February 24, 2006

DA ITAD BIR RULING NO. 014-06

Articles 5 (Permanent Establishment), 8 (Business Profits) Philippines-United States of America tax treaty
Regalado Bautista & Menzon Law Offices
Suite 710 City & Land Mega Plaza
ADB Ave. corner Garnet Street
Ortigas, Pasig City
Attention: Atty. Edith Abana-Bautista
Atty. Rhodora Corcuera-Menzon
Gentlemen :
This refers to your letter dated December 20, 2005 requesting confirmation that payments received by
Quality Logic, Inc. (Quality Logic) arising from the sale of its Software Test Product (Software) to Canon
Info Tech-Philippines, Inc. (Canon-Philippines) constitute business income and consequently are subject
to Philippine tax if it is attributable to a permanent establishment within the purview of the Agreement
between the Republic of the Philippines and the United States of America for the Avoidance of Double
Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (Philippines-US tax
treaty). ACTISD
It is represented that Quality Logic is a nonresident foreign corporation, organized and existing under the
laws of the. United States of America, with principal office at 5401 Tech Circle-Moorpark, CA 93021; that
Quality Logic is not registered either as a corporation or as a partnership in the Philippines, as confirmed
by the Certification of Non-Registration of Corporation/Partnership dated November 23, 2005 issued by
the Securities and Exchange Commission; that Canon-Philippines is a corporation duly organized and
existing under the laws of the Philippines with office address at 2nd Floor Plaza One, 18 Orchard Road,
Eastwood, Quezon City; that it is engaged in the business of hardware design and software development
involving imaging, communications and related technologies; that Canon-Philippines purchased a
Software Test Product (software) from Quality Logic; that under the Quality Logic-Software License
Agreement (Agreement), Quality Logic grants to Canon-Philippines a non-exclusive right to use and
display the software up to five (5) computers (i.e. with up to five (5) CPU's) in a single department, at a
single company site; that if the computers on which Canon-Philippines uses the software are multi-user
systems, the license covers up to five (5) users on a single multi-user system; that Quality Logic reserves
all rights not expressly granted to Canon-Philippines; that Canon-Philippines shall own the magnetic or
other physical media on which the software is originally or subsequently recorded or fixed, but Quality
Logic shall retain title and ownership of the software recorded on the original disk copy(ies) of the
software, regardless of the form or media in or on which the original and other copies may exist; that the
license is not sale of the original software or any copy; that Canon-Philippines may not distribute, copies
of the software or accompanying written materials to other employees, departments, divisions,
subsidiaries, joint venture companies, suppliers or any other company except as expressly provided in
the Agreement; that Canon-Philippines may not modify, adapt, translate, reverse engineer, decompile,
disassemble, or create derivative works based on the Utility Programs; that the software is licensed only,
to Canon-Philippines; that Canon-Philippines may transfer the software provided the original software
and all copies are purged from the original Licensee prior to the transfer; that any authorized transferee
of the software shall be bound by the terms and conditions of the Agreement; that in no event may
Canon-Philippines transfer, assign, rent, leases, sell or otherwise dispose of the software on a temporary
or permanent basis except as expressly provided under the Agreement; that the software and the
accompanying written materials are copyrighted; that Quality Logic will provide Canon-Philippines
support for the software for a period of ninety (90) days and make available to Canon-Philippines
extended support contracts that can be purchased on an annual basis; and that Canon-Philippines will
pay Quality Logic $5,700 US Dollars inclusive of freight and other miscellaneous charges payable within
60 days from date of invoice.
In reply please be informed as follows:
Concerning software payments, the Bureau of Internal Revenue has issued two Revenue Memorandum
Circulars (RMC) that govern the taxation of software payments. The first Circular (RMC 77-20031) covers
software payments made as of November 18, 2003 and until the effectivity of the second Circular and
generally treats software payments as royalties, thus: HDAaIc
"Definition of Royalties Includes Payments for the Use of Software:
The term 'royalties' as generally used means payment 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 cinematograph films,
or films or tapes used for radio or television broadcasting, any patent, trade mark, design, or model,
plan, secret formula or process, or for the use of, or the right to use, industrial, commercial or scientific
equipment, or for information concerning industrial, commercial or scientific experience. The term 'use'
as contained herein shall include the reselling or distribution of software.
