ITAD Ruling No. 159-03

October 20, 2003 ITAD RULING NO. 159-03 Articles 5 and 7 Philippines-United Kingdom Tax Treaty Punongbayan & Araullo Ernst & Young International 20th Floor, Tower 1 6766 Ayala Avenue, 1200 Makati City Attention: Atty. Romeo H. Duran Tax Principal Gentlemen : This refers to your letter dated July 23, 2002 requesting confirmation of your opinion that income derived by ABN Amro Bank, Inc. (AAB Manila) from financial derivative 1 transactions shall be treated as ordinary income subject to thirty-two percent (32%) regular corporate income tax, and that derived by ABN Amro Bank NV London (AAB London) from similar transactions shall be exempt from corporate income tax pursuant to the Permanent Establishment and Business Profits articles of the Philippines-United Kingdom tax treaty. It is represented that AAB Manila is a corporation organized and existing under the laws of the Philippines with principal address at 17th Floor, LKG Tower, 6801 Ayala Avenue, Makati City, and that it is a wholly-owned subsidiary of ABN Amro Bank NV (ABN Amro Bank) , a company organized and existing under the laws of the Netherlands; that AAB London is a branch in the United Kingdom of ABN Amro Bank , with principal address at 250 Bishopsgate, London, EC2M 4AA, England; that, presently, ABN Amro Bank operates its financial derivative trading business in Asia through a centralized trading hub in Singapore; that financial derivative traders in Singapore trade on behalf of clients in Singapore and on behalf of clients in a number of other (remote) Asian locations; that the local booking name for each of these remote locations (India, Korea, Malaysia, Taiwan and Thailand) is reflected in the documentation related to transactions undertaken by and between the traders and the counterparties; that, recently, it was proposed that AAB Manila will be added as a new remote location; that, pursuant thereto, AAB Manila will enter into the following transactions: 1. Peso denominated transaction a. Transaction 1 . AAB Manila , and customers and other onshore interbank counterparties will enter into a swap agreement. This transaction will remain in the books of AAB Manila . AAB Manila will be responsible for all profits and losses arising from these positions, including any losses due to credit default or impairment. In the event that the transaction includes non-local currency element, for example, a cross currency swap, AAB Manila may wish to consider hedging part of that currency risk on a portfolio basis. b. Transaction 2 . To hedge the above transactions arising on the portfolio, AAB Manila may enter into swap agreement with AAB London . cHAaCE c. Transaction 3 . AAB Manila will reimburse both ABN Amro Singapore (AAB Singapore) on a cost plus 10 percent basis for trader time and any marketer time (since AAB Singapore will be the hub), as well as AAB London on a cost plus 10 percent basis for bank office costs. 2. Non-peso denominated transaction (Back-to-back booking method) a. Transaction 1 . AAB Manila enters into a swap arrangement with a counterparty/customer. b. Transaction 2 . The above transaction is mirror booked from AAB Manila to AAB London. 3. Direct booking to AAB London a. Transaction 1 . The customer/counterparty in the Philippines enters into a suitable derivatives agreement directly with AAB London . AAB Manila , where involved, acts as a marketer between the customer/counterparty and AAB London . b. Transaction 2 . In the event that AAB Manila acts as a marketer, AAB London pays AAB Manila regulatory fees. In view of the foregoing, you request confirmation that income derived by AAB Manila from such transactions (namely, interest rate swaps and currency swaps) shall be treated as ordinary income subject to 32% regular corporate income tax, and that income derived by AAB London from the same transactions shall be exempt from corporate income tax pursuant to the Permanent Establishment and Business Profits articles of the Philippines-United Kingdom tax treaty. In reply, it is important to take into account first the concept of swaps as an agreement between two companies to exchange cash flows in the future. The agreement defines the dates when the cash flows are to be paid and the way in which they are to be calculated. Usually, the calculation of the cash flows involves the future values of one or more market variables. 2 In an interest rate swap, a counterparty agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional principal 3 for a number of years. In return, it receives interest at a floating rate 4 on the same notional principal for the same period of time. Banks (such as AAB Manila and AAB London ) and other financial institutions derive income from interest rate swaps by way of acting as an intermediary between two counterparties (in most instances non-financial companies) in a swap ( i.e. offsetting ), or by way of them (banks or other financial institutions) entering into a swap with a counterparty without necessarily offsetting the risks of the swap by entering into another swap with another counterparty ( i.e. , warehousing ). The bank enters into a contract with a counterparty or counterparties, which calls for the bank to exchange interest payments (fixed for floating, and vice versa) with a counterparty or counterparties. 