ITAD BIR Ruling No. 154-15

June 2, 2015 ITAD BIR RULING NO. 154-15 Articles 5 (Permanent Establishment) and 7 (Business Profits), Philippines-Korea tax treaty Korea Exchange, Inc. Beomil-dong, Nulwon Building 134 Jaesong-ro, Dong-gu Busan, Korea Attention: Mr. Jeong Seong Yeop This refers to your tax treaty relief application filed on January 13, 2014 requesting that payments made by the Securities and Exchange Commission ("SEC") to Korea Exchange, Inc. ("KRX") are exempt from income tax pursuant to the Convention between the Republic of the Philippines and the Republic of Korea for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income ("Philippines-Korea tax treaty") . Facts KRX is a foreign corporation and a resident of Korea based on its amended Articles of Incorporation and Certificate of Business Registration issued by the Busanjin District Tax Office on October 23, 2013. KRX is located at Beomil-dong, Nulwon Building, 134, Jaseong-ro, Dong-gu, Busan, Korea. The company's primary purpose is the operation and management of business related to Korean Composite Stock Price Index Market, Korean Securities Dealers Automated Quotations Market, and Derivatives Market; businesses related to the trading of securities and exchange-traded derivatives products; businesses related to the listing of securities; businesses related to the auctioning of securities; and businesses related to the development and operation of computer systems in connection with the operation of the securities and derivatives markets. It is not registered as a corporation or partnership in the Philippines based on the Certificate of Non-Registration issued by the Securities and Exchange Commission on September 23, 2013. On the other hand, SEC is a government agency with a mission to strengthen the corporate and capital market infrastructure of the Philippines, and to maintain a regulatory system, based on international best standards and practices, that promotes the interests of investors in a free, fair and competitive business environment. SEC is located at SEC Building, EDSA, Greenhills, Mandaluyong City, Philippines. On February 26, 2013, SEC and KRX entered into a Contract for the Delivery, Testing and Commissioning of a Packaged Software of a Market Surveillance System where the Bids and Awards Committee of SEC awarded to KRX the bid to supply services to SEC in the sum of 37,000,000 pesos. The contract has a term of 12 months. Payment of the contract price is subject to the following schedule: a) Advance payment shall be made only after prior approval and shall not exceed 15 percent of the price. b) On contract signature, 10 percent of the price shall be paid within 60 calendar days from signing and upon submission of a claim and a bank guarantee. c) On delivery, 70 percent of the price shall be paid within 60 days after the date of receipt of the goods and upon submission of pertinent documents. d) On acceptance, the remaining 20 percent of the price shall be paid within 60 days after the date of submission of the acceptance and inspection certificate. e) All progress payments shall first be charged against the advance payment until the latter has been fully exhausted. The project is divided into the following milestones/deliverables: 1. Analysis and Design Systems Requirements Specification (10 percent of contract price) Functional Specification Document (10 percent) 2. Hardware/Third Party Software Licenses Installation (15 percent) 3. User's Acceptance Test (5 percent) 4. Migration of Completed Application/Packaged with Tailor-fitting Software (5 percent) 5. Conduct of Users/Technical and Administrator Training (10 percent) 6. Back-up/Restoration/Recoveries Facilities, Programs and Scripts (10 percent) 7. Full Acceptance of the Project (20 percent) The Packaged Software, excluding the Hardware, and Third Party Software, is composed of software originally coded in Korea. Minor analysis and system test activities are expected to be performed in the Philippines, which constitute less than 10 percent of the full Packaged Software. Based on the Certification issued by the SEC Bids and Awards Committee on April 6, 2015, KRX had sent its personnel to the Philippines to deliver, test and commission the SEC Market Surveillance System at SEC during the following period: April June August October November December January Total 2013 2013 2013 2013 2013 2013 2014 - Analysis - Analysis - Design - Test Integration -Integration - User Server Test Test Acceptance Installation - Users' Test Training - Pilot - User Operation Acceptance Test 15-19 5-7 12-16 16-18 18-30 1-6 1-17 9-13 20-31 16-31 5 3 5 3 13 27 29 85 days < The concerned personnel were Lee Seung Jun, Shin Hong Hee, II Yong Kim, Choon Sik Kim, Seong Yeop Jeong, Gi Yong Park, Sang Yole Lee, Seo Tai Sek and Bae Jung Woo. Based on the certified copy of the Confirmation of Full Acceptance of the Project issued by the SEC Bids and Awards Committee on May 27, 2014, the SEC Market Surveillance System has been successfully completed by KRX as Project supplier to the full satisfaction of SEC as Procuring Entity with the scope of work performed within the 12-month period from February 26, 2013 to February 25, 2014. Based on the email of KRX dated February 26, 2015, in line with the warranty requirement of the Contract of two years in the case of the software package third party software licenses and three years for equipment (servers, storage and other related equipment supplied for the Project),KRX has provided minor correction services after the issuance of the Confirmation of Full Acceptance but such services were performed remotely in Korea and none in the Philippines. Based on the Certification issued by the Land Bank of the Philippines 1 on December 19, 2013, SEC paid KRX an amount of 3,131,516.18 pesos on that date. 