ITAD Ruling No. 062-05

June 27, 2005 ITAD RULING NO. 062-05 Articles 5 (Permanent Establishment) and 7 (Business Profits) Philippines-Japan tax treaty and Philippines-Malaysia tax treaty; BIR Ruling No. DA-ITAD 187-02 Aranas Consunji Barleta Unit 106, Ground Floor, Le Metropole Building 326 Tordesillas corner De La Costa Streets Salcedo Village, Makati City Attention: Atty. Jesus Clint O. Aranas Gentlemen : This refers to your letter dated May 3, 2005 requesting this Office's opinion on the tax treatment of income derived by Soode Nagano Company, Ltd. (Soode Japan) and Soode (Johor) Sdn. Bhd. (Soode Malaysia) from the sale of their raw materials to Hitachi Global Storage Technologies Philippines, Pte.,Ltd. (Hitachi Philippines) , under the pertinent provisions of the Philippines-Japan and the Philippines-Malaysia tax treaties. It is represented that Soode Japan and Soode Malaysia are nonresident foreign corporations, organized and existing under the laws of Japan and Malaysia, respectively; that Soode Japan's principal office is at 2-13-19, Osachi Gosyo, Okaya,,Nagano, Japan, as confirmed by its Amended Articles of Incorporation, and Soode Malaysia's principal office is at Lot 5, Kawasan Perindustrian Lukit, 81900 Kota Tinggi, Johor, Malaysia, as confirmed by its Memorandum and Articles of Association and the relevant Certificate dated April 6, 2005 issued to it by the Registrar of Company of Malaysia; that Soode Japan and Soode Malaysia are not registered either as corporations or partnerships to engage in business in the Philippines as confirmed by the respective Certificates of Non-Registration of Corporation/Partnership dated March 11, 2005 and April 13, 2005 issued by the Securities and Exchange Commission; that, on the other hand, Hitachi Philippines is a domestic corporation, organized and existing under the laws of the Philippines, with principal office at Special Export Processing Zone, Laguna Technopark, Bian, Laguna, Philippines; that on April 27, 2005, Hitachi Philippines entered into separate Participation Agreements with Soode Japan and with Soode Malaysia ,pursuant to existing Vendor Management Inventory Arrangements between Hitachi Philippines and Soode Japan ,and Hitachi Philippines and Soode Malaysia ;that under the Participation Agreements, Soode Japan and Soode Malaysia shall, according to Hitachi Philippines ' purchase orders, deliver raw materials to Hitachi Philippines for its exclusive benefit; that the raw materials shall be delivered and stored at Hitachi Philippines ' warehouse, and title and ownership of the raw materials shall be of Soode Japan's and Soode Malaysia's until Hitachi Philippines makes a "pull notice" to Soode Japan and Soode Malaysia to use the raw materials for its own account. In reply, please be informed that payments derived by Soode Japan and Soode Malaysia from the sale of their raw materials to Hitachi Philippines under their respective Participation Agreements are business profits of Soode Japan and Soode Malaysia , taxable under the respective paragraphs 1, Article 7 (Business Profits) of the Philippines-Japan and Philippines-Malaysia tax treaties, to wit: Japan: "Article 7 "1. The profits of an enterprise of a Contracting State shall be taxable only in that Contracting State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in that other Contracting State but only so much of them as is attributable to that permanent establishment." Malaysia: "Article 7 BUSINESS PROFITS "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 business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much thereof as is attributable to that permanent establishment." The respective paragraphs 1 above state that the payments in question are subject to Philippine income tax if they are attributable to permanent establishments which Soode Japan and Soode Malaysia have or might have in the Philippines. A permanent establishment ,as defined in the respective paragraphs 1 and 2, Article 5 (Permanent Establishment) of the relevant tax treaties, means "a fixed place of business through or in which the business of an or the enterprise is wholly or partly carried on," and includes, for example, "a place of management, a branch, an office, a factory, a workshop, a store or other sales outlet, and a warehouse." In the contractual arrangements between Hitachi Philippines and Soode Japan and between Hitachi Philippines and Soode Malaysia where Hitachi Philippines shall permit Soode Japan and Soode Malaysia to use its ( Hitachi Philippines) warehouse to store their ( Soode Japan's and Soode Malaysia's ) raw materials prior to its use of the raw materials, such a warehouse which will be utilized (in whole or in part) by Soode Japan and Soode Malaysia can be considered a permanent establishment if the general requisites of a permanent establishment are attendant in the use of the warehouse. In relation, the 2003 Organization for Economic Cooperation and Development (OECD) Model Tax Convention Commentary (pages 85-91) gives guidance as to when a facility such as a warehouse can become a permanent establishment, as it explains: "Paragraph 1 gives a general definition of the term "permanent establishment" which brings out its essential characteristics of a permanent establishment in the sense of the Convention (tax treaty),i.e.,a distinct "situs",a "fixed place of business".The paragraph defines the term "permanent establishment" as a fixed place of business through which the business of an enterprise is wholly or partly carried on. This definition, therefore, contains the following conditions: the existence of a "place of business",i.e.,a facility such as premises or, in