ITAD Ruling No. 136-04

November 24, 2004 ITAD RULING NO. 136-04 Article 13 (Royalties) Philippines-United States of America tax treaty BIR Ruling No. DA-ITAD 28-04 Romulo Mabanta Buenaventura Sayoc & De Los Angeles Attorneys At Law 30th Floor, Citibank Tower Citibank Plaza 8741 Paseo de Roxas Makati City Attention: Atty. Priscilla B. Valer Gentlemen : This refers to your letter dated October 12, 2004 addressed to Mr. Nestor Valeroso (Regional Director, Bureau of Internal Revenue, Revenue Region No. 7 Quezon City) and endorsed to the International Tax Affairs Division of this Bureau for the resolution of the issue of the applicability of the 15 percent income tax rate on royalties to be paid by IBM Services Delivery, Inc. (IBM Philippines) to IBM World Trade Corporation (IBM U.S.A.) pursuant to the pertinent provision of the Philippines-United States of America (U.S.A.) tax treaty. It is represented that IBM U.S.A. is a nonresident foreign corporation organized and existing under the laws of the U.S.A. with principal office at New Orchard Road, Armonk, New York, 10504, U.S.A., as confirmed by the relevant Certificate issued by IBM U.S.A. on September 6, 2002 certified by the County Clerk and Clerk of the Supreme Court and County Court of Westchester, Government of the State of New York on September 10, 2002; that IBM U.S.A. is not registered either as a corporation or as a partnership and has not been licensed to engage in business in the Philippines as confirmed by the Certification of Non-Registration issued by the Securities and Exchange Commission on October 14, 2004; that, on the other hand, IBM Philippines (formerly, Center for Information Technology Exponents, Inc .) is a domestic corporation organized and existing under the laws of the Philippines with principal office at 5th Floor, IBM Plaza, No. 8 Eastwood Avenue, Eastwood City, E. Rodriguez Avenue, Libis, Quezon City; that IBM U.S.A and IBM Philippines are both engaged primarily in the business of computers and information technology; that, on December 27, 1999, IBM U.S.A. and IBM Philippines entered into a Marketing Royalty Agreement, where IBM U.S.A. agreed to grant to IBM Philippines the license to use its patents, trademarks, copyrighted materials, know-how, and other forms of intellectual property, 1 which are significant to IBM Philippines ' business of providing computer related services 2 and selling maintenance parts and Vendor Developed Products 3 to third parties; that in consideration, IBM Philippines agreed to pay to IBM U.S.A. royalties based on the former's total gross charges equivalent to (a) four percent (4%) for the provision of services for any Vendor Developed Products (except the provision of maintenance services for any Information Technology Systems Products that are not Vendor Developed Products) and for the provision of maintenance parts for Vendor Developed Products, (b) two percent (2%) for the sale or lease of any Vendor Developed Products bearing an IBM Trademark and for the sale of supplies that do not operate as part of a machine's basic mechanism like recording media (e.g., paper, cards and tapes) and intermediaries between the mechanism and the media (e.g., ribbons), and (c) an undetermined percentage for the provision of maintenance services and maintenance parts for any Information Technology Systems Products other than Vendor Developed Products; that such royalties shall be paid in U.S. dollars within thirty (30) days following the end of each month in which they become due; and that the Agreement took effect on May 1, 1999 with a term of one (1) year and renewable automatically for subsequent one year periods. In reply, please be informed that paragraph 2, Article 13 (Royalties) of the Philippines-U.S.A. tax treaty provides as follows: "Article 13 ROYALTIES "1. Royalties derived by a resident of one of the Contracting States from sources within the other Contracting State may be taxed by both Contracting States. "2. However, the tax imposed by that other Contracting State shall not exceed a) In the case of the United States, 15 percent of the gross amount of the royalties, and b) In the case of the Philippines, the least of: (i) 25 percent of the gross amount of the royalties, (ii) 15 percent of the gross amount of the royalties, where the royalties are paid by a corporation registered with the Philippine Board of Investments and engaged in preferred areas of activities, and (iii) the lowest rate of Philippine tax that may be imposed on royalties of the same kind paid under similar circumstances to a resident of a third State." "xxx xxx xxx" Paragraph 2(b) states that royalties arising in the Philippines and paid to a resident of the U.S.A. may be taxed in the Philippines, but the tax so charged shall not exceed: (a) 25 percent of the gross amount of the royalties in general, (b) 15 percent of the gross amount of the royalties if they are paid by a corporation registered with the Board of Investments and engaged in preferred areas of activities, and (c) the lowest rate of Philippine income tax that may be imposed on royalties of the same kind paid under similar circumstances to a resident of a third State (also known as the most favored-nation tax treatment of royalties). Regarding the most-favored-nation tax treatment of royalties, the Supreme Court, in Commissioner of Internal Revenue vs. S.C. Johnson and Son Inc. and Court of Appeals (G.R. No. 127105 dated June 25, 1999), has cited two conditions for royalties arising in the Philippines and derived by a resident of another country (in this case, the U.S.A.) to be subject to the most-favored-nation tax treatment (in this case, a rate lower