ITAD Ruling No. 023-02

March 5, 2002 ITAD RULING NO. 023-02 RP-US Tax Treaty, Article 12 &13 RP-Russia Tax Treaty, Article 12 CTRP, Section 34 BIR Ruling No. ITAD 195-00 BIR Ruling No. ITAD 10-01 Joaquin Cunanan & Co. 29th Floor Philamlife Tower 8767 Paseo de Roxas 1226 Ayala Avenue Makati City Attention: Atty. Mary A.S. Bautista-Villareal Principal Tax Services Department Gentlemen : This refers to your application requesting confirmation of your opinion on behalf of your client, Sony Music Entertainment Philippines, Inc. (SONY-RP), that (1) the interest payments on loan granted by Sony Corporation of America (SONY-US) are subject to a 15% preferential tax rate pursuant to the RP-US Tax Treaty; (2) the royalty payments made by SONY-RP to SONY-US are subject to 15 percent final withholding tax pursuant to the "most favored nation" clause of the RP-US Tax Treaty in relation to the RP-Russia Tax Treaty; and (3) the subject royalty payments are considered deductible business expenses under Section 34(a)(1) of the Tax Code as amended. It is represented that SONY-US is a non-resident foreign corporation duly organized and existing under the laws of the State of New York, USA; that it is not registered either as a corporation or as a partnership licensed to do business in the Philippines per certification issued by the Securities and Exchange Commission dated October 10, 2000; that SONY-RP is a corporation duly organized and existing under Philippine Laws engaged in the development, production, origination, licensing, importation, marketing, rental and sale (on wholesale basis only) of records, cassette tapes, compact discs, computer software, and other audio and audio-visual carriers for entertainment and education, musical copyrights and music publishing in any media; that on September 19, 1995, SONY-RP entered into a Loan Agreement with SONY-US in the amount of Seven Hundred Thousand US Dollars (US$700,000.00) payable in full on September 30, 1998 with interest rate of 6.20% per annum and future interest payments will be determined by adding 20bp (basis point) to the 30-day London Interbank Offering Rate report the first business day of the month; that on October 1, 1995 SONY-RP entered into a Royalty Matrix Agreement with SONY-US; that under the Agreement, SONY-US granted SONY-RP the exclusive license under the copyright laws to exploit the Sony Catalog Master Recording; that in consideration of the said grant, SONY-RP shall pay SONY-US: 1) Royalties on Sony Philippines' sales of the Sony Music Catalog; 2) Synchronization Fees; and 3) Video Royalties; that on September 28, 1998, SONY-US and SONY-RP signed an Addendum to Loan Agreement #284 increasing the amount of loan to Two Million United States Dollars (US$2,000,000.00) with the following breakdown: a) principal loan amount in September 1995 of US$700,000.00; plus b) the total accumulated interest on US$700,000.00 from September 19, 1995 up to April 30, 1999 which is US$160,170.79; plus c) On May 1, 1999, the loan is increased by US$1,139,829.21 which will be applied to SONY-RP's royalties payable to SONY-US; that the term of the Loan was extended for another three (3) years making the full amount of the loan payable on September 30, 2001; and that all the other terms and conditions set forth in the Loan Agreement #284 dated September 17, 1995, from Section 3 to Section 14 still remain the same and in full force. It is further represented that on July 31, 2000, SONY-US and Sony Music Entertainment Inc. (SME), a non-resident foreign corporation duly organized and existing under the laws of the State of Delaware, entered into an Assignment and Assumption Agreement on the loan balance of SONY-RP from SONY-US in the amount of Two Million One Hundred Fifty Four Thousand Seven Hundred Fifty Nine US Dollars and Eighty Eight Cents (US$2,154,759.88); that in consideration of the transfer of the loan from SONY-US to SME, SME agreed to pay SONY-US an amount equal to the said loan balance. In reply thereto, please be informed that Article 12 of the RP-US Tax Treaty states that: "Article 12 INTEREST "1. Interest 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. Interest derived by a resident of one of the Contracting States from sources within the other Contracting State shall not be taxed by the other Contracting State at a rate in excess of 15 percent of the gross amount of such interest. (emphasis supplied) "3. Interest derived by a resident of one of the Contracting States from sources within the other Contracting State with respect to public issues of bonded indebtedness shall not be taxed by the other Contracting State at a rate in excess of 10 percent of the gross amount of such interest. xxx xxx xxx Based