Software is generally assimilated as a literary, artistic or scientific work protected by the copyright laws of
various countries including the Philippines; thus payments in consideration for the use of, or the right to
use, a copy or a copyrighted article relating to software are generally royalties."
On the other hand, the second Circular (RMC 44-2005 2 ) covers payments made as of September 8,
2005 and onwards and substantially amends the first Circular by treating software payments either as
business income, royalties, rental income, or capital gains, depending on the nature of the transaction
out of which such payments are made. It provides:
"Section 5. CHARACTERIZATION OF TRANSACTIONS — The character of payments received in a
transaction involving the transfer of computer software depends on the nature of the rights that the
transferee acquires under the particular arrangement regarding the use and exploitation of the program.
a. Transfer of copyright rights. A transfer of software is classified as a transfer of a copyright right if,
as a result of the transaction, a person acquires any one or more of the rights described below:
i. The right to make copies of the software for purposes of distribution to the public by sale or
other transfer of ownership, or by rental, lease or lending; aSTAIH
ii. The right to prepare derivative computer programs based upon the copyrighted software;
iii. The right to make a public performance of the software;
iv. The right to publicly display the computer program; or
v. any other rights of the copyright owner, the exercise of which by another without his authority
shall constitute infringement of said copyright.
The determination of whether a transfer of a copyright right in a software is a sale or exchange of
property is made on the basis of whether, taking into account all facts and circumstances, there has been
a transfer of all substantial rights in the copyright. A transaction that does not constitute a sale or
exchange because not all substantial rights have been transferred will be classified as a license
generating royalty income.
When only copyright rights are transferred, payments made in consideration therefor are royalties. On
the other hand, when copyright ownership is transferred, payments made in consideration therefor are
business income.
b. Transfer of copyrighted articles. A copyrighted article incorporating a software includes a copy of
the software from which the work can be perceived, reproduced, or otherwise communicated, either
directly or with the aid of a machine or device. The copy of the software may be fixed in the magnetic
medium of a floppy disk or a CD-ROM, or in the main memory or hard drive of a computer, or in any
other medium.
If a person acquires a copy of a software but does not acquire any of the rights described above (or only
acquires a de minimis grant of such rights), and the transaction does not involve the provision of services
or of know-how, the transfer of the copy of the software is classified solely as a transfer of a copyrighted
article and payments for which constitute business income. CIETDc
xxx xxx xxx"
The substantial difference between the two Circulars is their characterization of payment from the
purchase of a copyrighted article incorporating a software, like the license fee for the Licensed Software
where the licensee (Canon-Philippines) is merely granted access to and use of the Licensed Software and
not readily the right to market or exploit the Licensed Software. Under the first Circular, the license fee is
treated as royalties and taxable as such, while under the second Circular, the license fee is treated as
business income (or business profits) and taxable as such, as described above.
The fact that what is being transferred to Canon-Philippines is the magnetic or other physical media on
which the software is originally or subsequently recorded or fixed and the Quality Logic retains title and
ownership, including pertinent rights protected under relevant intellectual property laws, of the
software recorded on the original disk copy(ies) of the software, Revenue Memorandum Circular (RMC)
44-2005, Section 5b thereof, will apply in this case which states that "If a person acquires a copy of a
software but does not acquire any of the rights described above (or only acquires a de minimis grant of
such rights), and the transaction does not involve the provision of services or of know-how, the transfer
of the copy of the software is classified solely as a transfer of a copyrighted article and payments for
which constitute business income."
