Tax treatment of software payments

Revenue Memorandum Circular 7703 and 44-05; and BIR Ruling No. ITAD 013-10
By: Earl Charles N. Villarin Tax Department Meeting September 15, 2010

The Facts:
j Silverlake (Netherlands) B.V. (Silverlake) entered into a

License Agreement between United Coconut Planters Bank, wherein the former granted UCPB a non-exclusive, non-transferable and perpetual license to use the Core Banking System Software Package (the Product) and that the Product shall be used by UCPB for their internal processing requirements in the Philippines only. j The Product is developed and owned by Silverlake. j The License Agreement only deals with the licensed use of the Product and not the transfer of ownership or other rights in or to the Product.

The Issue:
j Whether or not the payment made by UCPB to Silverlake

pursuant to the License Agreement is considered a business profit? j (If it is in the affirmative, and since Silverlake does not have a permanent establishment in the Philippines, the payments made by UCPB to Silverlake shall be exempt from Philippine income tax as provided under Art. 7(1), of the Philippines-Netherlands tax treaty.)

Held:
j The BIR-ITAD applied Sec. 5

(Characterization of Transactions), of RMC 44-05, which held that payments for the use of software are business profits when the person concerned merely acquired a copy of the software and/ or merely acquired a de minimis rights for the use of the software.

The following facts were considered..

j Under the License Agreement, UCPB is permitted to use

the Product only where UCPBs production and back up computers are located (i.e. Primary Head Office data Center and Disaster Recovery Data Center). j UCPB is not permitted to translate, adapt, vary, modify, disassemble, decompile, or reverse engineer the software in whole or in part. j UCPB may retain one copy of the software upon prior written authorization from Silverlake. (the same is considered a de minimis right which may be exercised with or without authorization under Sec. 189, of the IP Code [R.A. 8293])

Nota Bene
j Under Article IV of the License Agreement,

UCPB under certain conditions may access the Source Code. In addition, it is given the option to purchase the Source Code at 50% of the contract price of the License Agreement, for the sole purpose of maintaining the Product and not for resale purposes. j Based on this, the BIR-ITAD considered the payment made under Article IV, supra, as royalties, subject to a preferential tax rate of 15% (Art. 12(2)(b), Philippine-Netherlands tax treaty)

Revenue Memorandum Circular No. 44-2005, effective September 8, 2005 (Definition of Terms)
j Software is a program, or a series of programs, containing

instructions for a computer required either for the operational processes of the computer itself (operational software) or for the accomplishment of other tasks (application software). It can be transferred through a variety of media, for example in writing or electronically. On a magnetic tape or disk, or on a laser disk, or CDROM, or it can be downloaded through the internet or through a network. It may be standardized with a wide range of application or be customized for specific users. It can be transferred as an integral part of the computer hardware or in an independent form available for used on a variety of hardware. (The same with RMC No. 77-03 dated November 18, 2003)

Revenue Memorandum Circular No. 44-2005, effective September 8, 2005 (Definition of Terms)
j RMC No. 44-05 j Royalties means payments of any j RMC No. 77-03 j Includes the phrase: The term

kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic, or scientific work, including cinematographic films or films or tapes used for radio or television broadcasting, and patent, trade mark, design or model, plan, secret formula or process. j Definition covers payments or compensation which a person would be obliged to pay for fraudulently copying or infringing the right. j Definition of royalties include payments for the use of copyright over software.

use as contained herein shall include the reselling and distribution of software j No provision on infringing use j All else the same.

Revenue Memorandum Circular No. 44-2005, effective September 8, 2005 (Explained)

j 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 generally taxable as royalty. j 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 2. Transfer of copyrighted articles 3. After-sales service 4. Site License/Enterprise License/Network License

Arrangements 5. Supply of Information 6. Transfer of Ownership

Transfer of copyright rights

j (Definition) A transfer of software

j j j j

is classified as a transfer of copyright right if a person acquires any of the following: 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; The right to prepare a derivative computer program; The right to make public performance of the software; The right to publicly display the program; Any other rights, which would constitute an infringement of copyright when done without the owners consent.

j (Determination) 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. (i.e.that is only when copyright rights are transferred) j When copyright ownership is transferred, payments made shall be considered business income.

Transfer of copyrighted articles

j (Definition) A copyrighted j (Determination) If a person

article incorporating a software includes a copy of a software from which the work can be perceived, reproduced or otherwise communicated, whether directly or with the aid of a machine or device.

acquires a copy of a software but does not acquire any of the rights described above (transfer of copyright rights) or only acquires a de minimis grant of such rights, and the transaction does not involve the provision of services or or know-how, the payments for which constitute business income.

After-sales Service
j (Definition) Contracts for the j (Determination) The part of the

use of software are often accompanied with the provision of services (e.g. installation, maintenance, and customization of the software) by personnel of the relevant foreign licensor/ owner or of the relevant local subsidiary, reseller and distributor.

payments representing the use of the software will be treated as royalties, and taxable as such and the other part of the payments representing the provision of services will be treated as income from services and taxable as such.

Site license/ Enterprise license/ Network license arrangements

j (Definition) These refers to j (Determination) Payments

arrangements in which the transferee obtains rights to make multiple copies of the program for operation only within its own business. j Right to make multiple copies are generally limited to those necessary for the purpose of enabling the operation of the program. Reproduction for any other purpose is not permitted.

made under such arrangements will generally be considered as business income.

Supply of information
j (Definition) In case a software j (Determination) Generally

house or computer programmer agrees to supply information about the ideas and principles underlying the program, such as logic, algorithms, or programming techniques or languages.

considered as royalty payments.

Transfer of ownership
j (Definition) Where j (Determination) They are

consideration is paid for the transfer of full or partial ownership of the rights in the copyright.

considered business income or capital gains.

In General..
1. 2. 3.

4. 5.

6.

Transfer of copyright rights payments is classified as royalty; Transfer of copyrighted articles payments is classified as business income; 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; Site License/Enterprise License/Network License Arrangements payment is classified as business income 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; Transfer of Ownership. payment is classified as either business income or capital gains.

Easy Guide: (Determining Business Income)

j Note that payments for software is characterized as

business income under any of the following circumstances: 1. There is a transfer of ownership [transfer of copyright article and copyright rights] 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 [transfer of copyright article alone] 3. An arrangement where the transferee obtains the right to make multiple copies of the program only for operation within its own business.

Applied to the case of Silverlake

Criteria
The transfer of Ownership

Facts
No UCPB acquired the right to use and own the Product (as a copyright article) but not all the copyright rights can be exercised by UCPB in relation to the Product (e.g. the right to reverse engineer, alter or modify).

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 An arrangement where the transferee obtains the right to make multiple copies of the program for operation only within its own business.

Yes UCPB acquired the right to use the Product as an incident of its use.

Yes UCPB may only use and reproduce the Product in designated sites mentioned under the License Agreement.

Following the pronouncement in the Silverlake case

j A License Agreement providing for the following shall be considered j j

j j j

as a business income: acquisition of software [article], a grant of a non-exclusive, non-transferable license or right to use the software in specified locations using specified computers or computer networks and only for the internal 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 over the copyright rights