ITAD Ruling No. 136-03

August 29, 2003 ITAD RULING NO. 136-03 Articles 5, 8, & 13 of the RP-US Tax Treaty BIR Ruling No. 39-03 Sycip Gorres Velayo & Co. 6760 Ayala Avenue 1226 Makati City Attention: Cirilo P. Noel Tax Division Gentlemen : This refers to your letter dated October 15, 2001, requesting confirmation of your opinion that: 1) Educational Testing Service (ETS) does not have a permanent establishment in the Philippines in accordance with the provisions of the RP-US tax treaty; 2) Without a permanent establishment, ETS is not subject to Philippine income tax on the business profits or income derived from its sale of services; and 3) The service fees derived by ETS from the Philippines are not subject to the 10% value-added tax (VAT). It is represented that ETS is a non-profit corporation duly organized and existing under the laws of the United States with office address at Princeton, New Jersey, USA; that ETS has devoted considerable resources to developing tests over a number of years; all of this research and development has been performed in the US; that ETS is now internationally recognized as the leader in the field of educational testing including test development, methodology and scoring; that all tests are scored by ETS in the US using methods and technology devised in the US; that ETS has no personnel, property, offices, or other places of business outside the US; that the services rendered by ETS include the qualifying of applicants to take the following examinations at different authorized testing centers and the evaluation of test results: a) Graduate Record Examinations (GRE) which are taken by individuals applying in graduate schools, b) Graduate Management Admission Test (GMAT) which is designed to help graduate schools of business assess the qualifications of applicants for advanced study in business and management, and c) Test of English as a Foreign Language (TOEFL) which is required by colleges and universities for admission purposes. that ETS has developed and owns the rights to the GRE and TOEFL tests, and the GMAT tests are copyrighted to GMAC; that currently, ETS is offering two formats of tests, the paper and pencil, and the computer based test (CBT) outside the US; that the arrangements for test administration depends on the format of the test: For Computer Based Testing (CBT) : As ETS does not have the resources itself to manage and operate the international CBT test centers, it has contracted with an independent third party corporation incorporated in the US ("the Contractor"), to fulfill this function throughout the world. The Contractor has contracted with a second entity established in the Netherlands ("Sub-contractor BV") to administer the CBT tests outside the US. In order for its CBT to be administered by the Contractor, ETS transmits an item bank of computerized test questions to the Contractor. In turn, the Contractor transmits the tests to local test centers, or in the case the test files are too large (re: TOEFL), a secured CD-ROM is hand delivered or shipped to the test centers. In the Philippines, the examinees who wish to take an ETS test in CBT format contact a regional registration center (RRC) in Malaysia which advises the candidate which test center to attend and on what date. The RRC is a branch of a subsidiary of Sub-contractor BV. Sub-contractor BV contracted with the following independent entities (IE), which provide the testing and administer the CBT tests in: Manila Ateneo Professional School of the Ateneo de Manila University Cebu City TREAD Inc. For Paper and Pencil : ETS contracts directly with independent entities, which provide the testing facilities and administer the paper and pencil tests. These include: Cagayan de Oro City Xavier University Davao City Ateneo de Davao University Baguio and Quezon City University of the Philippines Cebu City University of San Carlos Iloilo Central Philippines University Dumaguete Silliman University these testing centers are non-stock, non-profit educational institutions organized and existing under and by virtue of Philippine laws; that payments for the international tests are generally made in the form of credit card or check sent to ETS (through the RRC in the case of CBT); that checks are made payable to ETS or more usually to an ETS program (such as ETS-TOEFL), ETS deposits them in its US bank account; that in the case of payment by credit card, receipts and statements of the test candidates indicate either the name of ETS or one of its programs as the vendor; that settlement of credit card payments takes place in the US; that ETS assumes all credit risk and if payment is made in cash, it is remitted to ETS without any deductions; that upon payment of the CBT fees, the RRC issues to the examinee an appointment confirmation number, the test date and the test center address in the Philippines; that the candidates can order the test preparation materials directly from ETS in the US or from the National Book Store; that the functions and features of the independent entities are as follows: cECaHA 1) The independent entities provide the test centers and facilities. 2) On the scheduled testing date, the independent entity will administer the test to the examinee upon presentation of his appointment confirmation number and identification documents. 3) The independent entities will not have the power to contractually bind ETS (or the Contractor, or Sub-contractor BV) in any manner. 