ITAD BIR Ruling No. 041-10

September 21, 2010 ITAD BIR RULING NO. 041-10 Art. 13, Philippines-United States of America Tax Treaty; BIR Ruling No. ITAD-127-06; BIR Ruling No. DA-ITAD-032-08; BIR Ruling No. DA-ITAD-105-08; BIR Ruling No. DA-ITAD-024-09; BIR Ruling No. DA-ITAD-060-07 SyCip Gorres Velayo & Co. Ernst & Young 6760 Ayala Avenue 1226 Makati City Attention: Luis Jose P. Ferrer Partner, Tax Advisory and Advocacy Group Gentlemen : This refers to your letter dated May 7, 2009 requesting confirmation of your opinion that the royalties paid by WENPHIL CORPORATION (Wenphil) to WENDY'S INTERNATIONAL, INC. (WII) are subject to a preferential tax rate of ten percent (10%) of the gross amount of royalty payments in accordance with the "most-favored-nation" clause of the Philippines-United States of America (Philippines-US) tax treaty in relation to Article 12 of the Philippines-Czech tax treaty. It is represented that WII is a resident of the United States of America for purposes of taxation as evidenced by the Certification issued by Ivy S. McChesney, Field Director, Accounts Management, Department of the Treasury, Internal Revenue Service, Philadelphia, PA 19255 dated September 29, 2008; that its principal office is at One Dave Thomas Blvd., Dublin, Ohio 43017; that WII is not registered either as a corporation or as a partnership in the Philippines as confirmed by the Certification of Non-Registration of Corporation/Partnership dated January 23, 2009 issued by the Securities and Exchange Commission; that, on the other hand, Wenphil is a domestic company with principal office at 2nd Floor UNI-OIL Building, 1222 Commerce Avenue corner Acacia Street, Madrigal Business Park, Ayala Alabang, Muntinlupa City. It is further represented that on March 6, 2006, WII and Wenphil executed a Franchise Agreement whereby WII, as the Franchisor, grants to Wenphil, as the Franchisee, the right to operate the Franchised Business 1 at the Restaurant 2 in strict compliance with the Agreement and the standards and procedures set forth in the Manual 3 and to use the Proprietary Marks 4 and the System 5 only in connection with the Franchised Business 6 at the Approved Location; 7 that in consideration for the grant, the Franchisee shall pay the Franchisor a technical assistance fee and continuing monthly royalty fee from the opening or scheduled opening of the Restaurant, whichever is earlier, and during the term of the Agreement; that a separate Franchise Agreement is executed for each Approved Location but the terms and conditions for each is similar; that the Agreement shall commence on the Effective Date 8 and end on the earlier of (i) ten (10) years from the date on which the Restaurant is opened for business, (ii) the effective date of termination if the Agreement is terminated under Article 14, (iii) immediately upon an assignment or transfer of the Agreement not approved in advance by Franchisor under Article 13, or (iv) the date on which the lease for the Restaurant expires or is terminated and Franchisee loses the right to possession of the Approved Location; and that the issue or transaction subject of above application is not under investigation, on-going audit, administrative protest, claim for refund or issuance of a tax credit certificate, collection proceedings, or a judicial appeal. DHSaCA 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 to royalty payments received by nonresident foreign corporations. It provides: "Section 28. Rates of Income Tax on Foreign Corporations. xxx xxx xxx (B) Tax on Nonresident Foreign Corporation. (1) In General. Except as otherwise provided in this Code, a foreign corporation not engaged in trade or business in the Philippines shall pay a tax equal to thirty-five percent (35%) of the gross income received during each taxable year from all sources within the Philippines, such as interests, dividends, rents, royalties, salaries, premiums (except reinsurance premiums), annuities, emoluments or other fixed or determinable annual, periodic or casual gains, profits and income, and capital gains, except capital gains subject to tax under subparagraph 5(c): 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 relation thereto, the provisions of the Philippines-US tax treaty may apply to your request for relief particularly its Article 13, which provides: "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. ITHADC 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. xxx xxx xxx" Paragraph 2 (b) (iii) above provides that royalties arising in the Philippines and derived by a resident of the United States shall 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 (commonly known as the most-favored-nation tax treatment of royalties). The Supreme Court, in Commissioner of Internal Revenue vs. S.C. Johnson and Son, Inc. and Court of Appeals (G.R. No. 127105 dated June 25, 1999), has cited two conditions for royalties arising in the Philippines and derived by a resident of another country (in this case, the United States) to be qualified for a most-favored-nation tax treatment. 