ITAD BIR Ruling No. 078-14

June 10, 2014 ITAD BIR RULING NO. 078-14 Article 12 (Royalties), Philippines-Japan tax treaty Arkray Industry, Inc. Lot 22 Phase 1A First Philippine Industrial Park Sta. Anastacia, Santo Tomas Batangas Attention: Ms. Gemma S. Mapola Accounting Manager Gentlemen : This refers to your tax treaty application ("TTRA") filed on July 1, 2013, requesting confirmation that royalties paid by Arkray Industry, Inc. ("AII") to Arkray Factory, Inc. ("AFI") are subject to income tax at the rate of 10% pursuant to the Convention between the Government of the Republic of the Philippines and the Government of Japan with respect to Taxes on Income, ("Philippines-Japan tax treaty"), as amended by the 2009 Protocol. HAIDcE AFI is a non-resident foreign corporation organized and existing under the laws of Japan with business address at 1480, Koji, Konan-cho Koka-shi, Shiga, 520-3306, Japan per certificate of fiscal residence issued on January 16, 2013 by the District Director of Minakuchi Tax Office. It is not registered as a corporation or a partnership in the Philippines per certification of non-registration issued by the Securities and Exchange Commission on February 13, 2013. On the other hand, AII is a domestic corporation organized and existing under the laws of the Philippines with principal address at Lot 22 Phase 1A, First Philippine Industrial Park, Sta. Anastacia, Sto. Tomas, Batangas. It is represented that on November 1, 2011, AFI and AII entered into a Technical Assistance Agreement ("Agreement") which shall be effective from the effective date until October 31, 2012 and shall be renewed for the additional period of one (1) year, unless AFI gives notice to AII its intention to terminate this Agreement thirty (30) days prior to the intended date of termination; that under the Agreement, AFI granted to AII a non-exclusive license to sell and manufacture the products using the Manufacturing Technology which is the know-how and technologies necessary to manufacture the products; that AII shall not transfer, create collateral on or grant sublicenses of the Manufacturing Technology to any person or entities; that AFI shall provide AII with the necessary assistance to enable AII to manufacture the products; that AII shall report to AFI, on or before the last day of the month following the last month of each quarter ("reporting deadline"), the technical assistance fee equivalent to five percent (5%) of the sales amount of the products in the same quarter; that AFI shall invoice AII for the technical assistance fee on or before the last day of the month following the month to which the reporting date belongs to ("invoice deadline"); and that AII shall permit AFI to examine books and records to review the calculation of the technical assistance fee. The parties also consented that AFI disclaims all representations and warranties relating to the Manufacturing Technology and that AII acknowledges that the Manufacturing Technology disclosed by AFI is provided on as is basis; and that the proprietary information of AFI including but not limited to, technical information, know-how, pending patents and patents shall remain confidential between the parties to the Agreement. As payment of the technical assistance fee, the parties agreed that it shall be made by Japanese Yen, US Dollars or any other currency, by telegraphic transfer to the bank account designated by AFI, on or before the last day of the month following the month to which the invoice deadline belongs to; and that on March 25, 2013 AII paid AFI the total amount of 68,000,000 Japanese Yen less tax as technical assistance fee. It is finally represented that, per sworn statement issued by AII on June 18, 2013, that the issue or transaction subject of this request for ruling is not under investigation, on-going audit, administrative protest, claims for refund or issuance of a tax credit certificate, collection proceedings, or judicial appeal. 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: "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 interest, 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%). (Emphasis supplied) xxx xxx xxx" However, said income derived by a nonresident foreign corporation may be exempt or partially exempt from income tax pursuant to a treaty obligation to which the Philippine government is bound. Thus, Section 32 (B) (5) of the Tax Code of 1997, as amended provides, viz. : TcHCDE "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." However, since tax treaties follow the principal method of classification and assignment in mitigating the effects of double taxation of income derived by a resident of a Contracting State from sources in the other Contracting State, it is important to know how income derived by AFI under the Agreement is classified for purposes of the Philippines-Japan tax treaty. Payments for services to be made by AII to AFI are generally treated as business profits unless otherwise proven as royalties such as if the activity involves the grant to use or the right to use an intangible property like know-how (information concerning industrial, commercial or scientific experience). To distinguish between payments for the supply of services and payments for the supply of know-how, the Organization for Economic Co-operation and Development Model Tax Convention on Income and on Capital (Condensed Version, July 22, 2010) made the following commentaries on the subject, thus: "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 recognised 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: DTCSHA 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." 