certain instances, machinery or equipment; this place of business must be "fixed",i.e.,it must be established at a distinct place with a certain degree of permanence; the carrying on of the business of the enterprise through this fixed place of business. This means usually that persons who, in one way or another, are dependent on the enterprise (personnel) conduct the business of the enterprise in the State in which the fixed place is situated." (Paragraph 2) "The term "place of business" covers any premises, facilities or installations used for carrying on the business of the enterprise whether or not they are used exclusively for that purpose. A place of business may also exist where no premises are available or required for carrying on the business of the enterprise and it simply has a certain amount of space at its disposal. It is immaterial whether the premises, facilities or installations are owned or rented or are otherwise at the disposal of the enterprise. A place of business may thus be constituted by a pitch in a market place, or by a certain permanently used area in a customs depot (e.g.,for the storage of dutiable goods).Again the place of business may be situated in the business facilities of another enterprise. This may be the case for instance where the foreign enterprise has at its constant disposal certain premises or a part thereof owned by the other enterprise." (Paragraph 4) "As noted above, the mere fact that an enterprise has a certain amount of space at its disposal which is used for business activities is sufficient to constitute a place of business. No formal legal right to use that place is therefore required. Thus, for instance, a permanent establishment could exist where an enterprise illegally occupied a certain location where it carried on its business." (Paragraph 4.1) "Whilst no formal legal right to use a particular place is required for that place to constitute a permanent establishment, the mere presence of an enterprise at a particular location does not necessarily mean that the location is at the disposal of that enterprise. These principles are illustrated by the following examples where representatives of one enterprise are present on the premises of another enterprise. A first example is that of a salesman who regularly visits a major customer to take orders and meets the purchasing director in his office to do so. In that cases, the customer's premises are not at the disposal of the enterprise for which the salesman is working and therefore do not constitute a fixed place of business through which the business of that enterprise is carried on (depending on the circumstances, however, paragraph 5 (of the Article) could apply to deem a permanent establishment to exist)." (Paragraph 4.2) "A second example is that of an employee of a company who, for a long period of time, is allowed to use an office in the headquarters of another company (e.g.,a newly acquired subsidiary) in order to ensure that the latter company complies with its obligations under contracts concluded with the former company. In that case, the employee is carrying activities related to the business of the former company and the office that is at his disposal at the headquarters of the other company will constitute a permanent establishment of his employer, provided that the office is at his disposal for a sufficiently long period of time so as to constitute a "fixed place of business" and that the activities that are performed there go beyond the activities referred to in paragraph 4 of the Article." (Paragraph 4.3) "A third example is that of a road transportation enterprise which would use a delivery dock at a customer's warehouse every day for a number of years for the purpose of delivering goods purchased by that customer. In that case, the presence of the road transportation enterprise at the delivery dock would be so limited that that enterprise could not consider that place as being at its disposal so as to constitute a permanent establishment of that enterprise." (Paragraph 4.4) "A fourth example is that of a painter who, for two years, spends three days a week in the large office building of its main client. In that case, the presence of the painter in that office building where he is performing the most important functions of his business (i.e.,painting) constitute a permanent establishment of that painter." (Paragraph 4.5) "According to the definition, the place of business has to be a "fixed" one. Thus in the normal way there has to be a link between the place of business and a specific geographical point. .." (Paragraph 5) "For a place of business to constitute a permanent establishment the enterprise using it must carry on its business wholly or partly through it. The activity need not be of a productive character. Furthermore, the activity need not be permanent in the sense that there is no interruption of operation, but operations must be carried out on a regular basis." (Paragraph 7) "The business of an enterprise is carried on mainly by the entrepreneur or persons who are in paid-employment relationship with the enterprise (personnel).This personnel includes employees and other persons receiving instructions from the enterprise (e.g. dependent agents).The powers of such personnel in its relationship with third parties are irrelevant. It makes no difference whether or not the dependent agent is authorized to conclude contacts if he works at the fixed place of business. .." (Paragraph 10) Accordingly, the subject warehouse can constitute a permanent establishment if (1) it is a place of business at the disposal of Soode Japan and Soode Malaysia ,(2) it is fixed, or