Tax - SITUS (Supporting Laws and Doctrines)

8/10/2019 Tax - SITUS (Supporting Laws and Doctrines)

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DATE: DECEMBER 07, 2014TO: PROF. DINA D. LUCENARIOFROM: JERRY KENT O. ABAD (2005-61892)SUBJECT: REPORT – Tax 1

COVERAGE: SITUS OF INCOME (under GROSS INCOME and EXCLUSIONS)

Section 42, NIRC

SEC. 42. Income from Sources Within the Philippines.- (A) Gross Income From Sources Within the Philippines. - The following items

of gross income shall be treated as gross income from sources within thePhilippines:

(1) Interests. - Interests derived from sources within the Philippines, andinterests on bonds, notes or other interest-bearing obligation of residents,corporate or otherwise;

(2) Dividends. - The amount received as dividends:

(a)

from a domestic corporation; and(b) from a foreign corporation, unless less than fifty percent (50%) of

the gross income of such foreign corporation for the three-yearperiod ending with the close of its taxable year preceding thedeclaration of such dividends or for such part of such period asthe corporation has been in existence) was derived from sourceswithin the Philippines as determined under the provisions of thisSection; but only in an amount which bears the same ration tosuch dividends as the gross income of the corporation for suchperiod derived from sources within the Philippines bears to itsgross income from all sources.

(3) Services. - Compensation for labor or personal services performed in thePhilippines;

(4) Rentals and royalties. - Rentals and royalties from property located inthe Philippines or from any interest in such property, including rentals orroyalties for –

(a) The use of or the right or privilege to use in the Philippines anycopyright, patent, design or model, plan, secret formula orprocess, goodwill, trademark, trade brand or other like property orright;

(b) The use of, or the right to use in the Philippines any industrial,commercial or scientific equipment;

(c) The supply of scientific, technical, industrial or commercial

knowledge or information;(d) The supply of any assistance that is ancillary and subsidiary to,

and is furnished as a means of enabling the application orenjoyment of, any such property or right as is mentioned inparagraph (a), any such equipment as is mentioned in paragraph(b) or any such knowledge or information as is mentioned inparagraph (c);

(e) The supply of services by a nonresident person or his employee in



connection with the use of property or rights belonging to, or theinstallation or operation of any brand, machinery or otherapparatus purchased from such nonresident person;

(f) Technical advice, assistance or services rendered in connectionwith technical management or administration of any scientific,industrial or commercial undertaking, venture, project or scheme;and

(g) The use of or the right to use:i. Motion picture films;ii. Films or video tapes for use in connection with television;

andiii. Tapes for use in connection with radio broadcasting.

(5) Sale of Real Property. - gains, profits and income from the sale of realproperty located in the Philippines; and

(6) Sale of Personal Property. - gains; profits and income from the sale ofpersonal property, as determined in Subsection (E) of this Section.

(B)

Taxable Income From Sources Within the Philippines. – (1) General Rule. - From the items of gross income specified in Subsection

(A) of this Section, there shall be deducted the expenses, losses andother deductions properly allocated thereto and a ratable part ofexpenses, interests, losses and other deductions effectively connectedwith the business or trade conducted exclusively within the Philippineswhich cannot definitely be allocated to some items or class of grossincome: Provided, That such items of deductions shall be allowed only iffully substantiated by all the information necessary for its calculation. Theremainder, if any, shall be treated in full as taxable income from sourceswithin the Philippines.

(2) Exception. - No deductions for interest paid or incurred abroad shall beallowed from the item of gross income specified in subsection (A) unlessindebtedness was actually incurred to provide funds for use in connectionwith the conduct or operation of trade or business in the Philippines.

(C) Gross Income From Sources Without the Philippines. - The followingitems of gross income shall be treated as income from sources without thePhilippines:

(1) Interests other than those derived from sources within the Philippines asprovided in paragraph (1) of Subsection (A) of this Section;

(2) Dividends other than those derived from sources within the Philippines asprovided in paragraph (2) of Subsection (A) of this Section;

(3)

Compensation for labor or personal services performed without thePhilippines;

(4) Rentals or royalties from property located without the Philippines or fromany interest in such property including rentals or royalties for the use ofor for the privilege of using without the Philippines, patents, copyrights,secret processes and formulas, goodwill, trademarks, trade brands,franchises and other like properties; and

(5) Gains, profits and income from the sale of real property located without



the Philippines.

