F. Tech R&D Philippines, Inc.

October 19, 2018 ITAD BIR RULING NO. 091-18 Articles 5 and 7 Philippines-Japan tax treaty, as amended F. Tech R&D Philippines, Inc. F. Tech Annex Building 123 North Avenue, Laguna Technopark 4024 Bian, Laguna Attention: AAA _______________ Gentlemen : This refers to your tax treaty relief applications filed on July 16, 2015 and June 9, 2016 requesting confirmation that license fee for software paid by F. Tech R&D Philippines, Inc. ("F. Tech Philippines") to Delight Company Ltd. ("Delight") are exempt from income tax 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 SaIHDA It is represented that Delight is a corporation organized and existing under the laws of Japan and a resident thereof based on its Articles of Incorporation and Certificate of Residence issued by the Kawasakinishi Tax Office in Japan; that Delight is engaged in importing, exporting, selling, purchasing, leasing, and licensing of computer programs, in providing consultancy services relating to computer programs, and in conducting research, development, selling, and purchasing technology relating to computer programs; that Delight 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; that, on the other hand, F. Tech Philippines is a corporation organized and existing under the laws of the Philippines, engaged in information technology-based research and in development of automotive parts such as pedals, clutches and other underbody products for car manufacturers; 2 that F. Tech Philippines is registered with the Philippine Economic Zone Authority ("PEZA") as an economic zone export enterprise engaged in research and development of automotive products; and that F. Tech Philippines is a subsidiary of F. Tech, Inc. of Japan. 3 It is also represented that on July 19, 2013, F. Tech Philippines and Delight entered into a Software License Agreement where Delight agreed to provide F. Tech Philippines certain computational fluid dynamics computer software, related documentation, and supporting services; that software means program code, documentation, manuals, routines and subroutines along with any subsequent solutions, corrections, new release modifications and updates which constitute Delight 's proprietary software products and software from third parties which may be distributed by Delight to end users; that Delight grants F. Tech Philippines a non-transferable and non-exclusive license to use the software in its computers within its premises; that Delight will deliver the software in digital media including the user's manual; that F. Tech Philippines will use the software for its internal needs only, and the license does not permit F. Tech Philippines to sell, sublicense, market, lease, or convey the software to third parties without prior written authorization from Delight ; that the software includes a license manager and other security mechanisms which limit concurrent processes and which deactivate the software at a predetermined expiration date; that, in addition, Delight will provide installation support and program checkout to F. Tech Philippines , which can be done on-site, or by mail, telephone, or computer link; that Delight will also provide maintenance and support to F. Tech Philippines in the form of problem solutions, unlimited hotline support, and software modifications, refinements and enhancements; and that in consideration, F. Tech Philippines will pay a license fee to Delight for the use of software; It is further represented that the software referred above is the AAPD Volume Version the copyright and licensing of which is owned by and exclusive of Delight ; and that the annual license fee for the software in 2013 is _____________. It is further represented that F. Tech Philippines and Delight entered into subsequent Software License Agreements on July 19, 2014, July 19, 2015, and July 19, 2016 for the purpose of renewing the software license; and that the annual license fee in 2014 is _____________, and _____________ in 2015, and _____________ in 2016. It is further represented based on several certifications issued by F. Tech Philippines in 2016 and 2015: 1. That no service will be physically conducted by Delight in the Philippines, and, based on the agreements, support will be made thru unlimited hotline support during Delight 's normal business hours in Tokyo, Japan; 2. That BBB, a Japanese and representative of Delight , has not entered the Philippines as evidenced by his passport; 3. That no service was performed and will be physically conducted in the Philippines by employees or representative of Delight in connection with the agreements, and the software installer was sent thru email; and 4. That the income subject of this ruling is not under investigation or on-going audit, administrative protest, claim for refund or issuance of tax credit certificate, collection proceedings, or judicial appeal. 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 by a foreign corporation not engaged in trade or business is subject to income tax at the rate of 30%, 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, such income is exempt to the extent required by a treaty obligation on the Philippine government, thus: TCEaDI " 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 connection, paragraph 1, Article 7 of the Philippines-Japan tax treaty provides as follows: " Article 7 1. The profits of an enterprise of a Contracting State shall be taxable only in that Contracting 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 that other Contracting State but only so much of them as is attributable to that permanent establishment." Under Article 7, profits derived by an enterprise of a Contracting State in the other Contracting State may be taxed in the other State, but only so much of the profits as are attributable to a permanent establishment situated in that State. The term permanent establishment is defined in paragraphs 1, 2 and 6, Article 5 of the treaty below: " Article 5 1. For the purposes of this Convention, 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' includes especially: a) a store or other sales outlet; b) a branch; c) an office; d) a factory; e) a workshop; f) a warehouse; g) a mine, an oil or gas well, a quarry or other place of extraction of natural resources." "6. An enterprise of a Contracting State shall be deemed to have a permanent establishment in the other Contracting State if it furnishes in that other Contracting State consultancy services, or supervisory services in connection with a contract for a building, construction or installation project through employees or other personnel other than an agent of an independent status to whom paragraph 7 applies provided that such activities continue (for the same project or two or more connected projects) for a period or periods aggregating more than six months within any twelve-month period. However, if the furnishing of such services is effected under an agreement between the Governments of the two Contracting States regarding economic or technical cooperation, that enterprise shall, notwithstanding any provisions of this Article, not be deemed to have a permanent establishment in that other Contracting State." 