ITAD Ruling No. 106-03

July 29, 2003 ITAD RULING NO. 106-03 Article 10 Philippines-Japan Tax Treaty BIR Ruling No. ITAD-93-03 Diaz Murillo Dalupan (L.C. Diaz & Co.) Certified Public Accountants 5th Floor, Don Jacinto Building Dela Rosa Street corner Salcedo Streets Legaspi Village, Makati City Attention: Atty. Francisco I. Naputo Senior Tax Consultant Atty. Enrique M. Sobrecarey Tax Consultant Gentlemen : This refers to your letter dated July 8, 2003 requesting confirmation that dividends declared by Precision Springs Manila, Incorporated (Precision-Manila) and Precision Springs Cebu, Incorporated (Precision-Cebu) on February 8 and 23 and September 3 and 24, 2001 in favor of Mitsubishi Steel Manufacturing Company, Ltd. (Mitsubishi) are subject to 10 percent income tax pursuant to Article 10(2)(a) of the Philippines-Japan tax treaty. It is represented that Mitsubishi is a corporation organized and existing under the laws of Japan with principal office at 2-22, 3-chome, Harumi, Chuo-Ku, Tokyo, 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 March 30, 2001 issued by the Securities and Exchange Commission; that Precision-Manila and Precision-Cebu are corporations organized and existing under the laws of the Philippines which principal offices are respectively located at Light Industrial Science Park II, Barrio Real, Calamba, Laguna and at 5th Street, Philippine Economic Zone Authority-Mactan, Pusok, Lapu-Lapu City, Mactan Island, Cebu, and that they are registered Philippine Economic Zone Authority enterprises; that Precision Manila declared dividends on February 8 and September 3, 2001 respectively amounting to P37,825,059.00 and P55,679,000.00, and Precision-Cebu declared dividends on February 23 and September 4, 2001 respectively amounting to P23,640,662.00 and P30,000,000.00, both in favor of Mitsubishi ; that as of the dates of declaration at issue, the name Mitsubishi was not yet reflected in the stock and transfer books of Precision Manila and Precision-Cebu , which name was reflected only after the issuance of BIR Ruling No. 80-01 on September 24, 2001. In reply, please be informed that Article 10 of the Philippines-Japan tax treaty provide: "1. Dividends 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 dividends may also be taxed in the Contracting State of which the company paying the dividends is a resident, and according to the laws of that Contracting State, but if the recipient is the beneficial owner of the dividends the tax so charged shall not exceed: a) 10 per cent of the gross amount of the dividends if the beneficial owner is a company which holds directly at least 25 per cent either of the voting shares of the company paying the dividends or of the total shares issued by that company during the period of six months immediately preceding the date of payment of the dividends; CAIHaE b) 25 per cent of the gross amount of the dividends in all other cases. xxx xxx xxx" Based on the aforequoted provisions, the Philippines may tax dividends paid by a Philippine corporation to a Japanese corporation which is the beneficial owner of such dividends at a rate not exceeding (a) 10 percent if the Japanese corporation holds directly at least 25 percent either of the voting shares or of the total shares of the Philippine corporation for a period of six months immediately preceding the date of payment of the dividends, or (b) 25 percent in all other cases. In order for the dividends declared by Precision-Manila and Precision-Cebu in favor of Mitsubishi on February 8 and 23 and September 3 and 24, 2001 to be subject to 10 percent as above, Mitsubishi , aside from being a resident of Japan, must (1) be the beneficial owner of such dividends; and (2) directly hold at least 25 percent either of the voting shares or of the total shares of the domestic companies for a period of six months immediately preceding the date of payment of the dividends. In view of the above, please be informed of the following discussions. 1) Whether Mitsubishi was the beneficial owner of the dividends : In general, the beneficial owner of a share of stock is the person who enjoys the benefits (i.e., rights to dividends, to vote, to appreciation in value, and to transfer rights of ownership) and bears the risk of loss with respect to the shares of stock. 1 In the case at hand, it is clear that Mitsubishi was the beneficial owner of the shares of stock of Precision-Manila and Precision-Cebu upon the transfer of such shares of stock to Mitsubishi . The declaration by Precision-Manila and Precision-Cebu of the subject dividends in favor of Mitsubishi shows that Mitsubishi enjoys the benefits (i.e., rights to dividends, to vote, to appreciation in value, and to transfer rights of ownership) as well as bears the risk of loss with respect to the shares of stock. 