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 which are subject to the most-favored-nation tax treatment under the existing tax treaty between the Philippines and the third country. Second, the mechanism employed by the other country (the United States) in mitigating the effects of double taxation of foreign-sourced income derived by its residents must be the same with that employed by the third country, which can be determined by taking into account and comparing the respective articles on Elimination of Double Taxation of the other country (the United States) and the third country under their respective tax treaties with the Philippines. In looking for a third country which grants a most-favored-nation tax treatment on royalties, you cited the Czech Republic, particularly, the Convention between the Government of the Republic of the Philippines and the Government of the Czech Republic for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (Philippines-Czech tax treaty), which entered into force on September 23, 2003, and whose provisions on taxes apply on income derived or which accrued beginning January 1, 2004. Article 12 of this 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. xxx xxx xxx" According to paragraph 2, royalties arising in the Philippines and derived by a resident of Czech are subject to income tax at the rate of (a) 10% 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 (except those for cinematograph films, and films or tapes for television or radio broadcasting), 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, or (b) 15% of the gross amount of the royalties for 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. HTSIEa Applying the Philippines-Czech tax treaty, the royalty fee to be paid by Wenphil to WII for the right to use the Proprietary Marks and the System only in connection with the Franchised Business at the Approved Location, may be subject to 10% based on the gross amount thereof, provided the two conditions for the most-favored-nation tax treatment of royalties (as described above) are both satisfied. On whether the first condition is satisfied, we note that under paragraph 3, Article 13 of the Philippines-US tax treaty quoted below, payments received as a consideration for the use or the right to use of patents, information concerning industrial, commercial or scientific experience (know-how), and copyright of literary, artistic or scientific work (to which the royalty fee for the use or the right to use of the Licensed Patents, Licensed Trademark and Technical Information, are assimilated, (respectively) are all considered royalties, 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." In the same manner, although lacking a separate paragraph for the definition of royalties in its article, paragraph 2 (a), Article 12 of the Philippines-Czech tax treaty, as quoted above, provides that royalties arising from the use or the right to use of patents, information concerning industrial, commercial or scientific experience (know-how), and copyright of literary, artistic or scientific work, among others, are subject to income tax rate of 10% of the gross amount thereof. This being the case, the first condition for the most-favored-nation tax treatment of royalties is satisfied, which requires the royalties derived by a resident of the US must be of the same kind as those derived by a resident of Czech. As to the second condition, under paragraph 1, Article 23 of the Philippines-US tax treaty below, the mechanism employed in mitigating the effects of double taxation of income from foreign source is the ordinary credit method. It provides: "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. xxx xxx xxx" Under the ordinary credit method, the US (as country of residence) would limit a taxpayer's allowable tax credit to that portion of the taxpayer's tax liability in the US that is attributable to the income that is taxed in the Philippines (the country of source or country of situs). As a result of this limitation, if the Philippines has an effective tax rate that exceeds the effective tax rate of the US on a particular income, the US would not grant the taxpayer a full credit for the income tax imposed by the Philippines on such income. In the same manner, under paragraph 2, Article 22 of the Philippines-Czech tax treaty below, it can be seen that that ordinary credit method is also employed by Czech Republic as a mechanism for mitigating the effects of double taxation of income derived by its residents from foreign sources, thus: cAHDES "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 the tax on the remaining income of such resident, take into account the exempted income. xxx xxx xxx" This being the case, the second condition for the most-favored-nation tax treatment of royalties, which requires that the mechanism employed by the US in mitigating the effects of double taxation of income derived by its residents from foreign sources must be the same with that employed by Czech Republic, is also satisfied. In fine, by reason that the conditions for the most-favored-nation tax treatment of royalties laid down by the Supreme Court in the S.C. Johnson case are both satisfied, royalty fees to be paid by Wenphil to WII for the use or the right to use of the Proprietary Marks and the System only in connection with the Franchised Business at the Approved Location is subject to 10% income tax based on the gross amount thereof. (BIR Ruling No. ITAD 127-06 dated October 23, 2006; BIR Ruling No. DA-ITAD-032-08 dated May 9, 2008; BIR Ruling No. DA-ITAD 105-08 dated December 12, 2008; BIR Ruling No. DA-ITAD 024-09 dated February 27, 2009; and BIR Ruling No. DA-ITAD 060-07 dated May 11, 2007) Finally, as regards value-added tax (VAT), the royalties for the use or the right to use of the Proprietary Marks and the System only in connection with the Franchised Business at the Approved Location to be paid by Wenphil to WII are subject to VAT under Section 108 (A) of the Tax Code of 1997, as amended, 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. . . . 