ITAD BIR Ruling No. 152-12

April 4, 2012 ITAD BIR RULING NO. 152-12 Articles 13 (Royalties) and 23 (Relief from Double Taxation); Philippines-United States of America tax treaty; BIR Ruling No. ITAD 13-09; BIR Ruling No. ITAD 127-06 Isla Lipana & Co. 29th Floor, Philamlife Tower 8767 Paseo de Roxas, Makati City Attention: Mary Assumption S. Bautista-Villareal Principal Tax Services Gentlemen : This refers to your tax treaty relief application ("TTRA") filed on October 16, 2006 requesting confirmation that development fee paid by The Real American Doughnut Company ("Real American") to Krispy Kreme Doughnut Corporation ("Krispy Kreme") under a Development Agreement is considered business profits and exempt from income tax pursuant to Article 8, in relation to Article 5, of the Convention between the Government of the Republic of the Philippines and the Government of the United States of America with Respect to Taxes on Income ("Philippines-United States tax treaty"). Basic Facts Krispy Kreme is a foreign corporation organized and existing under the laws of the United States and is a resident thereof based on the Certificate of Residence issued by the Internal Revenue Service of the United States on September 11, 2006. Krispy Kreme is situated at 370 Knollwood Street, Suite 500, Winston-Salem, North Carolina, United States. Krispy Kreme is not registered as a corporation or partnership in the Philippines based on the Certification of Non-Registration issued by the Securities and Exchange Commission on October 16, 2006. On the other hand, Real American is a domestic corporation situated at the 4th Floor, Salustiana D. Ty Building, Paseo de Roxas, Makati City, Philippines. On April 26, 2006, Krispy Kreme and Real American entered into a Development Agreement where Krispy Kreme granted Real American the right to develop and operate Krispy Kreme Stores 1 in the Philippines during the term of the Agreement from April 26, 2006 to December 31, 2010 ("Development Period"), and in compliance with the following Development Quota: 2 ISAcHD 2006 2007 2008 2009 2010 Total Factory Store 1 2 3 0 1 7 Tunnel Oven Store 0 1 1 3 2 7 Fresh Shop Store 0 4 5 6 5 20 1 7 9 9 8 34 == Krispy Kreme also granted Real American the right to develop a Commissary 3 in the Philippines. In consideration, Real American will pay Krispy Kreme the following Development Fee 4 which will be fully earned by Krispy Kreme upon the execution of the Agreement: Fee per Store Number of Stores Total Fee Factory Store $25,000.00 7 $175,000.00 Tunnel Oven Store $15,000.00 7 $105,000.00 Fresh Shop Store $10,000.00 20 $200,000.00 Total $480,000.00 ========== Real American may open additional stores upon written approval from Krispy Kreme and upon paying the same Development Fee and the Initial Franchise Fee (as defined in the Franchise Agreement) 5 per Store and executing the Franchise Documents. 6 Notwithstanding any provision in the Development Agreement, Krispy Kreme does not grant Real American any right to use the Marks 7 or any of Krispy Kreme' s confidential information, copyrighted work, or patent and that right to these intangible properties are granted only under the Franchise Agreements to be executed by the parties. Krispy Kreme' s obligation to grant franchises to Real American in the Philippines will expire upon the expiration of the term of the Agreement, unless earlier terminated. Under certain conditions, Real American will have the right to develop additional Krispy Kreme Stores in the Philippines for a renewal of term of five years under Krispy Kreme' s then-current Development Agreement consistent with its then current fees and operating practices. Ruling Relative thereto, please be informed that under Section III (2) of Revenue Memorandum Order No. 1-00 (Procedures for Processing Tax Treaty Relief Application) ("RMO 1-2000"), any availment of tax treaty relief (exemption from income tax or reduction of tax) shall be preceded by an application filed at the International Tax Affairs Division ("ITAD") of this Bureau at least fifteen days before the intended transaction or payment of income, thus: "III. Policies: In order to achieve the above-mentioned objectives, the following policies shall be observed: ICHcaD xxx xxx xxx 2. Any availment of the tax treaty relief shall be preceded by an application by filing BIR Form No. 0901 (Application for Relief from Double Taxation) with ITAD at least 15 days before the transaction i.e. ,payment of dividends, royalties, etc.,accompanied by supporting documents justifying the relief. .." (Emphasis ours) This condition was emphasized by the Court of Tax Appeals in Mirant (Philippines) Operations Corporation vs. Commissioner of Internal Revenue (C.T.A. Case No. 6382 dated June 7, 2005) where it ruled: " However, it must be remembered that a foreign corporation wishing to avail of the benefits of the tax treaty should invoke the provisions of the tax treaty and prove that indeed the provisions of the tax treaty applies to it, before the benefits may be extended to such corporation . In other words, a resident or non-resident foreign corporation shall be taxed according to the provisions of the National Internal Revenue Code, unless it is shown that the treaty provisions apply to the said corporation, and that, in cases the same are applicable, the option to avail of the tax benefits under the tax treaty has been successfully invoked. Under Revenue Memorandum Order 01-2000 of the Bureau of Internal Revenue, it is provided that the availment of a tax treaty provision must be preceded by an application for a tax treaty relief