5 On the other hand, a currency swap involves exchanging principal and interest payments in one currency for principal and interest payments in another currency. A currency swap agreement requires the principal to be specified in each of the two currencies. The principal amounts are usually exchanged at the beginning and at the end of the life of the swap. Usually, the principal amounts are chosen to be approximately equivalent, using the exchange rate at the swap's initiation. Similar with an offsetting transaction involving interest rate swaps, banks and other financial institutions derive income from currency swaps by way of acting as an intermediary between two counterparties (in most instances non-financial companies) in a swap. The bank enters into a contract with the counterparties, which calls for the bank to transform the interest rate in one currency of one counterparty to the interest rate in another currency if the other counterparty, and vice versa. 6 Generally, interest rate swaps and currency swaps are transactions entered into by banks and financial institutions when they perform a function known in international finance as hedging . 7 Banks perform a number of functions in international finance, but three functions have been distinguished as the important basic services rendered in this field, namely, the transfer function ( i.e. , facilitating payments in foreign currencies), the credit function ( i.e. , granting of loans and upgrading of credit), and the hedging function (covering risks related to future fluctuations in interest rates and foreign exchange). 8 Based on the above, income derived by AAB Manila from interest rate swaps and currency swaps is subject to either 10 percent final income tax or 32 percent corporate income tax depending on the denomination of the transactions. The income is subject to 10 percent if it pertains to AAB Manila 's foreign currency transactions (interest income, bank charges, commissions, service fees, and net foreign exchange transaction gains), and to 32 percent 10 in all other cases. On the part of AAB London , its income from interest rate swaps and currency swaps are business profits covered by paragraph 1 of the Business Profits article of the Philippines-United Kingdom tax treaty, which provides: "The profits of an enterprise of a Contracting State shall be taxable only in the State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is directly or indirectly attributable to that permanent establishment." SaDICE In effect, based on the above-quoted provision, income derived by AAB London from interest rate swaps and currency swaps, being in the nature of business profits, are exempt from Philippine income tax if they are not attributable to a permanent establishment which AAB London may have in the Philippines. Paragraphs 1 and 2, Permanent Establishment article of the same tax treaty defines a permanent establishment as a fixed place of business in which the business of the enterprise is wholly or partly carried on (e.g., a place of management, branch, an office, a factory, a workshop). While AAB London does not have fixed place of business (e.g., a branch) in the Philippines, paragraph 5 of the same article, however, treats as a permanent establishment of AAB London "a person who acts on its behalf (other than an agent of an independent status and who has, and habitually exercises, an authority to conclude contracts in its name." Paragraph 5 (the Agency Rule ) is intended to extend the scope of permanent establishment beyond fixed places of business as when the transaction belong economically to principal's business operation rather than to the agent's business operations. If a principal can be sued for its agent's actions in a Contracting State, then the principal's participation in the economic life of the host of the State may be considered sufficient to warrant taxation by that State. 11 By referring to a person who acts on behalf of another person and who has an authority to conclude contracts in that other person's name, the Agency Rule seems to refer one who would considered an agent under Article 1868 (and subsequent articles) of the Civil Code of the Philippines which states: "By the contract of agency a person binds himself to render some services or to do something in representation or on behalf of another, with consent or authority of the latter." Article 1868 defines the contract of agency. Agency is a relationship which implies a power in agent to contract with a third person on behalf of a principal. It is this power to effect the principal's contractual relations with third persons that differentiates an agent from an employee, a servant, or an independent contractor. Where an agency exists, the relationship of the third party with whom the agent has contracted, to the principal, is the same as that in a contract in which there is no agent. Since an agent's contract is not his own but his principal's third party liability on such contract is to the principal and not to the agent, and liability to such third party is enforceable against the principal, not the agent. Normally, the agent has neither rights nor liabilities as against the third party. He cannot sue or be sued on the contract. 