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; aIAcCH xxx xxx xxx" 9 With regard to the procedures for withholding and paying the VAT, Sections 4 and 6 of Revenue Regulations No. 4-2000, Section 3 of Revenue Regulations No. 8-2002, and Section 7 of Revenue Regulations No. 14-2002, provide that Wenphil shall be responsible for the withholding of the VAT on the royalties before remitting them to WII. In remitting to the Bureau of Internal Revenue the VAT withheld on the royalties, Wenphil shall use BIR Form No. 1600 (Monthly Remittance Return of VAT and Other Percentage Taxes Withheld). If a VAT-registered taxpayer, Wenphil may use as documentary substantiation for its claim of input VAT the duly filed BIR Form No. 1600 and the proof of payment accompanying it. In addition, Wenphil is required to issue in quadruplicate the Certificate of Final Tax Withheld at Source (BIR Form No. 2306), the first three copies for WII and the fourth copy for Wenphil as its file copy. 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. "Franchised Business" means the business of constructing and equipping the Restaurant, locating sources of supply, obtaining utility service, hiring and training staff, obtaining permits and approvals, establishing accounting and financial reporting systems, purchasing inventory, opening, and operating the Restaurant at the Approved Location in compliance with this Agreement. 2. "Restaurant" means the Wendy's restaurant operated by Franchisee at the Approved Location pursuant to and in accordance with this Agreement during the term of this Agreement. 3. "Manual" means Franchisor's Operating Manual including all supplements, revisions, replacements and updates, which Franchisor lends to Franchisee and includes any translations of the Operating Manual made or obtained by Franchisee. 4. "Proprietary Marks" means the trademarks, service marks, trade names, logos, designs, devices and indicia of origin, including but not limited to marks "Wendy's", "Wendy's device", "Wendy", "Wendy device" and "Wendy's Old Fashioned Hamburgers", which Franchisor has designated or may designate, from time to time, for use in connection with the Wendy's System. 5. "System" means the distinctive format and system relating to the establishment and operation of Wendy's restaurants featuring, among other things, hamburgers, chili, salads, French fries, assorted chicken and other sandwiches, and other food and beverages and includes, without limitation, distinctive exterior and interior design, dcor, color schemes, and furnishings; menu items prescribed by Franchisor; uniform standards, specifications, and procedures for operations; quality and uniformity of products and services offered; procedures for management and inventory control; training and assistance; and advertising and promotional programs; all of which may be changed, improved, and further developed by Franchisor from time to time. 6. "Franchised Business" means the business of constructing and equipping the Restaurant, locating sources of supply, obtaining utility service, hiring and training staff, obtaining permits and approvals, establishing accounting and financial reporting systems, purchasing inventory, opening, and operating the Restaurant at the Approved Location in compliance with this Agreement. 7. "Approved Location" means the premises located at Ground Floor, South Parking Building, SM Mall of Asia, SM Central Business Park, Bay City, Pasay City, Philippines. 8. March 6, 2006. 9. Republic Act No. 9337 (An Act Amending Sections 27, 28, 34, 106, 107, 108, 109, 110, 111, 112, 113, 114, 116, 117, 119, 121, 148, 151, 236, 237 and 288 of the National Internal Revenue Code of 1997, As Amended, and for Other Purposes), which was signed into law on May 24, 2005 and became effective on November 1, 2005, amended Section 108 (A) to read as: "SEC. 108. Value-added Tax on Sale of Services and Use or Lease of Properties. (A) Rate and Base of Tax. There shall be levied, assessed and collected, a value-added tax equivalent to ten percent (10%) of gross receipts derived from the sale or exchange of services, including the use or lease of properties: Provided, that the President, upon the recommendation of the Secretary of Finance, shall, effective January 1, 2006, raise the rate of value-added tax to twelve percent (12%), after any of the following conditions has been satisfied: (i) Value-added tax collection as a percentage of Gross Domestic Product (GDP) of the previous year exceeds two and four-fifth percent (2 4/5%); or (ii) National government deficit as a percentage of GDP of the previous year exceeds one and one-half percent (1 1/2%). . . . The phrase 'sale or exchange of services' shall likewise means the performance of all kinds of services in the Philippines for others for a fee, remuneration or consideration, xxx xxx xxx" 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.