ITAD BIR Ruling No. 255-12

June 8, 2012 ITAD BIR RULING NO. 255-12 Article 12, Philippines-Japan tax treaty, as amended; BIR Ruling No. ITAD 216-11 JGC Philippines, Inc. JGC Philippines Building 2109 Prime Street, Madrigal Business Park Ayala Alabang, Muntinlupa City Attention: Koji Shimero President Gentlemen : This refers to your tax treaty relief application ("TTRA") filed on December 21, 2010 requesting confirmation that royalties paid by JGC Philippines, Inc. ("JGC Philippines") to JGC Corporation ("JGC") are subject to income tax at the rate of 10 percent pursuant to 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 a Protocol 1 effective January 1, 2009. Facts JGC is a foreign corporation organized and existing under the laws of Japan and is a resident thereof based on its Articles of Association and on its Residence Certificate issued by the Kojimachi Tax Office in Japan on October 8, 2010. JGC is situated at 2-1 Ohtemachi 2-chome, Chiyoda-ku, Tokyo, Japan. Based on the Certification issued by the Securities and Exchange Commission ("SEC") on October 5, 2010, JGC is licensed to establish a representative office in the Philippines under the name 'JGC Corporation Manila Regional Operating Headquarters' ("JGC Representative Office") under Registration No. A200018164. On the other hand, JGC Philippines is a domestic corporation situated at 2109 Prime Street, Madrigal Business Park, Ayala Alabang, Muntinlupa City, Philippines. JGC Philippines is registered with the Philippine Economic Activity * ("PEZA") as an ecozone information technology enterprise under Certificate of Registration No. 07-14-IT issued on February 27, 2007. On March 30, 2010, JGC and JGC Philippines entered into a Basic Agreement for Use of Software where JGC agreed to make available and deliver to JGC Philippines copies of software developed by and belonging to JGC ("Software") .For this purpose, JGC will issue a confirmation note to JGC Philippines which will be completed by the latter after delivery of the Software. In consideration, JGC Philippines will pay fees to JGC as indicated in the relevant invoice. JGC Philippines shall use the Software only for the purpose stated in the confirmation note and at the place stated therein. JGC Philippines shall not carry out any action on the Software such as duplication, revision, version-up, reverse engineering, without prior written consent of JGC. JGC Philippines shall keep in secrecy the information provided to it by JGC and any of JGC's confidential information known to JGC Philippines in connection with the use of the Software and shall not disclose them to any third party or use them for other purposes not stated in the Agreement. The Agreement took effect on March 30, 2010 and will remain in effect for two years, or up to March 29, 2012. The Software and their license fees are as follows: DHSACT 1. Basic Engineering Software. This includes the J-Pegasus Application Software which can be installed from the J-Pegasus Application Portal in Yokohama, Japan. The Basic Engineering Software is relevant in the fields of process design, energy process, gas chemical process, system engineering, civil engineering, plant and piping, control engineering, machinery and package, combustion and heat transfer, health, safety and environment system, and information technology. Annual license fee Cost Grade Number of user Annual fee Annual fee employees (in US dollars) (in Japanese yen) R0 <100 3,000.00 300,000.00 R1 100-499 6,000.00 600,000.00 R5 500-999 9,000.00 900,000.00 R10 >1,000 12,000.00 1,200,000.00 2. Project Management Systems 1 and 2. Project Management System 1 is a document handling software and Project Management System 2 is a procurement software. Annual license fee Project Management Project Management System 1 System 2 Cost Grade Number Annual fee Annual fee Annual fee Annual fee of user (in US (in (in US (in employees dollars) Japanese dollars) Japanese yen yen R0 <100 1,800.00 180,000.00 600.00 60,000.00 R1 100-499 3,600.00 360,000.00 1,200.00 120,000.00 R5 500-999 5,400.00 540,000.00 1,800.00 180,000.00 R10 >1,000 7,200.00 720,000.00 2,400.00 240,000.00 3. Material Take-Off and Control System. This uses the Intergraph Smart Plant Reference Data and the Intergraph Smart Plant Materials within. Monthly fee Project Size Fee Fee (in US dollars) (in US dollars) (in Japanese yen) <100 million 1,000.00 100,000.00 100-299 million 2,000.00 200,000.00 300-999 million 8,000.00 800,000.00 >1 billion 16,000.00 1,600,000.00 4. Construction Management System and Construction Cost