Punongbayan & Araullo

March 27, 2018 ITAD BIR RULING NO. 050-18 Article 13, Philippines-USA tax treaty; Article 12, Philippines-Czech tax treaty Punongbayan & Araullo 20th Floor, Tower 1 The Enterprise Center 6766 Ayala Avenue, Makati Attention: AAA Gentlemen : This refers to your Tax Treaty Relief Application filed on July 29, 2010, on behalf of your clients, IBM PHILIPPINES, INC. (" IBM Phil "), IBM DAKSH BUSINESS PROCESS SERVICES PHILIPPINES, INC. (" IBM Daksh ") and IBM SOLUTIONS DELIVERY INCORPORATED (" IBM Solutions "), requesting confirmation of your opinion that the royalty payments made to IBM WORLD TRADE CORPORATION (" IBM World Trade ") by your clients under the Marketing Royalty Agreement are subject to the preferential tax rate of 10 percent pursuant to Article 13 (2) [b] (iii) of the Convention between the Government of the Republic of the Philippines and the Government of the United States of America with Respect to Taxes on Income (" Philippines-USA tax treaty ") in relation to Article 12 of the Convention between the Republic of the Philippines and 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 "). It is represented that IBM World Trade is a nonresident foreign corporation organized and existing under the laws of the State of Delaware per Restated Certificate of Incorporation of IBM World Trade; that IBM World Trade is primarily engaged in the manufacture, sale, distribution and dealing in, as well as handling any and all types of machines, machinery, and commodities of every kind and description, without restriction or limit as to amount, in any part of the world; that IBM World Trade is not registered as a corporation or as a partnership in the Philippines as evidenced by the Certification of Non-Registration of Company issued by the Securities and Exchange Commission; that, on the other hand, IBM Phil, IBM Daksh and IBM Solutions are corporations duly organized and existing under and by virtue of the laws of the Philippines. acHTIC It is further represented that on different dates, January 1, 2003 for IBM Phil, January 1, 2008 for IBM Daksh and January 1, 2009 for IBM Solutions, IBM World Trade entered into separate Marketing Royalty Agreements with the aforementioned companies for terms of one year, renewable automatically for subsequent one year periods; that the terms are identical as to the rights of the parties, wherein: a. A non-exclusive, non-transferable license under IBM Intellectual Property, 1 which is necessary to enable Licensee 2 to provide Services 3 related to ITS Products 4 and Programs to Unaffiliated Customers; 5 b. A non-exclusive, non-transferable license under IBM Intellectual Property necessary to enable Licensee to manufacture and have made maintenance parts (other than hard drive maintenance parts) for ITS Products and to acquire hard disk drive maintenance parts for ITS Products from Subsidiaries in order to: sell or lease such maintenance parts to Unaffiliated Customers and to use or otherwise dispose of such maintenance parts. c. A non-exclusive license and rights under IBM's Services Copyrights: 6 (1) to license and distribute copies for their ultimate use by Unaffiliated Customers, (2) to use in revenue producing activities, (3) to use internally, (4) to make of have made hard copies for the purpose described above, for distribution to Subsidiaries, 7 and for translation or modification, and (5) to allow their Unaffiliated Customers, for the customers internal use only, to use, copy, and modify such licensed IBM Service Copyrights pursuant to the terms of their respective agreements with their customers; d. A license during the term of the Agreement to use all IBM Trademarks on or in association with: (1) Services; (2) Maintenance Parts, and (3) Vendor Developed Products, 8 and to use in its trade names the IBM Trademark "IBM," but only so long as Services, Maintenance Parts, and Vendor Developed Products are manufactured in accordance with standards, specifications, and instructions, laid down and approved by IBM World Trade or IBM; e. Access to all knowledge and technical know-how, both confidential and other related to the first and second above-mentioned grants; that for and in consideration of the licenses and rights granted, IBM Phil, IBM Daksh and IBM Solutions shall pay royalties equal to the following percentages of the total gross charges, after discounts and other allowances made during each calendar month (and as adjusted for accrual purposes at year end), by IBM Phil, IBM Daksh, and IBM Solutions or any of their assignees to Unaffiliated Customers during or after the term of the Agreement. I. For IBM Daksh and IBM Solutions: a. A royalty equal to _% of such total gross charges for: (1) the provision of Services including maintenance services; (2) the provision of maintenance parts for Vendor Developed Products; and, (3) License of Service Copyrights; b. A royalty equal to _% of such total gross charges for: (1) the sale or lease of any Vendor Developed Product bearing an IBM Trademark; and, (2) the sale of supplies that do not operate as part of a machine basic mechanism such as, without limitation, recording media ( e.g. , paper, cards and tapes) and intermediaries between the mechanism and the media ( e.g. , ribbons); II. For IBM Phil: a. __% of the total gross charges for: (1) the provision of Services including maintenance services for any Vendor Developed Products, but not including maintenance services for ITS Products that