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 store or other sales outlet, a branch, an office, a factory, and a workshop. It includes also the furnishing of consultancy services, or supervisory services in connection with a contract for a building, construction or installation project through employees or other personnel, provided such activities continue (for the same or connected projects) for a period or periods aggregating more than six months within any twelve-month period. With respect to the characterization of payments for the use of software, under Section 5 of Revenue Memorandum Circular No. 44-2005 4 (Taxation of Payments of Software) ("RMC 44-2005") , such payments are considered royalties when copyright rights are transferred to the licensee, and business profits when the licensee acquires merely a copy of a software but not any copyright rights or acquires merely a de minimis grant of those rights, thus: " Section 5. Characterization of Transactions . The character of payments received in a transaction involving the transfer of computer software depends on the nature of the rights that the transferee acquires under the particular arrangement regarding the use and exploitation of the program. a. Transfer of copyright rights. A transfer of software is classified as a transfer of copyright right if, as a result of the transaction, a person acquires any one or more of the rights described below: i. The right to make copies of the software for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease or lending; ii. The right to prepare derivative computer programs based upon the copyrighted software; iii. The right to make a public performance of the software; iv. Any other rights of the copyright owner, the exercise of which by another without his authority shall constitute infringement of said copyright; The determination of whether a transfer of a copyright in a software is a sale or exchange of property is made on the basis of whether, taking into account all facts and circumstances, there has been a transfer of all substantial rights in the copyright. A transaction that does not constitute a sale or exchange because not all substantial rights have been transferred will be classified as a license generating royalty income. When only copyright rights are transferred, payments made in consideration thereof are royalties. On the other hand, when copyright ownership is transferred, payments made in consideration therefor are business income . b. Transfer of copyrighted articles . A copyrighted article incorporating a software includes a copy of the software from which the work can be perceived, reproduced, or otherwise communicated, either directly or with the aid of a machine or device. The copy of the software may be fixed in the magnetic medium of a floppy disk or a CD-ROM, or in the main memory of hard drive of a computer, or in any other medium. If a person acquires a copy of a software but does not acquire any of the rights described above (or only acquires a de minimis grant of such rights), and the transaction does not involve the provision of services or of know-how, the transfer of the copy of the software is classified solely as a transfer of a copyrighted article and payments for which constitute business income ." (Underscoring ours) In the instant case, F. Tech Philippines obtained merely a copy of the AAPD Volume Version software in digital media and accompanying user's manual, and F. Tech Philippines will use the software for its internal needs only in its computers within its premises. Delight does not permit F. Tech Philippines to exploit the copyright rights in the software as the latter cannot sell, sublicense, market, lease, or convey the software to third parties without being authorized by Delight . This being so, the annual license fee for the use of the software, for the installation of and program checkout for the software, and for the provision of maintenance and support to F. Tech Philippines during the license period, is in the nature of business profits and not royalties taxable under the provisions of Articles 5 and 7 of the Philippines-Japan tax treaty. DaHcAS Accordingly, since Delight is not engaged in trade or business in the Philippines, and it does not have a branch, office, or other fixed place of business in the Philippines, and it does not furnish services in the Philippines but provided them remotely, Delight is not deemed to have a permanent establishment pursuant to paragraphs 1, 2 and 6, Article 5 of the Philippines-Japan treaty. This being the case, the annual license fee for the AAPD software paid by F. Tech Philippines to Delight is exempt from income tax pursuant to paragraph 1, Article 7 of the treaty. Finally, under Section 108 (A) of the Tax Code, the sale or exchange of services and the use or lease of properties (including intangible property like software) in the Philippines are subject to VAT at the rate of 12%, 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: Provided, that the President, upon the recommendation of the Secretary of Finance, shall, effective January 1, 2006, raise the rate of value-added tax to twelve percent (12%). . ." However, since F. Tech Philippines is a PEZA-registered enterprise and entitled to fiscal incentives under Republic Act No. 7916, 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 ." Applying the ruling to the instant case, since the use by F. Tech Philippines of the AAPD software licensed from Delight is directly connected with F. Tech Philippines ' business activities of conducting information technology-based research and development of automotive parts, F. Tech Philippines is not subject to VAT on the use of this software. As PEZA-registered enterprise, PASAR cannot be treated as a regular VAT taxpayer with respect to its registered activities. Likewise, PASAR cannot be shifted or passed-on with VAT on its purchase of goods and services and the use of property related to its registered activities. 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. 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. http://www.frdp.com.ph/ 3. http://www.ftech.co.jp/en/company 4. Entitled Taxation of Payments of Software . n Note from the Publisher: Copied verbatim from the official document.