Estimation System. Monthly fee for Construction Management System Project Size Fee Fee (in US dollars) (in US dollars) (in Japanese yen) <500 million 1,000.00 100,000.00 500-999 million 3,950.00 395,000.00 1-1.499 billion 6,250.00 620,000.00 1.5-1.999 billion 8,450.00 845,000.00 >2 billion 10,700.00 1,070,000.00 5. NetDoc System. This is a web-based document management system for middle or small size projects and available only in Japan. Annual fee Cost Grade Number of user Fee employees (in Japanese yen) R0 <100 180,000.00 R1 100-499 360,000.00 R5 500-999 540,000.00 R10 >1,000 720,000.00 Based on the Sworn Statement issued by the President of JGC Philippines on February 7, 2011, the royalties paid by JGC Philippines to JGC are not effectively connected with JGC Representative Office. HcaDIA Ruling In reply, please be informed that under Section 14 of Revenue Memorandum Order No. 72-2010 (Guidelines on the Processing of 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 ("ITAD") of this Bureau before the first taxable event subject of the TTRA, thus: "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. Failure to properly file the TTRA with ITAD within the period prescribed herein shall have the effect of disqualifying the TTRA under the RMO." (Emphasis ours) In view of the foregoing, since the Basic Agreement for Use of Software that gives rise to the license fees took effect on March 30, 2010 and will remain in effect for two years or up to March 29, 2012, but since the subject TTRA was filed only on December 21, 2010, this Office hereby DENIES relief on license fees paid by JGC Philippines to JGC on and before such date of filing on December 21, 2010, pursuant to Section 14 of RMO 72-2010. Accordingly, these fees shall be subject to income tax at the rate of 30 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 license fees paid by JGC Philippines to JGC on December 22, 2010 and thereafter, as royalties for the use of or the right to use information concerning industrial, commercial or scientific experience ("know-how") and copyright of literary, artistic or scientific work, shall be subject to income tax at the rate of 10 percent under paragraph 2 (b), in relation to paragraph 4, of Article 12 of the Philippines-Japan tax treaty, to wit: "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. TcaAID 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 percent of the gross amount of the royalties in all other cases. xxx xxx xxx 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. " (Emphasis ours) (BIR Ruling No. ITAD 216-11 dated August 18, 2011) Royalties in the mentioned case represent consideration for the use of know-how and for the use of copyright. As for know-how, this is because JGC Philippines will be provided confidential information by JGC in connection with the use of the Software and that JGC Philippines shall not disclose them to any third party. The following commentaries of the Organisation for Economic Co-operation and Development ("OECD") Model Tax Convention on Income and on Capital (Condensed Version, July 22, 2010) mention in this regard: "11.5 In the particular case of a contract involving the provision, by the supplier, of information concerning computer programming, as a general rule the payment will only be considered to be made in consideration for the provision of such information so as to constitute know-how where it is made to acquire information constituting ideas and principles underlying the program, such as logic, algorithms or programming languages or techniques, where this information is provided under the condition that the customer not disclose it without authorisation and where it is subject to any available trade secret protection." (Page 226) (Emphasis ours) As for copyright, this is so since JGC Philippines, with the prior consent of JGC, may carry out certain actions on the Software such as duplication, revision, version-up, or reverse engineering. The following commentaries of the OECD Model Convention mention in this regard: "13.1 Payments made for the acquisition of partial rights in the copyright (without the transferor fully alienating the copyright rights) will represent a royalty where the consideration is for granting of rights to use the program in a manner that would, without such license, constitute an infringement of copyright. Examples of such arrangements include licenses to reproduce and distribute to the public software incorporating the copyrighted program, or to modify and publicly display the program. In these circumstances, the