are not Vendor Developed Products; (2) the provision of maintenance parts for Vendor Developed Products; and, (3) License of Service Copyrights; b. __% of the total gross charges for the provision of maintenance parts and maintenance parts for any ITS Products other than Vendor Developed Products; ScaCEH c. __% of the total gross charges for the sale or lease of any Vendor Developed Product bearing an IBM trademark; the sales of supplies that do not operate as part of a machine basic mechanism such as, without limitation, recording media and intermediaries between mechanism and media. It is further represented that on January 4, 2008, a Transition Agreement between IBM World Trade and IBM Phil was executed, amending the initial Agreement between them; that the rights and obligations of IBM World Trade and IBM Phil, granted in the initial Agreement, shall remain in full force and effect with regard to ITS Products which IBM Phil acquired on or before October 31, 2006 and: i) that are not installed with an Unaffiliated Customer as of November 1, 2006; ii) that are not installed internally as of November 1, 2006; or, iii) that are on lease with an Unaffiliated Customer as of November 1, 2006; that the royalties to be paid by IBM Phil, to IBM World Trade shall be US$______ for 2008; US$ ______ for 2009; US$ ______ for 2010; and US$ ______ for the years 2011-2014; and that, on January 1, 2008, the Agreement between IBM World Trade and IBM Phil was further amended: i) reducing the consideration from the rate of __% to __% of the total gross charges for the provision of Services, maintenance parts, and license of Services Copyrights; ii) deleting the __% royalty imposition; and, iii) deleting the limitation as to the provision of Services. 9 It is further represented that the issue/s or transaction subject of the above request for ruling is not under investigation neither is it subject of an on-going audit, administrative protest, claim for refund or issuance of a tax credit certificate, collection proceedings nor a judicial appeal based on the Certification of IBM Phil dated July 23, 2010 and Certifications of IBM Daksh and IBM Solutions dated July 27, 2010. It is finally represented, that royalty payments in various amounts, pursuant to the subject Marketing Royalty Agreements entered into by the parties, were sent to IBM World Trade on various dates from July 2010 up to May 2012. 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 royalties derived in the Philippines by a nonresident foreign corporation. 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 . . ., royalties . . .: Provided, That effective January 1, 2009, the rate of income tax shall be thirty percent (30%). x x x" 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 this particular case, Article 13 of the Philippines-USA tax treaty which is invoked. It 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. xxx xxx xxx 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. x x x" Paragraph 2 (b) (iii) above provides that the Philippines may tax the royalties paid by a Philippine company to a company which is a resident of the United States of America, but the rate of income tax that may be imposed thereon shall not exceed the lowest rate that may be imposed on royalties of the same kind paid under similar circumstances to a resident of a third State (" most favored-nation tax rate "). Relative thereto, 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) (" S.C. Johnson case "), requires two conditions for the "most-favored-nation" tax rate on royalties to apply. First , the royalties arising in the Philippines and derived by a resident of the other State, in this case, the United States, must be of the same kind as those arising in the Philippines and derived by a resident of a third State to which the latter's tax treaty with the Philippines subjects the latter royalties to a "most-favored-nation" tax rate. Second , the method of elimination of double taxation applied by the other State, in this case, the United States, on such royalties derived by the resident of the United States must be the same as that applied by the third State on such royalties derived by the resident of that State. Relevant portions of the SC Johnson case read: "We are unable to sustain the position of the Court of Tax Appeals, which was upheld by the Court of Appeals, that the phrase 'paid under similar circumstances' in Article 13(2)(b), (iii) of the RP-US Tax Treaty should be interpreted to refer to payment of royalty, and not to the payment of the tax, for the reason that the phrase 'paid under similar circumstances' is followed by the phrase 'to a resident of a third state.' The respondent court held that 'Words are to be understood in the context in which they are used,' and since what is paid to a resident of a third state is not a tax but a royalty 'logic instructs' that the treaty provision in question should refer to royalties of the same kind paid under similar circumstances. The above construction is based principally on syntax or sentence structure but fails to take into account the purpose animating the treaty provisions in point. To begin with, we are not aware of any law or rule pertinent to the payment of royalties, and none has been brought to our attention, which provides for the payment of royalties under dissimilar circumstances. The tax rates on royalties and the circumstances of payment thereof are the same for all the recipients of