ITAD BIR Ruling No. 144-15

May 4, 2015 ITAD BIR RULING NO. 144-15 Articles 5 (Permanent Establishment) and 7 (Business Profits), Philippines-Thailand tax treaty Mahle Filter Systems Philippines Corporation Block 8, Lots 5, 6 and 7, PEZA Drive First Cavite Industrial Estate Langkaan, Dasmarias Cavite Attention: Mr. Satoshi Nomiyama President Mr. Noboru Ohashi Director and Treasurer Ms. Eleanor F. Ledesma Department Head General Accounting and Tax Gentlemen : This refers to your tax treaty relief application requesting confirmation that service fees paid by Mahle Filter Systems Philippines Corporation ("Mahle Philippines") (formerly " Mahle Tennex Philippines Corporation ") to Mahle Engine Components (Thailand) Company Ltd. ("Mahle Thailand") (formerly Izumi Piston Manufacturing Company (Thailand) Company Ltd.) are exempt from income tax pursuant to the Convention between the Government of the Republic of the Philippines and the Government of the Kingdom of Thailand for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income ("Philippines-Thailand tax treaty") . Facts Mahle Thailand is a foreign corporation and a resident of Thailand based on the Affidavit issued by the Bangkok Partnerships and Companies Registration Office in Thailand on September 25, 2009 and its Certificate of Residence issued by the Revenue Department of Thailand on August 4, 2011. Mahle Thailand is located at 9/1-2 Soi Serithai 56, Serithai Road, Kwaeng Kannayao, Khet Kannayao, Bangkok, Thailand. It is not registered as a corporation or partnership in the Philippines based on the Certification of Non-Registration of Corporation/Partnership issued by the Securities and Exchange Commission on June 24, 2009. On the other hand, Mahle Philippines is a domestic corporation located at Block 8, Lots 5, 6 and 7, PEZA Drive, First Cavite Industrial Estate, Langkaan, Dasmarias, Cavite, Philippines. It is registered with the Philippine Economic Zone Authority ("PEZA") as an ecozone export enterprise under Certificate of Registration No. 96-67 issued on June 3, 1996. On November 5, 2009, Mahle Philippines and Mahle Thailand entered into a Comprehensive Service Agreement where Mahle Thailand agreed to provide services to Mahle Philippines in the areas of accounting, finance, and information technology. Management support services for information technology systems consist of support for systems design, installation, improvements and maintenance of hardware and software. Management support services for accounting and financing activities consist of support for financial reporting, strategic budget planning, finance activities, cost accounting, internal and external audit, tax matters and full assistance to guidelines observed by the Mahle Group of Companies. Services can be done thru e-mail or telephone, or on-site if necessary. In consideration, Mahle Philippines will pay service fees to Mahle Thailand totaling 1,000,000.00 every year (500,000.00 for information technology services and 500,000.00 for financial and accounting management services). The service fees are payable every month and due within sixty days after each month. The Agreement took effect on January 1, 2009 and is in effect indefinitely. Based on the Certification issued by Mahle Philippines on June 29, 2011, Mahle Thailand sent its personnel, Mr. Shuichi Kosa and Damien Deroide, to the Philippines to perform services to Mahle Philippines pursuant to the Agreement. Their length of stay in the country is as follows: 2009 Total Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec. 25-29 - - - - - 22-26 - - - - - 5 - - - - - 5 - - - - - 10 2010 Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec. 22-27 - - - - - 21-24 - - - - - 6 - - - - - 4 - - - - - 10 2011 Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec. 25-28 - - - - - 20-23 - - - - - 4 - - - - - 4 - - - - - 8 Grand Total 28 ===== Ruling 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 in the Philippines by a foreign corporation not engaged in trade or business is generally subject to income tax at the rate of 30 percent, 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 or partially exempt to the extent required by any treaty obligation on the Philippines, to wit: "SEC. 32. Gross Income . xxx xxx xxx (B) Exclusions from Gross Incomes . 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 paragraph 1, Article 7 of the Philippines-Thailand tax treaty, which provides: "Article 7 Business Profits 1. The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on or has carried on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment." Under this article, profits derived by an enterprise of Thailand from sources in the Philippines may be taxed in the Philippines if the profits are attributable to a permanent establishment which the enterprise has therein; otherwise, such profits are exempt. In relation thereto, paragraphs 1 and 2, Article 5 of the treaty define a permanent establishment as follows: "Article 5 Permanent Establishment 1. For the purposes of this Convention, the term 'permanent establishment' means a fixed place of business through which the business of the enterprise is wholly or partly carried on. 2. The term 'permanent establishment' includes especially: a) a place of management; b) a branch; c) an office; d) a factory; e) a workshop; f) a mine, an oil or gas well, a quarry or any other place of extraction of natural resources; g) a building site or construction project where such site or project continues for a period of more than six months; h) an assembly or installation project