2) Whether Mitsubishi was the direct holder of the shares of stock of Precision-Manila and Precision-Cebu as of the dates of declaration at issue : The term " direct holding " is not categorically defined in the Philippines-Japan tax treaty; but paragraph 2, Article 3 (General Definitions) of the tax treaty provides that any term not defined in the tax treaty shall have the meaning that it has under the laws of the Contracting State concerning the taxes to which the tax treaty applies . In interpreting an undefined term, the Philippines, being the Contracting State which imposes taxes on dividends to which the term " direct holding " is relevant, takes into account the rules of interpretation under the Vienna Convention on the Law of Treaties, to which the Philippines is a signatory. Paragraph I, Article 31 (General Rule of Interpretation), Section 31 (Interpretation of Treaties) of the Vienna Convention states that a treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose . Under this rule, an interpretation of a term consistent with its ordinary meaning refers to such meaning or meanings generally attributed to a term while taking into account the context and purpose for which the term is used and intended by the drafters of the relevant treaty. In the light of the above circumstances, a term not defined in the treaty has to be given meaning in the sense of Philippine domestic law and jurisprudence. Thus, in the absence of a treaty definition of the term " holds directly ", an interpretation thereof may be drawn from various Philippine laws, to wit: a) The Civil Code: A vendee is a direct holder of a thing sold if ownership of that thing is transferred to him, and the thing sold is delivered to him . Article 1495 of the Civil Code states: "Article 1495. The vendor is bound to transfer the ownership of and deliver, as well as warrant the thing which is the object of the sale." prLL The obligations of a vendor are (1) to transfer ownership of the thing sold; (2) to deliver the thing sold; and (3) to warrant the thing sold. The obligations to transfer ownership of and to deliver the thing sold are essential in any contract of sale, but the obligation of warranty may be waived, diminished, or even suppressed (Article 1548). 2 Under Article 1495, a vendee essentially becomes a direct holder of a thing sold if ownership of that thing is transferred to him, and the thing sold is delivered to him. In the case at hand, Mitsubishi became the direct holder of the shares of stock of Precision-Manila and Precision-Cebu upon the execution on August 31, 2000 in Japan of the relevant Purchase and Sale Agreements between Precision Springs Company, Ltd. (Precision-Japan) the transferor, and Mitsubishi , the transferee. The shares of stock were constructively delivered to Mitsubishi upon its recognition by Precision-Manila and Precision-Cebu as their new stockholder, and more importantly, upon the declaration by the domestic companies of dividends in favor of Mitsubishi . Once ownership is transferred, the buyer acquires all the rights and obligations over the thing sold. At the same time, the buyer may be said to have been placed in the shoes of the seller with respect to the object of the contract. Accordingly, when Mitsubishi acquired all the rights and obligations previously held by Precision-Japan over the shares of stock of Precision-Manila and Precision-Cebu , Mitsubishi was placed in the shoes of Precision-Japan insofar as the acquired shares are concerned. There is no question that Precision-Japan was a " direct holder " of Precision-Manila and Precision-Cebu during the time it owned the subject shares of stock. Therefore, when Mitsubishi acquired the rights and assumed the place of Precision-Japan, Mitsubishi likewise assumed the latter's status as a direct holder of Precision-Manila and Precision-Cebu . b) Section 2, Presidential Decree 2029 (Defining Government-Owned or Controlled Corporations and Identifying Their Role In National Development): Concept of "direct holding/ownership ". Section 2 of PD No. 2029, dated February 4, 1986, in its definition of a government-owned or controlled corporation, states that an indirect shareholding of ownership, in contrast to a direct one, is one that is made through another entity. We quote the relevant provision of