such royalties and there is no disparity based on nationality in the circumstances of such payment. On the other hand, a cursory reading of the various tax treaties will show that there is no similarity in the provisions on relief from or avoidance of double taxation as this is a matter of negotiation between the contracting parties . As will be shown later, this dissimilarity is true particularly in the treaties between the Philippines and the United States and between the Philippines and West Germany . HCSAIa xxx xxx xxx As stated earlier, the ultimate reason for avoiding double taxation is to encourage foreign investors to invest in the Philippines a crucial economic goal for developing countries. The goal of double taxation conventions would be thwarted if such treaties did not provide for effective measures to minimize, if not completely eliminate, the tax burden laid upon the income or capital of the investor. Thus, if the rates of tax are lowered by the state of source, in this case, by the Philippines, there should be a concomitant commitment on the part of the state of residence to grant some form of tax relief whether this be in the form of a tax credit or exemption. Otherwise, the tax which could have been collected by the Philippine government will simply be collected by another state, defeating the object of the tax treaty since the tax burden imposed upon the investor would remain unrelieved. If the state of residence does not grant some form of tax relief to the investor, no benefit would redound to the Philippines, i.e., increased investment resulting from a favorable tax regime, should it impose a lower tax rate on the royalty earnings of the investor, and it would be better to impose the regular rate rather than lose much-needed revenues to another country . At the same time, the intention behind the adoption of the provision on 'relief from double taxation' in the two tax treaties in question should be considered in light of the purpose behind the most favored nation clause. The purpose of a most favored nation clause is to grant to the contracting party treatment not less favorable than that which has been or may be granted to the 'most favored' among other countries. The most favored nation clause is intended to establish the principle of equality of international treatment by providing that the citizens or subjects of the contracting nations may enjoy the privileges accorded by either party to those of the most favored nation. The essence of the principle is to allow the taxpayer in one state to avail of more liberal provisions granted in another tax treaty to which the country of residence of such taxpayer is also a party provided that the subject matter of taxation, in this case royalty income, is the same as that in the tax treaty under which the taxpayer is liable. Both Article 13 of the RP-US Tax Treaty and Article 12(2)(b) of the RP-West Germany Tax Treaty, above-quoted, speaks of tax on royalties for the use of trademark, patent, and technology. The entitlement of the 10% rate by U.S. firms despite the absence of a matching credit (20% for royalties) would derogate from the design behind the most favored nation clause to grant equality of international treatment since the tax burden laid upon the income of the investor is not the same in the two countries. The similarity in the circumstances of payment of taxes is a condition for the enjoyment of most favored nation treatment precisely to underscore the need for equality of treatment . We accordingly agree with petitioner that since the RP-US Tax Treaty does not give a matching tax credit of 20 percent for the taxes paid to the Philippines on royalties as allowed under the RP-West Germany Tax Treaty, private respondent cannot be deemed entitled to the 10 percent rate granted under the latter treaty for the reason that there is no payment of taxes on royalties under similar circumstances ." (Emphasis ours) In looking for a third country which grants a "most-favored-nation" tax treatment on royalties, you invoked Article 12 of the Philippines-Czech tax treaty. It 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." Under paragraph 2 above, royalties or payments with respect to the use of, or the right use, any copyright of literary, artistic or scientific work (except that on cinematograph films, and films or tapes for television or radio broadcasting), patent, trade mark, design or model, plan, secret formula or process, information concerning industrial, commercial or scientific experience (" know-how "), industrial, commercial or scientific equipment, arising in the Philippines and derived by a resident of Czech are subject to income tax in the Philippines at the reduced rate of 10 percent of the gross amount thereof. Applying the Philippines-Czech tax treaty, the royalty fee to be paid by IBM Phil, IBM Daksh and IBM Solutions to IBM World Trade pursuant to the Agreement and Transition Agreement, may be subject to 10 percent 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-USA 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: CaSAcH "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, 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 percent 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. Concerning the second condition , paragraph 1, Article 23 of the Philippines-USA tax treaty, vis--vis paragraph 2, Article 22 of the Philippines-Czech tax treaty, provide: SaIEcA United States: " 