ITAD Ruling No. 046-02

April 10, 2002 ITAD RULING NO. 046-02 RP-Singapore, Articles 5, 7 & 12 NIRC,Sections 107 (A) & 108 (A) BIR Ruling No. ITAD-144-00 BIR Ruling No. 100-99 Tan Concepcion & Bawagan Law Offices Suites 2104-2106, 21st Flr., Medical Plaza-Ortigas San Miguel Avenue, Ortigas Center 1661 Pasig City Attention: Atty. Fides C. Cordero-Tan Atty. Fe L. Concepcion Gentlemen : This refers to your letter dated February 22, 2001, received by this Office on July 18, 2001, on behalf of your client, Compaq Computer Asia Pty., Ltd. (Compaq), requesting a ruling regarding certain income characterization issues under the Philippine-Singapore tax treaty arising from the project consulting services agreement between Compaq and Philippine Long Distance Telephone Company and/or ePLDT (ePLDT). It is represented that Compaq is a corporation organized and existing under the laws of Singapore with principal office address at Compaq Centre, Tampines Plaza, 5 Tampines Central, 1#05-01, Singapore 529541; that it is not registered either as a corporation or as a partnership licensed to do business in the Philippines per certification dated July 19, 2001 issued by the Securities and Exchange Commission (SEC); that ePLDT is a corporation organized and existing under the laws of the Philippines; that Compaq and ePLDT entered into a project consulting services agreement whereby the former will provide the latter with the following: (i) a CashCard Application System consisting of the supply and delivery by Compaq of both hardware and software which include servers, access servers, encryption-decryption equipment, cryptoservers, and routers ("Hardware") and ACI BASE 24 and NETS-Cashcard software which shall be customized by Compaq to meet the requirements of ePLDT as well as operating system software needed to operate the Hardware ("Software" [emphasis ours]); and (ii) training, maintenance, technical support and other services relating to the CashCard Application System. It is further represented that, under the Agreement, the supply and delivery of the Hardware involve an outright sale and the same becomes the sole property of ePLDT; that as to the supply of the Software, ePLDT is granted by Compaq a non-exclusive, nontransferable, royalty free, internal use license to copy, load, execute, modify or merge with other software on processors owned, leased and under the control of ePLDT, any software provided or developed by Compaq, its subcontractors and third party suppliers under the Agreement for the purpose of operating the Hardware and any of the software products in the Philippines and for the use of said Software in providing services to ePLDT's clients; that ePLDT is required to acknowledge that the Software contains proprietary technology of Compaq and third parties and no ownership in, or title to, the Software is transferred to ePLDT; that with respect to the rendition of training, maintenance, technical support and other services by Compaq through Compaq's employees or other personnel in connection with the CashCard Application System, the same shall be done primarily outside of the Philippines and, to the extent that such services are performed in the Philippines, they will not involve activities that will continue within the Philippines for a period or periods aggregating more than 183 days; that during the training, there will be no transfer of technology in which Compaq has proprietary interest; and that in consideration for the aforementioned Hardware, Software and services, ePLDT shall pay Compaq a fee in the amount of Six Million Four Hundred Twenty Thousand Fifty Three U.S. Dollars and Seven Cents (US$6,420,053.07) payable as follows: Tandem Himalaya $558,662.80 Bracom Security 57,620.25 NAC Controller 159,235.05 NERA PC 26,150.25 ACI BASE (software) 630,000.00 NETS-CashCard license (software) 2,600,000.00 Proliant servers/storage/rack 114,984.50 AR cryptoserver 57,500.00 CISCO Routers 110,245.15 Foreign Services: ACI-customization 325,896.00 NETS-customization 600,000.00 Service Component 500,000.00 NETS-maintenance fee 400,000.00 Local Services: Service Component 754,519.26 Freight for CISCO 19,895.31 TOTAL $6,914,708.87 Less Agreed Upon Discount 494,655.80 NET(exclusive of VAT) $6,420,053.07 In the light of the foregoing representations, you now request a confirmation of your opinion that payments by ePLDT to Compaq under the Agreement are not subject to Philippine tax pursuant to the RP-Singapore tax treaty, more particularly as follows: (1) that payments relating to the supply and delivery of Hardware and Software by Compaq under the agreement are not in the nature of royalties within the purview of the RP-Singapore tax treaty; and (2) that payments for the rendition of training, maintenance, technical support and other services by Compaq through Compaq's employees or other personnel in connection with the CashCard Application System are not subject to Philippine income tax pursuant to the same treaty. In reply, this Office is of the opinion and so holds as follows: 1. Whether the payments relating to the supply and delivery of Hardware and Software by Compaq are royalties. Payments for the outright sale of Hardware, by which the Hardware becomes the sole property of ePLDT, payments therefor are not being received by Compaq for the "use of or right to use" the Hardware. Thus, such payments are not in the nature of "royalties'"' under the RP-Singapore tax treaty but may constitute "business profits" under Article 7 of the RP-Singapore tax treaty which provides that "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 that permanent establishment." or alternatively, "gains from the alienation of property" under Article 13 of the RP-Singapore tax treaty provides that "1. Gains from the alienation of immovable property may be taxed in the Contracting State in which such property is situated. 2. Gains from the alienation of movable property forming part of the business property of a permanent establishment which an enterprise of a Contracting State has in the other Contracting State or of movable property pertaining to a fixed base available to a resident of a Contracting State in the other Contracting State for the purpose of performing professional services, including such gains from the alienation of such permanent establishment (alone or together with the whole enterprise) or of such a fixed base may be taxed in the other State. However, gains derived by an enterprise of a Contracting State from the alienation of ships and aircraft operated in international traffic and movable property pertaining to the operation of such ships or aircraft, shall be taxable only in that State. 