ITAD Ruling No. 158-03

October 17, 2003 ITAD RULING NO. 158-03 Article 11 (Interest) Philippines-Germany tax treaty BIR Ruling No. ITAD 123-02 Sycip Salazar Hernandez & Gatmaitan SSHG Law Centre 105 Paseo de Roxas Makati City Attention: Atty. Emmanuel C. Paras Atty. Mark A. Gutierrez Gentlemen : This refers to your letter dated June 4, 2003 requesting confirmation that interest payments on the credit sale of electronic components made to Nobile AG by Nobile, Inc. are subject to 10 percent income tax pursuant to Article 11 (Interest) of the Philippines-Germany tax treaty. It is represented that Nobile AG is a foreign company engaged in the manufacture and sale of lamps, other custom-made products related to lamps, house accessories, and electronic components; that Nobile AG is organized and existing under the laws of Germany with principal office at Wasserweg 8-10, 60594 Frankfurt, Germany; that Nobile AG is not registered to engage in business in the Philippines as confirmed by the Certificate of Non registration issued by the Securities and Exchange Commission on June 4, 2002; that, on the other hand, Nobile, Inc. is a company organized and existing under the laws of the Philippines with principal office at Victoria Wave Ltd., SEPZ, Malaria Road, Tala, Caloocan City; that Nobile Inc., on a regular basis, purchases certain electronic components such as transistors and capacitors from Nobile AG which Nobile, Inc. utilizes as raw materials in manufacturing transformers and halogen lamps; that Nobile, Inc. purchases these electronic components on credit with additional 5 percent interest based on the total price of the electronic components purchased; that this 5 percent interest, which Nobile AG termed as "handling charges" , is reflected as interest expense in Nobile, Inc. 's financial documents; and that you are of the opinion that the electronic components sold on credit by Nobile AG to Nobile, Inc. are industrial and commercial equipment so that handling charges paid thereon constitute interest subject to 10 percent income tax under Article 11(2)(a)(i) of the Philippines-Germany tax treaty, which provides: "Article 11 INTEREST 1. Interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State. 2. However, such interest may be taxed in the Contracting State in which it arises, and according to the law of that State, but the tax so charged shall not exceed: a) 10 per cent if such interest is paid: (i) in connection with the sale on credit of any industrial, commercial or scientific equipment, or (ii) on any loan of whatever kind granted by a bank, or (iii) in respect of public issues of bonds, debentures or similar obligations, b) 15 per cent of the gross amount of such interest in all other cases. xxx xxx xxx" (emphasis yours) In reply, please be informed that the term "equipment" (industrial, commercial, and scientific alike), to which the electronic components sold on credit by Nobile AG to Nobile, Inc. may be classified as, is not categorically defined in the Philippines-Germany tax treaty. However, Article 3(2) (General Definitions) of the same tax treaty provides that any term not otherwise defined shall have the meaning which it has under the laws of that Contracting State relating to the taxes which are the subject of the tax treaty. In interpreting an undefined term, the Philippines, being the Contracting State that imposes taxes on interest to which term "equipment" 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 1, 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. HTSaEC In giving ordinary meaning to the term "equipment," we wish to cite the meaning given or may have been given to such term by the Webster's dictionary, the Civil Code, and Article 12 (Royalties) of the Philippines-Germany tax treaty. 1. Equipment as machinery or tools. Webster's Third New International Dictionary (copyright 1971) defined "equipment" as "implements (as machinery or tools) used in an operation or activity." The electronic components in question, which are utilized essentially as raw materials and not as machinery or tools in manufacturing transformers and halogen lamps, are not equipment within the meaning of the Webster's dictionary. To make a distinction, equipment, at all stages of production, retain their characteristic as separate objects and do not become part of the (new) object being produced, while raw materials, at a certain stage or stages of production, lose their characteristic as separate objects and eventually become part of the (new) object being produced. In the case of the electronic components in question, it is apparent that they, being merely as raw materials, lose their characteristic as separate objects and eventually become part of the (new) object produced ( i.e. , transformers and halogen lamps) at a certain stage or stages of production; thus they cannot be considered as equipment. 2. Equipment as objects becoming immovable property by destination. Section 5, Article 415 of the Civil Code considers equipment (machinery, instruments, or implements), deemed as movable property in their original state, as becoming immovable when they are placed by the owner of the tenement for an industry or works which may be carried on in a building or on a piece of land, and which tend directly to meet the needs of the said industry or works . Unlike raw materials such as the electronic components in question which are also deemed as movable property in their original state, equipment, defined as implements (as machinery or tools) used in an operation or activity, when attached permanently to an immovable property like lands, buildings, roads, and all kinds of constructions adhered to the soil, consequently become an immovable property. (Machinery & Engineering Supplies, Inc. vs. Court of Appeals, et. al., 96 Phil. 7) 3. Equipment as objects of lease that give rise to royalties. Article 12(3) (Royalties) of the Philippines-Germany tax treaty and all other tax treaties includes as royalties, payments of any kind received as a consideration for the use or the right to use of any industrial, commercial, or scientific equipment. Unlike raw materials such as the electronic components in question, equipment, defined as implements (as machinery or tools) used in an operation or activity, when leased, normally give rise to royalties which in some instances subject to preferential tax treatment. (BIR Ruling Nos. ITAD 149-00, 33-01, 150-02, and 153-02) In view of all the foregoing definitions, there is no instance when the electronic components in question may be put into the same classification as equipment (specifically, industrial and commercial equipment ) so that interest on the sale on credit of such articles may be subject to 10 percent income tax rate under paragraph 2(a)(i), Article 11 of the Philippines-Germany tax treaty. This being the case, pursuant to paragraph 2(b), Article 11 of the tax treaty, interest payments on the credit sale of the subject electronic components made to Nobile AG by Nobile, Inc . are instead subject to 15 percent income tax of the gross amount thereof. ( BIR Ruling No. ITAD 123-02 dated July 17, 2002 ) 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