ITAD Ruling No. 057-04

June 3, 2004 ITAD RULING NO. 057-04 Articles 5, 8 & 13, Philippines-United States tax treaty NIRC, Sec. 28, 42 and 108 BIR Ruling No. DA-ITAD-49-02 BIR Ruling No. DA-ITAD-39-03 BIR Ruling No. DA-ITAD-136-03 Quiason Makalintal Barot Torres & Ibarra 21st Floor, Robinsons-Equitable Tower 4 ADB Avenue cor Pedro Poveda St. 1605 Ortigas Center, Pasig City Attention: Atty. Wilfrido E. Sanchez Atty. Ruelito Q. Soriano Atty. Benedict R. Tugonon Gentlemen : This refers to your letter dated April 26, 2004, on behalf of your client, Tropical Hut, Inc. (Tropical Hut), requesting confirmation of your opinion that: (a) the service fees payable by the Mercury Group of Companies, Inc. ("Mercury Group") to Tropical Hut as payment for the procurement, research, development, consultancy and advisory services for the Mercury Group are ordinary business profits and not royalties; (b) the subject service fees by the Mercury Group to Tropical Hut are not subject to Philippine income tax pursuant to the Philippines-United States tax treaty: and (c) since the subject services will be performed outside the Philippines, the said service fees are not subject to Philippine income tax and the 10% value-added tax. It is represented that Tropical Hut is a nonresident foreign corporation duly organized and existing under the laws of the State of California, United States of America (USA) with principal address at 3190 Stevens Creek Blvd., San Jose California, 95117 USA; 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 issued by the Securities and Exchange Commission dated April 16, 2004; that the Mercury Group is a corporation duly organized and existing under the laws of the Republic of the Philippines with principal place of business at 7 Mercury Avenue Bagumbayan, Quezon City; that on November 14, 2003, Tropical Hut and the Mercury Group entered into a Memorandum of Agreement (MOA) whereby Tropical Hut will render the following services to the Mercury Group outside the Philippines, particularly in California, USA, to wit: a. Identify goods and merchandise that may be suitable or desirable for Mercury Group or its subsidiaries/affiliates; caDTSE b. Conduct market research and provide business development plans relative to the Mercury Group's Business; c. Evaluate developments and emerging trends in the global market that may affect any of the Mercury Groups Businesses and make timely recommendations to the Mercury Group on the trends which the latter can adopt; d. Provide product development studies and reports as may be requested by the Mercury Group from time to time; e. Provide marketing and promotional plans as may be requested by the Mercury Group from time to time; f. Submit recommendations on office or store layout and branch expansion as may be requested by the Mercury Group from time to time; g. Provide advice on the value-added services and miscellaneous products which the Mercury Group can offer to its customer; h. Represent the Mercury Group in international conferences and conventions held outside the Philippines relating to the Pharmaceutical Business, Personal Care Products, food, medical supplies and equipments, chemicals and other products that the Mercury Group may be interested; i. Advice on the use of generic products; j. Such other services which are analogous to the foregoing." It is further represented that in consideration for the abovementioned services, the Mercury Group shall pay Tropical Hut an annual service fee in the amount of One Hundred Thousand United States Dollars (US$100,000.00); that Mercury Group shall likewise pay Tropical Hut a fee equivalent to 3% of the value of whatever goods, merchandise or products that the latter may order for the former; that the aforementioned services do not involve the licensing of any technological or proprietary rights to the Mercury Group; that none of the services to be performed by Tropical Hut requires performance within the Philippines; that Tropical Hut will perform all the said services outside of the Philippines, particularly in California, USA; and that the information needed by Tropical Hut in the performance of its services will be provided for by Mercury Group and will be communicated electronically or by telephone to the staffs of Tropical Hut who will liaise with Mercury Group's staff in the course of the performance of the services. In reply, this Office is of the opinion and so holds: 1. The service fees payable by Mercury Group to Tropical Hut under the MOA are ordinary business profits and not royalties . Article 13 of the Philippines-United States tax treaty defines the term "royalties", as follows: " Article 13 ROYALTIES "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." The tax treaty defines " royalties " to include "payment of any kind received as a consideration for information concerning industrial, commercial or scientific experience." According to the commentaries of the ORGANISATION FOR ECONOMIC COOPERATION AND DEVELOPMENT (OECD) Committee on Fiscal Affairs on the Model Tax Convention [par. 11, Commentary on Article 12 (royalties), ( 1998, p. 151), such information alludes to the concept of "know-how". The definition of know-how, which has been adopted by the said Committee, is "all the undivulged technical information, whether capable of being patented or not, that is necessary for the industrial reproduction of a product or process, directly and under the same conditions; inasmuch as it is derived from experience, know-how represents what a manufacturer cannot know from mere examination of the product and