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 by a foreign corporation not engaged in trade or business in the Philippines is subject to a general 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, the income might be exempt (or partially) under a treaty obligation, thus: "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 particular case you invoke the Philippines-Korea tax treaty. Paragraph 1, Article 7 thereof 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 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 Article 7, profits derived by an enterprise of Korea are taxable only in Korea unless the enterprise carries on business in the Philippines through a permanent establishment and the profits are attributable to the permanent establishment. In relation to a permanent establishment, this is defined in paragraphs 1, 2 and 3, Article 5 of the treaty 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 an 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) premises used as a sales outlet; and h) a warehouse, in relation to a person providing storage facilities for others. 3. a) a building site or construction, installation or assembly project or supervisory activities in connection therewith, constitute a permanent establishment only if such site, project or activity continues for a period of more than six months; b) the furnishing of services including consultancy services by an enterprise through an employee or other personnel constitutes a permanent establishment only if activities of that nature continue within a Contracting State for a period or periods exceeding in the aggregate 183 days within any twelve-month period; and" 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. A permanent establishment also includes the furnishing of services including consultancy services by an enterprise (through employees or other personnel thereof) which continue within a Contracting State for an aggregate period of 183 days within any 12-month period. HTcADC Accordingly, since KRX is not engaged in trade or business in the Philippines to which an office or a branch is necessary, and it did not furnish services in the Philippines for more than an aggregate of 183 days within any 12-month period, but for 85 days only, KRX is not deemed to have a permanent establishment in the Philippines under paragraphs 1, 2 and 3, Article 5 of the Philippines-Korea tax treaty. This being the case, payments made to KRX by SEC for the delivery, testing and commissioning of the SEC Market Surveillance System are exempt from income tax pursuant to paragraph 1, Article 7 of the treaty. On the characterization of the payments as business profits (which are exempt from income tax if not attributable to a permanent establishment) as against payments for know-how or royalties (which are subject to reduced income 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 Contract for the Delivery, Testing and Commissioning of the SEC Market Surveillance System did not call for KRX to supply existing information or reproduce existing material to SEC, but to deliver a full packaged software to SEC, install it in the latter's IT system, and test the software, this contract is clearly a contract for the performance of services and not the supply of know-how or other royalty-bearing property. Moreover, by reason that a substantial number of personnel were required to implement the project and they performed work in Korea and in the Philippines, KRX certainly incurred a greater level of expenditure (such as salaries and wages of personnel) to fulfil its contractual obligations to SEC. This being the case, payments made to KRX for the project constitute as business profits and not payments for know-how or royalties . Finally, under Section 108 (A) in relation to Section 105 of the Tax Code, payments made to KRX (although a nonresident foreign person) for the delivery, installation and testing of the software 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 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, 2 raise the rate of value-added tax to twelve percent (12%)..." "SEC. 105. Persons Liable . Any person who, in the course of trade or business, sells, barters, exchanges, leases goods or properties, renders services, and any person who imports goods shall be subject to the value-added tax (VAT) imposed in Sections 106 to 108 of this Code. . . The rule of regularity, to the contrary notwithstanding, services as defined in this Code rendered in the Philippines by nonresident foreign persons shall be considered as being rendered in the course of trade or business ." Relative thereto, SEC shall withhold VAT on the payments at the rate of 12 percent before remitting them to KRX. SEC shall use BIR Form No. 1600 (Monthly Remittance Return of Value-Added Tax and Other Percentage Taxes Withheld).The duly filed form and accompanying proof of payment shall serve as SEC's documentary substantiation for its claim of input VAT on the payments; otherwise, SEC may treat the 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. 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. Head office located at Land Bank Plaza, 1598 M.H. Del Pilar corner Dr. J. Quintos Streets, Malate, Manila, Philippines. 2. 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. 3. 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 corporation, individuals, estates and trust, 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." n Note from the Publisher: The phrase "and (d) above" no longer appears in RA 9337, the law amending this provision.