ITAD Ruling No. 034-01

March 15, 2001 ITAD RULING NO. 034-01 RP-US, Art. 13, RP-Germany, Art. 12 & 24 NIRC, Sec. 108 (A) (1) BIR Ruling No. ITAD-13-01 Benitez Parlade Africa Herrera Parlade & Panga Law Offices 15th Floor, Security Bank Centre 6776 Ayala Avenue, Makati City Attention: Atty . Simeon G . Hildawa Gentlemen : This refers to your letter dated May 8, 1999, on behalf of your client, BUSINESS ONE INC., (BUSINESS 1) requesting confirmation of your opinion that the royalties payable by it to OFFICE 1 SUPERSTORES INTERNATIONAL (OFFICE 1), a U.S. corporation, are subject to the preferential tax rate of ten percent (10%) pursuant to the provisions of the RP-US Tax Treaty in relation to the RP-WEST GERMANY Tax Treaty. It is represented that BUSINESS 1 is a corporation organized and existing under Philippine laws with principal office address at 270 Vito Cruz St., Makati City; that it entered into a MASTER FRANCHISE AGREEMENT with OFFICE 1, a non-resident foreign corporation incorporated under the laws of the State of Delaware, U.S.A.; that under the Agreement, BUSINESS 1 was granted the right to establish and operate business establishments in the Philippines known as "OFFICE 1 SUPERSTORES", utilizing OFFICE 1's name and mark as well as the unique and comprehensive system developed by OFFICE 1 in the sales and distribution of office supplies and light machines and other complementary products and services; that in consideration for the rights granted under the Agreement, BUSINESS 1 paid an initial franchise fee of Two Hundred Twenty Five Thousand United States Dollars (US $ 225,000.00) and undertook to pay OFFICE 1 a monthly royalty fee based on its net sales from the operations of "OFFICE 1 SUPERSTORES" according to the following schedule: (a) Three percent (3%) on net sales up to Three Million U.S. Dollars, (b) Two percent (2%) on net sales between Three million to Ten million U.S. Dollars and (c) One percent (1%) on net sales over Ten Million U.S. Dollars; that BUSINESS 1 shall withhold from the payments to OFFICE 1 the applicable income tax; that the Agreement was registered with the Intellectual Property Office of the Department of Trade and Industry under a Certification of Registration No. 2107, valid for ten (10) years from December 23, 1997 to December 22, 2007. Based on the foregoing representations, you are requesting relief from double taxation under Article 13 of the RP-US Tax Treaty which provides, viz : "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) xxx xxx xxx (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 the Philippine tax that may be imposed on royalties of the same kind and under similar circumstances to a resident of a third State.(Emphasis supplied) "xxx xxx xxx In this connection, the lowest rate given to a third State is 10% as provided in Article 12 of the RP-Germany Tax Treaty, viz : "ARTICLE 12 Royalties "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, such royalties may also be taxed in the Contracting State in which they arise, and according to the law of that State, but the tax so charged shall not exceed: (a) xxx xxx xxx (b) 10 per cent of the gross amount of royalties arising from the use of, or the right to use, any patent, trade mark, design or model, plan, secret formula or process, or from the use of, or the right to use, industrial, commercial or scientific equipment, or for information concerning industrial, commercial or scientific experience. IACDaS For as long as the transfer of technology, under Philippine law, is subject to approval, the limitation of the tax rate mentioned under (b) shall, in the case of royalties arising in the Republic of the Philippines, only apply if the contract giving rise to such royalties has been approved by the Philippine competent authorities. xxx xxx xxx you now claim that the royalties arising as a consequence of the Master Franchise Agreement between OFFICE 1 and BUSINESS 1 are subject to the 10% preferential rate pursuant to the most favored nation clause of the RP-US Tax Treaty in relation to the RP-West Germany Tax Treaty. In reply, please be informed that the above-quoted Article 13(2)(b)(iii) of the RP-US Tax Treaty, otherwise known as the "most favored nation clause", must be interpreted not only in relation to Article 12 of the RP-Germany Tax Treaty but also in connection with Article 24 of the same treaty, to wit: "ARTICLE 24 Relief from Double Taxation "1. Tax shall be determined in the case of the resident of the Federal Republic of Germany as follows: xxx xxx xxx b) Subject to the provisions of German tax law regarding credit for foreign tax, there shall be allowed as a credit against German income and corporation tax payable in respect of the following items of income arising in the Republic of the Philippines, the tax paid under the laws of the Philippines in accordance with this Agreement on: xxx xxx xxx dd) royalties, as defined in paragraph 3 of Article 12; xxx xxx xxx c) For the purpose of the credit referred in subparagraph b) the Philippine tax shall be deemed to be xxx xxx xxx cc) in the case of royalties for which the tax is reduced to 10 or 15 percent according to paragraph 2 of Article 12, 20 percent of the gross amount of such royalties . (Emphasis supplied) xxx xxx xxx The Supreme Court in Commissioner of Internal Revenue vs. S.C. Johnson and Son Inc. and Court of Appeals (June 25, 1999) held that unlike the RP-US Tax Treaty, the RP-West Germany Tax Treaty allows a tax credit of 20 percent of the gross amount of such royalties arising in the Philippines against German income and corporation tax, where the tax rate is reduced to 10 or 15 percent under such treaty. Therefore, the taxes on royalties under the RP-US Tax Treaty are not paid under circumstances similar to those in the RP-Germany Tax Treaty because of the absence of the said matching credit provision in the former convention. In so ruling, the Highest Tribunal further declares: "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 nation 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-U S Tax Treaty and Article 12 (2)(b) of the RP-Wes t Germ any T ax Treaty, above-quoted, speaks of tax on royalties for 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 nation 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." The foregoing Supreme Court decision has become final and executory in September 10, 1999. Moreover, the said decision and its doctrine shall be applied prospectively as provided in BIR Ruling No. 163-99 dated October 20, 1999. Such being the case, your opinion that the royalties paid by your client BUSINESS 1 to OFFICE 1 are subject to the preferential tax rate of ten percent (10%) is hereby confirmed but only so much of the royalty payments made from December 23, 1997 to September 10, 1999. With respect to royalty payments made after September 10, 1999 and onward, the 10% tax rate shall no longer be applicable for being contrary to the above-mentioned doctrine. In view of this, a new tax treaty relief application may be filed for transactions covering the said period applying the "most favored nation clause" of the RP-US Tax Treaty in relation with other RP Tax Treaties. (BIR Ruling No. ITAD-13-01 dated February 16, 2001) Moreover, the monthly royalty fees of 3%, 2% and 1% arising in the Philippines, based on its net sales from the operations of "OFFICE 1 SUPERSTORES," shall be subject to 10% value-added tax (VAT) pursuant to Section 108 (A)(1) of the Tax Code and that BUSINESS 1 shall, before making payment of royalties to OFFICE 1, withhold and remit to this Bureau the 10% VAT due thereon, by filing a quarterly return for and on behalf of the said non-resident foreign corporation using BIR Form 1600. The duly validated VAT declaration / return is sufficient evidence for BUSINESS 1 in claiming input tax credit. (Section 4. 110-3(b) of the Revenue Regulations No. 7-95) This ruling is being 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.) LILIAN B. HEFTI Deputy Commissioner Legal and Inspection Group