ITAD Ruling No. 160-05

December 16, 2005 ITAD RULING NO. 160-05 Articles 11 (Interest), 13 (Capital Gains) and 22 (Other Income) Philippines-France tax treaty BIR Ruling No. DA-ITAD 160-05 Bayer Philippines, Inc . Canlubang Industrial Estate Calamba, Laguna 4028 Attention: Ms. Eva Marlene B. Villena Finance and Accounting Manager Mr. Homer T. Soniega Tax Supervisor Gentlemen : This refers to your letter dated August 16, 2004 requesting confirmation that any penalty charges for late payment due to Bayer CropScience SA (Bayer CS France) (formerly, Aventis CropScience SA ) from the sale of its shares of stock in Bayer CropScience, Inc. (Bayer CS Philippines) to Bayer Philippines, Inc. (Bayer Philippines) are not subject to final withholding tax pursuant to Article 11 (Interest) of the Convention between the Government of the Republic of the Philippines and the Government of the French Republic for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (Philippines-France tax treaty). It is represented that Bayer CS France is a foreign corporation, organized and existing under the laws of France, with registered office at 16, rue Jean-Marie Leclair 69006 Lyon, France, as confirmed by its updated Articles of Association of October 9, 2003; that Bayer CS France's business activities are, among others, the manufacture, purchase, packaging and sale of agriculture related products, in particular chemical products and their derivatives, and by-products of agricultural, veterinary or household nature, and those relating to public health; that, on the other hand, Bayer CS Philippines and Bayer Philippines are domestic corporations, organized and existing under the laws of the Philippines, with the same registered office at Bayer House, Canlubang Industrial Estate, Calamba, Laguna 4028, Philippines; that Bayer CS Philippines' business activities are manufacturing, processing, buying, selling, importing and exporting all types of agricultural and environmental health related chemicals, and Bayer Philippines' business activities are the manufacture, sale, importation and exportation of chemical, medicinal, pharmaceutical and biological products; that on November 10, 2003, Bayer CS France entered into a Stock Purchase Agreement (Agreement) with Bayer Philippines whereby Bayer CS France sold, assigned and transferred to Bayer Philippines all its 2,700 shares of stock in Bayer CS Philippines with a nominal value of PHP 1,000 each; that under the Agreement, Bayer Philippines agreed to pay Bayer CS France 2,500,000 Euros (PHP 160,362,500.00) in consideration for the transfer of the subject shares of stock and this amount shall be due for payment on the effective date of the Agreement on November 10, 2003 and in case of delay this amount shall carry interest (penalty charges) as from that date at the applicable Bayer intra-group cash polling interest rates; and that pursuant to Certification No. ITAD SN-CGT-04-001 dated January 20, 2004, the above sale, assignment and transfer by Bayer CS France of its shares in Bayer CS Philippines to Bayer Philippines is not subject to capital gains tax under Article 13 (Capital Gains) of the Philippines-France tax treaty but subject to documentary stamp tax at the amount of PHP 20,250.00. EaICAD Relative thereto, you are of the opinion that the penalty charges are not subject to 15 percent income tax on interest under Article 11 of the Philippines-France tax treaty because this article does not cover thereunder penalty charges for late payments like those to be paid by Bayer Philippines to Bayer CS France ,and that the penalty charges are exempt from capital gains tax pursuant to Certification No. ITAD SN-CGT-04-001. tax06cd In reply please be informed as follows. With respect to the first part of your opinion, we agree that the penalty charges are not subject to 15 percent income tax on interest under Article 11 of the Philippines-France tax treaty because this article in the first place does not cover thereunder as interest, penalty charges for late payments like those to be paid by Bayer Philippines to Bayer CS France ,to wit: "Article 11 INTEREST xxx xxx xxx 4. The term "interest " as used in this Article means income from debt claims of every kind, whether or not secured by mortgage, and whether or not carrying a right to participate in the debtor's profits, and in particular, income from government securities and income from bonds or debentures, including premiums and prizes attaching to bonds or debentures. Penalty changes for late payment shall not be regarded as interest for the purpose of this Article .