ITAD BIR Ruling No. 041-17

November 20, 2017 ITAD BIR RULING NO. 041-17 Articles 5 (Permanent Establishment) and 7 (Business Profits) Philippines-Australia tax treaty Reyes Tacandong & Co. Phinma Plaza 39 Plaza Drive, Rockwell Center Makati City 1200 Attention: AAA _______________ Gentlemen : This refers to your tax treaty relief application filed on April 1, 2015 requesting confirmation that service fees paid by Philippine Electricity Market Corporation ("PEMC") to Birdanco Nominees Pty. Ltd. ("Birdanco") are exempt from income tax pursuant to the Agreement between the Government of the Republic of the Philippines and the Government of Australia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income ("Philippines-Australia tax treaty") . HTcADC FACTS Birdanco is a foreign corporation organized and existing under the laws of Australia and a resident thereof based on its amended Memorandum and Articles of Association and amended Certificate of Incorporation and Certificate of Residency issued by the Australian Taxation Office on March 16, 2015. Birdanco is originally known as Erintara Pty. Ltd. and formally known now as Birdanco Nominees Pty. Ltd. as Trustee for Birdanco Practice Trust Practising as RSM Bird Cameron . It is a firm of chartered accountants and business advisers formed in and carrying on business in Australia. Birdanco is not registered as a corporation or partnership in the Philippines based on the Certification of Non-registration of Company issued by the Securities and Exchange Commission on April 20, 2015. On the other hand, PEMC is a domestic corporation organized and existing under the laws of the Philippines with primary purpose of facilitating the trading of electricity supply in the Philippines at the wholesale electricity spot market ("WESM") where power suppliers disclose energy outputs and agree on energy prices. On February 3, 2015, PEMC and Birdanco entered into a Contract for External Audit Services where Birdanco agreed to provide to PEMC the following services as external auditor: 1. Market software and systems review; 2. Information security and technology review; 3. Process and compliance review; 4. Bid to bill analysis; and 5. Review of rules and manuals. Under WESM rules, the Audit Committee of PEMC is mandated to conduct, coordinate and supervise effective and independent audits of the operations of the spot market and of PEMC as market operator in order to reinforce confidence of power suppliers as trading participants in the transparency and adequacy of the operation of WESM. Birdanco will commence the service five days from receipt of notice of commencement letter and shall complete the services on or before May 31, 2015. The contract amount for the services is US$__________, payable as follows: 1. 20 percent of the amount within 10 days after PEMC 's acceptance of the inception report; 2. 25 percent of the amount within 10 days after PEMC 's acceptance of the second progress report; 3. 25 percent of the amount within 10 days after PEMC 's acceptance of the last progress report; and 4. 30 percent of the amount within 15 days after PEMC 's acceptance of the final report and all remaining deliverables. The services will be carried out by personnel of Birdanco in accordance with agreed time schedules. Birdanco shall ensure that a resident audit team leader or project manager will take charge of the operations of the audit team. The project will run for 18 weeks from the first week of February to the first week of June 2015 with 10 weeks to be done in the Philippines. Based on the Certificate of Final Acceptance issued by the Audit Committee of PEMC on August 18, 2015, PEMC has accepted the Final Audit Reports (Public and Non-Public) for the 5th Independent Operational Audit of the Systems and Procedures on Market Operations of PEMC as submitted by Birdanco . Based on the Certificate of Presence in the Philippines issued by PEMC on September 8, 2016, the following personnel were sent by Birdanco to the Philippines in 2015 to render services to PEMC pursuant to the contract: Personnel Dates Number of Days in Month Work BBB February 2-3 February: 16 days Initial introduction meeting CCC February 14-27 Planning DDD February 14-27 Planning EEE February 14-18 Planning FFF February 14-20 Planning GGG February 15-27 Planning HHH February 22-27 Planning III February 23-25 Planning FFF March 15-16 March: 13 days Planning BBB March 15-16 Planning DDD March 21-31 Fieldwork CCC March 22-31 Fieldwork FFF March 22-27 Fieldwork GGG March 26-31 Fieldwork DDD April 1-10 April: 10 days Fieldwork CCC April 1-10 Fieldwork GGG April 1-10 Fieldwork BBB August 27-29 August: 3 days Reporting and completion Total 42 days RULING In reply, please be informed that under Section 28 (B) (1) of the National Internal Revenue Code of 1997, as amended ("Tax Code") , income derived in the Philippines by a foreign corporation not engaged in trade or business is subject to income tax at the rate of 30 percent, to wit: aScITE " 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: n 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, the income is exempt or partially exempt 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." In this regard, paragraph 1, Article 7 of the Philippines-Australia tax treaty provide