (Tax Code) of 1997, as amended, applies in general. It 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 subparagraph 5(c): Provided, That effective January 1, 2009, the rate of income tax shall be thirty percent (30%)." However, Section 32 (B) (5) of the Tax Code of 1997, as amended provides: DIHETS "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." With respect to a treaty that may be invoked by Silverlake and other residents of the Netherlands, there is the Philippines-Netherlands tax treaty. Since tax treaties follow the principal method of classification and assignment in mitigating the effects of double taxation of income derived by a resident of a Contracting State from sources in the other Contracting State, it is important to know how income derived by Silverlake under the License Agreement is classified for purposes of the Philippines-Netherlands tax treaty. Because the License Agreement grants UCPB the right to use the Product, the characterization of payments involving the use of software is generally covered by Revenue Memorandum Circular No. 44-2005 (Taxation of Payments for Software), effective September 8, 2005. Section 5 of this Circular provides: "Section 5. Characterization of Transactions . The character of payments received in a transaction involving the transfer of computer software depends on the nature of the rights that the transferee acquires under the particular arrangement regarding the use and exploitation of the program. xxx xxx xxx b. Transfer of copyrighted articles . A copyrighted article incorporating a software includes a copy of the software from which the work can be perceived, reproduced, or otherwise communicated, either directly or with the aid of a machine or device. The copy of the software may be fixed in the magnetic medium of a floppy disk or a CD-ROM, or in the main memory or hard drive of a computer, or in any other medium. If a person acquires a copy of a software but does not acquire any of the rights described above (or only acquires a de minimis grant of such rights), and the transaction does not involve the provision of services or of know-how, the transfer of the copy of the software is classified solely as a transfer of a copyrighted article and payments for which constitute business income." Under Section 5, payments for the use of software can give rise to either royalties or business profits . Payments for the use of software are business profits when the person concerned merely acquired a copy of the software and/or merely acquired a de minimis right or rights for the use of the software. Under the License Agreement, UCPB is permitted to use the Product where UCPB's production and backup computers are located, more specifically, its Primary Head Office Data Center and its Disaster Recovery Data Center, the location of which shall be notified to Silverlake from time to time, but such use does not permit UCPB to translate, adapt, vary, modify, disassemble, decompile, or reverse engineer the software in whole or in part. However, UCPB may, with the prior written authorization of Silverlake , retain one copy of the software for archive purposes only or for other purposes authorized by Silverlake under certain conditions imposed on the continued retention of the software. Because of the limited rights that UCPB can exercise with respect to the use of the software, payments to be made by UCPB to Silverlake cannot give rise to royalties but should be characterized as business profits , in accordance with the guidelines laid down in Section 5 of Revenue Memorandum Circular No. 44-2005. ESHAIC That UCPB may retain one copy of the Product for archive purposes only or for other purposes authorized by Silverlake under certain conditions imposed on the continued retention of the software refers to a de minimis right which may be exercised with or without the authorization of Silverlake under Section 189 of the Intellectual Property Code of 1998 (Republic Act No. 8293). Section 189 provides: "Section 189. Reproduction of Computer Program . 189.1. Notwithstanding the provisions of Section 177, the reproduction in one (1) backup copy or adaptation of a computer program shall be permitted, without the authorization of the author of, or other owner of copyright in, a computer program, by the lawful owner of that computer program; Provided, That the copy or adaptation is necessary for : (a) The use of the computer program in conjunction with a computer for the purpose, and to the extent, for which the computer program has been obtained; and (b) Archival purposes, and, for the replacement of the lawfully owned copy of the computer program in the event that the lawfully obtained copy of the computer program is lost, destroyed or rendered unusable . 189.2. No copy or adaptation mentioned in this Section shall be used for any purpose other than the ones determined in this Section, and any such copy or adaptation shall be destroyed in the event that continued possession of the copy of the computer program ceases to be lawful. 