ITAD BIR Ruling No. 203-15

June 5, 2015 ITAD BIR RULING NO. 203-15 Article 12, Philippines-Japan tax treaty, as amended; Section 28 (B) (1) and Section 32 (B) (5), Tax Code of 1997, as amended Philippine Parkerizing, Inc. 1148 R. Bernal Street, Rosario Pasig City Attention: Mr. Charlie Sy President Gentlemen : This refers to your tax treaty relief application filed on December 16, 2012, requesting confirmation that royalties received by NIHON PARKERIZING CO. LTD. (" Nihon ") from PHILIPPINE PARKERIZING, INC. (" Philippine Parkerizing ") are subject to income tax at a preferential tax rate of 10 percent pursuant to Article 12 of 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") , as amended by Protocol 1 effective January 1, 2009. Facts It is represented that Nihon is a corporation organized and existing under the laws of Japan and is a resident of Japan based on the Certification of Residence issued by the Nihonbashi Tax Office in Japan on October 31, 2012; that Nihon is situated at Parker Building, 15-1 Nihonbashi 1-Chome, Chuo-ko, Tokyo, Japan; that Nihon is not registered as corporation or partnership in the Philippines based on the Certification of Non-Registration of Company issued by the Securities and Exchange Commission on December 13, 2012; and that Philippine Parkerizing is a domestic corporation situated at 1148 R. Bernal Street, Rosario, Pasig City, Philippines. It is further represented that on July 1, 2012, Nihon and Philippine Parkerizing executed a Blanket Technical License Agreement for Metal Surface Treatment Technologies ("Agreement") where Nihon grants Philippine Parkerizing the following: acEHCD 1. Non-exclusive license to use the know-how for manufacturing and selling Nihon Products in and outside the Philippines; 2. Advisory assistance on the organization for manufacturing of Product, manufacturing and packaging methods for the Product, marketing know-how, distribution, logistics and sales of Product; 3. Provision of technical support necessary for the manufacturing and/or sales of Product by Philippine Parkerizing or the application of processing know-how for the purpose of performing the rust prevention and heat treatment process in the Philippines which is mainly provided by Nihon's personnel stationed at Philippine Parkerizing ; 4. Provision of trainings by Nihon 's personnel stationed in Philippine Parkerizing . Product means any and all products used in the technology fields. Technology fields are those utilized for metal surface treatment and relevant technologies, including patents, patent applications and know-how, and shall include technologies applied to processing operations such as rust prevention and heat treatment. Philippine Parkerizing has no right to sublicense, transfer, subcontract, assign or otherwise made available for the use by a third party. In consideration for the technology, technical information, processing know-how, technical support and training provided by Nihon to Philippine Parkerizing , the latter shall pay the royalty fee in the amount equal to 4 percent of the sum of the following: 1) Net Sales Price of all product manufactured and sold by utilizing the Technology, including those exported to any of other countries. 2) Net Contract Processing Costs obtained by using Processing Know-How. The Net Selling Price shall mean the amount as the basis for calculating the royalty to be paid which is equal to the total amount of Selling Price less the followings: provided that such deduction specified shall not exceed 10 percent of the Selling Price: 1) CIF purchase price for intermediate products procured from Nihon and import duty imposed upon importation; and 2) Costs and expenses for packing materials, transportation, insurance, sales credit and returns. The Net Contract Processing Costs shall mean the amount as the basis for calculating the royalty to be paid from Philippine Parkerizing to Nihon , which is equal to the total amount of selling price obtained through contract processing ( e.g. , rust prevention and heat treatment) less the followings; provided that such deduction specified below shall not exceed 10 percent of the contract processing price: 1. Costs and expenses for packing materials, transportation, insurance, sales credits and returns. Royalty payment has been made by Philippine Parkerizing to Nihon covering the period from July 1, 2012 to December 31, 2012 on July 17, 2013 as evidenced by the machine validated Application for Miscellaneous Transactions of Metropolitan Bank & Trust Company. SDHTEC It is further represented that the Agreement shall be effective for a term of five (5) years commencing on July 1, 2012, unless terminated earlier, and may be extended thereafter; and that the Agreement complied with the provisions of the Intellectual Property Code of the Philippines on Voluntarily Licensing under Certificate of Compliance No. 5-2012-00045 issued by the Intellectual Property Office on July 1, 2012, valid for five years from July 1, 2012 to June 30, 2017. It is finally represented that the