(Emphasis supplied) xxx xxx xxx" With respect to the second part of your opinion, however, we do not agree that the penalty charges are exempt from capital gains tax pursuant to Certification No. ITAD SN-CGT-04-001. As mentioned previously, the Certification ruled that the above sale, assignment and transfer by Bayer CS France of its shares in Bayer CS Philippines to Bayer Philippines is not subject to capital gains tax under Article 13 of the Philippines-France tax treaty which provides: "Article 13 CAPITAL GAINS 1. Gains from the alienation of immovable property, as defined in paragraph 2 of Article 6 or from the alienation of shares or comparable interest in a real property cooperative or in a company the assets of which consist principally of immovable property, may be taxed in the Contracting State in which such property is situated. (Emphasis supplied) xxx xxx xxx" While the term "gains or capital gains from the alienation of shares" as used in paragraph 1 above may serve as a catch-all phrase to cover any income or gains relating to the alienation of shares of a company, whether directly or merely incidental, the relevant commentary by the Organization for Economic Cooperation and Development (OECD) on the subject matter suggests "that the domestic law of the State concerned shall be taken into account in computing such gains or capital gains," thus: "The Article does not specify how to compute a capital gain, this being left to the domestic law applicable. As a rule, capital gains are calculated by deducting the cost from the selling price. To arrive at cost all expenses incidental to the purchase and all expenditure for improvements are added to the purchase price ..." Likewise, the commentary notes that such gains or capital gains are calculated by deducting the cost of the property from its selling price. Under Section 28(B)(5)(c) of the National Internal Revenue Code of 1997 (Tax Code), the basis or amount upon which the capital gains tax is imposed on the sale of shares of stock of a company not traded through a local stock exchange by a nonresident foreign corporation (like the subject shares in Bayer CS Philippines sold by Bayer CS France to Bayer Philippines ) is the "net capital gain" derived from the sale, to wit: "SEC. 28. Rates of Income Tax on Foreign Corporation . xxx xxx xxx (B) Tax on Nonresident Foreign Corporation . xxx xxx xxx (5) Tax on Certain Incomes Received by a Nonresident Foreign Corporation . xxx xxx xxx (c) Capital Gains from sale of Shares of Stock not traded in the Stock Exchange . A final tax at the rates prescribed below is hereby imposed upon the net capital gains realized during the taxable year from the sale, barter, exchange or other disposition of shares of stock in a domestic corporation, except shares sold, or disposed of through the stock exchange: Not over P100,000 5% On any amount in excess of P100,000 10%" The same basis or amount is used when the shares of stock not traded through a local stock exchange is sold by a citizen of the Philippines, a resident alien, a nonresident alien engaged in trade or business in the Philippines, a domestic corporation, and a resident foreign corporation, under Sections 24(C), 27(D)(2), 28(A)(7)(c) of the Tax Code. The term "net capital gain", as defined in Section 39(A)(2) of the Tax Code, means "the excess of the gains from sales or exchanges of capital assets over the losses from such sales or exchanges." In the case of net capital gain from the sale of shares of stock not traded through a local stock exchange, the net capital gain is computed basically by deducting the acquisition cost of the shares from its gross selling price, 1 similar with the rule suggested in the OECD commentary above. Thus for Bayer CS France ,its net capital gain on the sale is PHP 157,662,500.00, after deducting the acquisition cost of the shares (PHP 2,700,000) from its gross selling price (PHP 160,362,500.00).This net capital gain, being income or gain that is directly connected to the sale of the shares, has been ruled exempt from capital grins tax under Certification No. ITAD SN-CGT-04-001 pursuant to paragraph 1, Article 13 of the Philippines-France tax treaty. On the question as to whether or not penalty charges to be paid by Bayer Philippines to Bayer CS France on the sale of the shares of stock in Bayer CS Philippines are exempt from capital gains tax pursuant to the Certification, it is very clear that the penalty charges, being income or gain that is merely incidental to the sale, are not readily or subsequently exempt. In keeping with the formula envisaged in the OECD commentary and in the Tax Code for computing capital gains from the alienation of shares not traded through a local stock exchange, the penalty charges did not form part of the gross selling price of the shares at the time of their alienation, which if included would otherwise increase the net capital gain due to Bayer CS France and accordingly the capital gains tax due thereon. Excluding penalty charges from the gross selling price of the shares at the time of the alienation is understandable considering that the imposition of the penalty charges cannot be warranted unless Bayer Philippines delays in fulfilling its obligations to Bayer CS France of paying the purchase price for the shares that was due on the effective date of the Stock Purchase Agreement. Likewise, determining the exact amount of the penalty charges at the time of the effective date of the Agreement is not possible because the number of days delayed and the applicable Bayer intra-group cash polling interest rates are not determined yet at that time. In fine, for treaty characterization purposes, penalty charges are not considered as interest or as capital gains governed by the provisions of Articles 11 and 13 of the Philippines-France tax treaty; the taxation of the penalty charges is now left to Article 22 of the tax