189.3. This provision shall be without prejudice to the application of Section 185 whenever appropriate." (Emphasis supplied) As business profits, payments to be made by UCPB to Silverlake are subject to the provisions of paragraph 1, Article 7 of the Philippines-Netherlands tax treaty as follows: "Article 7 Business Profits 1. The profits of an enterprise of one of the States shall be taxable only in that State unless the enterprise carries on business in the other 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 that permanent establishment." Under paragraph 1, such payments made to Silverlake may be taxed in the Philippines if the same are attributable to a permanent establishment which Silverlake has in the Philippines. Relative thereto, a permanent establishment is defined in paragraphs 1 and 2, Article 5 of the Philippines-Netherlands tax treaty as follows: "Article 5 Permanent Establishment 1. For the purposes of this Convention, the term 'permanent establishment' means a fixed place of business in 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; f) a mine, quarry or other place of exploration or extraction of natural resources; g) a building site or construction or assembly project or supervisory activities in connection therewith, where such site, project or activity continues for a period of more than 183 days; h) the furnishing of services including consultancy services by an enterprise through an employee or other personnel where activities of that nature continue (for the same or a connected project) for a period or periods exceeding in the aggregate 183 days within any twelve-month period. DTISaH 3. 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 for collecting information, for the enterprise; e) the maintenance of a fixed place of business solely for the purpose of advertising, for the supply of information, for scientific research or for similar activities which have a preparatory or auxiliary character, for the enterprise. 4. A person acting in one of the States on behalf of an enterprise of the other 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 the first-mentioned State, an authority to conclude contracts in the name of the enterprise, unless his activities are limited to the purchase of goods or merchandise for the enterprise; or b) he maintains in the first-mentioned State a stock of goods or merchandise belonging to the enterprise from which he regularly delivers goods or merchandise on behalf of the enterprise. 5. An insurance enterprise of one of the States shall, except with regard to reinsurance, be deemed to have a permanent establishment in the other State if it collects premiums in the territory of that other State or insures risks situated therein through an employee or through a representative who is not an agent of an independent status within the meaning of paragraph 6. 6. An enterprise of one of the States shall not be deemed to have a permanent establishment in the other State merely because it carries on business in that other State through a broker, general commission agent or any other agent of an independent status, where such persons are acting in the ordinary course of their business. 7. The fact that a company which is a resident of one of the States controls or is controlled by a company which is a resident of the other State, or which carries on business in that other State (whether through a permanent establishment or otherwise), shall not of itself constitute either company a permanent establishment of the other." Based on the Certification of Non-Registration of Corporation/Partnership dated November 18, 2008, issued by the Securities and Exchange Commission that Silverlake is not registered either as a corporation or as a partnership in the Philippines, it is deemed that Silverlake do not have a branch or an office , and, consequently, a permanent establishment , in the Philippines at least as of the date of the Certification on November 18, 2008. This being the case, payments to be made by UCPB to Silverlake pursuant to the License Agreement, for the use by UCPB of the Core Banking System Software Package, are exempt from Philippine income tax. DSTCIa On whether Article 12 (Royalties) of the Philippines-Netherlands tax treaty will apply, Paragraph 4 of Article 12 defines the term royalties as follows: "4. 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 cinematograph films or tapes for radio or television broadcasting, any patent, trademark, design or model, plan, secret formula or process, or for the use of, or the right to use, industrial, commercial or scientific equipment, or for information concerning industrial, commercial or scientific experience." The UN Commentary on Article 12 (paragraph 14.3, p. 185, OECD 2005) provides: "14.3. Another type of transaction involving the transfer of computer software is the more unusual case where a software house or computer programmer agrees to supply information about the ideas and principles underlying the program, such as logic, algorithms or programming languages or techniques. In these cases, the payments may be characterized as royalties to the extent that they represent consideration for the use of, or the right to use, secret formulas or for information concerning industrial, commercial or scientific experience which cannot be separately copyrighted. This contrasts with the ordinary case in which a program copy is acquired for operation by the end user." Under Article IV of the License Agreement, UCPB under certain condition may access the Source Code. In addition, it is given the option to purchase the Source Code at 50% of the contract price of the License Agreement, for the sole purpose of maintaining the Product and not for re-sale purposes. Said payment shall be made within 30 days after UCPB receives the invoice from Silverlake . Based on this, the Office is of the opinion and so holds that should UCPB make any payment to Silverlake for the Source Code under Article IV of the License Agreement, the same will result to royalty payments since