ITAD BIR Ruling No. 070-11

March 1, 2011 ITAD BIR RULING NO. 070-11 Articles 13 (Royalties) and 23 (Relief from Double Taxation), Philippines-United States of America tax treaty; BIR Ruling No. ITAD 13-09; BIR Ruling No. ITAD 127-06 Salvador and Associates Attorneys-At-Law 815-816 Tower One and Exchange Plaza Ayala Triangle, Ayala Avenue Makati City Attention: Atty. Maria Rosario L. Bernardo Atty. Ronald V. Bernas Atty. Francesca Marie R. Velasco-Lao Gentlemen : This refers to your application for tax treaty relief dated August 18, 2010 requesting confirmation that royalties to be paid by Nestl Philippines, Inc. ("Nestl Philippines") to American Dairy Queen Corporation ("American Dairy Queen") are subject to income tax in the Philippines at the reduced rate of 10 percent, pursuant to 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-United States tax treaty"), in relation to the Convention between the Czech Republic and the Republic of the Philippines for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income ("Philippines-Czech tax treaty"). EICSDT Basic Facts It is represented that American Dairy Queen is a foreign corporation organized and existing under the laws of the United States and is a resident thereof, based on the Certificate of Residence issued by the Internal Revenue Service of the United States on January 4, 2010; that American Dairy Queen is situated at 7505 Metro Boulevard, Minneapolis, Minnesota, United States; that American Dairy Queen is not registered as a corporation or as a partnership in the Philippines based on the Certification of Non-Registration of Company issued by the Securities and Exchange Commission on June 9, 2010; and that, on the other hand, Nestl Philippines is a corporation situated at Barrio Niugan, Cabuyao, Laguna, Philippines. It is further represented that on August 1, 2008, Nestl Philippines and American Dairy Queen entered into an International Authorized Mix Supplier Agreement where American Dairy Queen appointed Nestl Philippines as a non-exclusive manufacturer and supplier of Dairy Queen mix ("Authorized Mix") to be manufactured in its plant at 710 Aurora Boulevard, Quezon City, Philippines; that Nestl Philippines shall ensure that all Authorized Mix shall strictly conform to the applicable specifications and formula provided by American Dairy Queen from time to time, and shall be merchantable and fit for their intended purpose and shall not be adulterated or misbranded; that Nestl Philippines shall maintain its processing facilities and equipment in clean and sanitary conditions, and shall use only the special Dairy Queen stabilizer and flavoring as provided by American Dairy Queen or the latter's designee; that Nestl Philippines shall ensure that any and all Authorized Mix will be distributed and sold only to authorized Dairy Queen, Dairy Queen/Brazier, or Treat Center stores in the Philippines, and to authorized warehouses designated by American Dairy Queen; that American Dairy Queen grants Nestl Philippines the limited license to imprint the Dairy Queen trademark, service mark, trade name and other related trademarks ("Trademarks") on the labels, containers, cartons and packaging materials for the Authorized Mix, in strict conformity with the specifications and other directions given by American Dairy Queen ; that in consideration, Nestl Philippines shall submit to American Dairy Queen in United States dollars an amount equal to 1 percent of its net sales of the Authorized Mix; that the amount will be computed and paid based upon each quarter's sales and are due to American Dairy Queen by wire transfer by the fifteenth day of the month following the end of each calendar quarter; and that the Agreement took effect on January 1, 2007, and shall continue until terminated by either party, as provided therein. It is finally represented that the royalties subject of the application are not under investigation, on-going audit, administrative protest, claim for refund or issuance of a tax credit certificate, collection proceedings, or judicial appeal, based on the Certification issued by Nestl Philippines on September 21, 2010. Ruling A. On income tax In reply, please be informed that royalties derived by American Dairy Queen , being a foreign corporation not engaged in trade or business in the Philippines, are subject to income tax in the Philippines at the rate of 30 percent of the gross amount thereof. Section 28 (B) (1) (a) of the National Internal Revenue Code of 1997 ("Tax Code of 1997") , as amended, provides: "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 subparagraphs 5(c) and (d) above: Provided, That effective 1, 2009, the rate of income tax shall be thirty percent (30%)." DcTaEH However, such royalties may be exempt or partially exempt (if subject to a reduced rate only) to the extent required by any treaty obligation binding upon the Philippines. Section 32 (B) (5) of the Tax Code of 1997, as amended, provides: "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, you invoke the Philippines-United States tax treaty. Paragraphs 1, 2 and 4, Article 13 thereof provide: "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 SHCaEA (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 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 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." Under paragraph 2 (b) (iii) above, royalties arising in the Philippines and paid to a resident of the United States may be taxed in the Philippines, 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 (also known as the "most-favored-nation tax rate" ). Under paragraph 4, the term "royalties" 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. 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. For this purpose, you invoke the Philippines-Czech tax treaty. Concerning the first condition , paragraphs 1 and 2, Article 12 thereof provide: "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. ACTESI 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. This being the case, the amount to be paid by Nestl Philippines to American Dairy Queen under the Agreement for the use of the Trademarks on the labels, containers, cartons and packaging materials for the Authorized Mix, being essentially royalties with respect to the use of, or the right use, a trademark, may be subject to the same tax rate of 10 percent under paragraph 2 (a), Article 12 of the Philippines-Czech tax treaty. Concerning the second condition , paragraph 1, Article 23 of the Philippines-United States tax treaty, vis--vis paragraph 2, Article 22 of the Philippines-Czech tax treaty, provide: HaECDI 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." EAIaHD 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 S.C. Johnson case are present under the Philippines-Czech tax treaty, namely, that the royalties arising in the Philippines and derived by a resident of the United States are of the same kind as those arising in the Philippines and derived by a resident of Czech, and that the method of elimination of double taxation applied by the United States on such royalties derived by a resident thereof is the same as that applied by Czech on such royalties derived by a resident of Czech, the amount to be paid by Nestl Philippines to American Dairy Queen under the Agreement for the use of the Trademarks on the labels, containers, cartons and packaging materials for the Authorized Mix, being essentially royalties with respect to the use of, or the right use, a trademark, 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. (BIR Ruling No. ITAD 13-09 dated April 15, 2009; BIR Ruling No. ITAD 127-06 dated October 23, 2006) B. On value-added tax Finally, such amount to be paid by Nestl Philippines to American Dairy Queen under the Agreement for the use of the Trademarks, being payment for the use or lease of (intangible) properties in the Philippines, is subject to value-added tax ("VAT"). Section 108 (A) of the Tax Code of 1997, as amended, 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%) . . . The phrase 'sale or exchange of services' means the performance of all kinds of services in the Philippines for others for a fee, remuneration or consideration . . . 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; xxx xxx xxx Lease of properties shall be subject to the tax herein imposed irrespective of the place where the contract of lease or licensing agreement was executed if the property is leased or used in the Philippines. The term 'gross receipts' means the total amount of money or its equivalent representing the contract price, compensation, service fee, rental or royalty, including the amount charged for materials supplied with the services and deposits and advanced payments actually or constructively received during the taxable quarter for the services performed or to be performed for another person, excluding value-added tax." (Emphasis ours) 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. 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.