mere knowledge of the progress of technique." In a know-how contract, one of the parties agrees to impart to the other, so that he can use them for his own account, his special knowledge and experience which remain unrevealed to the public. (BIR Ruling No. DA-ITAD No. 49-02 dated April 15, 2002) Further, in the case of Philippine Refining Company vs. CIR , CTA Case No. 2872 dated January 15, 1986, the Court of Tax Appeals had an occasion to rule on the distinction of service fees from royalties, to wit: "To distinguish between compensation for service and royalty payments, one must inquire on whether the payee has proprietary interest in the property giving rise to the income. If the payee has none, then the payment is a compensation for personal services, if the payee has proprietary interest then the payment is royalty." Applying the above discussions to the instant case, there is nothing in the subject MOA that would require transfer into the Philippines of technology, equipment or other property where Tropical Hut has proprietary interest or would otherwise permit Tropical Hut to impart to Mercury Group their special knowledge and experience which remain unrevealed to the public. Likewise, inasmuch as Tropical Hut shall render these services using their customary skills, then the compensation to be received therefor shall not constitute as 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 transfer of technology. Accordingly, the service fees to be paid by the Mercury Group to Tropical Hut are not within the purview of the definition of "royalties" under Article 13 of Philippines-United States tax treaty but rather, shall constitute as ordinary business profits derived from sources outside the Philippines. (BIR Ruling No. DA-ITAD-39-03 dated March 4, 2003) 2. The service fees being derived from sources outside the Philippines shall be exempt from Philippine income tax . Inasmuch as it has been represented that the subject services are to be performed by Tropical Hut exclusively in the United States, then the Philippines-United States tax treaty does not apply as the herein transaction does not result in a case of double taxation for which a tax treaty relief is sought. (BIR Ruling No. DA-ITAD-63-03 dated April 15, 2003) In this regard, Section 28(B)(1), in relation to Section 42(A)(3), both of the National Internal Revenue Code provide, viz : "SEC. 28. Rates of Income Tax on Foreign Corporations . "xxx xxx xxx" "(B) Tax on Nonresident Foreign Corporation . "(1) In General . Except as otherwise provided in this Code, a foreign corporation not engaged in trade or business in the Philippines shall pay a tax equal to thirty-five percent (35%) of the gross income received during each taxable rear from all sources within the Philippines, such as interests, dividends, rents, royalties, salaries, premiums (except reinsurance premiums), annuities, emoluments or other fixed or determinable annual, periodic or casual gains, profits and income, and capital gains, except capital gains subject to tax under subparagraphs 5(c): Provided, host effective January 1, 1998, the rate of income tax shall be thirty-four percent (34%); effective January 1, 1999, the rate shall be thirty-three percent (33%); and, effective January 1, 2000 and thereafter, the rate shall be thirty-two percent (32%). "SEC. 42. Income from Sources Within the Philippines . "(A) Gross Income From Sources Within the Philippines . The following items of gross income shall be treated as gross income from sources within the Philippines: "xxx xxx xxx" "(3) Services . Compensation for labor or personal services performed in the Philippines : "xxx xxx xxx" Under the afore-cited provisions, a nonresident foreign corporation is taxable only on income derived from sources within the Philippines. Considering that the aforementioned services under the MOA are to be performed by Tropical Hut exclusively in the United States, the subject service fees are deemed income derived from sources outside the Philippines. Accordingly, the service fees by the Mercury Group to Tropical Hut are considered income derived from sources outside the Philippines and are, therefore, not subject to Philippine income tax and consequently to withholding tax, pursuant to Section 28(B)(1) of the Tax Code. 3. Since the subject services will be performed outside the Philippines, the said service fees are not subject to Philippine income tax and the 10% value-added tax . In defining the phase "sale or exchange of services" subject to 10% VAT, Section 108 of the National Internal Revenue Code (NIRC) provides: "The phrase "sale or exchange of services" means the performance of all kinds of services in the Philippines for others for a fee, remuneration or consideration,. . . . . . " (emphasis supplied) Clearly, the VAT imposed under Section 108 of the Tax Code applies only to services performed in the Philippines and not to services rendered outside the Philippines. Accordingly, since the services are exclusively to be performed by Tropical Hut in the United States, the subject service fees to be paid by the Mercury Group to Tropical Hut are not subject to VAT. (BIR Ruling No. DA-ITAD 39-03 dated March 4, 2003) This ruling is issued on the basis of the foregoing facts as represented. However, if upon investigation it shall be disclosed or discovered that the facts are different, then this ruling shall be without force and effect insofar as the herein parties are concerned. Very truly yours, Commissioner of Internal Revenue By: (SGD.) MILAGROS V. REGALADO Assistant Commissioner Legal Service