(D) Taxable Income From Sources Without the Philippines. - From the itemsof gross income specified in Subsection (C) of this Section there shall bededucted the expenses, losses, and other deductions properly apportioned orallocated thereto and a ratable part of any expense, loss or other deductionwhich cannot definitely be allocated to some items or classes of gross income.The remainder, if any, shall be treated in full as taxable income from sourceswithout the Philippines.

(E) Income From Sources Partly Within and Partly Without thePhilippines.- Items of gross income, expenses, losses and deductions, otherthan those specified in Subsections (A) and (C) of this Section, shall be allocatedor apportioned to sources within or without the Philippines, under the rules andregulations prescribed by the Secretary of Finance, upon recommendation of theCommissioner. Where items of gross income are separately allocated to sourceswithin the Philippines, there shall be deducted (for the purpose of computing the

taxable income therefrom) the expenses, losses and other deductions properlyapportioned or allocated thereto and a ratable part of other expenses, losses orother deductions which cannot definitely be allocated to some items or classes ofgross income. The remainder, if any, shall be included in full as taxable incomefrom sources within the Philippines. In the case of gross income derived fromsources partly within and partly without the Philippines, the taxable income mayfirst be computed by deducting the expenses, losses or other deductionsapportioned or allocated thereto and a ratable part of any expense, loss or otherdeduction which cannot definitely be allocated to some items or classes of grossincome; and the portion of such taxable income attributable to sources withinthe Philippines may be determined by processes or formulas of generalapportionment prescribed by the Secretary of Finance. Gains, profits and incomefrom the sale of personal property produced (in whole or in part) by the taxpayerwithin and sold without the Philippines, or produced (in whole or in part) by thetaxpayer without and sold within the Philippines, shall be treated as derivedpartly from sources within and partly from sources without the Philippines.

Gains, profits and income derived from the purchase of personal property withinand its sale without the Philippines, or from the purchase of personal propertywithout and its sale within the Philippines shall be treated as derived entirelyform sources within the country in which sold: Provided, however, That gainfrom the sale of shares of stock in a domestic corporation shall be treated asderived entirely form sources within the Philippines regardless of where the said

shares are sold. The transfer by a nonresident alien or a foreign corporation toanyone of any share of stock issued by a domestic corporation shall not beeffected or made in its book unless:

(1) the transferor has filed with the Commissioner a bond conditioned uponthe future payment by him of any income tax that may be due on thegains derived from such transfer, or



(2) the Commissioner has certified that the taxes, if any, imposed in this Titleand due on the gain realized from such sale or transfer have been paid. Itshall be the duty of the transferor and the corporation the shares ofwhich are sold or transferred, to advise the transferee of thisrequirement.

(F)

Definitions. - As used in this Section the words 'sale' or 'sold' include 'exchange'or 'exchanged'; and the word 'produced' includes 'created', 'fabricated,''manufactured', 'extracted,' 'processed', 'cured' or 'aged.'

Sec. 152 – 165, Revenue Regulations No. 2

Section 152. Income from sources within the Philippines. — The law divides theincome of taxpayers into three classes:(1) Income which is derived in full from sources within the Philippines;(2) Income which is derived in full from sources without the Philippines; and

(3)

Income which is derived partly from sources within and partly from sources withoutthe Philippines.

Non-resident alien individuals and foreign corporations are taxable only upon incomefrom sources within the Philippines. Citizens and residents of the Philippines anddomestic corporations are taxable upon income derived from sources both within andwithout the Philippines.

The taxable income from sources within the Philippines includes that derived in full fromsources within the Philippines and that portion of the income which is derived partlyfrom sources within and partly from sources without the Philippines which is allocated or

apportioned to sources within the Philippines.

Section 153. Interest. — Interest on bonds or notes or other interest bearingobligations of residents, corporate or otherwise, constitutes income from sources withinthe Philippines.

Section 154. Dividends. — Gross income from sources within the Philippines includesdividends, as defined by Section 83 of the Code:(a) From a domestic corporation; and(b) From a foreign corporation unless less than 50 per cent of its gross income for the

three-year period ending with the close of its taxable year preceding the declarationof such dividends, or for such part of such period as it has been in existence, was

derived from sources within the Philippines; but only in an amount which bears thesame ratio to such dividends as the gross income of the corporation for such periodderived from sources within the Philippines bears to its gross income from allsources.