4) The Philippine examinees will effectively transact with ETS. 5) Upon completion of the test, the electronic files (for the CBT) or test booklets (for the paper based tests) of the examinees' answers are sent to ETS in the US. 6) The independent entities neither receive nor collect money from the examinees. that ETS performs the official scoring in the US and mails from the US the score report directly to the examinees or the colleges as requested by the examinees; that additional score reports are also furnished by ETS from the US as requested by the examinees; that any special test accommodations are processed and approved by ETS in the US; that for the services rendered in the administration of the examination, the independent entities receive fees from Sub-contractor BV; that the business profits derived by ETS are in payment for services performed abroad which relate to educational testing and include test design and development and, most importantly scoring; that upon completion of the test, the electronic files (for the CBT) or test booklets (for the paper based tests) of the examinees are sent to ETS in the US to mark and issue score reports to the examinees or colleges as appropriate; that ETS performs all its activities in the US. In reply, please be informed of this Office's ruling on the issues raised are as follows: 1. The service fees are not in the nature of royalties . Article 13 of the RP-US tax treaty provides that: "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." 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. An examination of the records satisfies us that far be it from a comedy of errors, In all these undertakings, Unilever Ltd., (payee) does not have interest or right to whatever is the result of services performed. The results of all of these services, and the products manufactured by PRC (payor) to which these are integrated are owned by PRC. Unilever has no interest or right to them." In the instant case, the payment for services performed abroad which relates to educational testing and includes test design and development and scoring are not within the definition of "royalties" under Article 13 of RP-US tax treaty. Specifically, nothing in the arrangement would require transfer into the Philippines of technology, equipment or other property where the payee has proprietary interest or would otherwise permit ETS to impart to the IE their special knowledge and experience which remain unrevealed to the public. It is also noteworthy that ETS does not have interest or right to whatever is the result of the services performed. Therefore, the payments received by ETS from the examinees cannot be considered royalties but are in the nature of business profits arising from services rendered abroad and, as such, are derived from sources outside the Philippines. 2. The service fees are business profits not subject to Philippine taxation . Article 8 of the RP-US tax treaty states: "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. "xxx xxx xxx." In relation thereto, Article 5 of the same tax treaty provides: "Article 5 "PERMANENT ESTABLISHMENT "1. For the purposes of this Convention, the term "permanent establishment" means a fixed place of business through which a resident of one of the Contracting States engages in a trade or business. "2. . . . j) The furnishing of services, including consultancy services, by a resident of one of the Contracting States 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." It is clear from the above-quoted provisions that if a corporation which is a resident of US does not carry on business in the Philippines through a permanent establishment situated therein, the profits of that corporation shall not be subject to Philippine tax. For this purpose, a corporation which is a resident of US may be deemed to have a permanent establishment in the Philippines if, among others, the furnishing of services through its employees continue (for the same or a connected project) within the Philippines for a period or periods aggregating more than 183 days. As represented, ETS performs all its activities in the US and does not have any personal property or offices in the Philippines. It is also important to note that the IEs do not have the power to contractually bind ETS, and are not devoted wholly or exclusively to ETS because the activities of these testing centers are not limited to administering the tests of ETS. The activities of the test centers merely facilitate and are ancillary to the educational testing services provided by ETS. The testing centers have the freedom and autonomy to carry out its educational activities without any immediate interference or control from ETS. The testing centers remain free to engage in other activities with other parties. Thus, the testing centers which are made available by the IEs are not dependent agents of ETS, they merely provide services to ETS in return for fees. In view of all the above, this Office is of the opinion and so holds that the payments by the examinees to ETS are not subject to Philippine income tax pursuant to Article 8 in relation to Article 5 of the RP-US tax treaty. Furthermore, the service fees are not subject to the 10% VAT since these are services performed outside of the Philippines. ( BIR Ruling No. DA-ITAD 39-03 dated March 4, 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. AEHCDa Very truly yours, Commissioner of Internal Revenue By: (SGD.) MILAGROS V. REGALADO Assistant Commissioner, Legal Service