established at a distinct place with a certain degree of permanence, and (3) it is used for carrying on the businesses of Soode Japan and Soode Malaysia where personnel dependent on them conduct businesses on their behalf at the warehouse. (Paragraph 3, Commentary.) Concerning requirement number (1),the subject warehouse owned by Hitachi Philippines can become a place of business at the disposal of Soode Japan and Soode Malaysia if the warehouse will be used for a sufficiently long period of time and if the activities that will be performed in the warehouse go beyond preparatory and auxiliary activities. (Paragraph 4.3, Ibid. ) As to whether or not the warehouse will be used for a sufficiently long period, the fact that the relevant Participation Agreements do not contain therein a fixed term of at most six months for Soode Japan and Soode Malaysia to deliver raw materials to Hitachi Philippines and to use the warehouse to store the raw materials there is conclusive proof that the warehouse will be used for a sufficiently long period of time, unless proven otherwise. As to whether or not the activities that will be performed in the warehouse go beyond preparatory and auxiliary activities, the respective subparagraphs (a) and (b), paragraphs 4 and 3, Article 5 of the Philippines-Japan and Philippines-Malaysia tax treaties provide that "the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise" and "the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery" by themselves are activities of a preparatory and auxiliary character. The fact that the activities of storing and delivering the raw materials are of a preparatory and auxiliary character, the warehouse for this purpose cannot be regarded as a place of business that will constitute a permanent establishment of Soode Japan and Soode Malaysia . HICSaD Concerning requirement number (2),the fact that the warehouse is established at a distinct place in the Philippines with a certain degree of permanence makes it a fixed place of business. Concerning requirement number (3),although not expressly mentioned in the relevant Participation Agreements, the fact that Hitachi Philippines will store the raw materials in its warehouse prior to its use thereof for its own account so that Hitachi Philippines personnel will be responsible for the storage, inventory and security of the raw materials, is sufficient to consider these personnel as dependent on Soode Japan and Soode Malaysia who conduct businesses on behalf of them. In view of the foregoing, this Office is of the opinion and so holds that the subject warehouse, although a fixed place of business through which the businesses of Soode Japan and Soode Malaysia can be wholly or partly carried on, is not a permanent establishment because the activities that are performed therein are merely of a preparatory and auxiliary character. This is buttressed by the fact that Soode Japan and Soode Malaysia are not licensed to engage in business in the Philippines as confirmed by the relevant certificates issued by the Securities and Exchange Commission which support the conclusion that Soode Japan and Soode Malaysia do not have other fixed places of business in the Philippines which may be constituted as their permanent establishments. Hence, payments received by Soode Japan and Soode Malaysia from the sale of their raw materials to Hitachi Philippines are exempt from Philippine income tax. (BIR Ruling No. DA-ITAD 187-02 dated October 22, 2002) Finally, the sale of the raw materials is subject to the value-added tax (VAT) of 10 percent, based on the gross amount of the payments for the raw materials, under Section 106(A) of National Internal Revenue Code of 1997, which provides: "Section 106. Value-added Tax on Sale of Goods or Properties . "(A) Rate and Base of Tax . There shall be levied, assessed and collected on every sale, barter or exchange of goods or properties, a value-added tax equivalent to ten percent (10%) of the gross selling price or gross value in money of the goods or properties sold, bartered or exchanged, such tax to be paid by the seller or transferor." With regard to the procedures for withholding and paying the VAT, Sections 4 and 6 of Revenue Regulations No. 4-2000, Section 3 of Revenue Regulations No. 8-2002, and Section 7 of Revenue Regulations No. 14-2002, provide that the resident company, Hitachi Philippines ,making the payments to the nonresident companies shall be responsible for the withholding of the 10 percent VAT on such payments before remitting them to the nonresident companies, Soode Japan and Soode Malaysia .In remitting to the Bureau of Internal Revenue the VAT withheld on such payments, Hitachi Philippines shall use BIR Form No. 1600 (Monthly Remittance Return of VAT and Other Percentage Taxes Withheld).If a VAT-registered taxpayer, Hitachi Philippines may use as documentary substantiation for its claim of input VAT the duly filed BIR Form No. 1600 and the proof of payment accompanying it. If a non-VAT-registered taxpayer, Hitachi Philippines may include as part of the cost of the services provided to it by Soode Japan and Soode Malaysia the VAT consequently shifted or passed on to it and may treat such VAT either as expense or asset ,whichever is applicable. In addition, upon the request of Soode Japan and/or Soode Malaysia , Hitachi Philippines is required to issue in quadruplicate the relevant Certificate of Final Tax Withheld at Source (BIR Form No. 2306),the first three copies to be given to Soode Japan and/or Soode Malaysia and the fourth copy to be retained by Hitachi Philippines as its file copy. DISaEA 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