ITAD BIR Ruling No. 163-12

April 16, 2012 ITAD BIR RULING NO. 163-12 Articles 5 (Permanent Establishment) and 7 (Business Profits); Philippines-New Zealand tax treaty Isla Lipana and Co. 29th Floor, Philamlife Tower 8767 Paseo de Roxas Makati City Attention: Alexander B. Cabrera Managing Partner Tax Services Gentlemen : This refers to your tax treaty relief application ("TTRA") filed on January 11, 2011 requesting confirmation that software payments made by the Bank of the Philippines Islands ("BPI") to Fronde Anywhere Ltd. ("Fronde") are exempt from income tax pursuant to the Convention between the Government of the Republic of the Philippines and the Government of New Zealand for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income ("Philippines-New Zealand tax treaty"). Facts Fronde is a corporation organized and existing under the laws of New Zealand and is a resident thereof based on the Company Extract issued by the Companies Office of New Zealand on January 31, 2011, and on the Certificate of Status of Enterprise issued by the Inland Revenue Department of New Zealand on November 23, 2010. Fronde is situated at 3 Queens Wharf, Wellington, New Zealand. Fronde is not registered as a corporation or partnership in the Philippines based on the Certification of Non-Registration of Company issued by the Securities and Exchange Commission ("SEC") on January 6, 2011. On the other hand, BPI is a domestic corporation situated at BPI Building, Ayala Avenue, Makati City, Philippines. On December 9, 2010, Fronde and BPI entered into a License and Software Assurance Agreement where Fronde granted BPI a non-exclusive and nontransferable license to use the Software in the Philippines for an initial term of 36 months from the date of signature of the Agreement. Software means the following application software: SCHIac Application Function 1. Mobile Banking iPhone and Client side applications for iPhone and Android Customer Software Android mobile devices. Functionality that is defined in the existing EOL Lite integration proxy. Functionality defined for the eLink (business banking) integration adaptor. 2. Mobile Browser Services Browser services for mobile banking. Device browser requires conformance to the XHTML 1.0 specification. 3. One Additional Provider License Isolates administration views between EOL and ExpressLink. Allows user licenses to be allocated to each module. 4. Business Banking Module for Business banking module 50,000 Users 5. Anywhere Platform Server Administration Software Console Data encryption Token management Auditing Account Balance Transaction history Funds transfers Person to person payments Bill payments Automatic payments BPI shall not, among others, (a) copy the Software or any related documentation in whole or in part in any visual or machine-readable form, except to the extent that such copying is necessary for BPI's own back-up purposes; (b) reproduce, translate, decompile, reverse-engineer, or sublicense the Software (or cause or permit any person to do so); and (c) transfer, assign or otherwise deal with or grant a security interest in the Software or BPI's rights under the Agreement. Fronde will provide BPI or the Implementation Partner the installation package of the Software to enable the installation and implementation of the Software by the Implementation Partner. Implementation Partner means Incuventure Partners Corporation ("Incuventure"), a corporation registered with the SEC and situated at 3002 Tycoon Centre, Pearl Drive Street, Ortigas Center, Pasig City, Philippines. In consideration, BPI will pay license fees to Fronde amounting US$150,000.00 for the initial term of the Agreement ( US$4,166.67 every month for 36 months). Fronde is entitled to increase the license fees on the third anniversary of the Agreement and on each subsequent anniversary provided Fronde notifies BPI in writing at least 30 days prior to the anniversary. Fronde will also provide support services to BPI related to the Software and, in consideration therefor, BPI will pay support fees to Fronde the amount of which to be agreed upon by the parties. The support services do not include (a) customization, personalization or installation of the Software; (b) integration of the Software with the Operating Environment; (c) hosting services; (d) disaster recovery or back-up services; and (e) work which becomes necessary as a result of improper installation of the Software, or use of the Software which is not in accordance with the given specifications or other misuse of the Software, among others. The Agreement took effect on December 9, 2010 and will be in effect for 36 months. The Agreement may be extended thereafter as agreed upon by the parties. Based on the Certification issued by the Senior Vice President of BPI on January 27, 2011, Fronde has not sent any personnel to the Philippines to provide support services to BPI and, in the event it will send such personnel, the duration of the services they will perform in the Philippines will be less than six months. Ruling Relative thereto, please be informed that under Section 14 of Revenue Memorandum Order No. 72-2010 (Guidelines on the Processing Tax Treaty Relief Applications (TTRA) Pursuant to Existing Philippine Tax Treaties) ("RMO 72-2010") , effective November 4, 2010 , 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 of this Bureau before the intended transaction or payment of income , to wit: "Filing should always be made BEFORE the transaction. Transaction for purposes of filing the TTRA shall mean before the occurrence of the first taxable event. HASDcC Failure to properly file the TTRA with ITAD within the period prescribed herein shall have the effect of disqualifying