12 Under the typical offsetting transaction where AAB Manila, after entering into a swap contract with a counterparty, subsequently enters into another swap contract with AAB London to offset the risk on the first swap, AAB Manila actually plays the role of an intermediary between the counterparty and AAB London . These contracts call for AAB Manila to exchange interest payments with the counterparty and AAB London . In most instances, the counterparty will not even know that AAB Manila has entered into an offsetting swap with AAB London , and vice versa. If one of the parties (the counterparty and AAB London ) defaults, AAB Manila still has to honor its contract with the other party. In this transaction, it is evident that AAB Manila does not become an agent of AAB London . AAB Manila 's contract is with the counterparty and not with AAB London ; the counterparty's liability on such contract is to AAB Manila and not to AAB London, and the counterparty's rights are enforceable against AAB Manila, not against AAB London. However, where AAB Manila acts as a marker ( i.e. a broker or middleman employed to make bargains and contracts between other persons, in matters of trade, commerce, or navigation, for a compensation) in a swap contract entered into by a counterparty and AAB London, this could give rise to an agency if the following essential elements of agency 13 are present: (a) There is consent express or implied, in this case, by AAB Manila and AAB London to establish the relationships; (b) The object is the execution of a juridical act in relation to the counterparty; (c) AAB Manila acts merely as representative of AAB London, and not for its own favor; (d) AAB Manila acts within the scope of the authority given it by AAB London. Even if deemed an agent under the Civil Code, AAB Manila would only constitute a permanent establishment of AAB London if AAB Manila habitually exercises and authority to conclude contracts on behalf of AAB London . Where a permanent establishment does not exist, income derived by AAB London, from interest rate swaps and currency swaps it entered into with counterparties are exempt from Philippine income tax, in accordance with paragraph , Business Profits article of the Philippines-United Kingdom tax treaty. On the other hand, where the relationship between AAB London and AAB Manila as explained above would permit for a permanent establishment to exist, AAB London shall deemed a nonresident foreign corporation and income it derived from such swaps shall be subject to 32 percent income tax at gross. 14 ( BIR Ruling Nos. ITAD 182-00 dated December 26, 2000 and 193-02 dated October 29, 2002 ) This ruling is issued based 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. ICTacD Very truly yours, (SGD.) MILAGROS V. REGALADO Assistant Commissioner, Legal Service Footnotes 1. Derivatives may be thought of as any financial instrument other than traditional debt and equity securities. The term refers to the fact that many derivatives such as equity options and equity and interest rate swaps can be said to "derive" from traditional equity and debt securities. (Income Tax Treaties of the United States, Peter H. Blessing, 1996, pp. [10]-105-107.) 2. Fundamentals of Futures and Options, 4th Edition, John C. Hall, 2000, pp. 133155. 3. In most instances, interest rates swapped (fixed for floating rate, and vice versa) have equivalent principals. In an interest rate swap, the counterparties exchange only the interest rates and not the principals; this is why it is termed the notional principal. (Ibid.) 4. The floating rate is the actual rate at the date of payment of such interest which varies from time to time for every payment period. The floating rate in many interest rate swap agreements is the London Interbank Offer rate (LIBOR) , the rate of interest offered by banks on deposits from other banks in Eurocurrency markets. One-month LIBOR is the rate offered on one-month deposits, three-month LIBOR is the rate offered on three-month deposits, and so on. LIBOR rates are determined by trading between banks and change frequently so that the supply of funds in the interbank market equals the demand for funds in that market. Just as prime rate is often the reference of rate of interest for floating-rate loans in the domestic financial market, LIBOR is a reference rate of interest for loans in international financial markets. ( Ibid. ) 5. Ibid. 6. Ibid. 7. Hedge v.t. to enclose with a hedge; to obstruct; to surround; to protect oneself from loss on, by compensatory transactions. ( The Wordsworth Concise English Dictionary, 1994 ) . 8. International Finance, Charles N. Henning, 1958, pp. 1112. 9. Section 27(D)(3), National Internal Revenue Code of 1997 ; and, Sections 2.27 and 2.28, Revenue Regulations 1098. 10. Section 27(A), National Internal Revenue Code of 1997. 11. Income Tax Treaties of the United States, Peter H. Blessing, 1996, pp. [3]-5152. 12. Comments and Cases on Partnership, Agency, and Trusts, 5th Edition, Hector S. de Leon and Hector M. de Leon, Jr.,1999, pp. 350351 . 13. Ibid . 14. Section 28(B)(1), National Internal Revenue Code of 1997.