Dividends will be treated as an income from sources within the Philippines unless thetaxpayer submits sufficient data to establish to the satisfaction of the Commissioner ofInternal Revenue that they should be excluded from gross income under Section



37(a)(2)(B).

Section 155. Compensation for labor or personal services. — Gross income fromsources within the Philippines includes compensation for labor or personal servicesperformed within the Philippines regardless of the residence of the payor, of the place inwhich the contract for service was made, or of the place of payment. If a specificamount is paid for labor or personal services performed in the Philippines, such amountshall be included in the gross income. If no accurate allocation or segregation ofcompensation for labor or personal services performed in the Philippines can be made,or when such labor or service is performed partly within and partly without thePhilippines, the amount to be included in the gross income shall be determined by anapportionment of the time basis, i.e., there shall be included in the gross income anamount which bears the same relation to the total compensation as the number of daysof performance of the labor or services within the Philippines bears to the total numberof days performance of labor or services for which the payment is made. Wagesreceived for services rendered inside the territorial limits of the Philippines and wages ofan alien seaman earned on a coastwise vessel are to be regarded as from sources within

the Philippines.

Section 156. Rentals and royalties. — Gross income from sources within thePhilippines includes rentals or royalties from property located within the Philippines orfrom any interest in such property, including rentals or royalties for the use of or theprivilege of using in the Philippines, patents, copyrights, secret processes and formulas,goodwill, trademarks, trade brands, franchises, and other like property. The incomearising from the rental of property whether tangible or intangible located within thePhilippines, or from the use of property, whether tangible or intangible, located withinthe Philippines, is from sources within the Philippines.

Section 157. Sale of real property. — Gross income from sources within thePhilippines includes gain, computed under the provisions of Section 35, derived from thesale or other disposition of real property located in the Philippines. For the treatment ofcapital gains and losses, see Sections 132 to 135 of these regulations.

Section 158. Income from sources without the Philippines. — Gross income fromsources without the Philippines includes:(1) Interest other than that specified in Section 37(a)(1), as being derived from sources

within the Philippines;(2) Dividends other than those derived from sources within the Philippines as provided

in Section 37(a)(2);(3) Compensation for labor or personal services performed without the Philippines;

(4)

Rentals or royalties derived from property without the Philippines or from anyinterest in such property, including rentals or royalties for the use of or for theprivilege of using without the Philippines, patents, copyrights, secret processes andformulas, goodwill, trade-marks, trade brands, franchises, and other like property;and

(5) Gain derived from the sale of real property located without the Philippines.

Section 159. Sale of personal property. — Income derived from the purchase and



sale of personal property shall be treated as derived entirely from the country in whichsold. The world "sold" includes "exchanged". The "country in which sold" ordinarilymeans the place where the property is marketed. This section does not apply to incomefrom the sale of personal property produced (in whole or in part) by the taxpayer withinand sold without the Philippines or produced (in whole or in part) by the taxpayerwithout and sold within the Philippines. (See Section 162 of these regulations.)

Section 160. Apportionment of deductions. — From the items specified in Section37(a) as being derived specifically from sources within the Philippines there shall bededucted the expenses, losses, and other deductions properly apportioned or allocatedthereto and a ratable part of any other expenses, losses or deductions which can notdefinitely be allocated to some item or class of gross income. The remainder shall beincluded in full as net income from sources within the Philippines.

The ratable part is based upon the ratio of gross income from sources within thePhilippines to the total gross income.

EXAMPLE: A non-resident alien individual whose taxable year is the calendaryear, derived gross income from all sources for 1939 of P180,000, includingtherein:

Interest on bonds of a domestic corporation P9,000Dividends on stock of domestic corporation 4,000Royalty for the use of patents within the Philippines 12,000Gain from sale of real property located within the Philippines 11,000

———— Total P36,000

that is, one-fifth of the total gross income was from sources within thePhilippines. The remainder of the gross income was from sources without thePhilippines, determined under Section 37(c).

The expenses of the taxpayer for the year amounted to P78,000. Of theseexpenses the amount of P8,000 is properly allocated to income from sourceswithin the Philippines and the amount of P40,000 is properly allocated to incomefrom sources without the Philippines.

