ITAD BIR Ruling No. 120-11

April 11, 2011 ITAD BIR RULING NO. 120-11 Articles 5 and 7 Philippines-Japan tax treaty; BIR Ruling No. ITAD 16-10 Punongbayan and Araullo Certified Public Accountants 20th Floor, Tower 1, The Enterprise Center 6766 Ayala Avenue, Makati City Gentlemen : This refers to your letter dated October 14, 2008 requesting confirmation that service fees to be paid by Tokyo Steel Philippines Corporation ("Tokyo Steel Philippines") to Tokyo Steel Company Ltd. ("Tokyo Steel") are exempt from income tax in the Philippines 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") . Basic Facts It is represented that Tokyo Steel is a foreign corporation organized and existing under the laws of Japan based on the Certificate of Status of Taxable Person issued by the Hachioji Tax Office in Japan on March 5, 2008; that Tokyo Steel is situated at 3766-1 Kawaguchi-machi, Hachioji City, Tokyo, Japan; that Tokyo Steel is not registered as a corporation or partnership in the Philippines based on a Certificate of Corporate Filing/Information issued by the Securities and Exchange Commission on April 28, 2008; that, on the other hand, Tokyo Steel Philippines is a domestic corporation situated at 5th Street, 3rd Avenue, Mactan Export Processing Zone 1, Ibo, Lapu-Lapu City, Cebu, Philippines; and that Tokyo Steel Philippines is registered with the Philippine Economic Zone Authority ("PEZA") as an ecozone export enterprise under Certificate of Registration No. 97-036 issued by PEZA on May 8, 1997. It is also represented that on March 26, 2008, Tokyo Steel and Tokyo Steel Philippines entered into a Service Agreement where Tokyo Steel agreed to provide the following services to Tokyo Steel Philippines : 1. Procurement/sourcing of qualified vendors residing overseas. 2. Marketing and sales promotion planning. 3. Customer relations and handling of product complaints. 4. Other related services. That the services will not involve the transfer by Tokyo Steel of its technology, processes, know-how, or other intellectual property rights to Tokyo Steel Philippines ; that in consideration, Tokyo Steel Philippines will pay service fees to Tokyo Steel of 339,339.00 every month or 4,072,068.00 for a completed year of service; that Tokyo Steel will submit its billings to Tokyo Steel Philippines on a yearly basis for services rendered in any given twelve-month period, payable within 90 days from the date of invoice; that the parties will review the amount of the service fees to determine any adjustment thereon and on the effectivity of such adjustment; that the Agreement has an initial term of one year commencing on January 14, 2008, and ending on January 14, 2009; that upon the lapse of this term, the Agreement will be renewed automatically for successive twelve-month periods, unless terminated later. It is further represented that, based on the Certification issued by the General Manager of Tokyo Steel Philippines on October 6, 2008, Tokyo Steel sent its President, Mr. Yoshito Akui , to the Philippines to provide services to Tokyo Steel Philippines under the Agreement and on the following dates: ITESAc Dates Purpose Number of days January 13-17, 2008 To discuss the nature of 4 days services that Tokyo Steel will perform outside the Philippines under Agreement February 19-24, 2008 To finalize the terms of 5 days the Agreement April 16-23, 2008 To discuss marketing and 7 days sales promotion Total 16 days ====== It is finally represented that the transaction subject of the application for tax treaty relief is 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 the same General Manager on May 26, 2008. Ruling A. On income tax In reply, please be informed that the service fees to be paid to Tokyo Steel, 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 23 (F) 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 subparagraph 5(c) and (d) above: Provided, That effective 1, 2009, the rate of income tax shall be thirty percent (30%)" However, such fees may be exempt or partially exempt (if subject to a reduced rate only) to the extent required by any treaty obligation on the Philippines. Section 32 (B) (5) of the same Code 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-Japan tax treaty. Under tax treaties, payments for the supply of services are treated as business profits , unless they are otherwise treated as royalties when they concern the use of know-how or any other intangible property (copyright, patent, trademark, design or model, plan, secret formula or process design). To distinguish between payments for the supply of services and payments for know-how, the following commentaries of the Organisation for Economic Co-operation and Development ("OECD") Model Tax