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 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." Czech " 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 tax on the remaining income of such resident, take into account the exempted income." Under paragraph 1 of Article 23 above, in eliminating or mitigating the effects of double taxation of income including royalties derived by a resident of the United States from sources in the Philippines, the United States shall allow as credit against the United States income tax due on such income and payable by that resident, the Philippine income tax imposed on that income. In the same manner, under paragraph 2 (a) of Article 22, in eliminating or mitigating the effects of double taxation of income including royalties derived by a resident of Czech from sources in the Philippines, Czech shall allow as deduction against the Czech income tax due on such income and payable by that resident, the Philippine income tax imposed on that income. Accordingly, since the two conditions laid down in the SC Johnson case are present under the Philippines-Czech tax treaty, the royalties to be paid by IBM Phil, IBM Daksh and IBM Solutions to IBM World Trade pursuant to the Agreement, are subject to income tax in the Philippines at the reduced rate of 10 percent of the gross amount thereof, pursuant to paragraph 2 (b) (iii), Article 13 of the Philippines-United States tax treaty, in relation to paragraph 2 (a), Article 12 of the Philippines-Czech tax treaty, and pursuant to paragraph 1, Article 23 of the Philippines-United States tax treaty, in relation to paragraph 2 (a) of Article 22, of the Philippines-Czech tax treaty. 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. CcSTHI Very truly yours, (SGD.) CAESAR R. DULAY Commissioner of Internal Revenue Footnotes 1. " IBM Intellectual Property " pertains to any and all technologies, procedures, processes, designs, inventions, discoveries, know-how, and works of authorship, including without limitation, documentation and all issued patents, utility models, and the like and applications therefore; copyrights, whether or not registered, and other rights in works of authorship; mask work rights; trade secrets; confidential information and any other intellectual property rights constituting, embodied in, or pertaining thereto and, the rights to extract data from databases under current and future laws except IBM Trademarks and Services Copyrights. 2. " Licensee " shall pertain to IBM Phil, IBM Daksh, and IBM Solutions. 3. " Services " shall mean maintenance services, systems integration, outsourcing, networking services, consultancy, educations services, and other services. 4. " Information Technology Systems Products (" ITS Products ") shall pertain to any instrumentality or aggregate of instrumentalities adapted to compute, classify, process, transmit, receive, retrieve, originate, switch, store, display, manifest, measure, detect, record, reproduce, handle or utilize any form of information, intelligence or data for business, scientific, control or other purposes, including any and all apparatus, parts, documentation and supplies used in the manufacture, marketing or utilization of such instrumentality or aggregate of instrumentalities except programs which are not in microcode. 5. " Unaffiliated Customer " shall mean any customer of the Licensee excluding International Business Machines Corporation (" IBM "), IBM World Trade and all Subsidiaries (other than such leasing, financing, or other special purpose Subsidiaries or any other Subsidiaries as are from time to time designated as Unaffiliated Customers by IBM World Trade. 6. " Services Copyrights " shall mean copyrights, whether or not registered, and rights in works of authorship, developed and used in the provision of Services, but not including copyrights that are generally made available now or in the future as software products or other copyrighted products, including but not limited to such products IBM licenses under its International Program License Agreement, the IBM Agreement for Licenses Programs or similar agreement. 7. " Subsidiary " means a corporation or company or other entity: a. more than 50% of whose outstanding shares or securities (representing the right to vote for the election of directors, or other managing authority) are, now or hereafter, owned or controlled, directly or indirectly, by IBM World Trade and/or IBM; or which does not have outstanding shares or securities, as may be the case in partnership, joint venture or unincorporated association, but more than 50% of whose ownership interest representing the right to make the decisions for such corporation, company or other entity is no or hereafter, owned or controlled, directly or indirectly, by IBM World Trade and/or IBM, but such corporation, company or other entity shall be deemed to be a Subsidiary so long as such ownership or control exists. 8. " Vendor Developed Products " shall mean Information Technology Systems Products developed by parties other than IBM or subsidiaries thereof (except those Subsidiaries of IBM, or organizations within a Subsidiary of IBM, which are designated by IBM World Trade to be treated as vendors for purposes of the Agreement) the marketing of which by the Licensee does not require the exercise of a license of IBM Intellectual Property. 9. Deleting the phrase, "but not including maintenance services for ITS Products that are not Vendor Developed Products."