ITAD Ruling No. 028-04

March 29, 2004 ITAD RULING NO. 028-04 Articles V (Permanent Establishment), VII (Business Profits) and XXII (Royalties), Philippines-Canada tax treaty BIR Ruling Nos. DA-ITAD 176-02 and DA-ITAD 14-04 The Prumerica Life Insurance Company, Inc. 34th Floor, Tower I, the Enterprise Center 6766 Ayala Avenue corner Paseo de Roxas Makati City Attention: Mr. Lope Jose U. Garde, Jr. Senior Vice President and Chief Actuary Officer-in-Charge for Finance Ms. Maria Victor G. San Luis Finance Manager Gentlemen : This refers to your letter dated February 5, 2004 requesting confirmation that royalty payments made by The Prumerica Life Insurance Company, Inc. (Prumerica) to Insurance Software Solutions Corporation (Insurance Software) are subject to the preferential income tax rate under the existing Philippines-Canada tax treaty. It is represented that Insurance Software is a foreign company engaged in the licensing and developing of certain computer programs and the provision of certain services for businesses in the insurance industry; that Insurance Software is organized and existing under the laws of Canada with principal office at 5925 Airport Road, Mississauga, Ontario, Canada; that Insurance Software is not registered either as a corporation or as a partnership and has not been licensed to engage in business in the Philippines as confirmed by a Certification of Non-Registration issued by the Securities and Exchange Commission on January 8, 2004; that Prumerica , on the other hand, is a domestic company engaged in the provision of insurance and financial products and services in the business and consumer markets; that Prumerica is organized and existing under the laws of the Philippines with principal office at 34th Floor, Tower I, the Enterprise Center, 6766 Ayala Avenue corner Paseo de Roxas, Makati City, Philippines; that Prumerica is an Affiliate 1 of The Prudential Insurance Company of America (Prudential) , a foreign company also engaged in the provision of insurance and financial products and services in the business and consumer markets; that Prudential is organized and existing; under the laws of the United States of America with principal office at 80 Livingstone Avenue, Roseland, New Jersey, United States of America. The Master License and Services Agreement between Prudential and Insurance Software That on August 31, 1997, Prudential and Insurance Software entered into a Master License and Services Agreement (Master Agreement), where Insurance Software has granted Prudential and its Affiliates a license to use, copy, and modify Insurance Software's Systems 2 for the use in Prudential's and the Affiliates' insurance business; that aside from the license, Insurance Software , shall also provide Prudential and its Affiliates services relevant to the application of the Systems; that in order for an Affiliate to be entitled to the license and the services under the Master Agreement, that Affiliate, on its own behalf, must enter into a supplementary agreement (Attachment) with Insurance Software . The Attachment between Prumerica and Insurance Software That on September 21, 1998, Prumerica , an Affiliate, entered into an Attachment with Insurance Software , where Insurance Software has granted Prumerica a license to use, copy, and modify Insurance Software's Systems for the use in Prumerica's insurance business; that these Systems (software) comprise of the Base Programs (INGENIUM Release 5.5.2), and (if Prumerica so prefers) the Additional Programs (Apex Release 1.2) and the Modifications made on these two Programs; that aside from the license, Insurance Software shall also provide Prumerica the following services relevant to the application of the Programs: (1) Development Services; (2) Interface Services; (3) Data Conversion Services; (4) Maintenance Services; (5) Training Services; and (6) Consulting and Other Additional Services; and that the cost of the license and the services are as follows: 1. Base Programs a) INGENIUM Version 5.5 License Fee $400,000 b) INGENIUM Consulting Services Payment Schedule Programmer Analyst $95/hour Senior Programmer Analyst $115/hour Business Analyst $115/hour Senior Business Analyst $140/hour Senior Application Specialist $140/hour Director, Insurance Consulting $150/hour Project Manager or Corporate Consultant $170/hour Senior Management $200/hour c) INGENIUM Maintenance Fee $60,000 per year 2. Additional Programs APEX License Fee can be determined upon delivery of the software. Licensee fees as royalties In reply, please be informed that the license fees paid by Prumerica to Insurance Software for the use of the Base Programs, the Additional Programs, and the Modifications made thereon, being payments for software, are royalties for the use or the right to use of a copyright , as mentioned in paragraph 3, Article XII (Royalties) of the Philippines-Canada tax treaty and in the recent Revenue Memorandum Circular No. 77-2003 dated November 18, 2003, to wit: Philippines-Canada 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 , patent, trademark, 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, and includes payments of any kind in respect of motion picture films and works on films or videotapes for use in connection with television."