ITAD BIR Ruling No. 042-16

April 4, 2016 ITAD BIR RULING NO. 042-16 Article 12, Philippines-Japan tax treaty Punongbayan and Araullo 20th Floor, Tower 1 The Enterprise Center 6766 Ayala Avenue Makati City Attention: Mr. Edward L. Roguel Partner, Tax Advisory and Compliance Gentlemen : This refers to your tax treaty relief application filed on April 5, 2011 requesting confirmation that royalties paid by Furukawa Electric Autoparts Philippines, Inc. ("Furukawa Philippines") to Furukawa Electric Company Ltd. ("Furukawa") are subject to income tax rate of 10 percent 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 ("Philippines-Japan tax treaty") . 1 Facts Furukawa is a foreign corporation organized and existing under the laws of Japan and a resident thereof based on its Certificate of Residence issued by the Kojimachi Tax Office December 18, 2009. It manufactures and sells products related to telecommunications (optical fiber cables, metal communication cables, semiconductor optical devices); energy and industry (copper wires and aluminum wires, power transmission cable, insulated wires); electronics and automotive systems (automotive components and wiring harness, magnet wires, electronic component materials); and metals (copper and copper alloy, functional surface products, electrodeposited copper foil) and in providing logistics, IT processing services, and software development. Furukawa is registered with the Securities and Exchange Commission based on the Certificate issued by SEC on December 22, 2009. Based on the Affidavit issued by Furukawa on December 9, 2010, Furukawa had a branch office in the Philippines which had not been operating since August 15, 2001. It also had a representative office in the Philippines which had not been operating since April 30, 2002. On the other hand, Furukawa Philippines is a domestic corporation organized and existing under the laws of the Philippines. Furukawa Philippines is registered with the Philippine Economic Zone Authority ("PEZA") engaged in the manufacture and assembly of various automotive parts such as steering roll connectors, connector models, relay box assembly parts, rotator, stator, sub-stator, stator housing, cancel cam, flexible flat cable assembly, junction box, and battery statement sensor. AScHCD On May 13, 1998, Furukawa Philippines and Furukawa entered into a Technical Assistance Agreement where Furukawa granted an exclusive license to Furukawa Philippines to manufacture in the Philippines steering roll connectors (contract products) designed by Furukawa and by using the latter's technical knowledge, experience, know-how and other information, including drawings, data, specifications and manuals. These information concern the processes for manufacture of the contract products, ranging between the main body assembly, inspection, and testing, and the machinery, apparatus, and raw materials for use in the processes. Furukawa has long engaged in the commercial manufacture in Japan of the contract products and has substantial amount of technical information and know-how in respect thereof. Furukawa Philippines is desirous to receive such information and know-how in order to start the production of the contract products. In consideration, Furukawa Philippines will pay Furukawa a running royalty of 1 percent on the net sales prices of the contract products or fair market value of the products sold by Furukawa Philippines during the period of the Agreement. The running royalty shall become due and payable when the invoice of the contract products is made out by Furukawa Philippines for its customers, which shall be on or before the day of February and the last day of August of each year. The royalties shall be paid thru telegraphic transfer in US dollars into Furukawa 's bank account in Japan. The Agreement took effect on May 13, 1998, and shall continue to be in effect for a period of 10 years. The Agreement was amended on February 12, 2000 for the purpose of amending the royalty rate to 5 percent, which took effect on January 1, 2000. The Agreement was again amended on November 15, 2000 for the purpose of amending the payment of royalties on or before the last day of February, May, August and November of each calendar year. The amendment took effect on October 1, 2000. The Agreement was amended for the third time on April 30, 2008 for the purpose of extending the Agreement after the lapse of ten years where it shall be automatically and indefinitely extended for every three-year period. The amendment took effect on April 30, 2008. Based on the Certification issued by Furukawa Philippines on November 16, 2009, February 11, 2015, the income subject of this ruling is not under investigation, on-going audit, administrative protest, claim for refund or issuance of a tax credit certificate, collection proceeding, or judicial appeal. 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: "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." For this purpose, Article 12 of the Philippines-Japan tax treaty provides relief to royalties as follows: " 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: AcICHD 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. xxx xxx xxx 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 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." Under this article, the royalties may be taxed in the Philippines at a rate not to exceed (a) 15 percent if the royalties are for of the use of, or the right to use, cinematograph films and films or tapes for radio or television broadcasting, and (b) 10 percent in all other cases. Intangible properties within item (b) are copyright of literary, artistic or scientific work (except including cinematograph films and films or tapes for radio or television broadcasting); patent; trade mark; design or model; plan; secret formula or process; industrial, commercial or scientific equipment; and information concerning industrial, commercial or scientific experience. Accordingly, since technical knowledge, experience, know-how and other information used by Furukawa Philippines to manufacture steering roll connectors are not in the category of cinematograph films and films or tapes for radio or television broadcasting, but information concerning industrial, commercial or scientific experience or know-how , royalties paid by Furukawa Philippines to Furukawa for the use of this know-how are subject to income tax at the rate of 10 percent , pursuant to paragraph 2 (b), Article 12 of the Philippines-Japan tax treaty. With respect to value-added tax ("VAT"), Section 108 (A) of the Tax Code subjects to VAT payments for the use or lease of know-how, 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 selling price or gross value in money of the goods or properties sold, bartered or exchanged, such tax to be paid by the seller or transferor: Provided, that the President, upon the recommendation of the Secretary of Finance, shall, effective January 1, 2006, 2 raise the rate of value-added tax to twelve percent (12%) . . . " However, the Supreme Court ruled in Commissioner of Internal Revenue vs. Seagate Technology (Philippines) (G.R. No. 153866 dated February 11, 2005) that: "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: First, RA 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. 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 RA 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." Accordingly, since Furukawa , the licensor, is a nonresident foreign person and not a VAT-registered taxpayer to begin with, royalties paid to it by Furukawa Philippines , a PEZA-registered entity, is treated as VAT-exempt and not as VAT zero-rated transaction. In either case, no output VAT is shifted or passed-on to Furukawa Philippines in the payment of the royalties. 3 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. As amended by the 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 effective January 1, 2009 . 2. The VAT rate is 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. 3. Revenue Regulations No. 16-2005 (Consolidated Value-Added Tax Regulations of 2005) , as amended, provides: "SEC. 4.106-5. Zero-Rated Sales of Goods or Properties . A zero-rated sale of goods or properties (by a VAT-registered person) is a taxable transaction for VAT purposes, but shall not result in any output tax. However, the input tax on purchases of goods, properties or services related to such zero-rated sale, shall be available as tax credit or refund in accordance with these Regulations." " SEC. 4.109-1 . VAT-Exempt Transactions . (A) In general . 'VAT-exempt transactions' refer to the sale of goods or properties and/or services and the use or lease of properties that is not subject to VAT (output tax) and the seller is not allowed any tax credit of VAT (input tax) on purchases. The person making the exempt sale of goods, properties or services shall not bill any output tax to his customers because the said transaction is not subject to VAT." n Note from the Publisher: The phrase "and (d) above" no longer appears in RA 9337, the law amending this provision.