3. Gains from the alienation of shares of a company, the property of which consists principally of immovable property situated in a Contracting State, may be taxed in that State. Gains from the alienation of an interest in a partnership or a trust, the property of which consists principally of immovable property situated in a Contracting State, may be taxed in that State. 4. Gains from the alienation of any property, other than those mentioned in paragraphs 1, 2, and 3 shall be taxable only in the Contracting State of which the alienator is a resident." (emphasis supplied) Since Compaq does not have a permanent establishment or a fixed base of business in the Philippines, payments relating to the supply and delivery by Compaq of Hardware to ePLDT would fall under paragraph 4 of Article 13 of the RP-Singapore tax treaty and should be taxable only in Singapore. As regards the payment relative to the supply of Software, it is noteworthy that the object of the contract between Compaq and ePLDT is not the delivery of Hardware and Software per se but rather the delivery of a system, more particularly the CashCard Application System. The Hardware and Software, though essential to the operation of such system, are merely components of the system. Further, inasmuch as Compaq uses the Software for its own products or use, it only granted a license, albeit royalty-free, to ePLDT so that ePLDT may make use of such system. However, in view of the features discussed above, the fact that such license is granted does not make the payment for the Software a royalty payment. In this regard, the Commentaries of the ORGANIZATION FOR ECONOMIC COOPERATION AND DEVELOPMENT (OECD) Committee on Fiscal Affairs on the Model Tax Convention [par. 12-17, Commentary on Article 12 (Royalties), 1998, p. 152-153] provide as follows: "12. Whether payments received as consideration for computer software may be classified as royalties poses difficult problems but is a matter of considerable importance in view of the rapid development of computer technology in recent years and the extent of transfers of such technology across national borders. Software may be described as a programme, or series of programmes containing instructions for a computer required either for the operational processes of the computer itself (operation software) or for the accomplishment of other tasks (application software). It can be transferred through a variety of media, for example in writing, on a magnetic tape or disc, or on a laser disc. It may be standardized with a wide range of applications or be tailor-made for single users. It can be transferred as an integral part of computer hardware or in an independent form available for use on variety of hardware. The rights in computer software are a form of intellectual property. Research into the practices of OECD Member countries has established that all but one protect software rights either explicitly or implicitly under copyright law. Transfers of rights occur in many different ways ranging from the alienation of the entire rights to the sale of a product which is subject to restrictions on the use to which it is put. The consideration paid can also take numerous forms. These factors may make it difficult to determine where the boundary lies between payments that are properly to be regarded as royalties and other types of payment. 13. Three situations are considered. The first is of payments made where less than the full rights in software are transferred. In a partial transfer of rights the consideration is likely to represent a royalty only in very limited circumstances. One such case is where the transferor is the author of the software (or has acquired from the author his rights of distribution and reproduction) and he has placed part of his rights at the disposal of a third party to enable the latter to develop or exploit the software itself commercially, for example by development and distribution of it. It should be noted that even where a software payment is properly to be regarded as a royalty there are difficulties in applying the copyright provisions of the Article to software royalties since paragraph 2 requires that software should be classified as a literary, artistic or scientific work. None of these categories seems entirely apt but treatment as a scientific work might be the most realistic approach. Countries for which it is not possible to attach software to any of those categories might be justified in adopting in their bilateral treaties an amended version of paragraph 2 which either omits all references to the nature of copyrights or refers specifically to software. 14. In other cases, the acquisition of the software will generally be for the personal or business use of purchaser. The payment will then fall to be dealt with as commercial income in accordance with Articles 7 or 14. It is of no relevance that the software is protected by copyright or that there may be restrictions on the use to which the purchaser can put it . (emphasis supplied) 15. The second situation is where the payments are made as consideration for the alienation of rights attached to the software. It is clear that where the consideration is paid for the transfer of the full ownership, the payment cannot represent a royalty and the provisions of the Article are not applicable. Difficulties can arise where there are extensive but partial alienations of rights involving: exclusive right of use during a specific period or in a limited geographical are; additional consideration related to usage; consideration in the form of a substantial lump-sum payment. 