royalties subject of this ruling are 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 President of Philippine Parkerizing on December 14, 2012. Ruling In reply, please be informed that Section 28 (B) (1) of the National Internal Revenue Code of 1997 (" Tax Code "), as amended, provides that gains derived by Nihon , 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, thus: "Section 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): Provided, That effective January 1, 2009, the rate of income tax shall be thirty percent (30%). xxx xxx xxx" However, Section 32 (B) (5) of the Code provides that the gains may be exempt from income tax or subject to a reduced rate to the extent required by any treaty obligation on the Philippines, viz. : "Section 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. xxx xxx xxx" For this purpose, you invoke the provisions of the Philippines-Japan tax treaty. The Agreement is in nature a mixed contract. The relevant provisions of the Philippines-Japan tax treaty are found in Article 12 (Royalties) and Article 7 (Business Profits), in relation to Article 5 (Permanent Establishment). Paragraphs 1, and 2, Article 12 thereof provide: "Article 12 1. Royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other Contracting State. 2. However, such royalties may also be taxed in the Contracting State in which they arise, and according to the laws of that Contracting State, but if the recipient is the beneficial owner of the royalties the tax so charged shall not exceed: (a) 15 per cent of the gross amount of the royalties if the royalties are paid in respect of the use of or the right to use cinematograph films and films or tapes for radio or television broadcasting; (b) 10 per cent of the gross amount of the royalties in all other cases. 3. Notwithstanding the provisions of paragraph 2, the amount of tax imposed by the Philippines on the royalties paid by a company, being a resident of the Philippines, registered with the Board of Investments and engaged in preferred pioneer areas of investment under the investment incentives laws of the Philippines to a resident of Japan, who is the beneficial owner of the royalties, shall not exceed 10 per cent of the gross amount of the royalties. HESIcT 4. 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 cinematograph films and films or tapes for radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or for the use of, or the right to use, industrial, commercial or scientific equipment or for information concerning industrial, commercial or scientific experience. xxx xxx xxx." Based on the foregoing provisions, royalties arising in the Philippines and paid to a resident of Japan may be taxed in the Philippines at a rate not to exceed (a) 10 percent of the gross amount of the royalties if the company paying the royalties is registered with the Board of Investment and engaged in preferred areas of investments under the investment incentive laws of the Philippines; (b) 15 percent of the gross amount of the royalties if they are paid in respect of the use of or the right to use cinematograph films and films or tapes for radio or television broadcasting; and (c) 10 percent of the gross amount of the royalties, in all other cases. The Agreement covers both know-how and the provision of technical assistance, where the Licensor imparts his knowledge and experience to the Licensee and, in addition, provides him varied technical assistance, which, in certain cases, is backed up with financial assistance and the supply of goods. Based on the OECD Commentary to Article 12, " the appropriate course of action to take with a mixed contract is, in principle, to break down, on the basis of the information contained in the contract or by means of a reasonable apportionment, the whole amount of the stipulated consideration according to the various parts of what is being provided under the contract, and then apply to each part of it so determined the taxation treatment proper thereto . If, however, one part of what is being provided constitute by far the principal purpose of the contract and the other parts stipulated therein are only of an ancillary and largely unimportant character, then the treatment applicable to the principal part should generally be applied to the whole amount of the consideration." In practice, it can be difficult to distinguish between payments for know-how (royalty) and payments for the provision of services. The following criteria are relevant for purposes of making distinction: - Contracts for the supply of know-how concern information 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. (OECD Commentary on Article 12 paragraph 11.3 pages 225-226) caITAC Payments for exclusivity, which means that Licensor agrees not to supply or grant anyone else that information or right, for example the use of trademark, should generally fall under the definition of royalties. Exclusive distribution rights, meaning payments that are solely made in return for obtaining the exclusive distribution rights of a product or service in a specific territory do not generally constitute royalties. 