Written by Carlos T. Carado II, 5 January 2007
When a person downloads software from a server located abroad, is this considered importation of goods under the VAT law? If it is, should the importer pay import VAT? If yes, then how should the VAT be paid?
These issues were addressed in a ruling issued by the BIR last November. The facts of the ruling are fairly straightforward.
A Philippine entity (Licensee) purchased a specific software from a non-resident foreign entity based in Germany (Licensor) under a single-user licence basis.
Under the terms of the purchase, the German Licensor granted to the Licensee a non-exclusive, non-transferable, perpetual, limited right and licence to install and use the software, on a per product or per module basis, for the purpose of creating applications, and to make copies for back-up or disaster recovery purposes. However, the licence granted precludes the Licensee from copying, modifying, or distributing the software. Sole and exclusive ownership of all right, title and interest in and to the Licensed Software and all modification and enhancements thereof (including ownership of all trade secrets and copyrights pertaining thereto), remains with the German licensor. The Philippine Licensee will acquire the software through electronic transfer (downloading). As consideration for the purchase of the software, the Philippine Licensee shall pay the German Licensor a one-time purchase price of $2,241.00.
On the income tax implications of the transaction, the BIR, applying Revenue Memorandum Circular No. 44-2005, classified the software payment as business profits and not royalties since the transaction involves merely the transfer of a copyrighted right incorporated in a software and not the transfer of ownership rights protected under intellectual property laws which remains with the licensor. As such, the BIR ruled that the $2,241.00 software payment is subject to Philippine income tax only if it is attributable to a permanent establishment which the licensor has in the Philippines in accordance with paragraph 1 of Article 7 of the Philippines-German Tax Treaty in relation to Article 5 of the same treaty.
Thus, since the German Licensor has no permanent establishment in the Philippines, i.e., it is not registered with the Philippine SEC and has no fixed place of business at its disposal in the Philippines through which it may use to carry on its business, income received from the sale of the software to the Philippine Licensee is exempt from income tax and consequently withholding tax.
Up to this point, the BIR ruling is in order as it is based on existing law and rules and regulations.
However, as to the VAT treatment of the transaction, the BIR appears to have taken an absurd position.
From a VAT perspective, the BIR ruled that the downloading of the software from the German Licensor is considered importation of software. As such, the transaction shall be subject to import VAT under Section 107 of the Tax Code which shall be paid through the VAT withholding tax mechanism provided under Section 114(C) of the Tax Code.
The term “importation” is not defined under Section 107 of the Tax Code and in related revenue regulations.
However, this term from a tax perspective refers to a transaction where tangible goods originating from a foreign source is brought into the Philippines which has a value on which the customs duties and taxes is based. Importation of an intangible good (e.g., software) occurs only when this is incorporated in a tangible good which is imported. In this case, the value of the intangible is usually factored in the total value of the imported tangible good.
Thus, for an intangible to be considered subject to import VAT, there must be a tangible object in which said intangible is imbedded. Otherwise, technically, there can be no importation to speak of.
In the present case, there is no tangible object to be imported since the software will be acquired by the Philippine Licensee through electronic transfer. Hence, in the absence of a tangible good in which the software is incorporated, there is no basis to apply the import VAT imposed under Section 107 of the Tax Code on the downloaded software.
Notwithstanding the absence of a clear basis to support its position, the BIR ruled that the downloading of the software is considered an importation of software and as such, is subject to import VAT.
However, since for obvious reasons collection of the VAT through the normal customs procedure is not possible, the BIR required the Philippine Licensee to withhold the VAT in accordance with the VAT withholding mechanism provided under Section 114(C) of the Tax Code, which again appears to be irregular as the VAT withholding under this provision strictly applies only to payments made by the government and payments for the lease or use of properties or property rights (e.g., royalties) to non-resident owners.
In addition, the BIR’s position in this ruling also appears to be incongruent with the provisions of RMC 44-05 which clearly characterises the licence fee to be paid to the German Licensor as business profits.
By imposing the import VAT on the downloaded software and requiring the Philippine Licensee to pay the VAT through VAT withholding, the BIR for VAT purposes, has effectively changed the classification of the licence fee from business profits to royalties.
The VAT implication of the transaction as discussed in this ruling needs to be revisited taking into account its legal basis and its practical implementation. While the rationale for this ruling could be the BIR’s desire to increase revenue collection, this should be done within the parameters of the law.