on the foregoing, interest payments with respect to public issues of bonded indebtedness will be taxed at a preferential rate not exceeding ten per cent (10%) of the gross amount of interest and not exceeding fifteen per cent (15%) of the gross amount of interest in all other cases. Accordingly, the interest to be paid by SONY-RP on the loan obtained from SONY-US, which was assigned to and assumed by SMB is subject to tax at 15% of the gross amount of such interest, the loan being not with respect to public issues of bonded indebtedness. Further, the loan agreement is subject to documentary stamp tax imposed under Section 180 of the Tax Code of 1997. (BIR Ruling No. ITAD 195-00) As regards the royalty payments of SONY-RP to SONY-US, Article 13 of the RP-US Tax Treaty provides: "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 that 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. (emphasis supplied) "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. The term "royalties" also includes gains derived from the sale, exchange or other disposition of any such right or property which are contingent on the productivity, use, or disposition thereof. "xxx xxx xxx" The "most favored nation" clause under Article 13(2)(b)(iii) of the RP-US Tax Treaty calls for the application of Article 12 of the RP-Russia Tax Treaty which provides: "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 State. "2. However, the royalties may also be taxed in the Contracting State in which they arise and according to the laws of the State, but the tax so charged shall not exceed 15 per cent of the gross amount of royalties. "xxx xxx xxx" Based on the above provisions, the final tax imposed on royalties derived by a US resident from sources within the Philippines shall be 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. The royalties arising from the Philippines and paid to a resident of Russia may also be taxed in the Philippines but the tax so charged shall not exceed 15 percent of the gross amount of royalties. The term "royalties" as used in this Article means any payment of any kind received as a consideration for the use of or right to use any patent, trademark, design or model, secret formula or process, or for the use of or the right to use, industrial, commercial or scientific experience. In the case of Commissioner of Internal Revenue vs. S.C. Johnson and Son and Court of Appeals , G.R. No. 127105 promulgated on June 25, 1999, the Supreme Court interpreted the "most favored nation" clause, particularly the phrase "paid under similar circumstances," as referring to the manner of payment of taxes and not to the subject matter of the tax which is royalties. Hence, the "most favored nation" clause of the RP-US Tax Treaty must be interpreted not only in relation to Article 12 of the RP-Russia Tax Treaty but also in connection with the provisions on the elimination of double taxation of both the RP-US Tax Treaty and the RP-Russia Tax Treaty. A perusal of the RP-US and RP-Russia Tax Treaties, particularly their provisions on the avoidance of double taxation, show that there is a similarity on the manner of payment of taxes, that is, allowable foreign tax credit on both treaties is the amount actually paid in the Philippines. In view thereof, and as it appears that the lowest rate of the Philippine tax imposed on royalties of the same kind paid under similar circumstances is provided under the RP-Russia Tax Treaty, the royalties payable by SONY-RP to SONY-US are subject to fifteen percent (15%) tax based on the gross amount of royalties pursuant to Article 13 of the RP-US Tax Treaty. (BIR Ruling No. ITAD-10-01) Moreover, the said royalties are subject to the 10% value-added tax (VAT) pursuant to Section 108 of the Tax Code and that SONY-RP shall, before paying royalties to SONY-US, withhold and remit to this Bureau the 10% VAT due thereon by filing a separate VAT return for and on behalf of SONY-US using BIR Form 1600. The duly validated VAT declaration/return is sufficient evidence for SONY-RP in claiming input tax credit (Sec. 4.110-3(b) of the Revenue Regulation No. 7-95). As regards your third query whether the subject royalty payments are considered deductible business expenses under Section 34(a)(1) of the Tax Code, as amended, please be informed that we decline to rule on the matter considering the factual nature of the issue raised. This ruling is issued on the basis of the foregoing facts as represented. However, if upon investigation it will be disclosed that the facts are different, then this ruling shall be considered null and void. Very truly yours, Commissioner of Internal Revenue By: (SGD.) EDMUNDO P. GUEVARA Deputy Commissioner Legal and Inspection Group