the TTRA under this RMO." In view of the foregoing, since the License and Software Assurance Agreement that gives rise to the payment of the license fees and support fees for the use of the Software took effect on December 9, 2010, but the subject TTRA was filed on January 11, 2011 , this Office hereby DENIES relief on such fees paid by BPI to Fronde on or before January 11, 2011 , pursuant to RMO 72-2010. Consequently, said fees shall be subject to income tax at the rate of 30 percent under Section 28 (B) (1) of the National Internal Revenue Code ("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 taxation of the license fees and support fees paid by BPI to Fronde on January 12, 2011 and thereafter depends on whether these fees are considered business profits or royalties. On the characterization of software payments, Section 5 of Revenue Memorandum Circular No. 44-2005 (Taxation of Payments for Software) 1 ("RMC 44-2005") provides: "Section 5. Characterization of Transactions . The character of payments received in a transaction involving the transfer of computer software depends on the nature of the rights that the transferee acquires under the particular arrangement regarding the use and exploitation of the program. a. Transfer of copyright rights . A transfer of software is classified as a transfer of a copyright right if, as a result of the transaction, a person acquires any one or more of the rights described below: i. The right to make copies of the software for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease or lending; EcHIDT ii. The right to prepare derivative computer programs based upon the copyrighted software; iii. The right to make a public performance of the software; iv. The right to publicly display the computer program; or v. any other rights of the copyright owner, the exercise of which by another without his authority shall constitute infringement of said copyright. The determination of whether a transfer of a copyright right in a software is a sale or exchange of property is made on the basis of whether, taking into account all facts and circumstances, there has been a transfer of all substantial rights in the copyright. A transaction that does not constitute a sale or exchange because not all substantial rights have been transferred will be classified as a license generating royalty income. When only copyright rights are transferred, payments made in consideration therefor are royalties. On the other hand, when copyright ownership is transferred, payments made in consideration therefor are business income . b. Transfer of copyrighted articles . A copyrighted article incorporating a software includes a copy of the software from which the work can be perceived, reproduced, or otherwise communicated, either directly or with the aid of a machine or device. The copy of the software may be fixed in the magnetic medium of a floppy disk or a CD-ROM, or in the main memory or hard drive of a computer, or in any other medium. If a person acquires a copy of a software but does not acquire any of the rights described above (or only acquires a de minimis grant of such rights), and the transaction does not involve the provision of services or of know-how, the transfer of the copy of the software is classified solely as a transfer of a copyrighted article and payments for which constitute business income." (Underscoring ours) Under RMC 44-2005, payments for the use of software are treated as business profits or business income when a person acquires merely a copy of a software and a de minimis right or rights to use the software. However, the right to use a software cannot be treated as de minimis when it involves: 1. The right to make copies of the software for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease or lending; 2. The right to prepare derivative computer programs based upon the copyrighted software; 3. The right to make a public performance of the software; 4. The right to publicly display the computer program; or 5. Any other rights of the copyright owner, the exercise of which by another without his authority shall constitute infringement of said copyright. Payment for the exercise of one or more of the above-mentioned rights does not result in business profits but royalties. EHACcT Thus, the license fees and support fees paid by BPI to Fronde do not give rise to royalties but business profits since BPI and the Implementation Partner, Incuventure, are not permitted to (a) copy the Software or any related documentation in whole or in part in any visual or machine-readable form, except to the extent that such copying is necessary for BPI's own back-up purposes; (b) reproduce, translate, decompile, reverse-engineer, or sublicense the Software (or cause or permit any person to do so); and (c) transfer, assign or otherwise deal with or grant a security interest in the Software or BPI's rights under the Agreement. With respect to the act by BPI or Incuventure of transferring the Software from a disk containing a copy thereof or from a computer disk or a server containing a copy of the software via a modem or an internet connection onto the hard disk of BPI's computers, to enable it to operate the program/s contained in the Software, this act is not necessarily a right to exploit the copyright or economic rights in the Software and is permitted even without any authorization from Fronde. Section 189 of the Intellectual Property Code 2 provides: "Section 189. Reproduction of Computer Program. 