ITAD BIR Ruling No. 018-12

January 12, 2012 ITAD BIR RULING NO. 018-12 Articles 5 (Permanent Establishment) and 7 (Business Profits); Philippines-New Zealand tax treaty Sycip Gorres Velayo and Co. 6760 Ayala Avenue 1226 Makati City Attention: Carolina A. Racelis Principal, Tax Services Gentlemen : This refers to your tax treaty relief application ("TTRA") filed on June 21, 2011 requesting confirmation that service fees paid by Microsoft Philippines, Inc. ("Microsoft Philippines") to Provoke Solutions Ltd. ("Provoke Solutions") are exempt from income tax pursuant to the Convention between the Government of the Republic of the Philippines and the Government of the New Zealand for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income ("Philippines-New Zealand tax treaty") . aCHDAE Facts It is represented that Provoke Solutions is a corporation organized and existing under the laws of New Zealand and is a resident thereof based on the computer-generated Company Extract issued by the Companies Office of New Zealand on May 5, 2011 and on the Certificate of Status of Taxable Company issued by the Inland Revenue Department of New Zealand on May 3, 2011; that Provoke Solutions is situated at Level 12, 22/28 Willeston Street, Wellington, New Zealand; that Provoke Solutions is not registered as a corporation or partnership in the Philippines based on the Certificate of Non-Registration of Company issued by the Securities and Exchange Commission on May 11, 2011; and that Microsoft Philippines ,on the other hand, is a domestic corporation situated at 16th and 17th Floors, 6750 Ayala Office Tower, 6750 Ayala Avenue, Makati City, Philippines. It is further represented that on April 21, 2011, Microsoft Philippines and Provoke Solutions entered into a Microsoft Consulting Services Subcontractor Work Order where Provoke Solutions agreed to provide services ("Work") to Microsoft Philippines described as follows: Provoke Solutions will deploy 2 SharePoint Developers and 1 Interaction Specialist to build SharePoint applications for 4 'Complex' Applications for Microsoft Philippines' customer, United Coconut Planter's Bank .These applications are (i) LRS, (ii) Swift, (iii) Compliance Awareness, and (iv) BOO Exception Reporting. These applications will be written to replace the current workflows in Lotus Notes which is being terminated as all new workflows will be written using SharePoint. During the entire development work and migration period, close interaction and handholding will be maintained with UCPB developers so that they become familiar with the workflow, design and operations, etc. of each application. On each successful project completion, UCPB developers will be able to support, maintain and monitor these newly built SharePoint applications. In addition, Provoke Solutions will procure and implement the Nintex workflow accelerator for UCPB to ensure a valid license for a production server is procured under the name of UCPB. Successful delivery will be considered when: (i) The migrated applications are running on SharePoint; (ii) The applications perform to the acceptance criteria as defined by a technical Steering committee; and (iii) The Nintex workflow solution is procured and deployed. That the Work will commence on April 25, 2011, or earlier, and will be completed on or before June 25, 2011, unless extended by the parties; and that in consideration, Microsoft Philippines will pay service fees to Provoke Solutions amounting to US$69,820.00 within 30 days from the end of the contract on June 25, 2011. It is further represented that based on the Certification issued by the General Manager of Microsoft Philippines on May 31, 2011, Provoke Solutions sent the following personnel to the Philippines to provide services to Microsoft Philippines and the latter's customer, UCPB, under the Work Order: 1. John Robson (British) 2. Henry Chong (Malaysian) 3. Jacques Botha (New Zealander) 4. Aaron Sew Hoy (New Zealander) And that these personnel were in the Philippines on April 24 to May 12, 2011, for 19 days. It is finally represented that the service fees subject of this ruling are not under investigation, on-going audit, administrative protest, claim for refund or issuance of a tax credit certificate, collection proceedings, or judicial appeal, based on the Sworn Statement issued by the Financial Director of Microsoft Philippines on June 6, 2011. Ruling In reply, please be informed that under Section 28 (B) (1) of the National Internal Revenue Code of 1997 ("Tax Code"), as amended, the service fees payable to Provoke Solutions are subject to income tax at the rate of 30 percent, to wit: "SEC. 28. Rates of Income Tax on Foreign Corporations. xxx xxx xxx (B) Tax on Nonresident Foreign Corporation. (1) In General. Except as otherwise provided in this Code, a foreign corporation not engaged in trade or business in the Philippines shall pay a tax equal to thirty-five percent (35%) of the gross income received during each taxable year from all sources within the Philippines, such as interests, dividends, rents, royalties, salaries, premiums (except reinsurance premiums), annuities, emoluments or other fixed or determinable annual, periodic or casual gains, profits and income, and capital gains, except capital gains subject to tax under subparagraph 5(c) and (d) above: Provided, That effective