ITAD Ruling No. 057-05

June 17, 2005 ITAD RULING NO. 057-05 Art. 5 and 8 of the Philippines-United States tax treaty BIR Ruling No. 110-90 ROHM LSI Design Philippines, Inc. 24/F Tower 1, The Enterprise Center 6766 Ayala Avenue corner Paseo de Roxas 1200 Makati City Attention: Mr. Yoshihiko Yamauchi Managing Director Gentlemen : This refers to your letter dated July 30, 2004, requesting confirmation that your royalty payments to Paragon IC Solutions, Inc. (PARAGON), a resident of the United States of America, are subject to the withholding tax rate of ten percent (10%) pursuant to the "most-favored-nation" clause of the Philippines-United States tax treaty in relation to the Philippines-Japan tax treaty, and that the payment of maintenance fee by Rohm LSI Design Philippines, Inc. (ROHM) to Paragon in consideration of after-sales service rendered are treated as income from services, hence, exempt from withholding tax. In your follow-up letter dated November 9, 2004, however, you requested that a separate ruling for the software maintenance be given due course and that the portion for the royalty payment be set aside, to be resolved later. It is represented that PARAGON is a corporation organized and existing under the laws of the United States of America (USA) with principal address at 4060 Campus Drive, Ste. 220 Newport Beach, CA 92660; that it is not registered either as a corporation or as a partnership licensed to do business in the Philippines per certification issued by the Securities and Exchange Commission dated March 2, 2004; that ROHM is a BOI-registered corporation organized and existing under the laws of the Philippines with principal address at 24/F, The Enterprise CTR., Tower 1, 6766 Ayala Ave., Makati City; that ROHM and PARAGON entered into a Software License Agreement which was amended by another Software License Agreement signed on December 21, 2004 and December 22, 2004, on behalf of PARAGON and ROHM, respectively; that under the said Agreements, PARAGON grants ROHM a non-exclusive and non-transferable license to use licensed software only on computer(s) as designated in the PARAGON license file; that the amended Agreement also includes an after-sale maintenance services to be rendered by PARAGON which is intended to commence at the time of shipment of the licensed program, and unless otherwise specified in a product quotation from PARAGON, the maintenance service shall have an initial term of 90 days and will not exceed a period or periods aggregating more than 183 days within a taxable year; that PARAGON will also provide adequate technical support by phone, email or other mutually acceptable forms of communication during normal business hours during the maintenance term. In reply, please be informed that with respect to the after-sales maintenance services under the subject Agreement, Article 12 of the Philippines-United States tax treaty provides: "Article 12 "Royalties "xxx xxx xxx" "3. The term 'royalties' as used in this Article means payments of any kind received as a consideration for the use of, or of the right to use, any copyright of literary, artistic or scientific work, including cinematographic film or films or tapes used for radio or television broadcasting, any patent, trademark, 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. "xxx xxx xxx" The 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 and 12, Commentary on Article 12 (Royalties), 2003, p. 175), such information alludes to " know-how ". The definition of know-how, adopted by the said Committee is, "all the indivulged 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) Furthermore, in the case of Philippine Refining Company (PRC) 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 discussion to the case at hand, it is clear that the payment made by ROHM to PARAGON in consideration of the maintenance services are not within the definition of "royalties" under Article 13 of the Philippines-United States tax treaty. Specifically, nothing in the Agreement would require transfer into the Philippines of technology, equipment or other property where PARAGON has proprietary interest, or would otherwise permit PARAGON to impart to ROHM its special knowledge and experience which remain unrevealed to the public. Inasmuch as PARAGON rendered the maintenance services using its customary skills, the payments received thereof are not in consideration for the use of, or the right to use, any copyright, trademark, design or model, plan, secret formula or process, or for the transfer of technology. Thus, the amount paid by ROHM to PARAGON are not royalties but are considered as business profits. (BIR Ruling No. DA-ITAD-39-03 dated March 4, 2003) Accordingly, maintenance fees relevant to the application of the software paid by ROHM to PARAGON are business profits subject to taxation under paragraphs 1 and 2, Article 8 in relation to Article 5 of the Philippines-United States tax treaty. TEDaAc "Article 8 "Business Profits "1. Business profits of a resident of one of the Contracting States shall be taxable only in that State unless the resident has a permanent establishment in the other Contracting State. If the resident has a permanent establishment in that other Contracting State, tax may be imposed by that other Contracting State on the business profits of the resident but only on so much of them as are attributable to the permanent establishment. "2. Where a resident of one of the Contracting States has a permanent establishment in the other Contracting State, there shall in each Contracting State be attributed to the permanent establishment the business profits which would reasonably be expected to have been derived by it if it were an independent entity engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the resident of which it is a permanent establishment. "xxx xxx xxx" "Article 5 Permanent Establishment "1. For the purposes of this Convention, the term 'permanent establishment' means a fixed place of business in which the business of the enterprise is wholly or partly carried on. "2. The term 'permanent establishment' includes especially but is not limited to; "xxx xxx xxx" "j) The furnishing of services, including consultancy services, by a resident of one of the Contracting State through employees or other personnel, provided activities of that nature continue (for the same or a connected project) within the other Contracting State for a period or periods aggregating more than 183 days. "xxx xxx xxx" Based on the foregoing, it is clear that when a corporation which is a resident of the United States does not carry on business in the Philippines through a permanent establishment situated therein, the profits derived in the Philippines by such corporation shall not be subject to Philippine income tax. For this purpose, a corporation based in United States may be deemed to have a permanent establishment in the Philippines if, among others, the furnishing of services by such corporation through its employees or other personnel continue for the same or a connected project within the Philippines for a period or periods aggregating more than 183 days. Inasmuch as it is represented that the maintenance services are to be performed outside of the Philippines by PARAGON, except for occasional visits to the Philippines, which in no case shall exceed 183 days in a taxable year, the furnishing of said services by PARAGON through its employees or other personnel shall not constitute carrying of business through a permanent establishment in the Philippines. TcIaHC In view of the foregoing, the part of that fee which represents maintenance fees for maintenance services under the Software License Agreement between ROHM and PARAGON shall be treated as business profits, and therefore exempt from Philippine income tax and consequently from withholding tax. (BIR Ruling No. 110-90 dated June 1, 1990) 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. Very truly yours, Commissioner of Internal Revenue By: (SGD.) JAMES H. ROLDAN Assistant Commissioner Legal Service