ITAD BIR Ruling No. 037-11

February 2, 2011 ITAD BIR RULING NO. 037-11 Article 12, Philippines-Japan tax treaty; Section 28, NIRC of 1997; BIR Ruling No. ITAD-48-10; BIR Ruling No. ITAD-11-10 Aranas Consunji Barleta Unit 106 G/F Le Metropole Building 326 Tordesillas cor. Dela Costa Sts. Salcedo Village, Makati City Attention: Pericles C. Consunji Gentlemen : This refers to your letter dated November 18, 2009, on behalf of your clients, Air Water, Inc. (hereinafter referred to as "AWI") and Air Water Philippines, Inc. (hereinafter referred to as "AWPI"), requesting confirmation that the royalty payments paid by AWPI to AWI is subject to preferential tax rate pursuant to the Convention between the Republic of the Philippines and Japan for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (hereinafter referred to as "Philippines-Japan tax treaty" ). It is represented that AWI is a nonresident foreign corporation duly organized and existing under the laws of Japan, with principal office address at 1-8 Nakahama-Cho, Amagasaki-Shi, Hyogo, 660-0091, Japan; that AWI is not registered either as a corporation or as a partnership in the Philippines as shown in the Certification of Non-Registration issued by the Securities and Exchange Commission on November 4, 2009; that AWPI is a corporation duly organized and existing under the laws of the Philippines with principal place of business at 119 East Main Avenue, Special Economic Zone, Laguna Technopark, Bian, Laguna; that AWPI is registered with the Philippine Economic Zone Authority (PEZA) with Certificate of Registration No. 02-055; and that AWPI is engaged in the business of metal treatment and other allied services including the importation of raw materials. It is further represented that on October 25, 2006, AWPI and AWI entered into a Technology Supply Contract (hereinafter referred to as "Contract" ) that shall be in force and effect for ten (10) years from the date of signing, whereby AWI agreed to transfer to AWPI the Process 1 and related technology to be made available by AWI to AWPI which shall be suitable for the material and form of the Products 2 to be treated, as well as the Production volume to be produced by AWPI. Accordingly, AWI shall supply to AWPI the following: 1. The main information concerning treatment by the Process; 2. The method of operation of the Facility; 3 3. A new version of the Process and related equipment, should there be any change to the production plan or to the materials and shape of the Products to be treated after the initial supply of the Process; IDEHCa 4. The main information concerning treatment by the Process changed in accordance with Article 3.3.4 of the Contract; 5. The method of the operation of the facility for a new version of the Process and related equipment, as revised in accordance with Article 3.3.4 of the Contract; 6. The method of maintenance of the Facility; 7. Technology information relative to the implementation of any technological improvement, should AWI implement the same after introduction of the original Process; and 8. Other technology and information related. In consideration for AWI's supply to AWPI of the technology, AWPI shall pay AWI an amount equivalent to 5% of the total sales of the commissioned finishing work implemented by AWPI; that Value added tax (VAT) shall be added to the agreed royalties, if applicable; and that the transaction subject of the herein request for ruling is not under investigation, on-going audit, administrative protest, claim for refund or issuance of a tax credit certificate, collection proceedings, or a judicial appeal of the taxpayers involved. In reply, please be informed that royalty payments to a nonresident foreign corporation are, in general, covered by Section 28 (B) (1) of the National Internal Revenue Code (Tax Code) of 1997, as amended. It provides: "Section 28. Rates of Income Tax on Foreign Corporations. xxx xxx xxx (B) Tax on Nonresident Foreign Corporation. (1) In General. Except as otherwise provided in this Code, a foreign corporation not engaged in trade or business in the Philippines shall pay a tax equal to thirty-five percent (35%) of the gross income received during royalties . . .: Provided, That effective January 1, 2009, the rate of income tax shall be thirty percent (30%). xxx xxx xxx" However, Section 32 (B) (5) of the Tax Code of 1997, as amended provides: "Section 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. xxx xxx xxx" In accordance with the foregoing, we apply Article 12 of the Philippines-Japan tax treaty which provides: HSTaEC "Article 12 1. Royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other Contracting State. 2. However, such royalties may also be taxed in the Contracting State in which they arise, and according to the laws of that Contracting State, but if the recipient is the beneficial owner of the royalties the tax so charged shall not exceed: a) 15 per cent of the gross amount of the royalties if the royalties are paid in respect of the use of or the right to use cinematograph films and films or tapes for radio or television broadcasting; b) 25 per cent of the gross amount of the royalties in all other cases. xxx xxx xxx 2. Notwithstanding the provisions of paragraph 2, the amount of tax imposed by the Philippines on the royalties paid by a company, being a resident of the Philippines, registered with the Board of Investments and engaged in preferred pioneer areas of investment under the investment incentives laws of the Philippines to a resident of Japan, who is the beneficial owner of the royalties, shall not exceed 10 per cent of the gross amount of the royalties. 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 cinematograph films and films or tapes for radio or television 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. xxx xxx xxx" Based on the foregoing, the royalty payments will be taxed at the preferential tax rate of 10 percent if the payor is a Board of Investments (BOI)-registered enterprise and engaged in preferred pioneer areas of investment, 15 percent if the payments are in respect of the use of or the right to use cinematograph films and films or tapes for radio or television broadcasting, and in all other cases, 25 percent of the gross amount of the royalties. In relation thereto, a Protocol Amending the Convention Between the Republic of the Philippines and Japan for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (hereinafter referred to as "Protocol Amending the Philippines-Japan tax treaty" ) took effect on January 1, 2009, Article V of which reads as follows: "ARTICLE V Paragraph (2) of Article 12 of the Convention shall be deleted and replaced by the following: "(2) However, such royalties may also be taxed in the Contracting