January 1, 2009, the rate of income tax shall be thirty percent (30%)." However, under Section 32 (B) (5) of the Tax Code, such fees may be exempt from income tax or subject to a reduced rate to the extent required by any treaty obligation on the Philippines, to wit: "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, you invoke the Philippines-New Zealand tax treaty. Under tax treaties, payments for services are considered generally business profits unless otherwise treated as royalties when the contract out of which the services are rendered involves primarily the use or lease of an intangible property like know-how. In this regard, the following commentaries of the Organisation for Economic Cooperation and Development Model Tax Convention on Income and on Capital (Condensed Version, July 22, 2010) mention: "11.1 In the know-how contract, one of the parties agrees to impart to the other, so that he can use them for his own account, his special knowledge and experience which remain unrevealed to the public. It is recognised that the grantor is not required to play any part himself in the application of the formulas granted to the licensee and that he does not guarantee the result thereof. EHIcaT 11.2 This type of contract thus differs from contracts for the provision of services, in which one of the parties undertakes to use the customary skills of his calling to execute work himself for the other party. Payments made under the latter contracts generally fall under Article 7. 11.3 The need to distinguish these two types of payments, i.e., payments for the supply of know-how and payments for the provision of services, sometimes gives rise to practical difficulties. The following criteria are relevant for the purpose of making that distinction: Contracts for the supply of know-how concern information of the kind described in paragraph 11 that already exists or concern the supply of that type of information after its development or creation and include specific provisions concerning the confidentiality of that information. In the case of contracts for the provision of services, the supplier undertakes to perform services which may require the use, by that supplier, of special knowledge, skill and expertise but not the transfer of such special knowledge, skill or expertise to the other party. In most cases involving the supply of know-how, there would generally be very little more which needs to be done by the supplier under the contract other than to supply existing information or reproduce existing material. On the other hand, a contract for the performance of services would, in the majority of cases, involve a very much greater level of expenditure by the supplier in order to perform his contractual obligations. For instance, the supplier, depending on the nature of the services to be rendered, may have to incur salaries and wages for employees engaged in researching, designing, testing, drawing and other associated activities or payments to sub-contractors for the performance of similar services. THCASc 11.4 Examples of payments which should therefore not be considered to be received as consideration for the provision of know-how but, rather, for the provision of services, include: payments obtained as consideration for after-sales service, payments for services rendered by a seller to the purchaser under a warranty, payments for pure technical assistance, payments for a list of potential customers, when such a list is developed specifically for the payer out of generally available information (a payment for the confidential list of customers to which the payee has provided a particular product or service would, however, constitute a payment for know-how as it would relate to the commercial experience of the payee in dealing with these customers), payments for an opinion given by an engineer, an advocate or an accountant, and payments for advice provided electronically, for electronic communications with technicians or for accessing, through computer networks, a trouble-shooting database such as a database that provides users of software with nonconfidential information in response to frequently asked questions or common problems that arise frequently." Applying these commentaries, the service fees payable to Provoke Solutions are not royalties but business profits since: 1. The Work Order between Microsoft Philippines and Provoke Solutions concerns primarily the supply of services and not the use or lease by Microsoft Philippines, or its customer, UCPB, of any intangible property like know-how belonging to Provoke Solutions . 