with its International Tax Affairs Division (ITAD). This is to prevent any erroneous interpretation and/or application of the treaty provisions with which the Philippines is a signatory to. The implementation of the said Revenue Memorandum Order is in harmony with the objectives of the contracting state to ensure that the granting of the benefits under the tax treaties are enjoyed by the persons or corporations duly entitled to the same . The Court notes that nowhere in the records of the case was it shown that petitioner indeed took the liberty of properly observing the provisions of the said order. Petitioner quotes various BIR, as well as ITAD, Rulings issued to several foreign corporations seeking for a tax relief from the office of the respondent. However, not any one of these rulings pertains to the petitioner. It must be stressed that BIR rulings are issued based on the facts and circumstances surrounding particular issue/issues in question and are resolved on a case-to-case basis. It would be thus erroneous to invoke the ruling of the respondent in specific cases, which have no bearing to the case of petitioner." (Emphasis ours) This decision was upheld by the Supreme Court in a Resolution (G.R. No. 168531) dated February 18, 2008. HATEDC Furthermore, the necessary requirement laid down in RMO 1-2000 is reiterated in subsequent rulings of the Court of Tax Appeals: Deutsche Bank AG Manila Branch vs. Commissioner of Internal Revenue (C.T.A. Case No. 456 dated May 29, 2009), CBK Power Company Ltd. vs. Commissioner of Internal Revenue (C.T.A. Case Nos. 6699, 6844 and 7166 dated March 29, 2010) and Manila North Tollways Corporation vs. Commissioner of Internal Revenue (C.T.A. Case No. 7864 dated April 12, 2011). In view of the foregoing, since the subject TTRA was filed on October 16, 2006, and the Development Agreement which called for Real American to pay the Development Fee to Krispy Kreme took effect on April 26, 2006, this Office hereby DENIES relief on fees paid before the fifteenth day following the date of filing of the TTRA or on October 31, 2006, pursuant to Section III (2) of RMO 1-2000. Accordingly, these fees shall be subject to income tax at the rate of 35 percent under Section 28 (B) (1) of the National Internal Revenue Code of 1997 ("Tax Code"), as amended, 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: Provided, That effective January 1, 2009, the rate of income tax shall be thirty percent (30%)." On the other hand, the Development Fee paid by Real American to Krispy Kreme on October 31, 2006 and thereafter is subject to relief under Article 13 of the Philippines-United States tax treaty, where such fee is considered royalties subject to the lowest rate of income tax in the Philippines imposed on royalties of the same kind paid under similar circumstances to a resident of a third State ("most-favored-nation treatment"), to wit: "Article 13 ROYALTIES 1. Royalties derived by a resident of one of the Contracting States from sources within the other Contracting State may be taxed by both Contracting States. 2. However, the tax imposed by that other Contracting State shall not exceed: a) In the case of the United States, 15 percent of the gross amount of the royalties, and b) In the case of the Philippines, the least of: (i) 25 percent of the gross amount of the royalties, (ii) 15 percent of the gross amount of the royalties, where the royalties are paid by a corporation registered with the Philippine Board of Investments and engaged in preferred areas of activities, and (iii) the lowest rate of Philippine tax that may be imposed on royalties of the same kind paid under similar circumstances to a resident of a third State. 3. 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 cinematographic films or films or tapes used for radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or other like right or property, or for information concerning industrial, commercial or scientific experience. The term 'royalties' also includes gains derived from the sale, exchange or other disposition of any such right or property which are contingent on the productivity, use, or disposition thereof." The Development Fee payable under the Development Agreement is in consideration of the right granted by Krispy Kreme to Real American to develop and operate Krispy Kreme Stores in the Philippines. We do not agree with the idea that the Development Fee cannot be characterized as royalties on the simple declaration that the right to use certain intangible properties pertaining to the Krispy Kreme System is governed by a separate Franchise Agreement between the same parties and not by the Development Agreement in question. This is because Real American, in developing and operating a particular store which has a potential of becoming a Krispy Kreme Store, will generally impose certain conditions on this store to meet such expectation. For example, Real American will ensure that the architectural and engineering design of the store will be in accordance with the architectural and engineering design set by Krispy Kreme for any potential Krispy Kreme Store. Under paragraph 3, Article 13 of the Philippines-United States tax treaty, payments of any kind received as a consideration for the use of, or the right to use, a design which is the property of a certain person and remains undivulged to the public constitutes royalties. In relation to the most-favored-nation treatment, the Supreme Court, in Commissioner of Internal Revenue vs. S.C. Johnson and Son, Inc. and Court of Appeals (G.R. No. 127105 dated June 25, 1999) ("S.C. Johnson