Thus, payments (license fee) made by Canon-Philippines to Quality Logic on November 30, 2005, being
business income (or business profits), is subject to income tax in the Philippines only if it is attributable
to a permanent establishment which Quality Logic has in the Philippines, under paragraph 1, Article 8 in
relation to Article 5 of the Philippines-US tax treaty, to wit:
"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 so much of them as are attributable to the
permanent establishment." DHTECc
"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. The term 'fixed place of business' includes but is not limited to:
a) A seat of management;
b) A branch;
c) An office;
d) A store or other sales outlet;
e) A factory;
f) A workshop;
g) A warehouse;
h) A mine, quarry, or other place of extraction of natural resources;
i) A building site or construction or assembly project or supervisory activities in connection
therewith, provided such site, project or activity continues for a period of more than 183 days; and
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. HcTDSA
xxx xxx xxx"
Based on the foregoing, in order for Quality Logic to be considered to have a permanent establishment
to which said business profit may be attributed, it must satisfy the following conditions 3 :
— the existence of a "place of business", i.e., a facility such as premises or, in certain instances,
machinery or equipment;
— this place of business must be "fixed", i.e., it must be established at a distinct place with a
certain degree of permanence;
— the carrying on of the business of the enterprise through this fixed place of business. This means
usually that persons who, in one way or another, are dependent on the enterprise (personnel) conduct
the business of the enterprise in the State in which the fixed place is situated." (Paragraph 2)
Since Quality Logic based on the documents submitted and or requested does not have a place of
business at its disposal which is fixed or established at a distinct place with a certain degree of
permanence in the Philippines through which it may use for carrying on its business, Quality Logic does
not have a permanent establishment to which said business profit may be attributed to.
This is further bolstered of the fact that it is not registered as a corporation nor as a partnership in the
Philippines.
Accordingly, Quality Logic not having a permanent establishment to which it may attribute any profits it
earned from the sale of the software to Canon-Philippines, said profits are not subject to Philippine
income tax at 32% of the gross amount thereof under Section 28(B)(1) of the National Internal Revenue
Code (NIRC) of 1997. 4
Finally, the sale of the Licensed Software by Quality Logic to Canon-Philippines is subject to ten percent
(10%) value-added tax (VAT) under Section 106(A) of the Tax Code, to wit: cTDECH
"SEC. 106. Value-added Tax on Sale of Goods or Properties. —
(A) Rate and Base of Tax. — There shall be levied, assessed and collected on every sale, barter or
exchange of goods or properties, a value-added tax equivalent to ten percent (10%) of the gross selling
price or gross value in money of the goods or properties sold, bartered or exchanged, such tax to be paid
by the seller or transferor.
xxx xxx xxx"
The gross amount of the license fee paid or payable to Quality Logic constitutes the gross selling price of
gross value in money of the Licensed Software on which the 10% VAT is imposed.
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 Canon-Philippines shall be responsible for the withholding of the
10 percent VAT on the license fee before remitting it to Quality Logic. In remitting to the Bureau of
Internal Revenue the VAT withheld on such, fee, Canon-Philippines shall use BIR Form No. 1600 (Monthly
Remittance Return of VAT and Other Percentage Taxes Withheld). If a VAT-registered taxpayer, Canon-
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, Canon-Philippines
may include as part of the cost of the services provided to it by Quality Logic the VAT consequently
shifted or passed on to it and may treat such VAT either as expense or asset, whichever is applicable. In
addition, upon Quality Logic's request, Canon-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 Quality
Logic and the fourth copy for Canon-Philippines as its file copy.
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. TICDSc
Very truly yours,
(SGD.) JOSE MARIO C. BUÑAG
Commissioner of Internal Revenue
Footnotes
1. Classification of Payments for Software for Income Tax Purposes
2. Taxation of Payments for Software
3. Organization for Economic Cooperation and Development (OECD), 2005 edition, paragraph 2,
pages 85-91.
4. Republic Act No. 9337 — new rate