relief on business profits as follows: " 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" Under Article 7, profits derived by an Australian enterprise from sources in the Philippines may be taxed in the Philippines if the profits are attributable to a permanent establishment situated therein. Relative thereto, Article 5 defines a permanent establishment as follows: " Article 5 PERMANENT ESTABLISHMENT 1. For the purposes of this Agreement, the term 'permanent establishment' means a fixed place of business through which the business of an enterprise is wholly or partly carried on. 2. The term 'permanent establishment' shall include especially a) a place of management; b) a branch; c) an office; d) a factory; e) a workshop; f) a mine, oil or gas well, quarry or other place of extraction of natural resources; g) an agricultural, pastoral or forestry property; 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 facilities for others; k) a place in one of the Contracting States through which an enterprise of the other Contracting State furnishes services, including consultancy services, for a period or periods aggregating more than six months in any taxable year or year of income, as the case may be, in relation to a particular project, or to any project connected therewith." HEITAD Under Article 5, 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 and a workshop. It includes also a place in the Philippines through which an enterprise of Australia furnishes services, including consultancy services, for a period or periods aggregating more than six months in any taxable year or year of income, as the case may be, in relation to a particular project, or to any project connected therewith. Accordingly, since Birdanco 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 it did not furnish services in the Philippines for more than six months in any taxable year, but for an aggregate of 42 days only, Birdanco is not deemed to have a permanent establishment in the Philippines, pursuant to paragraphs 1 and 2, Article 5 of the Philippines-Australia tax treaty. This being the case, service fees paid by PEMC to Birdanco for independent operational audit it performed on the systems and procedures on market operations of PEMC are exempt from income tax pursuant to paragraph 1, Article 7 of the treaty. On the characterization of the service fees as business profits (which are exempt from income tax if not attributable to a permanent establishment) rather than payments for know-how or royalties (which are subject to a reduced taxation), the following commentaries of the Organization for Economic Co-operation and Development Model Tax Convention on Income and on Capital (Condensed Version, July 22, 2010) mention that: "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 recognized 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. 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." (Pages 225-226) Based on the commentaries, in a contract for the supply of know-how, there would generally be very little more which needs to be done by the supplier other than to supply existing information or reproduce existing material. On the other hand, in a contract for the performance of services, this involves, in a majority of cases, a very much greater level of expenditure by the supplier in order to perform his contractual obligations to the other party, such as salaries and wages for employees engaged in researching, designing, testing, drawing and other associated activities or payments to subcontractors for the performance of similar services. ATICcS Accordingly, since the contract between PEMC and Birdanco did not call for Birdanco to supply existing information or reproduce existing material to PEMC , but for Birdanco to provide actual services to PEMC by performing independent operational audit of PEMC 's systems and procedures on market operations, this contract is clearly a contract for the performance of services and not supply of know-how or other royalty-bearing property. Moreover, by reason that some services are rendered in the Philippines by designated personnel of Birdanco , the latter certainly incurred a greater level of expenditure (such as salaries and other remuneration of personnel) in fulfilling its contractual obligations to PEMC . Therefore, the service fees paid to Birdanco constitute business profits and not payments for know-how or royalties . Although exempt from income tax, the service fees, however, are subject to value-added tax ("VAT") under Section 108 (A) of the Tax Code, 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: 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%). . ." Relative thereto, PEMC shall withhold VAT on the service fees at the rate of 12 percent before remitting them to Birdanco . PEMC 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 PEMC 's claim of input VAT on the fees; otherwise, PEMC may treat the 'passed-on' VAT as 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. Very truly yours, (SGD.) CAESAR R. DULAY 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 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: xxx xxx xxx (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." n Note from the Publisher: Copied verbatim from the official document.