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 warranty, Payments for pure technical assistance , Payments for a list of potential customers, when such a list is developed specifically for the payor 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, 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. In the Agreement executed between Nihon and Philippine Parkerizing , fees should be separately billed and breakdown into the following items: 1. Royalty fee; and 2. Technical Service Fee. The fees represent payments for the use of know-how and the payments for the provision of services. A close examination of the Agreement reveals that the fees are paid for the Nihon 's right to use the trademarks, patents and know-how in manufacturing and packaging the products, technical assistance, advisory and trainings done by the personnel of Nihon stationed in Philippine Parkerizing . ICHDca Based on the foregoing only royalty fees are considered as royalties under the treaty while fees for the technical assistance, advisory and trainings are payments for services. Thus, they are considered as business profits and taxed under Article 7 of the tax treaty. Paragraph (1) of Article 7 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." Based on paragraph 1, the profits of an enterprise of Japan shall be taxable only in Japan unless the enterprise carries on business in the Philippines through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the Philippines but only so much of them that is attributable to that permanent establishment. Relative thereto, under paragraphs 1, 2, 3 and 6, Article 5 of the treaty, a permanent establishment is defined 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. 3. A building site or construction or installation project constitutes a permanent establishment only if it lasts more than six months. 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 twelve-month period. 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." TCAScE Based on the foregoing paragraphs, Nihon is deemed to have a permanent establishment if it has a fixed place of business in the Philippines 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, or if it undertakes activities relating to a mine, an oil or gas well, a quarry or other place of extraction of natural resources, or a building site or construction or installation which continues for more than six months, or if it furnishes consultancy services, or supervisory services in connection with a contract for a building, construction or installation project for a period or periods aggregating more than six months within any twelve-month period. Accordingly, since Nihon is not engaged in trade or business in the Philippines to which a fixed place of business such as an office or a branch is necessary, and since it did not provide the services in the Philippines for a period or periods aggregating more than six months within any twelve-month period, Nihon is not deemed to have a permanent establishment with respect to such services. This being the case, the service fees to be paid by Philippine Parkerizing to Nihon under the Agreement are exempt from income tax, pursuant to paragraphs 1, Article 7, in relation to paragraphs 1, 2, 3 and 6, Article 5, of the Philippines-Japan tax treaty, as amended. As regards the royalty income, since Philippine Parkerizing is not registered with the BOI and the royalties in question are not in respect of the use of or the right to use cinematograph film or films or tapes for radio or television broadcasting, such royalties to be paid by Philippine Parkerizing to Nihon under the Agreement, being essentially royalties for the use of, or the right to use of, the trademark, patents and know-how of Nihon , are subject to income tax at the rate of 10 percent of the gross amount of the royalties pursuant to Article 12 paragraph 2 (b) of the same treaty. Finally, the royalties and the service fees, being payments for the use of intangible properties (patent, trademark, know-how) and for the provision of services in the Philippines, shall be subject to value-added tax ("VAT") under Section 108 (A) of the Tax Code, 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%) . . ." Relative thereto, Philippine Parkerizing shall withhold VAT at the rate of 12 percent before remitting them to Nihon . Philippine Parkerizing 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 Philippine Parkerizing claim of input tax on the royalties and services. Otherwise, if Philippine Parkerizing is not a VAT-registered taxpayer, 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. 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. cTDaEH Very truly yours, (SGD.) KIM S. JACINTO-HENARES Commissioner of Internal Revenue Footnotes 1. Protocol Amending 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. 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; (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."