ITAD Ruling No. 054-03

April 15, 2003 ITAD RULING NO. 054-03 Article 12 Philippines-Japan Tax Treaty BIR Ruling No. ITAD 103-02 Avisado Agan Nidea Montenegro & Associates Attorneys-at-Law 3rd Floor, P & L Building 116 Legazpi Street, Legazpi Village Makati City Attention: Atty. Rommel S. Agan Atty. Elvin Hayes E. Nidea Gentlemen : This refers to your letter dated February 24, 2003 requesting confirmation that royalties paid by Nittetsu Micrometal Corporation Philippines (Nittetsu) to Nippon Micrometal Corporation (Nippon) are subject to the preferential tax rate of 25 percent pursuant to Article 12(2)(b) of the Philippines-Japan tax treaty, and shall not be subject to the 10 percent (10%) value-added tax (VAT) under Section 109 of the National Internal Revenue Code of 1997 (Tax Code) . It is represented that Nippon is a corporation organized and existing under the laws of Japan with principal office at 158-1, Sayamagahara Iruma City, Saitama 358-0032, Japan, and that it is not registered either as a corporation or as a partnership and has not been licensed to do business in the Philippines per certification dated August 14, 2002 issued by the Securities and Exchange Commission ; that Nittetsu is a corporation organized and existing under the laws of the Philippines with principal office at First Philippine Industrial Park, Special Economic Zone, Sto. Tomas, Batangas, and that it is a registered Ecozone export enterprise per certification dated November 27, 2000 and numbered 00-096 issued by the Philippine Economic Zone Authority ; that on August 31, 2001, a Royalty Agreement was entered into between Nittetsu and Nippon whereby Nippon agrees to grant to Nittetsu the use and the right to use of patents and know-how related to the manufacture of bonding wires; and that as a consideration, Nittetsu shall, on a semiannual basis, pay Nippon a royalty of 3 percent (3%) based on the aggregate processing cost of the Target Wire on Patent manufactured by Nittetsu for its customers, and a royalty of 2 percent (2%) based on the aggregate processing cost of the Target Wire on Know-how manufactured by Nittetsu for its customers. In reply, as regards the income tax on royalties, please be informed that Article 12 of the Philippines-Japan tax treaty 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 Contracting State. 2. However, such royalties may also be taxed in the Contracting State in which they arise, and according to the laws of that Contracting State, but if the recipient is the beneficial owner of the royalties the tax so charged shall not exceed: a) 15 per cent of the gross amount of the royalties if the royalties are paid in respect of the use of or the right to use cinematograph films and films or tapes for radio or television broadcasting; b) 25 per cent of the gross amount of the royalties in all other cases. STaAcC 3. Notwithstanding the provisions of paragraph 2, the amount of tax imposed by the Philippines on the royalties paid by a company, being a resident of the Philippines, registered with the Board of Investments and engaged in preferred pioneer areas of investment under the investment incentives laws of the Philippines to a resident of Japan, who is the beneficial owner of the royalties, shall not exceed 10 per cent of the gross amount of the royalties. 4. 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 cinematograph films and films or tapes for radio or television broadcasting, any patent, trade mark, 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. xxx xxx xxx" Based on the abovecited tax treaty provision, royalties paid by a resident of the Philippines to a resident of Japan shall be subject to a preferential tax rate of: (a) 10 percent of the gross amount thereof if they are paid by a Philippine company registered with the Board of Investments and engaged in preferred pioneer areas of investment under the investment incentives laws of the Philippines; (b) 15 percent of the gross amount thereof if they are paid in respect of the use or the right to use of cinematograph films and films or tapes for radio or television broadcasting; and (c) 25 percent of the gross amount thereof in all other cases. Such being the case, since Nittetsu , the company paying the royalties, is not a Philippine company registered with the Board of Investments and engaged in preferred pioneer areas of investment under the investment incentives laws of the Philippines, and since such royalties paid by Nittetsu to Nippon are not in respect of the use or the right to use of cinematograph films and films or tapes for radio or television broadcasting, this Office is of the opinion that such royalties shall be subject to the preferential tax rate of 25 percent of the gross amount thereof pursuant to Article 12(2)(b) of the Philippines-Japan tax treaty. ( BIR Ruling No. DA-ITAD 115-02 dated June 4, 2002 ) As regards VAT on such royalties, 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% VAT. Under Section 4.102-2(c) of Revenue Regulations 7-95, the sale of services to Ecozone enterprises such as Nittetsu may be considered effectively zero-rated sale of services for VAT purposes if made to persons or entities who are granted indirect exemption from VAT 1 under special laws. However, since there is no express provision in the pertinent Special Economic Zone Act of 1995 (Republic Act 7916) granting such indirect exemption to Ecozone enterprises, the question whether the sale of services to such enterprises can be treated for VAT purposes as effectively zero-rated can be answered by taking into account the Cross Border Doctrine or Destination Principle of the VAT system, viz : " the country taxes all value-added, at home and abroad, for goods that have as their destination the consumers of that country. Exports are exempt, imports are taxable . . ."( VAT Ruling 9-99 dated January 21, 1999 ). Applying the Cross Border Doctrine to the case at hand, it is understood that the transfer of technology involving the use and the right to use by Nittetsu of Nippon's patents and know-how on the manufacture of bonding wires are in connection with the manufacture of products (i.e., bonding wires) supposedly for export; thus royalties arising therefrom shall not be subject to VAT. However, instead of the VAT zero-rating mechanism which is applicable to resident VAT registered sellers, transferors or lessors of goods, properties or services only and not to nonresident sellers, transferors or lessors of goods, properties or services such as Nippon , the provision for exemption from VAT under Section 109(q) of the Tax Code is particularly applicable to the case at hand. Under Section 109(q), transactions exempt from VAT include those exempt under special laws, which readily include the pertinent Special Economic Zone Act of 1995 (Republic Act 7916) specifically Section 1(A) of Rule XIV (Incentives to Ecozone Developers/Operators) thereof, to wit: " Exemption from National and Local Taxes and Licenses . An Ecozone Developer/Operator shall to the extent of its construction and operation, be exempt from payment of all national internal revenue taxes and local government impost, fees, licenses or taxes, including but not limited to the following: 1. Internal revenue taxes such as gross receipts tax, value-added tax , ad valorem and excise taxes; 2. Franchise, common carrier or value added taxes and other percentage taxes on public and service utilities and enterprises. xxx xxx xxx" (emphasis added) This means that Ecozone enterprises, if they become sellers, transferors or lessors of goods, properties or services, cannot pass on input VAT nor claim input VAT credit to offset those VATs previously shifted or passed on them by VAT registered sellers, transferors or lessors of goods, properties or services. It is a general rule that the obligation to withhold VAT on payments such as royalties made to nonresident sellers, transferors or lessors of goods, properties or services is upon the person making such payments. However, since Ecozone enterprises such as Nittetsu , cannot pass on input VAT nor claim input VAT credit, royalties which those enterprises paid to nonresident sellers, transferors or lessors of goods, properties or services are therefore exempt from VAT. ( BIR Ruling No. ITAD 103-02 dated May 28, 2002 ) 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. CITcSH Very truly yours, Commissioner of Internal Revenue By: (SGD.) MILAGROS V. REGALADO Assistant Commissioner Legal Service Footnotes 1. The VAT is an indirect tax and the amount of tax may be shifted or passed on to the buyer, transferee or lessee of the goods, properties or services. (Section 105, Tax Code .)