189.1. Notwithstanding the provisions of Section 177, the reproduction in one (1) backup copy or adaptation of a computer program shall be permitted, without the authorization of the author of, or other owner of copyright in, a computer program, by the lawful owner of that computer program; Provided, That the copy or adaptation is necessary for: (a) The use of the computer program in conjunction with a computer for the purpose, and to the extent, for which the computer program has been obtained ; and (b) Archival purposes, and, for the replacement of the lawfully owned copy of the computer program in the event that the lawfully obtained copy of the computer program is lost, destroyed or rendered unusable. 189.2. No copy or adaptation mentioned in this Section shall be used for any purpose other than the ones determined in this Section, and any such copy or adaptation shall be destroyed in the event that continued possession of the copy of the computer program ceases to be lawful. 189.3. This provision shall be without prejudice to the application of Section 185 whenever appropriate." (Emphasis ours) In addition, Section 189 of the Intellectual Property Code permits the act of making a backup copy of the Software for archival purposes or for the replacement of the lawfully owned copy of the Software in the event it is lost, destroyed or rendered unusable. As business profits , the license fees and support fees may be taxed in the Philippines if they are attributable to a permanent establishment which Fronde has in the Philippines. Paragraph 1, Article 7 of the Philippines-New Zealand tax treaty provides: "Article 7 BUSINESS PROFITS 1. The profits of an enterprise of one of the Contracting States 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 a) that permanent establishment ; or" With respect to the use of the Software and the provision of related support services thereon, Fronde is deemed to have a permanent establishment if it has a branch or an office in the Philippines or it furnished these services for an aggregate of more than 183 days within any twelve month period. Paragraphs 1 and 2, Article 5 of the treaty provide: "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. cHSIDa 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 place of exploration of natural resources; h) a building site or construction, installation or assembly project, or supervisory activities in connection therewith where such site, project or activity continues for more than six months; i) premises used as a sales outlet; j) a warehouse, in relation to a person providing storage mainly for some other person or persons; k) a place for the furnishing of services, including consultancy services by an enterprise through employees or other personnel where activities of that nature continue (for the same or a connected project) within the country for a period or periods aggregating more than 183 days within any twelve month period. " Accordingly, since Fronde is not engaged in trade or business in the Philippines to which an office or a branch is necessary, and to date, it has not sent any personnel to the Philippines to provide support services to BPI and, if the need arises, it will not provide such services for more than six months or 183 days, Fronde, in either case, does not have a permanent establishment in the Philippines. This being the case, the license fees and support fees paid by BPI to Fronde under the Agreement from January 12, 2011 and thereafter shall be exempt from income tax. Finally, under Section 108 (A), in relation to Section 105 of the Tax Code, the license fees and support fees (if any) paid by BPI to Fronde under the Agreement, being payments for use of intangible property (software) and the supply of services in the Philippines by a nonresident foreign person, 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, 3 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 value-added tax is an indirect tax and the amount of tax may be shifted or passed on to the buyer, transferee or lessee of the goods, properties or services. This rule shall likewise apply to existing contracts of sale or lease of goods, properties or services at the time of the effectivity of Republic Act No. 7716. The phrase 'in the course of trade or business' means the regular conduct or pursuit of a commercial or an economic activity, including transactions incidental thereto, by any person regardless of whether or not the person engaged therein is a non-stock, nonprofit private organization (irrespective of the disposition of its net income and whether or not it sells exclusively to members or their guests), or government entity. 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 ." (Emphasis ours) Relative thereto, BPI shall withhold VAT on the fees at the rate of 12 percent before remitting them to Fronde. BPI shall use BIR Form No. 1600 (Monthly Remittance Return of Value-Added Tax and Other Percentage Taxes Withheld). The duly filed BIR Form No. 1600 and its accompanying proof of payment shall serve as documentary substantiation for BPI's claim of input tax on the fees; otherwise, if BPI is not a VAT-registered taxpayer, it 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. 4 This ruling is issued on the basis of the facts as represented. However, if upon investigation it shall be disclosed that the facts are different, then this ruling shall be without force and effect insofar as the herein parties are concerned. TcADCI Very truly yours, (SGD.) KIM S. JACINTO-HENARES Commissioner of Internal Revenue Footnotes 1. Effective September 8, 2005. 2. Republic Act No. 8293 entitled An Act Prescribing the Intellectual Property Code and Establishing the Intellectual Property Office, Providing for its Powers and Functions, and for Other Purposes. 3. 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. 4. 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."