New year, new tax rule for cross-border services

By: Ariel Lleva

IT is an elementary rule in taxation that a foreign corporation, whether or not engaged in trade or business in the Philippines, is taxable only on income derived from sources within the Philippines.

Section 42(A)(3) in relation to Section 42(C)(3) of the Tax Code treats compensation for labor or personal service as income from Philippine sources if the service is performed in the country. The income from services performed outside the Philippines is, therefore, considered income from sources outside the country, which is not subject to final withholding tax (FWT) and final withholding VAT. This provision has been cited in numerous tax rulings as the basis for tax exemption.

Notwithstanding this rule, Section 32(B)(5) of the Tax Code exempts income payment to a foreign corporation to the extent required by any treaty obligation that binds the Philippine government. Basically, the tax treaty provision on business profits states that income payment to a foreign corporation is exempt from Philippine taxation if it has no permanent establishment in the country. A foreign corporation with no fixed place of business or designated dependent agent or has not exceeded the limit for the length of stay in the Philippines is considered to not have a permanent establishment; hence the income paid to such is not subject to FWT. A nonresident invoking the exemption can file a tax treaty relief application with the Bureau of Internal Revenue (BIR).

The above rules have been the long-standing tax position of the BIR for cross-border services until it issued Revenue Memorandum Circular (RMC) 5-2024 to further clarify the tax treatment of cross-border services in light of the Supreme Court's pronouncement in the case of Aces Philippines Cellular Satellite Corp. v. Commissioner of Internal Revenue, GR 226680, dated Aug. 30, 2022. In this circular, the BIR introduced the source-based taxation principle as the situs of taxation for cross-border services. This means the jurisdiction where the economic activity occurs should have the right to tax the income derived from that activity, regardless of where payment is made or received. The source of income is not necessarily determined by where the payment is disbursed or physically received but rather by the location where the business activities that produced the income took place.

This new rule applies to cross-border services, namely consulting, IT outsourcing, financial services, telecommunications, engineering and construction, education and training, tourism and hospitality, and other similar services that follow the same concept of being provided, processed, or performed overseas and then utilized, applied, executed, or consumed in the Philippines. Although carried out abroad, if the results or outputs are used in the Philippines, the income from these services will be considered sourced within the Philippines. Further, reimbursable or allocable expenses charged to a local company that reduces the expenses of a foreign corporation are considered income because these expenses represent a financial gain or savings for the company.

The income of a foreign corporation derived from activities that take place in the Philippines, even though the income does not relate to services performed in the Philippines, is subject to FWT and final withholding VAT.

With the issuance of the circular, some questions linger in the minds of taxpayers. Does the change in the rules represent the real intent of the Supreme Court, or does this only apply to satellite airtime fee payments? Does this apply to all types of cross-border services regardless of the factual circumstances? Does the Supreme Court decision intend to supersede Section 42(A)(3) and Section 42(C)(3) in determining income from Philippine sources? Are foreign corporations still allowed to avail of tax treaty relief under Section 32(B)(5) of the Tax Code?

RMC 5-2024 is the BIR's own interpretation of the court's decision and offers this framework for assessing the taxes on cross-border services. However, Supreme Court decisions are based on factual circumstances and available pieces of evidence put forth by the parties in a case. These rulings intend to interpret the law. It is essential that the court does so with due regard to legislative intent. In cases of conflict between the law and the law's rules and regulations, the law should always prevail. Based on these fundamental principles and in the absence of tax laws repealing Section 42(A)(3), Section 42(C)(3) and Section 32(B)(5) of the Tax Code, the same still has the force and effect of law.

Tax administrators should consider addressing taxpayers' doubts and questions regarding RMC 5-2024 to avoid confusion and to properly guide taxpayers in their compliance with tax requirements. On the other hand, taxpayers should secure a tax ruling to ensure the proper application of the tax rules to their transactions. In any case, it is a well-settled rule that laws and statutes granting tax exemptions are strictly construed against the taxpayer. Exemptions are never presumed, and the burden is upon the taxpayer to establish their right to exemption. Thus, taxpayers should consult and request confirmation with the BIR to verify their entitlement to any tax relief or exemption.

As published in The Manila Times on 22 January 2024. The author is a Director with the Tax & Corporate Services division of Deloitte Philippines.