(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 in consideration for the use of, or the right to use, a copyright or a copyrighted article relating to software are generally royalties ." (emphasis supplied) DAETcC Being royalties, the subject license fees are subject to the preferential income tax rate under paragraph 2(b), Article XII (Royalties) of the Philippines-Canada tax treaty, to wit: "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. Such royalties may also be taxed in the Contracting State in which they arise, and according to the law of that State. However, the tax so charged shall, provided that the royalties are taxable in the other Contracting State, not exceed a) in Canada, 10 per cent of the gross amount of the royalties, and b) in the Philippines, the lesser of (i) 25 per cent of the gross amount of the royalties, and (ii) the lowest rate of Philippine tax that may be imposed on royalties of the same kind paid in similar circumstances to a resident of a third State." Based on the abovequoted paragraph 2(b), royalties arising in the Philippines and derived by a resident of Canada shall be subject to an income tax rate of 25 percent of the gross amount of the royalties, or to the lowest rate of Philippine income tax that may be imposed on royalties of the same kind paid under similar circumstances to a resident of a third State (also known as the most favored nation tax treatment on royalties). Regarding the most favored nation tax treatment on royalties, 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), has cited two conditions in order for royalties arising in the Philippines and derived by a resident of another country (in this case, Canada) to be subject to the most favored nation tax treatment (in this case, a rate lower than 25 percent) as that granted by the Philippines to a resident of a third country under an existing tax treaty. First, the Court noted that the royalties arising and subject to tax in the Philippines and derived by a resident of Canada must be of the same nature as those derived by a resident of the third country. Second, the Court stressed that the mechanism for relieving double taxation of income employed by Canada with respect to royalties arising in the Philippines and derived by a resident of Canada must be the same with that employed by the third country with respect to royalties arising in the Philippines and derived by a resident of the third country. In looking for existing Philippine tax treaties that provide a most-favored nation tax treatment on royalties, it is noteworthy to take into account and use as basis the treaties with Denmark, Finland, Malaysia and the United Kingdom. Under the Royalties article of these treaties, royalties for the use or the right to use of a copyright, to which payments for software are assimilated as, arising in the Philippines and derived by a resident of each of the countries mentioned are subject to an income tax rate not exceeding 15 percent of the gross amount of the royalties. On the other hand, under the Relief from Double Taxation article of these treaties, the mechanism for relieving double taxation of income arising in the Philippines and derived by a resident of each of the countries is the ordinary credit method, similar with that of Canada. Under this method, only income taxes actually paid by a resident taxpayer with respect to income derived from foreign sources are allowed as credit against the taxpayer's taxable income subject to certain limitations. Such being the case, this Office is of the opinion and so holds that the license fees paid by Prumerica to Insurance Software for the use of the Base Programs, the Additional Programs, and the Modifications made thereon, being royalties, shall be subject to a preferential income tax rate of 15 percent of the gross amount thereof. (BIR Ruling No. ITAD 14-04 dated February 20, 2004) Payments for services as business profits On the other hand, please be informed that the service fees relevant to the application of the Programs paid by Prumerica to Insurance Software are business profits subject to taxation under paragraph 1, Article VII (Business Profits) of the Philippines-Canada tax treaty: ''1. The profits of an enterprise of a Contracting State 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 or has carried 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 