than 25 percent) as that granted by the Philippines to a resident of a third country under an existing tax treaty. First, the Court noted that the royalties arising and subject to tax in the Philippines and derived by a resident of the U.S.A. must be of the same nature as those derived by a resident of the third country. Second, the Court stressed that the mechanism for relieving double taxation of income employed by the U.S.A. with respect to royalties arising in the Philippines and derived by a resident of the U.S.A. must be the same with that employed by the third country with respect to royalties arising in the Philippines and derived by a resident of the third country. In looking for existing Philippine tax treaties that provide a most-favored-nation tax treatment of royalties, it is noteworthy to take into account and use as basis the treaties with Denmark, Finland, Malaysia and the United Kingdom of Great Britain and Northern Ireland. Under the article on Royalties of these treaties, royalties in general arising in the Philippines and derived by a resident of each of the countries mentioned are subject to an income tax rate not exceeding 15 percent of the gross amount of the royalties. On the other hand, under the article on Relief from Double Taxation of these treaties, the mechanism for relieving double taxation of income arising in the Philippines and derived by a resident of each of the countries is the ordinary credit method, similar with that of the U.S.A. Under this method, only income taxes actually paid by a resident taxpayer with respect to income derived from foreign sources are allowed as credit against the taxpayer's taxable income subject to certain limitations. Such being the case, this Office is of the opinion and so holds that royalties to be paid by IBM Philippines to IBM U.S.A. for the use by IBM Philippines of IBM U.S.A.'s patents, trademarks, copyrighted materials, know-how, and other forms of intellectual property are subject to 15 percent income tax rate based on the gross amount of the royalties. (BIR Ruling No. DA-ITAD 28-04 dated March 29, 2004) Finally, Section 108(A)[(1) and (3)] of the National Internal Revenue Code of 1997 states that "the lease or the use of or the right or privilege to use any copyright, patent, trademark, or other like property or right" and "the supply of scientific, technical, industrial or commercial knowledge or information"' (like the use by IBM Philippines of IBM U.S.A.'s patents, trademarks, copyrighted materials, know-how, and other forms of intellectual property) fall within the definition of sale or exchange of services subject to ten percent (10%) value-added tax (VAT). Accordingly, the subject royalties to be paid by IBM Philippines to IBM U.S.A. are subject to 10% VAT. (BIR Ruling No. DA-ITAD 28-04 dated March 29, 2004) 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 IBM Philippines , the resident person making the payments, shall be responsible for the withholding of the 10% VAT on such payments before remitting them to IBM U.S.A. , the nonresident person. In remitting to the Bureau of Internal Revenue the VAT withheld on such payments, IBM Philippines shall use BIR Form No. 1600 (Monthly Remittance Return of VAT and Other Percentage Taxes Withheld). If a VAT-registered taxpayer, IBM 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, IBM Philippines may include as part of the cost of the license granted to it by IBM U.S.A. the VAT consequently shifted or passed on to it by IBM U.S.A. and may treat such VAT either as expense or asset , whichever is applicable. In addition, upon IBM U.S.A.'s request, IBM Philippines is required to issue in quadruplicate the relevant Certificate of Final Tax Withheld at Source (BIR Form No. 2306), the first three copies for IBM U.S.A. and the fourth copy for IBM Philippines . 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 Footnotes 1. Intellectual Property shall mean any and all technologies, procedures, processes, designs, inventions, discoveries, know-how, and works of authorship, including without limitation, documentation and all (i) issued patents, utility models, and the like and applications therefore, (ii) copyrights, whether or not registered, and other rights in works of authorship, (iii) mask work rights, (iv) trade secrets, (v) confidential information and any other intellectual property rights constituting, embodied in, or pertaining thereto and, (vi) the right to extract data from databases under current and fixture laws. 2. Services shall mean services such as maintenance services, systems integration, outsourcing, networking services, consultancy, education services and other services. 3. Vendor Developed Products shall mean Information Technology Systems Products developed by parties other than IBM or Subsidiaries thereof (except those Subsidiaries of IBM, or organizations within a Subsidiary of IBM, which are designated by IBM U.S.A. to be treated as vendors for purposes of the Agreement) the marketing of which by IBM Philippines does not require the exercise of a license of IBM Intellectual Property granted herein. Information Technology Systems Products shall mean any instrumentality or aggregate of instrumentalities adapted to compute, classify, process, transmit, receive, retrieve, originate, switch, store, display, manifest, measure, detect, record, reproduce, handle or utilize any form of information, intelligence or data for business, scientific, control or other purposes, including any and all apparatus, parts, documentation and supplies used in the manufacture, marketing or utilization of such instrumentality or aggregate of instrumentalities.