State in which they arise, and according to the laws of that Contracting State, but if the recipient is the beneficial owner of the royalties the tax so charged shall not exceed: (a) 15 per cent of the gross amount of the royalties if the royalties are paid in respect of the use of or the right to use cinematograph films and films or tapes for radio or television broadcasting; (b) 10 per cent of the gross amount of the royalties in all other cases." Pursuant to Article V of the above Protocol, the royalty payments which will be taxed at the preferential tax rate of 15 percent are in respect of the use of or the right to use cinematograph films and films or tapes for radio or television broadcasting, and in all other cases, 10 percent of the gross amount of the royalties. HETDAC Such being the case, this Office is of the opinion and so holds that since AWPI is not a BOI-registered enterprise engaged in preferred pioneer areas of investment, and, since the subject royalty payments are not paid in respect of the use of or the right to use cinematograph films and films or tapes for radio or television broadcasting, the said royalty payments by AWPI to AWI under the said Contract shall be subject to tax at the rate not exceeding 25 percent of the gross amount of royalties covered by the Agreement but only so much of the payments made from October 25, 2006 to December 31, 2008. With respect to payment after January 1, 2009, the rate shall be 10 percent of the gross amount of the royalties, pursuant to Article V of Protocol Amending the Philippines-Japan tax treaty. As regards the imposition of the VAT on the transfer of technical know-how by AWI, please be informed further that Section 108 of the Tax Code of 1997, as amended, provides as follows: "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 twelve percent (12%) of gross receipts derived from the sale or exchange of services, including the use or lease of properties. (Emphasis supplied) xxx xxx xxx" Thus, in general, the VAT is imposed on the transfer of technical know-how by AWI in the Philippines, such that on every payment of royalty fee, AWPI is generally required to withhold such VAT and treat the same as a "passed on" VAT, pursuant to Section 4.110-3 (b) of Revenue Regulations No. 7-95 as amended [now Section 4.114-3 (b) of Revenue Regulations No. 16-05] . However, in Commissioner of Internal Revenue vs. Seagate Technology (Philippines) (G.R. No. 153866, February 11, 2005), the Supreme Court held, viz. : "Special laws may certainly exempt transactions from the VAT. However, the Tax Code provides that those falling under PD 66 are not. P.D. 66 is the precursor of R.A. 7916 the special law under which respondent was registered. The purchase transactions it entered into are, therefore, not VAT-exempt. These are subject to the VAT; respondent is required to register. xxx xxx xxx" Since the purchases of respondent are not exempt from the VAT, the rate to be applied is zero. Its exemption under both P.D. 66 and R.A. 7916 effectively subjects such transactions to a zero rate, because the ecozone within which it is registered is managed and operated by the PEZA as a separate customs territory. This means that in such zone is created the legal fiction of foreign territory. Under the cross-border principle of the VAT system being enforced by the Bureau of Internal Revenue (BIR), no VAT shall be imposed to form part of the cost of goods destined for free of the VAT, then the same rule holds for such exports from the national territory except specifically declared areas to an ecozone. xxx xxx xxx" Applying the special laws we have earlier discussed, respondent as an entity is exempt from internal revenue laws and regulations. This exemption covers both direct and indirect taxes, stemming from the very nature of the VAT as a tax on consumption, for which the direct liability is imposed on one person but the indirect burden is passed on to another. Respondent, as an exempt entity, can neither be directly charged for the VAT on its sales nor indirectly made to bear, as added cost to such sales, the equivalent VAT on its purchases. Ubi lex non distinguit, nec nos distinguere debemus . Where the law does not distinguish, we ought not to distinguish. Moreover, the exemption is both express and pervasive for the following reasons: . . ., R.A. 7916 states that 'no taxes, local and national, shall be imposed on business establishments operating within the ecozone'. Since this law does not exclude the VAT from the prohibition, it is deemed included. Exceptio firmat regulam in casibus non exceptis. An exception confirms the rule in cases not excepted; that is, a thing not being excepted must be regarded as coming within the purview of the general rule. HEITAD Moreover, even though the VAT is not imposed on the entity but on the transaction, it may still be passed on and, therefore, indirectly imposed on the same entity a patent circumvention of the law. That no VAT shall be imposed directly upon business establishments operating within the ecozone under R.A. 7916 also means that no VAT may be passed on and imposed indirectly. Quando aliquid prohibetur ex directo prohibetur et per obliquum. When anything is prohibited directly, it is also prohibited indirectly. xxx xxx xxx" Based on the foregoing, transactions exempt from VAT by reason of P.D. 66 and R.A. 7916 are effectively zero-rated. However, instead of zero-rating which is not available to non-resident suppliers, the provision for exempt transactions under Section 109 (q) [now Section 109 (K)] of the Tax Code of 1997 which provides VAT exemption for transactions that are exempt under special laws, e.g. , Republic Act No. 7916 or PEZA Law, is particularly applicable to the instant case. Such being the case, the payment of royalty fees by AWPI, being a PEZA-registered enterprise, to AWI under the Agreement should be, as it is hereby confirmed to be, exempt from VAT. 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.) KIM S. JACINTO-HENARES Commissioner of Internal Revenue Footnotes 1. "Process" shall refer to the nitriding process developed and commercialized by AWI which is carried out by creating an active fluoride layer on a metal surface as a pretreatment. Particularly, the Process subject of this contract shall cover Patent Numbers 2501925 (Method of Pre-treating Metallic Works) and 2138825 (Method of Nitriding Steel), which are duly registered in the name of AWI under applicable intellectual property laws of Japan. 2. "Product" refers to the parts and materials that have undergone treatment by the Process, and are intended for delivery to AWPI customers. 3. "Facility" refers to the specialized furnace and peripheral equipment used for the Process employed in the Business.