ITAD BIR Ruling No. 105-16

June 22, 2016 ITAD BIR RULING NO. 105-16 Article 12, Philippines-Japan tax treaty, as amended; BIR Ruling No. ITAD 011-10; BIR Ruling No. DA-ITAD 074-10 Castillo Laman Tan Pantaleon & San Jose Valero Tower, 122 Valero St., Salcedo Village, 1227 Makati City Attention: J. Gregson A. Castillo Rowena Romero Gentlemen : This refers to your letter Tax Treaty Relief Application filed April 22, 2010, on behalf of your client, HITACHI METALS, LTD. ("HML"), requesting confirmation that the royalty payments made by HML to SAN TECHNOLOGY, INC. ("STI") under the Technical Assistance Agreement prior to January 1, 2009 are subject to the preferential tax rate of 25 percent while those to be paid on or after January 1, 2009 are subject to the preferential 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") , as amended, and that the royalties paid are deductible as direct product costs from STI's gross income for purposes of computing the 5 percent income tax on gross income under Republic Act No. 7916, or the special tax on Philippine Economic Zone Authority ("PEZA")-registered enterprises. It is represented that HML is a foreign company engaged primarily in the manufacture and sale of high-grade specialty steels, high alloys, magnets and, other electronic and magnetic materials; that HML is organized and existing under the laws of Japan, with registered office at 2-1, Shibaura 1-chome, Minato-ku, Tokyo per Certificate of All Registered Items certified by the Director of the Tokyo Legal Affairs Bureau; that it is not registered either as a corporation or as a partnership in the Philippines per Certification of Non-Registration issued by the Securities and Exchange Commission dated November 23, 2009; that, on the other hand, STI is a corporation duly organized and existing under and by virtue of the laws of the Philippines, and is registered with the PEZA under Certificate of Registration No. 89-08, dated January 30, 2009; and that STI's principal office address is at Block 7 Phase 2, Cavite Economic Zone, Main Avenue, Rosario, Cavite; and that STI is a wholly owned subsidiary of HML and is engaged in the business of manufacture/assembly of computer components, Multi Sound Device, TFT-Chip Inductor, voice coil motor, and magnets among others. aDSIHc It is further represented that on April 1, 2007, HML and STI entered into a Technical Assistance Agreement ("Agreement") , whereby HML grants STI a non-exclusive license to: a.) make the Licensed Products 1 using Technical Information 2 and Patents 3 in the Republic of the Philippines; and, b.) sell and distribute the Licensed Products to countries and areas separately agreed upon by the Parties only through HML or HML's designated agent; that in consideration of the license, the right to use the Technical Information granted, STI shall pay to HML, as a non-refundable running royalty, three percent (3%) of the Net Selling Price of the Licensed Products; that the Agreement shall become effective from April 1, 2007 and shall remain in full force and effect until March 31, 2010, unless earlier terminated by an agreement between the parties; that on March 31, 2010, HML and STI executed a Memorandum, extending the term of the original Agreement for a period of three years, or until March 31, 2013; and that the dates of payment of the royalties under the Agreement are as follows: (a) May 26, 2010; (b) November 24, 2010; (c) May 27, 2011; (d) November 28, 2011; (e) May 2012; and (f) November 2012 based on the Certification issued by the Director of STI on March 15, 2012. It is finally represented that the 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 per Certification issued by HML dated March 23, 2010. 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 non-resident 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%). xxx xxx xxx" 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, the treaty involved is the Philippines-Japan tax treaty which, in its Article 12, provides: "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: 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) 25 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. ETHIDa 5. The provisions of paragraphs 1, 2 and 3 shall not apply if the beneficial owner of the royalties, being a resident of a Contracting State, carries on business in the other Contracting State in which the royalties arise, through a permanent establishment situated therein, or performs in that other Contracting State independent personal services from a fixed base situated therein, and the right or property in respect of which the royalties are paid is effectively connected with such permanent establishment or fixed base. In such case the provisions of Article 7 or Article 14, as the case may be, shall apply. 6. Royalties shall be deemed to arise in a Contracting State when the payer is that Contracting State itself, a political subdivision or a local authority thereof or a resident of that Contracting State. Where, however, the person paying the royalties, whether he is a resident of a Contracting State or not, has in a Contracting State a permanent establishment or a fixed base in connection with which the liability to pay the royalties was incurred, and such royalties are borne by such permanent establishment or fixed base, then such royalties shall be deemed to arise in the Contracting State in which the permanent establishment or fixed base is situated. 