xxx xxx xxx" Based on the abovequoted paragraph 1, business profits, arising in the Philippines and derived by an enterprise of Canada shall be subject to Philippine income tax if they are attributable to a permanent establishment which the enterprise has in the Philippines; otherwise such profits are exempt. The term "permanent establishment," as defined in paragraphs 1 and 2, Article V (Permanent Establishment) of the Philippines-Canada tax treaty, means a fixed place of business through which the business of an enterprise is wholly or partly carried on, which includes, for example, a place of management, a branch, and an office. Accordingly, since Insurance Software does not have a fixed place of business in the Philippines, as confirmed by the relevant Certificate of Non-Registration issued by the Securities and Exchange Commission, so as to constitute its permanent establishment in the Philippines, the service fees paid by Prumerica to Insurance Software relevant to the application of the Programs, being business profits, shall be exempt from Philippine income tax. This is further affirmed by the fact that, unlike the majority of other Philippine tax treaties, the Philippines-Canada tax treaty (especially the Permanent Establishment article thereof), apparently however, does not have a provision on the furnishing of services as constituting a permanent establishment for the enterprise doing it in a source-country for a considerable period like 183 days. ( BIR Ruling No. ITAD 176-02 dated October 9, 2002 ) It should be noted in this regard that the subject service fees exempt from income tax include only that part of the fees that represents as income of the Insurance Software itself. On the other hand, the part that represents as remuneration of the personnel themselves who will perform the services is not covered by the exemption, where taxation of such remuneration is governed separately under Article XV (Dependent Personal Services) of the tax treaty, to wit: "1. Subject to the provisions of Articles XVI, XVIII and XIX, salaries, wages and other similar remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State. If the employment is so exercised, such remuneration as is derived therefrom may be taxed in that other State. 2. Notwithstanding the provisions of paragraph 1, remuneration derived by a resident of a Contracting State in respect of an employment exercised in the other Contracting State shall be taxable only in the first-mentioned State if the recipient is present in the other Contracting State for a period or periods not exceeding in the aggregate 183 days in the calendar year concerned, and either a) the remuneration earned in the other Contracting State in the calendar year concerned does not exceed two thousand five hundred Canadian dollars ($2,500) or its equivalent in Philippine pesos or such other amount as may be specified and agreed in letters exchanged between the competent authorities of the Contracting States; or b) the remuneration is paid by, or on behalf of an employer who is not a resident of the other State, and such remuneration is not borne by a permanent establishment or a fixed base which the employer has in the other State." Based on the abovequoted paragraph 1, the remuneration of the concerned personnel are generally subject to Philippine income tax. However, such remuneration shall be exempt from income tax if, primarily, the concerned personnel is present in the Philippines for a period not exceeding in the aggregate 183 days in the relevant calendar year and, either , (1) the entire remuneration during that year does not exceed 2,500 Canadian dollars (or its equivalent in Philippine pesos), or (2) the remuneration is paid by, or on behalf of, an employer who is not a resident of the Philippines, and is not borne by a permanent establishment which Insurance Software has in the Philippines. Value-added tax Finally, Section 108(A)(1) of the Tax Code states that " the lease or the use of the right or privilege to use of any copyright " and " the supply of any assistance that is ancillary and subsidiary and is furnished as a means of enabling the application or enjoyment of such copyright " both fall within the definition of sale or exchange of services subject to 10 percent value-added tax (VAT). Accordingly, the subject license fees and service fees paid by Prumerica to Insurance Software are subject to 10 percent VAT. ( BIR Ruling Nos. ITAD 176-02 dated October 9, 2002 and ITAD 14-04 dated February 20, 2004 ) As regards the procedures for withholding and paying the VAT, Sections 4 and 6 of Revenue Regulations 4-2000, Section 3 of Revenue Regulations 8-02, and Section 7 of Revenue Regulations 14-2002, altogether state that Prumerica , the resident person making the payments, shall be responsible