payments are for the right to use the copyright in the program (i.e.,to exploit the rights that would otherwise be the sole prerogative of the copyright holder) ..." Section 5 of Revenue Memorandum Circular No. 44-2005 (Taxation of Payments for Software) and Section 177 of the Intellectual Property Code similarly provide: HIESTA "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; 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. " "Section 177. Copyright or Economic Rights. Subject to the provisions of Chapter VIII, copyright or economic rights shall consist of the exclusive right to carry out, authorise or prevent the following acts: 177.1. Reproduction of the work or substantial portion of the work ; 177.2. Dramatization, translation, adaptation, abridgment, arrangement or other transformation of the work ; CaAIES 177.3. The first public distribution of the original and each copy of the work by sale or other forms of transfer of ownership; 177.4. Rental of the original or a copy of an audiovisual or cinematographic work, a work embodied in a sound recording, a computer program, a compilation of data and other materials or a musical work in graphic form, irrespective of the ownership of the original or the copy which is the subject of the rental; 177.5. Public display of the original or a copy of the work; and 177.6. Other communication to the public of the work." (Emphasis ours) On the other hand, under paragraph 5, Article 12 of the Philippines-Japan tax treaty, the royalties paid to JGC, which has a permanent establishment 2 in the Philippines, that is, JGC Representative Office, shall not be subject to the reduced rate of 10 percent if the royalties are effectively connected with the permanent establishment, to wit: "5. The provisions of paragraphs 1, 2 and 3 shall not apply if the beneficial owner of the royalties, being a resident of a Contracting State, carries on business in the other Contracting State in which the royalties arise, through a permanent establishment situated therein, or performs in that other Contracting State independent personal services from a fixed base situated therein, and the right or property in respect of which the royalties are paid is effectively connected with such permanent establishment or fixed base. In such case the provisions of Article 7 or Article 14, as the case may be, shall apply." In connection therewith, since the royalties in fact are not effectively connected with JGC Representative Office, as certified by the President of JGC Philippines, such royalties paid by the latter to JGC shall continue to be subject to the reduced rate of 10 percent under paragraph 2 (a),Article 12 of the treaty. Finally, under Section 108 (A) of the Tax Code, the license fees paid by JGC Philippines to JGC under the Agreement, being payments for the use of intangible properties (know-how and copyright) 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, 3 raise the rate of value-added tax to twelve percent (12%)..." However, since JGC Philippines is registered with PEZA and governed by the provisions of Republic Act No. 7916 ,4 as amended, the Supreme Court, in Commissioner of Internal Revenue vs. Seagate Technology (Philippines) (G.R. No. 153866 dated February 11, 2005) ,ruled that: EHTIcD "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, JGC Philippines is not subject to VAT directly on its sale of goods and supply of services to its customers, and indirectly on its purchase of goods and services when such purchase is subject to VAT. With respect to the license fees at hand, since JGC is a foreign corporation and not a VAT-registered taxpayer, the fees paid to JGC by JGC Philippines shall be exempt from VAT, instead of being subject to VAT at zero percent. 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. 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. "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: xxx xxx xxx c) an office ;" 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. 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. Section 11 thereof provides: "CHAPTER II GOVERNING STRUCTURES SECTION 11. The Philippine Economic Zone Authority (PEZA) Board. There is hereby created a body corporate to be known as the Philippine Economic Zone Authority (PEZA) attached to the Department of Trade and Industry. .. The existing Export Processing Zone Authority (EPZA) created under Presidential Decree No. 66 shall evolve into the PEZA in accordance with the guidelines and regulations set forth in an executive order issued for this purpose.''