case"), required two conditions for such treatment to apply. First, royalties arising in the Philippines and paid to a resident of the United States must be of the same class as those derived in the Philippines by a resident of a third State to which the tax treaty between the Philippines and the third State subjects such royalties to a most-favored-nation treatment. Second, in eliminating or mitigating the effects of double taxation on the royalties, the United States must allow to its resident the same amount of tax credit or deduction as that allowed by the third State to the latter's resident against the income tax due of that resident in the third State with respect to the royalties. Pertinent portion of this ruling reads: "The purpose of a most favored nation clause is to grant to the contracting party treatment not less favorable than that which has been or may be granted to the 'most favored' among other countries. The most favored nation clause is intended to establish the principle of equality of international treatment by providing that the citizens or subjects of the contracting nations may enjoy the privileges accorded by either party to those of the most favored nation. The essence of the principle is to allow the taxpayer in one state to avail of more liberal provisions granted in another tax treaty to which the country of residence of such taxpayer is also a party provided that the subject matter of taxation, in this case royalty income, is the same as that in the tax treaty under which the taxpayer is liable. Both Article 13 of the RP-US Tax Treaty and Article 12(2)(b) of the RP-West Germany Tax Treaty, above-quoted, speaks of tax on royalties for the use of trademark, patent, and technology. The entitlement of the 10% rate by U.S. firms despite the absence of a matching credit (20% for royalties) would derogate from the design behind the most favored nation clause to grant equality of international treatment since the tax burden laid upon the income of the investor is not the same in the two countries. The similarity in the circumstances of payment of taxes is a condition for the enjoyment of most favored nation treatment precisely to underscore the need for equality of treatment . We accordingly agree with petitioner that since the RP-US Tax Treaty does not give a matching tax credit of 20 percent for the taxes paid to the Philippines on royalties as allowed under the RP-West Germany Tax Treaty, private respondent cannot be deemed entitled to the 10 percent rate granted under the latter treaty for the reason that there is no payment of taxes on royalties under similar circumstances ." (Emphasis ours) For this purpose, we cite the Convention between the Republic of the Philippines and the Czech Republic for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income effective January 1, 2004. Under paragraph 2, Article 12 thereof, royalties (except royalties for the use of, or the right to use, any copyright of cinematograph films, and films or tapes for television or radio broadcasting) arising in the Philippines and paid to a resident of Czech are subject to income tax at the rate of 10 percent, to wit: "Article 12 ROYALTIES 1. Royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State. 2. However, such royalties may also be taxed in the Contracting State in which they arise and according to the laws of that State, but if the beneficial owner of the royalties is a resident of the other Contracting State, the tax so charged shall not exceed: a) 10 per cent of the gross amount of the royalties arising from the use of, or the right to use, any copyright of literary, artistic or scientific work, other than that mentioned in sub-paragraph (b),any patent, trade mark, design or model, plan, secret formula or process, or from the use of, or the right to use, industrial, commercial or scientific equipment, or for information concerning industrial, commercial or scientific experience; b) 15 per cent of the gross amount of the royalties arising from the use of, or the right to use, any copyright of cinematograph films, and films or tapes for television or radio broadcasting. The competent authorities of the Contracting States shall by mutual agreement settle the mode of application of these limitations." On the first requirement, a design, model or plan is among those intangible properties where payments for the use of or the right to use thereof constitute royalties, under paragraph 3, Article 13 of the Philippines-United States tax treaty, and under paragraph 2, Article 12 of the Philippines-Czech tax treaty, as quoted. ICDcEA On the second requirement, under paragraph 1, Article 23 of the Philippines-United States tax treaty, and under paragraph 2 (a), Article 22 of the Philippines-Czech tax treaty, income tax paid or withheld in the Philippines on royalties arising therein and paid to a resident of the United States and a resident of Czech are allowed as tax credit or deduction against the income tax of these residents in the United States and Czech, to wit: United States: "Article 23 RELIEF FROM DOUBLE TAXATION Double taxation of income shall be avoided in the following manner: 1. In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof),the United States shall allow to a citizen or resident of the United States as a credit against the United States tax the appropriate amount of taxes paid or accrued to the Philippines. .." Czech: "Article 22 ELIMINATION OF DOUBLE TAXATION xxx xxx xxx 2. In the case of a resident of the Czech Republic, double taxation shall be eliminated as follows. a) The Czech