for the withholding of the 10 percent VAT on such payments before remitting them to Insurance Software . In remitting to the Bureau of Internal Revenue the VAT withheld on such payments, Prumerica shall use BIR Form 1600 (Monthly Remittance Return of VAT and Other Percentage Taxes Withheld). If a VAT-registered taxpayer, Prumerica may use as documentary substantiation for its claim of input VAT the duly filed BIR Form 1600 and the proof of payment accompanying it. If not a VAT-registered taxpayer, Prumerica may include as part of the cost of the license granted and the services furnished to it by Insurance Software , the VAT consequently shifted or passed on to it by Insurance Software and may treat such VAT either as expense or asset , whichever is applicable. In addition, upon Insurance Software's request, Prumerica is required to issue in quadruplicate the relevant Certificate of Final Tax Withheld at Source (BIR Form 2306), the first, second and third copies to be kept by Prumerica and the fourth copy by Insurance Software . The Settlement Agreement between Prumerica and Insurance Software Finally, it is represented that on November 30, 2001, Prumerica and Insurance Software entered into a Settlement Agreement, where both parties acknowledged and agreed that there had been a dispute in the effectiveness, timeliness and associated cost of the services and modifications provided by Insurance Software to Prumerica ; that both parties intended and agreed that all such disputes be resolved as follows; first, that all services and modifications provided by Insurance Software commencing on the date of effectivity of the Attachment on September 21, 1998 and concluding on the resolution date of the Settlement Agreement on November 30, 2001 shall be considered successfully acceptable to Prumerica , and that neither party may soon raise as a dispute any claims as to the acceptability of such services and modifications; second, that Insurance Software shall release Prumerica from any and all outstanding indebtedness (including fees, invoices, associated costs and expenses related thereto) it may have to Insurance Software with respect to the services, modifications, and any other services and deliverables provided by or performed by, or failed to be provided by or performed by, Insurance Software prior to the resolution date of the Settlement Agreement; and third, that as full settlement and release of all claims for outstanding indebtedness, Prumerica shall pay Insurance Software a settlement fee of $259,905.60, broken down as follows: (1) for license fee for INGENIUM $75,000.00; (2) for disputed functional specification work $81,773.60; (3) for disputed installation work $13,775.00; (4) for disputed technical assistance work $42,390.00; (5) for disputed base fix retrofit work $46,967.00. As regards the tax treatment of the settlement fee, please be informed that the part of that fee that represents as license fees shall be taxed in the same manner as royalties and that part that represents as service fees shall be taxed in the same manner as business profits. 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. cDaEAS Very truly yours, Commissioner of Internal Revenue By: (SGD.) MILAGROS V. REGALADO Assistant Commissioner Legal Service Footnotes 1. Affiliate(s) shall mean any entity in which Prudential has, directly or indirectly, a sufficient voting interest so as to ensure that significant actions by such entity cannot be taken without Prudential's affirmative consent. 2. System(s) shall mean each system comprised of the applicable Base Programs , Modifications and any other computer programs, in executable code, object code and source code form, and any Documentation thereto, licensed or developed under a particular Attachment. Base Programs shall mean the computer programs, in executable code, object code and source code form, and any Modifications and Documentation thereto, as described in the Attachments, licensed to Prudential and to a particular Affiliate, as applicable. Modification shall mean any update, modification, enhancement, customization, addition, correction, new version or new release (all in source code and object code form) to the applicable Base Programs, and any Documentation thereto, including without limitation, the applicable Country-Generic Modifications, Prudential-Specific Modifications and other Modifications set forth in the Attachments, and any Documentation thereto. Documentation shall mean source code, file layouts, report layouts, screen layouts, program narratives, user instructions, user manuals, technical manuals, operator instruction manuals, any applicable reference manuals, training manuals and any other written material describing the operations, functions or performance of a particular System, or any part thereof.