Convention on Income and on Capital (Condensed Version, July 17, 2008) mention: "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 recognized 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: ATHCDa Contracts for the supply of know-how concern information of that 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 guarantee, 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 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 186-187) Accordingly, based on the OECD commentaries, the service fees to be paid by Tokyo Steel Philippines to Tokyo Steel under the Agreement are business profits and not royalties since: 1. The Agreement concerns solely the supply of services and not the supply of information concerning industrial, commercial or scientific experience ("know-how") or any other intangible property that exists already or that is in its stage of development by Tokyo Steel. 2. Under the Agreement, Tokyo Steel undertakes to perform services to Tokyo Steel Philippines which merely require the use by Tokyo Steel of its special knowledge, skill and expertise on the subject, and not the transfer of such special knowledge, skill or expertise to Tokyo Steel Philippines. 3. To perform its contractual obligations, Tokyo Steel will actually perform a number of services (as described above) to Tokyo Steel Philippines , and not simply supply existing information or material to Tokyo Steel Philippines . DICcTa Therefore, as business profits, the service fees may be taxed in the Philippines if Tokyo Steel has a permanent establishment in the Philippines to which these fees may be attributed. Paragraph 1, Article 7 of the Philippines-Japan tax treaty provides: "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." The term "permanent establishment" is defined in paragraphs 1, 2 and 6, Article 5 of the tax treaty as follows: "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. xxx xxx xxx 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 taxable year. 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 the above-quoted provisions, Tokyo Steel is deemed to have a permanent establishment if it has a fixed place of business through which its business is wholly or partly carried on, such as, a store or other sales outlet, a branch, an office, a factory, a workshop, and a warehouse. Tokyo Steel is also deemed to have a permanent establishment if it furnishes consultancy services in the Philippines (through employees or other personnel thereof) for a period or periods aggregating more than six months within any taxable year. Accordingly, since Tokyo Steel is not engaged in trade or business in the Philippines, and since it did not provide consultancy services in the Philippines for a period more than an aggregate of six months within any taxable year (in fact, it only provided services in the Philippines for only 16 days in 2008 ), Tokyo Steel is not deemed to have a permanent establishment in the Philippines in 2008 . Therefore, the service fees to be paid by Tokyo Steel Philippines to Tokyo Steel under the Agreement in 2008 are exempt from income tax, pursuant to paragraph 1, Article 7, in relation to paragraphs 1, 2 and 6, Article 5, of the Philippines-Japan tax treaty. (BIR Ruling No. ITAD 16-10 dated August 11, 2010) B. On value-added tax Moreover, the portion of the service fees representing payments for the sale of services rendered in the Philippines, are subject to value-added tax ("VAT"). Section 108 (A) of the National Internal Revenue 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%) . . ." 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. cTIESD 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. EcDATH 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 Tokyo Steel Philippines is an enterprise registered with PEZA under Republic Act No. 7916, 2 as amended, operating within an economic zone, and being an "exempt" entity, it cannot be directly charged for VAT on its sales of goods or services nor indirectly made to bear, as added cost to such sales, the equivalent VAT on its purchase of goods and services when such purchase is subject to VAT. Therefore, since Tokyo Steel is a nonresident supplier who is not registered in the Philippines for VAT purposes, the service fees to be paid to it by Tokyo Steel Philippines under the Agreement are, instead being subject to VAT at zero percent, exempt from VAT. 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. 2. Entitled An Act Providing for the Legal Framework and Mechanism for the Creation, Operation, Administration, and Coordination of Special Economic Zones in the Philippines, Creating for this Purpose, the Philippine Economic Zone Authority (PEZA), and for Other Purposes.