ITAD Ruling No. 079-03

June 11, 2003 ITAD RULING NO. 079-03 Art. 12, 5 & 7, RP-Denmark Tax Treaty BIR Ruling No. DA-ITAD-39-03; 63-03; 49-02 Castillo Laman Tan Pantaleon & San Jose Law Office The Valero Tower 122 Valero Street, Salcedo Village 1227 Makati City Attention: Atty. Gregson A. Castillo Atty. Karen C. Pioquinto Gentlemen : This refers to your letter dated September 23, 2002, requesting confirmation of your opinion that the amount paid by your client, Danasia, Inc. (DI), to Scanasia DK, ApS (S-DK) are not subject to income tax, withholding tax and value added tax and are allowable deductions from DI's gross income for purposes of the corporate income tax. It is represented that S-DK is a corporation organized and existing under the laws of Denmark with principal address at Nordre Strandvej 165, 3140 Aalsgaarde, Denmark; that it is not registered either as 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 August 1, 2002; that DI is a corporation organized and existing under the laws of the Philippines with principal address at 3rd Floor, Molave Bldg., 2231 Chino Roces Ave., Makati City; that under a proposed Service Agreement between S-DK and DI, the former will provide administrative support services to the latter from time to time and as needed including coordination on the implementation of group policies and procedures, assistance in the source of products, promotion of DI in worldwide trade chambers, conducting of seminars and assistance in the procurement of materials and equipment; that the said services will be performed by S-DK outside the Philippines from its Denmark base using facilities and resources located in Denmark, and will be charged by reference to cost. In reply, please be informed of the following: 1. That the compensation paid by DI to S-DK for administrative support services does not constitute royalties and is not subject to income tax and withholding tax. Article 12 of the RP-Denmark tax treaty provides that: "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 the right to use, any copyright of literary, artistic or scientific work including cinematographic films and films and tapes for television or radio broadcasting, any patent, trademark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience, and for the use of, or the right to use, industrial, commercial or scientific equipment in connection therewith. "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 CO-OPERATION 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 (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 discussions to the case at hand, it is clear in the Service Agreement that the compensation to be paid by DI to S-DK are not within the definition of "royalties" under Article 12 of RP-Denmark tax treaty. Specifically, nothing in the agreement would require transfer into the Philippines of technology, equipment or other property where S-DK has proprietary interest or would otherwise permit S-DK to impart to DI their special knowledge and experience which remain unrevealed to the public. Inasmuch as S-DK 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. Thus, the amount to be paid to S-DK shall not be considered as royalties but shall constitute as business profits derived from sources outside the Philippines. (BIR Ruling No. DA-ITAD-39-03 dated March 4, 2003) As such, the business profits are governed by Section 28(B)(1), in relation to Section 42(A)(3), both of the National Internal Revenue Code which 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 year 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) and (d): Provided, That 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%). (Emphasis supplied) "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" Inasmuch as it has been represented that the administrative services provided by S-DK are to be performed exclusively in Denmark, then the Philippines-Denmark 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) Under the aforecited provisions, a nonresident foreign corporation is taxable only on income derived from sources within the Philippines so that if a nonresident foreign corporation furnishes and performs services in the Philippines, the service fees therefrom are taxable in the Philippines. Considering that the services of S-DK to DI under the proposed Service Agreement are rendered outside the Philippines, the payments by DI to S-DK are considered income derived from sources outside the Philippines. IHcTDA In view thereof, this Office is of the opinion as it hereby holds that payments of DI to S-DK pursuant to their proposed Service Agreement are to be 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. 2. That the administrative support services provided by S-DK to DI under the Agreement are not subject to VAT The administrative support services provided by S-DK to DI under the Agreement which are rendered outside the Philippines are not subject to the 10% VAT imposed under Section 108 of the Tax Code of 1997. 3. That the compensation paid by DI to S-DK are considered allowable expenses and are deductible from DI's gross income As regards your query on whether the above service fees of DI are considered allowable expenses deductible from gross income pursuant to Section 34(A)(1)(a) of the Tax Code of 1997, please be informed that we decline to rule on the matter considering the factual nature of the issue. However, this does not preclude the taxpayer to treat it as a deductible item which allowability is subject to the findings of an investigation pursuant to the substantiation requirements under Section 34(A)(1)(b) of the Tax Code of 1997. 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.) MILAGROS V. REGALADO Assistant Commissioner Legal Service