Tax treatment of software

payments
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Tax treatment of software payments

by Christian M. Cantera
Does your company have any plan of purchasing computer software? Are you in
the process of paying for a software you recently acquired?
For tax purposes and from the point of view of the recipients of these payments,
the next question would be: What tax or taxes would apply on these software
payments?
The BIR recently issued several rulings clarifying that payment for the acquisition
of computer softwares from nonresidents which shall be deemed to be a transfer
of a copyrighted article shall be considered as business profits, not royalties, and
may therefore be exempt from income and withholding tax in the Philippines.
When can acquisition of a software be considered a transfer of a copyrighted
article?
It may be recalled that the BIR has already issued two Revenue Memorandum
Circulars (RMCs) governing the taxation of these software payments. The first
circular RMC 77-2003, treats software payments generally as royalties.
Accordingly, payments in consideration for the use of, or the right to use, a copy
or a copyrighted article relating to software made during the effectivity of this
circular are are generally taxable as royalty.

The second circular, RMC 44-2005, covered payments made as of September 8,

2005 and onwards. This subsequent circular substantially amends RMC No. 77-
2003 by classifying the various types of software payments as (i) business
income, (ii) royalties, (iii) rental income, or (iv) capital gains, depending on the
nature of the transaction for which such payments are made. The
characterization of the payments would depend on the nature of the rights that
the transferee acquires under the particular arrangement regarding the use and
exploitation of the program. Section 5 of RMC 44-2005 characterizes the various
types of payments relating to computer software as follows:
 1. Transfer of copyright rights – payments is classified as royalty;
2. Transfer of copyrighted articles – payments is classified as business
income;
3. After-sales service – under a mixed contract, payment will be apportioned,
i.e., payments representing the use of the software is classified as royalty;
payments representing the provision of services is treated as income from
services;
4. Site License/Enterprise License/Network License Arrangements – payment
is classified as business income
5. Supply of Information – payments may be classified as royalties to the
extent that they represent, consideration for the use of, or the right to use,
secret formulas or for information concerning industrial, commercial or
scientific experience which cannot be separately copyrighted;
6. Transfer of Ownership. – payment is classified as either business income
or capital gains.

Note that payments for software is characterized as business income under the
following circumstances:
1. The transfer of copyright rights and all substantial rights has been
transferred
2. The transferee does not acquire any of the rights (or only acquires a de
minimis grant of such rights) described in the circular that would classify
the transfer of software as a transfer of copyright right
3. An arrangement where the transferee obtains the right to make multiple
copies of the program for operation within its own business.

The above characterization is important since payments made to a non-resident

entity which does not have a permanent establishment here in the Philippines
shall be exempt from the 35% final withholding income tax if the payment shall
be classified as business profits.
The rulings issued by the BIR clarified the acquisition of softwares that may be
classified in the nature of transfer of copyrighted articles. The transactions
involved the grant of a non-exclusive, n on-trans ferable license or right to use
the software in specified locations using specified computers or computer
networks and only for the i nternal processing and computing needs of the
grantee. The grantee is prohibited from sharing the use of the software for a fee
or providing computer services to third parties using the software. The grantee is
not allowed to sublicense, transfer or assign its rights. There is no transfer of
ownership of the copyrights. Ownership remains with the licensor.
Under the 2003 RMC, payments for such arrangements are treated as royalties.
In the rulings, the BIR confirmed that, following the classifications under RMC 44-
2005, such arrangements can be classified solely as transfers of copyrighted
articles and payments therefore shall be considered business profits which are
exempt from Philippine income tax and withholding tax if the recipient did not
have a permanent establishment in the Philippines.
Companies are therefore encouraged to review their existing software licensing agreements and to determine if the tax
treatment thereof has changed based on the provisions of RMC 44-2005. Securing a confirmatory ruling from the BIR may
be considered if these payments qualify for exemption.
(The author is a tax manager at Punongbayan & Araullo, member of Grant
Thornton International. For comments and inquiries, please e-
mail Christian.M.Cantera@pna.ph or call 886-5511.)