ITAD Ruling No. 014-04

February 20, 2004 ITAD RULING NO. 014-04 Article 13 (Royalties) Philippines-United States of America tax treaty BIR Ruling No. ITAD 90-03 Paper Handling Systems, Inc. 17 Gil Puyat Avenue Makati City Attention: Joel G. Santos Vice President Gentlemen : This refers to your application for relief from double taxation dated August 1, 2003 on behalf of Pitney Bowes requesting confirmation that the technology license fees paid by the Bureau of Internal Revenue ( Bureau ) to Pitney Bowes are exempt from Philippine income tax, pursuant to the National Internal Revenue Code of 1997 (Tax Code) and the Philippines-United States of America tax treaty. It is represented that Pitney Bowes is a nonresident foreign corporation engaged in providing solutions related to integrated mail and document management; that Pitney Bowes is organized and existing under the laws of the United States of America with principal office at World Headquarters, One Elmcroft Road, Connecticut 06926-0700, United States of America; that on January 1, 2003, a Technology License Agreement (Agreement) was entered into between the Bureau and Pitney Bowes , where Pitney Bowes grants the Bureau the license to use the latter's technical information for operating a Revenue Collection System and a Verification System , for the purpose of increasing the Bureau 's collection of documentary stamp taxes through electronic means; that the Revenue Collection System is designed to remotely enable the resetting of documentary stamp tax meters (meters) equipped with Pitney Bowes ' lock technology, while the Verification System will securely verify the authenticity of an indicia or image which is printed by a meter representing proof of tax payment; that the Revenue Collection System and the Verification System are series of software each containing trade secrets, and know-how of Pitney Bowes, which are considered proprietary, confidential, and of significant commercial value to Pitney Bowes . HDTISa That in consideration for the license granted, the Bureau shall pay Pitney Bowes an annual operating license fee in advance beginning on the date of execution of the Agreement on January 1, 2003, calculated in accordance with the following schedule: Revenue Collection System (based on the total number of meters installed as of the date of execution of the Agreement) Up to 1,500 meters U.S. $25,000 1,501 to 3,000 meters U.S. $45,000 3,001 to 4,000 meters U.S. $68,000 4,001 to 5,000 meters U.S. $90,000 5,001 to 12,500 meters U.S. $150,000 More than 12,500 meters Special Quote Verification System (based on the total number of verification systems installed as of the date of execution of the Agreement) Up to 5 Verification Systems U.S. $7,500 6-10 Verification Systems U.S. $15,000 11-20 Verification Systems U.S. $30,000 21-40 Verification Systems U.S. $50,000 41-75 Verification Systems U.S. $90,000 75+ Verification Systems Special Quote In reply, pleased be informed that the license fees paid by the Bureau to Pitney Bowes , being payments for software, are payments for the use or the right to use of a copyright of literary, artistic or scientific work and as such are considered royalties within the definition of such term in paragraph 3, Article 13 (Royalties) of the Philippines-United States tax treaty and under the recent Revenue Memorandum Circular No. 77-2003 (Classification of Payments for Software for Income Tax Purposes) dated November 18,2003: Philippines-United States tax treaty: "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." (emphasis supplied) Revenue Memorandum Circular No. 77-2003: "Software is generally assimilated as a literary, artistic or scientific work protected by the copyright laws of various countries including the Philippines, thus, payments is consideration for the use of, or the right to use, a copy or a copyrighted article relating to software are generally royalties." Accordingly, the license fees for the use or the right to use of the Revenue Collection System and the Verification System , being royalties, are subject to the preferential tax rate under paragraph 2(b), Article 13 of the tax treaty, 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 the 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." Based on the abovecited provision, royalties arising from sources within the Philippines and derived by a resident of the United States shall be subject to a preferential tax rate of: (a) 25 percent of the gross amount of the royalties; (b) 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; or (c) 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. Such being the case, since the Bureau is not a corporation registered with the Philippine Board of Investments and engaged in preferred areas of activities, royalties paid by the Bureau to Pitney Bowes shall be subject to either 25 percent of the lowest rate of Philippine tax imposed on royalties of the same kind paid under similar circumstances to a resident of a third State. In interpreting the phase " the lowest rate of Philippine tax imposed on royalties of the same kind paid under similar circumstances to a resident of a third State ," or commonly known as the most favored nation clause, 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), had cited two conditions that must be satisfied in granting such lowest rate. First, the income arising in the Philippines derived by a resident of the United States and subject to Philippine income tax must be of the same nature as that derived by a resident of the third country subject to a rate lower than 25 percent. Second, the mechanism for relieving double taxation of foreign-sourced income applied by the United States must be the same as that applied by the third country. The Court noted: "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 clause is intended to establish the principle of equality of international treatment by providing that the citizens or subject 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 of 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 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." In looking for tax treaties providing most-favored nation treatment of royalties arising in the Philippines, it is noteworthy to take into account and use as basis the existing Philippine tax treaties with Austria, Belgium, China, and the like. Under the Royalties article of these treaties, royalties from the use or the right to use of copyright literary or artistic, or scientific work arising in the Philippines shall be subject to tax at a rate not exceeding 15 percent of the gross amount of such royalties. Likewise, under the Relief from Double Taxation of these treaties, the mechanism for relieving double taxation of foreign-sourced income applied by these countries is the same as that applied by the United States; that is, only taxed actually paid on such foreign-sourced income are subject to relief from double taxation in all these countries. Such being the case, this Office is of the opinion and so holds that the license fees paid by the Bureau to Pitney Bowes for the use or the right to use of the Revenue Collection System and the Verification System , being royalties, shall be subject to income tax at a rate not exceeding 15 percent of the gross amount thereof. (BIR Ruling No. ITAD 90-03 dated July 2, 2003) Finally, Section 108(A)(1) of the Tax Code states that " the lease or the use of the right or privilege to use any copyright, patent, design or model, plan, secret formula or process, goodwill, trademark, trade brand or other like property or right " falls within the definition of sale or exchange of services subject to 10 percent value-added tax (VAT). Accordingly, the license fees paid by the Bureau to Pitney Bowes shall be subject to 10 percent VAT. (BIR Ruling No. ITAD 90-03 dated July 2, 2003) Under Sections 4 and 6 of Revenue Regulations 4-2000, Section 3 of Revenue Regulations 8-02, and Section 7 of Revenue Regulations 14-2002, the Bureau , being the resident withholding agent and payor in control of the payment, shall be responsible for the withholding of the 10 percent VAT on such license fees before paying them to Pitney Bowes . In remitting the VAT withheld, the Bureau shall use BIR Form 1600 (Monthly Remittance Return of Value-Added Tax and Other Percentage Taxes Withheld). If the Bureau is a VAT-registered taxpayer, the duly filed BIR Form 1600 and proof of payment thereof shall serve as documentary substantiation for the claim of input VAT by the Bureau upon filing its own VAT. If not a VAT-registered taxpayer, the passed-on VAT withheld shall form part of the cost of the service purchased which may be treated as an " expense " or " asset " on the part of the Bureau , whichever is applicable. In addition, the Bureau is required to issue the Certificate of Final Tax Withheld at Source (BIR Form 2306) in quadruplicate upon request of Pitney Bowes , the first three copies to be kept by the Bureau and the fourth copy by Pitney Bowes as its file. cCSDTI 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. Very truly yours, Commissioner of Internal Revenue By: (SGD.) MILAGROS V. REGALADO Assistant Commissioner Legal Service