PD 2029 as follows: "Section 2. Definitions . A government-owned or controlled corporation is a stock or a non-stock corporation, whether performing governmental or proprietary functions, which is directly chartered by special law or if organized under the general corporation law is owned or controlled by the government directly, or indirectly through a parent corporation or subsidiary corporation, to the extent of at least a majority of its outstanding capital stock or of its outstanding voting capital stock." Under PD 2029, indirect ownership is taken to mean ownership of shares through another corporation, which in turn directly owns such shares. The BIR had the occasion to take a similar interpretation in issuing rulings. Thus, in BIR Ruling DA-052-03-25-02, Hydro Electric Development Corporation (HEDCOR) was considered directly owned by Aboitiz Power Corporation (APC) prior to the year 2000 and indirectly owned by APC in the year 2000 after the latter's entire direct holdings in HEDCOR were sold to Philippine Hydropower Corporation (PHC) , which in turn is wholly-owned by APC . Conversely, Mitsubishi is considered a direct holder of the subject shares in Precision-Manila and Precision-Cebu because there is no intervening company as contemplated by PD 2029 and BIR Ruling DA-052-03-25-02. Thus, in the absence of any intervening entity, holding the shares in the concept of an owner, between the investor and the investee, the shares would be considered as being directly owned or held. ATCEIc c) Relevant commentaries of the Organization for Economic Co-operation and Development (OECD) Committee on Fiscal Affairs: A parent company resident in a Contracting State which owns directly a substantial holding in a subsidiary resident in the other Contracting State should be taxed less heavily in the other State on profits remitted by the subsidiary to avoid recurrent taxation and to facilitate international investment . Concerning the more preferential tax rate on dividends where the company recipient of the dividends owns directly a substantial holding in the company paying the dividends, the relevant commentaries of the OECD Committee on Fiscal Affairs notes: ". . . A lower rate (5 percent) is expressly provided in respect of dividends paid by a subsidiary company to its parent company. If a company of one of the States owns directly a holding of at least 25 percent in a company of the other State, it is reasonable that payments of profits by the subsidiary to the foreign parent company should be taxed less heavily to avoid recurrent taxation and to facilitate international investment . . ." 3 According to the above commentaries, a more preferential tax rate on dividends is justified in order to avoid or mitigate economic double taxation, i.e., the simultaneous taxation of the company's profits at the level of the company and of the dividends at the level of the shareholder, and in order to facilitate international investment, since a more preferential tax rate on dividends becomes an incentive to direct or substantial investors as against "portfolio" investors. The more preferential tax rate clearly intends to cover dividends declared by Precision-Manila and Precision-Cebu in favor of Mitsubishi . The increased control and ownership in direct or substantial investments translates to a business relationship that facilitates cross-border transactions and transfers of technology among other things that provide broader economic benefits to the subsidiary's state of residence. In view of all the foregoing, this Office is of the opinion and so holds that dividends declared by Precision-Manila and Precision-Cebu on the dates of declaration at issue and onwards in favor of Mitsubishi are subject to 10 percent income tax. ( BIR Ruling No. ITAD-93-03 dated July 15, 2003 ) 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, (SGD.) MILAGROS V. REGALADO Assistant Commissioner, Legal Service Footnotes 1. Income Tax Treaties of the United States, Peter H. Blessing, c. 1996, p. 921. 2. Article 1548. Eviction shall take place whenever by a final judgment based on a right prior to the sale or an act imputable to the vendor, the vendee is deprived of the whole or of a part of the thing purchased. The vendor shall answer for the eviction even though nothing has been said in the contract on the subject. The contracting parties, however, may increase, diminish. (The Civil Code) 3. Model Tax Convention on Income and on Capital (Updated as of 29 April 2000), OECD Committee on Fiscal Affairs, Chapter 10, p. 3, paragraph 10.