2. To perform the services, Provoke Solutions will merely use its special knowledge, skill and expertise on the subject, and not the transfer of such special knowledge, skill or expertise to Microsoft Philippines or UCPB. 3. To fulfill its contractual obligations, Provoke Solutions will actually perform or had actually performed services to Microsoft Philippines or UCPB by sending its personnel (2 SharePoint Developers and 1 Interaction Specialist) to the Philippines to build SharePoint applications for 4 'Complex' Applications for UCPB, and not simply supply existing information or material to Microsoft Philippines or UCPB. On the taxation of business profits, paragraph 1, Article 7 of the Philippines-New Zealand tax treaty provides that profits derived by enterprise of New Zealand from sources in the Philippines may be taxed in the Philippines if they are attributable to a permanent establishment which the enterprise has therein, to wit: "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 ..." Relative thereto, paragraphs 1 and 2, Article 5 of the treaty define a permanent establishment as follows: DTaAHS "Article 5 PERMANENT ESTABLISHMENT 1. For the purposes of this Convention, the term 'permanent establishment' means a fixed place of business through which the business of the enterprise is wholly or partly carried on. 2. The term 'permanent establishment' includes especially: a) a place of management; b) a branch; c) an office; d) a factory; e) a workshop; f) a mine, an oil or gas well, a quarry or any other place of extraction of natural resources; g) a place of exploration of natural resources; h) a building site or construction, installation or assembly project, or supervisory activities in connection therewith where such site, project or activity continues for more than six months; i) premises used as a sales outlet; j) a warehouse, in relation to a person providing storage mainly for some other person or persons; k) a place for the furnishing of services, including consultancy services by an enterprise through employees or other personnel where activities of that nature continue (for the same or a connected project) within the country for a period or periods aggregating more than 183 days within any twelve month period." Based on the aforequoted provisions, a permanent establishment means a fixed place of business through which the business of an enterprise is wholly or partly carried on, and includes especially, a place of management; a branch; an office; a factory; a workshop; a mine, an oil or gas well, a quarry or any other place of extraction of natural resources; a place of exploration of natural resources; premises used as a sales outlet; and a warehouse, in relation to a person providing storage mainly for some other person or persons. A permanent establishment also includes a building site or construction, installation or assembly project, or supervisory activities in connection therewith, which continue for more than six months, and a place for the furnishing of services, including consultancy services, which continue for a period or periods aggregating more than 183 days within any twelve month period. Accordingly, since Provoke Solutions is not engaged in trade or business in the Philippines to which a fixed place of business like an office or a branch is necessary, and since it did not furnish services in the Philippines for more than 183 days within any twelve-month period, but provided services to UCPB relating to the Work (as described in the Work Order) for an aggregate period of 19 days only (April 24 to May 12, 2011), Provoke Solutions is not deemed to have a permanent establishment with respect to the services it rendered in the Philippines. This being the case, the service fees paid by Microsoft Philippines to Provoke Solutions therefor shall be exempt from income tax pursuant to paragraph 1, Article 7, in relation to paragraphs 1 and 2, Article 5, of the Philippines-New Zealand tax treaty. Finally, regarding value-added tax ("VAT"), under Section 108 (A), in relation to Section 105 of the Tax Code, the portion of the service fees paid by Microsoft Philippines to Provoke Solutions for services rendered in the Philippines are subject to VAT, to wit: "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, 1 raise the rate of value-added tax to twelve percent (12%) . . . " aTEHIC "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) Relative thereto, Microsoft Philippines shall withhold VAT on the service fees at the rate of 12 percent before remitting them to Provoke Solutions . Microsoft Philippines shall use BIR Form No. 1600 (Monthly Remittance Return of Value-Added Tax and Other Percentage Taxes Withheld).The duly filed BIR Form No. 1600 and its accompanying proof of payment shall serve as documentary substantiation for Microsoft Philippines' claim of input tax on the fees. Otherwise, if Microsoft Philippines is not a VAT-registered taxpayer, it may treat the VAT as an asset or expense, whichever is applicable. VAT withheld shall be remitted within 10 days following the end of the month the withholding was made. 2 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. ECaTDc Very truly yours, (SGD.) KIM S. JACINTO-HENARES Commissioner of Internal Revenue Footnotes 1. The VAT rate was increased to 12 percent beginning 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. 2. Pursuant to Section 4.112-2 of Revenue Regulations No. 16-2005 (Consolidated Value-Added Tax Regulations of 2005) ,as amended by Revenue Regulations No. 4-2007 (Amending Certain Provisions of Revenue Regulations No. 16-2005, as Amended, Otherwise Known as the Consolidated Value-Added Tax Regulations of 2005) ,which 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 corporations, individuals, estates and trusts, 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) Services rendered to local insurance companies with respect to reinsurance premiums payable to non-residents; and (3) 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 'asset' or 'expense',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."