7. Where, by reason of a special relationship between the payer and the beneficial owner or between both of them and some other person, the amount of the royalties, having regard to the use, right or information for which they are paid, exceeds the amount which would have been agreed upon by the payer and the beneficial owner in the absence of such relationship, the provisions of this Article shall apply only to the last-mentioned amount. In such case, the excess part of the payments shall remain taxable according to the laws of each Contracting State, due regard being had to the other provisions of this Convention." With respect to the Philippines-Japan tax treaty, there is a 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 (Amending Protocol) , which was signed on December 9, 2006, and became effective on January 1, 2009. Article 12 of the existing tax treaty is amended as follows: "ARTICLE V Paragraph (2) of Article 12 of the Convention shall be deleted and replaced by the following: (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: (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" Based on the foregoing, royalty payments will be taxed at a preferential rate of 10 percent if the payor is a BOI-registered enterprise and engaged in preferred areas of investment under the investment incentives laws of the Philippines; 15 percent if the royalty payments are in respect of the use of or right to use cinematograph films and films or tapes for radio or television broadcasting; and in all other cases, 25 percent of the gross amount of the royalties for payments made prior to January 1, 2009, and 10 percent of the gross amount of royalties beginning January 1, 2009. Accordingly, since STI's royalty payments are not in respect of the use or right to use cinematograph films and films or tapes for radio or television broadcasting, this Office is of the opinion and so holds that the said payments by STI to HML under the Agreement, being essentially payment for know-how, are subject to the preferential tax rate of 25 percent of the gross amount of royalties for payments prior to January 1, 2009, pursuant to Article 12 (2) (b) of the Philippines-Japan tax treaty; and beginning January 1, 2009, to the preferential tax rate of 10 percent based on the gross amount thereof, pursuant to Article 12 of the Philippines-Japan tax treaty, as amended. (BIR Ruling No. ITAD 11-10 dated June 16, 2010; BIR Ruling No. DA-ITAD 074-10 dated July 9, 2010) In addition, transfer of technical know-how is generally subject to value-added tax ("VAT") pursuant to Section 108 (A) of the Tax Code of 1997, as amended. It 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, raise the rate of value-added tax to twelve percent (12%). . ." However, in Commissioner of Internal Revenue vs. Seagate Technology (Philippines) (G.R. No. 153866 dated February 11, 2005), the Supreme Court ruled that: "Applying the special laws we have earlier discussed, respondent as an entity is exempt from internal revenue laws and regulations. cSEDTC 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 STI is an enterprise registered with PEZA operating within an economic zone and as such is an exempt entity, it can neither be directly charged with VAT nor indirectly made to bear, as added cost, the equivalent VAT. Thus, the royalty fees to be paid by STI to HML under the Agreement as consideration for the transfer of Know-how are exempt from VAT. Finally, as for the deductibility of the royalty payments as direct product costs from STI's gross income for purposes of computing the 5 percent income tax on gross income under Republic Act No. 7916 or the special tax on PEZA-registered enterprise, the said request including all the precedents you have raised in your letter-request should be properly filed with the Law Division the same being under their jurisdiction. 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. "Licensed Products" shall mean the products manufactured by STI. 2. "Technical Information" shall mean all technical information, know-how (whether or not patentable) and other information including drawings, specifications, shop methods, processes, formulae and secrets of manufacture, and treatment of materials presently owned or controlled by HML and used by HML, and which HML has the right to license without payment of compensation to any third party, in the manufacture and use of Products as of the date of execution hereof, the technical contents of such information includes the following information relating to: i.) machining, surface treatments, inspection and assembly, and ii.) related information on specifications and operating manuals of equipments and/or machines for each process, and iii.) know-how for quality control and analysis method for defects of Products. 3. "Patents" shall mean any and all patents and patent applications which directly pertain to the design, manufacture and use of Licensed products and/or Technical Information and which at present HML owns or has the right to license or hereafter during the term of the Agreement owns or has the right to license.