11.4. Examples of payments which should therefore not be considered to be received as consideration for the provision of know-how but, rather, for the provision of services, include: Payments obtained as consideration for after-sales service; Payments for services rendered by a seller to the purchaser under a warranty; DHSEcI Payments for pure technical assistance; payments for a list of potential customers, when such a list is developed specifically for the payer out of generally available information (a payment for the confidential list of customers to which the payee has provided a particular product or service would, however constitute a payment for know-how as it would relate to the commercial experience of the payee in dealing with these customers); Payments for an opinion given by an engineer, an advocate or an accountant; and Payments for an advice provided electronically, for electronic communications with technicians or for accessing, through computer networks, a trouble-shooting database such as a database that provides users of software with non-confidential information in response to frequently asked questions or common problems that arise frequently. (Pages 225-226) Based on the commentaries, contracts for the supply of know-how concern information that already exists or concern the supply of that type of information after its development or creation and generally include specific provisions concerning the confidentiality of that information. Also, 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, in a contract for the performance 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. It also 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 sub-contractors for the performance of similar services. Accordingly, since AFI will not merely perform technical assistance and provide administrative services but will also impart technical know-how through the use of the Manufacturing Technology which requires the disclosure of special knowledge or experience to AII, and AFI does not guarantee the result of the use of the Manufacturing Technology and AII agreed to the confidentiality of the information disclosed under the Agreement, this Office is of the opinion and so holds that the Agreement involves the supply of know-how. This being the case, the technical assistance fees paid by AII to AFI constitute payment for royalties and not business profits. In determining whether these payments for royalties are subject to relief under the Philippine-Japan tax treaty, we refer to Article 12 of the treaty: "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: EScAHT (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. 3. Notwithstanding the provisions of paragraph 2, the amount of tax imposed by the Philippines on the royalties paid by a company, being a resident of the Philippines, registered with the Board of Investments and engaged in preferred pioneer areas of investment under the investment incentives laws of the Philippines to a resident of Japan, who is the beneficial owner of the royalties, shall not exceed 10 per cent of the gross amount of the royalties. 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." Based on the above-quoted provisions, the Philippines may tax the royalties paid by a resident thereof to a company which is a resident of Japan at a rate not exceeding 15 percent if the royalties are paid in respect of the use of or the right to use cinematograph films and films or tapes for radio and television broadcasting; and 10 percent of the gross amount of royalties in all other cases. In view thereof and considering that the royalties paid by AII to AFI are not in respect of the use of, or the right to use, cinematograph films and films or tapes for radio and television broadcasting, but represent consideration for information concerning industrial, commercial or scientific experience, i.e., provision of know-how, such royalty fees are subject to the 10 percent final withholding tax rate pursuant to Article 12 (2) (b) of the Philippines-Japan tax treaty, as amended. As regards the imposition of the VAT on royalties paid to AFI, please be informed further that Section 108 of the Tax Code of 1997, as amended, provides as follows: "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%) 1 of gross receipts derived from the sale or exchange of services, including the use or lease of properties. HETDAa The phrase 'sale or exchange of services' means the performance of all kinds of services in the Philippines for others for a fee . . . The phrase 'sale or exchange of services' shall likewise include: xxx xxx xxx (2) The supply of scientific, technical or commercial knowledge information; . . ." Thus, in general, the VAT is imposed on the fees earned by AFI in the Philippines, such that on every payment of the fees, AII is generally required to withhold such VAT and treat the same as a "passed on" VAT, pursuant to Section 4.110-3 (b) of Revenue Regulations No. 7-95 as amended [now Section 4.114-2 (b) of Revenue Regulations No. 16-05]. However, in Commissioner of Internal Revenue vs. Seagate Technology , 2 the Supreme Court held, viz. : "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: . . ., 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. ECDaTI 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. xxx xxx xxx" Based on the foregoing, sale of goods and/or services including the use of or lease of properties, to person or entities exempt from VAT by reason of PD 66 and RA 7916 are effectively zero-rated. However, instead of zero-rating which is not available to nonresident suppliers, the provision for exempt transactions under Section 109 (K) of the Tax Code of 1997 which provides VAT exemption for transactions that are exempt under special laws, e.g., Republic Act No. 7916 or PEZA Law, is particularly applicable to the instant case. Such being the case, the royalties paid by AII, being a PEZA registered enterprise, to AFI under the Agreement should be, as it is hereby confirmed to be, exempt from VAT. This ruling is issued on the basis of the foregoing 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. Effective February 1, 2006 the rate shall be 12%. 2. G.R. No. 153866, February 11, 2005.