16. Each case will depend on its particular facts but in general such payments are likely to be commercial income within Article 7 or 14 or a capital gains matter within Article 13 rather than royalties within Article 12. That follows from the fact that where the ownership of rights has been alienated in full or in part, the consideration cannot be for the use of the rights. The essential character of the transaction as an alienation cannot be altered by the form of the consideration, the payment of the consideration in installments or, in the view of most countries, by the fact that the payments are related to a contingency. 17. The third situation is where software payments are made under mixed contracts. Examples of such contracts include sales of computer hardware with built-in software and concessions of the right to use software combined with the provision of services. The methods set out in paragraph 11 of above dealing with similar problems in relation to patent royalties and know-how are equally applicable to computer software. Where necessary the total amount of the consideration payable under a contract should be broken down on the basis of the information contained in the contract or by means of a reasonable apportionment with the appropriate tax treatment being applied to each apportioned part." (emphasis supplied) "xxx xxx xxx" Hence, based on the above-quoted commentaries, the payment for the Software is not royalty for the following reasons, taken together: 1. ePLDT acquired a system, of which the Software is a component. The right to use is given to make the system useful to ePLDT; 2. The acquisition of the Software will generally be for the personal or business use of ePLDT and not for the purpose of developing or exploiting the Software itself for its commercialization and distribution; 3. The exclusive right of use by ePLDT is not for a specific period or in a limited geographical area; 4. The consideration is payable in full ( i. e. on or before the delivery of the Cash Card Application System but not later than February 15, 2001), rather than in installments; 5. No additional consideration other than as part of the entire package is to be paid by ePLDT; and 6. Payment for the Software is made under mixed contracts whereas the delivery of the Cash Card Application System by Compaq to ePLDT includes the outright sale of Hardware with built-in Software and concessions of the right to use the Software combined with the provisions for services. Such being the case, payments to Compaq arising from the supply of Software, the outright sale of Hardware and the rendition of training, maintenance, technical support and other services by Compaq in connection with the CashCard Application System are not in the nature of "royalties" under the RP-Singapore tax treaty but rather "business profits." Therefore, since Compaq is deemed not to have a permanent establishment in the Philippines to which its business profits may be attributed to, the payments as abovementioned to Compaq are not subject to Philippine tax pursuant to Article 7(1) in relation to Article 5 of the RP-Singapore tax treaty. 2. Whether payments for the rendition of training, maintenance, technical support and other services by Compaq through Compaq's employees or other personnel in connection with the CashCard Application System are exempt from Philippine income tax pursuant to the treaty. The rendition of training, maintenance, technical support and other services by Compaq through its employees or other personnel in connection with the CashCard Application System cannot be considered to constitute royalties as, based on the representation, there will be no transfer of technology in which Compaq has proprietary interest or know-how or any undivulged technical information, special knowledge, skills or expertise to ePLDT. Not being royalties, such payments may constitute business profits and, as already stated in No. 1, the profits of a foreign corporation shall be subject to Philippine income tax, but only so much of them as is attributable to a permanent establishment situated in the Philippines. For this purpose, a corporation which is a resident of Singapore may be deemed to have a permanent establishment in the Philippines if, among others, the furnishing of consultancy or supervisory services by such corporation, through its employees or other personnel, in the same or connected project, continue within the Philippines for a period or periods aggregating more than 183 days. Considering that Compaq does not carry on business in the Philippines as aforesaid, as evidenced by the certificate of non-registration of corporate/partnership issued by the SEC, and since the services to be performed by its personnel will be done primarily outside of the Philippines and will not involve activities that will continue within the Philippines for a period or periods aggregating more than 183 days, Compaq is deemed not to have a permanent establishment in the Philippines to which its business profits may be attributed to. Hence, income derived by Compaq which are in the nature of business profits are not subject to Philippine tax pursuant to Article 7(1) in relation to Article 5 of the RP-Singapore Tax Treaty. (BIR Ruling No. 100-99 dated July 9, 1999 and BIR Ruling No. ITAD-144-00 dated September 28, 2000) 3. Value Added Tax However, the importation of Hardware and Software and the gross receipts derived from the services rendered within the Philippines by Compaq to ePLDT shall be subject to the 10 percent value added tax (VAT) pursuant to Sections 107(A) and 108(A) of the Tax Code of 1997, respectively. Accordingly, ePLDT being the payor in control of the payment shall be responsible for the withholding of VAT on such fees on behalf of Compaq by filing a separate VAT return for and on behalf of Compaq using BIR Form No. 1600 (Monthly Remittance Return of Value-Added Tax and Other Percentage Taxes Withheld). The duly filed BIR Form 1600 and proof of payment thereof shall serve as sufficient basis for the claim of input tax to be applied against the output tax that may be due from ePLDT. In addition, ePLDT is required to issue the Certificate of Creditable Tax Withheld at Source (BIR Form 2307) in quadruplicate upon request of Compaq, the first three copies thereof to be given to Compaq and the fourth copy to be retained by ePLDT as its file copy. This ruling is issued on the basis of the foregoing facts as represented. However, if upon investigation it shall be discovered 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