treaty, which provides: "Article 22 OTHER INCOME 1. Items of income of a resident of a Contracting State, wherever arising, not dealt with in the foregoing Articles of this Convention shall be taxable only in that Contracting State. However, if such income is derived from sources within the other Contracting State, it may also be taxed in accordance with the law of that other State. xxx xxx xxx" Under paragraph 1, the penalty charges, being income not dealt with in the foregoing Articles 6 to 21 2 of the Philippines-France tax treaty, may be taxed in accordance with the law of the Philippines where the penalty charges arise. As to the income tax rate applicable to the penalty charges, the penalty charges are subject to thirty-two percent (32%) 3 income tax based on the gross amount thereof as imposed on a nonresident foreign corporation under Section 28(B)(1) of the Tax Code, as implemented by Section 2.57-1(I)(1) of Revenue Regulations 2-98 (Implementing Republic Act No. 8424, "An Act Amending the National Internal Revenue Code, as Amended" Relative to the Withholding on Income Subject to the Expanded Withholding Tax and Final Withholding Tax, Withholding of Income Tax on Compensation, Withholding of Creditable Value-Added Tax and Other Percentage Taxes), to wit: "SEC. 28. Rates of Income tax on Foreign Corporation . xxx xxx xxx (B) Tax on Nonresident Foreign Corporation . (1) In General . Except as otherwise provided in this code, a foreign corporation not engaged in trade or business in the Philippines shall pay a tax equal to thirty-five percent (35%) of the gross income received during each taxable year from all sources within the Philippines, . . . Provided, . . . and, effective January 1, 2000 and thereafter, the rate shall be thirty-two percent (32%)." xxx xxx xxx" "SEC. 2.57-1 Income Payments Subject to Final Withholding Tax The following forms of income shall be subject to final withholding tax at the rates herein specified: xxx xxx xxx (I) Income Derived From all Sources Within the Philippines by Non-Resident Foreign Corporation The following shall be subject to final withholding tax based on the gross amount of income and at the rate of tax prescribed therefor: (1) In General . On gross income derived from all sources within the Philippines. .. at the following rates: xxx xxx xxx 32% beginning January 1, 2000 and thereafter xxx xxx xxx" Finally, on the question whether the penalty charges are subject to ten percent (10%) value-added tax (VAT), Section 105 of the Tax Code provides that "any person who, in the course of trade or business, sells, barters, exchanges, leases goods or properties, renders services, and any person who imports goods shall be subject to VAT." For transactions involving the sale of goods or personal properties to be subject to VAT (to which the sale of shares of stock in Bayer CS Philippines might be closely categorized thereunder),Section 105 defines the phrase "in the course of trade or business" as "the regular conduct or pursuit of a commercial or economic activity including transactions incidental thereto ..." On account that the sale of the shares by Bayer CS France was not part of its regular conduct or pursuit of a commercial or economic activity (as described in the above representations) and the sale being a one-time transaction only on the part of Bayer CS France ,the subject sale, in particular any income or gain arising therefrom including the penalty charges, is therefore exempt from VAT. cESDCa Very truly yours, (SGD.) JOSE MARIO C BUNAG Commissioner of Internal Revenue Footnotes 1. The Law on Income Taxation Ninth Edition, Copyright 1998, Benjamin D. Teodoro and Hector S. de Leon, Pages 268-269. 2. Articles 6 (Income from Immovable Property),7 (Business Profits),8 (Shipping and Air Transport),9 (Associated Enterprise),10 (Dividends),11 (Interest),12 (Royalties),13 (Capital Gains),14 (Independent Personal Services),15 (Dependent Personal Services),16 (Directors' Fees),17 (Artistes and Athletes),18 (Pensions),19 (Government Service),20 (Students) and 21 (Teachers and Researchers) 3. Republic Act No. 9337 (An Act Amending Sections 27, 28, 34, 106, 107, 108, 109, 110, 111, 112, 113, 114, 116, 117, 119, 121, 148, 151, 151, 236, 237 And 288 Of The National Internal Revenue Code Of 1997, As Amended, And For Other Purposes), which was signed into law on May 24, 2005, increases the income tax rate on a nonresident foreign corporation to thirty-five percent (35%), thus: "SEC. 28. Rates of Income Tax on Foreign Corporations. xxx xxx xxx (B) Tax on Nonresident Foreign Corporation. (1) In General . Except as otherwise provided in this Code, a foreign corporation not engaged in trade or business in the Philippines shall pay a tax equal to thirty-five percent (35%) of the gross income received during each taxable year from all sources within the Philippines, such as interests, dividends, rents, royalties, salaries, premiums (except reinsurance premiums), annuities, emoluments or other fixed or determinable annual, periodic or casual gains, profits and income, and capital gains, except capital gains subject to tax under subparagraph 5(c): Provided, That effective January 1, 2009, the rate of income tax shall be thirty percent (30%) xxx xxx xxx"