Republic, when imposing taxes on its residents, may include in the tax base upon which such taxes are imposed the items of income which according to the provisions of this Convention may also be taxed in the Philippines, but shall allow as a deduction from the amount of tax computed on such a base an amount equal to the tax paid in the Philippines. Such deduction shall not, however, exceed that part of the Czech tax, as computed before the deduction is given, which is appropriate to the income which, in accordance with the provisions of this Convention, may be taxed in the Philippines." In view of the foregoing, the Development Fee, as royalties, paid by Real American to Krispy Kreme under the Development Agreement on October 31, 2006 and thereafter shall be subject to income tax at the rate of 10 percent, pursuant to paragraph 2 (a) (iii), Article 13 of the Philippines-United States tax treaty, in relation to paragraph 2 (a), Article 12 of the Philippines-Czech tax treaty. Finally, under Sections 108 (A) of Tax Code, as amended, the Development Fee paid by Real American to Krispy Kreme, being payment for the lease of intangible properties (design, model, plan) in the Philippines, is subject to value-added tax ("VAT"),to wit: SIDTCa "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, 8 raise the rate of value-added tax to twelve percent (12%)..." Relative thereto, Real American shall withhold VAT on the fee at the rate of 12 percent before remitting it to Krispy Kreme. Real American shall use BIR Form No. 1600 (Monthly Remittance Return of Value-Added Tax and Other Percentage Taxes Withheld).If Real American is a VAT-registered taxpayer, the duly filed BIR Form No. 1600 and its accompanying proof of payment shall serve as documentary substantiation for Real American's claim of input tax on the payments; otherwise, it may treat such VAT as an asset or expense, whichever is applicable. VAT withheld shall be remitted within ten days following the end of the month the withholding was made. 9 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. Store means a Krispy Kreme store developed and operating in the Philippines pursuant to the Development Agreement. 2. Development Quota means the minimum number of Krispy Kreme Stores which Real American agrees to have opened and in operation in the Philippines at the end of each development period. 3. Commissary means a production facility that prepares and packages Products in accordance with the Krispy Kreme System and distributes to Krispy Kreme Stores the Products and other items used in the operation of Krispy Kreme Stores. 4. Development Fee means the non-refundable fee that Real American agrees to pay Krispy Kreme as set forth under the Agreement. 5. Franchise Agreement means an agreement used by Krispy Kreme in the offer and sale of franchises for the operation of a Krispy Kreme Store at a specific location. 6. Franchise Documents means the Franchise Agreement together with any other documents required by Krispy Kreme to be executed in connection with the development of Krispy Kreme Stores by Real American pursuant to the Development Agreement. 7. Marks means the trademarks, service marks and other commercial symbols used in the operation of Krispy Kreme Stores, including without limitation, the trade and service marks "KRISPY KREME" and associated logos, as they may be changed, enhanced, or supplemented from time to time. 8. 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. 9. Pursuant to Section 4.112-2 of Revenue Regulations No. 16-2005 (Consolidated Value-Added Tax Regulations of 2005), as amended by Revenue Regulations No. 4-2007 (Amending Certain Provisions of Revenue Regulations No. 16-2005, as Amended, Otherwise Known as the Consolidated Value-Added Tax Regulations of 2005), which provides: "SEC. 4.114-2. Withholding of VAT on Government Money Payments and Payments to Non-Residents . xxx xxx xxx (b) The government or any of its political subdivisions, instrumentalities or agencies including GOCCs, as well as private corporations, individuals, estates and trusts, whether large or non-large taxpayers, shall withhold twelve percent (12%) VAT, starting February 1, 2006, with respect to the following payments: (1) Lease or use of properties or property rights owned by non-residents; and (2) Services rendered to local insurance companies with respect to reinsurance premiums payable to non-residents; and (3) Other services rendered in the Philippines by non-residents. In remitting VAT withheld, the withholding agent shall use BIR Form No. 1600 Remittance Return of VAT and Other Percentage Taxes Withheld. VAT withheld and paid for the non-resident recipient (remitted using BIR Form No. 1600),which VAT is passed on to the resident withholding agent by the non-resident recipient of the income, may be claimed as input tax by said VAT-registered withholding agent upon filing his own VAT Return, subject to the rule on allocation of input tax among taxable sales, zero-rated sales and exempt sales. The duly filed BIR Form No. 1600 is the proof or documentary substantiation for the claimed input tax or input VAT. Nonetheless, if the resident withholding agent is a non-VAT taxpayer, said passed-on VAT by the non-resident recipient of the income, evidenced by the duly filed BIR Form No. 1600, shall form part of the cost of purchased services, which may be treated either as an 'asset' or 'expense',whichever is applicable, of the resident withholding agent. VAT withheld under this Section shall be remitted within ten (10) days following the end of the month the withholding was made."