which exists for more than three months; i) premises used as a sales outlet; j) a warehouse, in relation to a person providing storage facilities for others; k) the furnishing of services, including consultancy services, by a resident of one of the Contracting States through employees or other personnel, provided activities of that nature continue (for the same or a connected project) within the other Contracting State for a period or periods aggregating more than 183 days." As defined, 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 place of management, a branch, an office, a factory, and a workshop. It includes also the furnishing of services, including consultancy services, which continues for a period or periods aggregating more than 183 days. Accordingly, since Mahle Thailand is not engaged in trade or business in the Philippines to which a branch, an office, or other fixed place of business is relevant, and it did not furnish services in the Philippines for more than an aggregate of 183 days, but to date, had furnished services in the country for an aggregate of 28 days only from 2009 to 2011, Mahle Thailand is not deemed to have a permanent establishment, under paragraphs 1 and 2, Article 5 of the Philippines-Thailand tax treaty. Therefore, service fees paid by Mahle Philippines to Mahle Thailand under the Agreement are exempt from income tax pursuant to paragraph 1, Article 7 of the same treaty. On the characterization of the service fees as business profits (which are exempt from income tax if not attributable to a permanent establishment) rather than payments for know-how or royalties (which are partially exempt from tax), the following commentaries of the Organisation for Economic Co-operation and Development Model Tax Convention on Income and on Capital (Condensed Version, July 22, 2010) mention that: "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: 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." (Pages 225-226) Based on the commentaries, in a contract for the supply of know-how, there would generally be very little more which needs to be done by the supplier other than to supply existing information or reproduce existing material. On the other hand, in a contract for the performance of services, this 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 the Comprehensive Service Agreement does not call for Mahle Thailand to supply existing information or reproduce existing material to Mahle Philippines , but for Mahle Thailand to provide actual services to Mahle Philippines in the areas of accounting, finance, and information technology, this agreement is a contract for the performance of services rather than for the supply of know-how or other intangible property. Moreover, on account that Mahle Thailand has employed personnel to provide these services to Mahle Philippines in the Philippines and in Thailand, Mahle Thailand certainly incurred a greater level of expenditure (such as salaries and wages of these personnel) to fulfil its contractual obligations to Mahle Philippines . This being the case, the service fees in question are in the nature of business profits rather than payments for know-how or royalties. Furthermore, under Section 108 (A) of the Tax Code, the service fees paid to Mahle Thailand for services done in the Philippines are subject to value-added tax ("VAT"), 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 services, including the use or lease of properties selling price or gross value in money the goods or properties sold, bartered or exchanged, such tax to be paid by the seller or transferor: Provided, that the President, upon the recommendation of the Secretary Finance, shall, effective January 1, 2006, 1 raise the rate of value-added tax to twelve percent (12%) . . ." However, since Mahle Philippines is a PEZA-registered enterprise and entitled to fiscal incentives pursuant to Republic Act No. 7916 , 2 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." Accordingly, since Mahle Thailand , the nonresident supplier of services, is not a VAT-registered taxpayer, service fees paid to it by Mahle Philippines shall, for VAT purposes, be treated as VAT-exempt rather than subject to zero-rated VAT; in either case, no output VAT is shifted or passed-on to Mahle Philippines . 3 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 is increased to twelve percent on 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. 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 , as amended. 3. Revenue Regulations No. 16-2005 (Consolidated Value-Added Tax Regulations of 2005) , as amended, provides: "SEC. 4.106-5. Zero-Rated Sales of Goods or Properties . A zero-rated sale of goods or properties (by a VAT-registered person) is a taxable transaction for VAT purposes, but shall not result in any output tax. However, the input tax on purchases of goods, properties or services related to such zero-rated sale, shall be available as tax credit or refund in accordance with these Regulations." "SEC. 4.109-1. VAT-Exempt Transactions . (A) In general. 'VAT-exempt transactions' refer to the sale of goods or properties and/or services and the use or lease of properties that is not subject to VAT (output tax) and the seller is not allowed any tax credit of VAT (input tax) on purchases. The person making the exempt sale of goods, properties or services shall not bill any output tax to his customers because the said transaction is not subject to VAT." n Note from the Publisher: The phrase "and (d) above" no longer appears in RA 9337, the law amending this provision.