there will be a transfer of know-how. It shall therefore be subject to the preferential tax rate of 15 percent of the gross amount of royalties pursuant to Article 12 (2) (b) of the Philippines-Netherlands tax treaty considering that UCPB is not a Board of Investments (BOI) registered enterprise engaged in preferred areas of activities in the Philippines. On whether such interest on overdue payments or penalty charges are covered by Article 11 (Interest) of the Philippines-Netherlands tax treaty, we take note that the same is not treated as interest under this article. Paragraph 5 of Article 11 defines the term interest as follows: "5. The term 'interest' as used in this Article means income from Government securities, bonds or debentures, whether or not secured by mortgage but not carrying a right to participate in profits, and debt-claims of every kind as well as all other income assimilated to income from money lent by the taxation law of the State in which the income arises. Penalty charges for late payment shall not be regarded as interest for the purpose of this Article ." (Emphasis supplied) Such interest on overdue payments or penalty charges cannot be covered either by a residual article on other income or an article on income not expressly covered by the preceding articles of a tax treaty as such article is not present in the Philippines-Netherlands tax treaty. Where such a residual article is lacking in the Philippines-Netherlands tax treaty, interest on overdue payments or penalty charges to be paid by UCPB to Silverlake under the License Agreement are taxable in accordance with the domestic tax laws of the Philippines. Particularly, and as previously mentioned, such income shall be subject to income tax at the rate of thirty-five percent (35%), now thirty percent (30%) based on the gross amount thereof under Section 28 (B) (1) of the Tax Code of 1997, as amended. Under Section 108 (A) (1) of the Tax Code of 1997, as amended by Republic Act No. 9337, the sale or exchange of services, including the use or lease of properties, in the Philippines is subject to value-added tax (VAT). Section 108 (A) (1) 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: 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: HAaDTI (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%). 4 The phrase 'sale or exchange of services' means the performance of all kinds of services in the Philippines for others for a fee, remuneration or consideration, . . ." Under Section 105 of the Tax Code of 1997, while the VAT is imposed on any person who sells, barters, exchanges, leases goods or properties, and renders services, generally in the course of its trade or business, this section likewise provides that services rendered in the Philippines by a nonresident foreign person like Silverlake is 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, non-profit 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) Accordingly, pursuant to Section 4.114-2 of Revenue Regulations No. 16-2005, 5 as amended by Revenue Regulations No. 4-2007, 6 UCPB, as the resident withholding agent, is liable to withhold VAT on all payments to be made by it to Silverlake , the nonresident recipient, pursuant to the License Agreement, at the rate of 12 percent beginning February 1, 2006, and onwards. Section 4.114-2 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. VAT withheld under this Section shall be remitted within ten (10) days following the end of the month the withholding was made." In addition, UCPB is required to Withhold Final Income Tax and issue the Certificate of Final Income Tax Withheld at Source, if it collects interest on overdue payments or penalty charges, otherwise it need not file if collections are purely for business profits for such is exempt under the Philippines-Netherlands tax treaty, (BIR Form No. 2306) in quadruplicate, the first three copies thereof to be given to Silverlake upon its request and the fourth copy to be retained by UCPB as its file copy. TSIDaH 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.) JOEL L. TAN-TORRES Commissioner of Internal Revenue Footnotes 1. Product means the Core Banking System software package which modules are stated in Annex A of the Agreement and Enhancements and Customizations made by SILVERLAKE for such modules in machine readable form together with manuals, specifications or other documentation in printed form including but not limited to listings, manuals, magnetic media to be furnished under the Agreement and references to Product shall include references to any part thereof (where applicable). 2. Site means the site where UCPB's production and backup computers are located as described in Annex B of the Agreement upon which the Product shall be installed for use by UCPB. Annex B provides as follows: "ANNEX B THE SITE Machine Type Site Production Machine Primary Head Office Data Center Back-up Machine Primary Head Office Data Center Development Machine Primary Head Office Data Center Disaster Recovery Machine Disaster Recovery Data Center 3. Warranty Period means a period of fifteen (15) months from Live Date. Live Date means the date that UCPB accepts the Product for live implementation in UCPB's production environment for the first Pilot Site. 4. 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. 5. Entitled Consolidated Value-Added Tax Regulations of 2005, dated September 1, 2005, and effective 15 days after its publication. 6. 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 effective 15 days after its publication.