The remainder of the expense, P30,000, cannot be definitely allocated to anyclass of income. A ratable part thereof, based upon the relation of gross incomefrom sources within the Philippines to the total gross income, shall be deducted

in computing net income from sources within the Philippines. Thus, there arededucted from the P36,000 of gross income from sources within the Philippinesexpenses amounting to P14,000 (representing P8,000 properly apportioned tothe income from sources within the Philippines and P6,000, a ratable part (one- fifth) of the expenses which could not be allocated to any item or class of grossincome). The remainder, P22,000, is the net income from sources within thePhilippines.



Section 161. Other income from sources within the Philippines. — Items ofgross income other than those specified in Section 37(a) and (c) shall be allocated orapportioned to sources within or without the Philippines, as provided in Section (37)(e).

The income derived from the ownership or operation of any farm, mine, oil or gas well,other natural deposit, or timber, located within the Philippines, and from the sale by theproducer of the products thereof within or without the Philippines, shall ordinarily beincluded in gross income from sources within the Philippines. If, however, it is shown tothe satisfaction of the Commissioner of Internal Revenue that due to the peculiarconditions of productions and sale in a specific case or for other reasons all of suchgross income should not be allocated to sources within the Philippines and to sourceswithout the Philippines shall be made as provided in Section 162 of these regulations.

Where items of gross income are separately allocated to sources within the Philippines,there shall be deducted therefrom, in computing net income, the expenses, losses, andother deductions properly apportioned or allocated thereto and a ratable part of otherexpenses, losses, or other deductions which cannot definitely be allocated to some item

or class of gross income.

Section 162. Income from the sale of personal property derived from sourcespartly within and partly without the Philippines. — Items of gross income notallocated by Sections 152 to 159 or 161 of these regulations to sources from within orwithout the Philippines shall (unless unmistakably from a source within or a sourcewithout the Philippines) be treated as derived from sources partly within and partlywithout the Philippines. EcICSA

The portion of such income derived from sources partly within the Philippines and partlywithin a foreign country which is attributable to sources within the Philippines shall bedetermined according to the following rules and cases:

PERSONAL PROPERTY PRODUCED AND SOLD: — Gross income derived from the sale ofpersonal property produced (in whole or in part) by the taxpayer within the Philippinesand sold within a foreign country, or produced (in whole or in part) by the taxpayerwithin a foreign country and sold within the Philippines shall be treated as derived partlyfrom sources within the Philippines and partly from sources within a foreign countryunder one of the cases below. As used herein the word "produced" includes created,fabricated, manufactured, extracted, processed, cured, or aged.

CASE 1. Where the manufacturer or producer regularly sells a part of his output towholly independent distributors or other selling concerns in such a way as to establish

fairly an independent factory or production price — or shows to the satisfaction of theCommissioner of Internal Revenue that such an independent factory or production pricehas been otherwise established — unaffected by considerations of tax liability, and theselling or distributing branch or department of the business is located in a differentcountry from that in which the factory is located or the production carried on, the netincome attributable to sources within the Philippines shall be computed by an accountingwhich treats the products as sold by the factory or productive department of thebusiness to the distributing or selling department at the independent factory price as



established. In all such cases the basis of the accounting shall be fully explained in astatement attached to the return.

CASE 2. Where an independent factory or production price has not been established asprovided under Case 1, the net income shall first be computed by deducting from thegross income derived from the sale of personal property produced (in whole or in part)by the taxpayer within the Philippines and sold within a foreign country or produced (inwhole or in part) by the taxpayer within a foreign country and sold within thePhilippines, the expenses, losses, or other deductions properly apportioned or allocatedthereto and a ratable part of any expenses, losses, or other deductions which can notdefinitely be allocated to some item or class of gross income. Of the amount of netincome so determined, one-half shall be apportioned in accordance with the value of thetaxpayer's property within the Philippines and within the foreign country, the portionattributable to sources within the Philippines being determined by multiplying such onehalf by a fraction the numerator of which consists of the value of the taxpayer's propertywithin the Philippines, and the denominator of which consists of the value of thetaxpayer's property both within the Philippines and within the foreign country. The

remaining one-half of such net income shall be apportioned in accordance with the grosssales of the taxpayer within the Philippines and within the foreign country, the portionattributable to sources within the Philippines being determined by multiplying such one-half by a fraction the numerator of which consists of the taxpayer's gross sales for thetaxable year or period within the Philippines, and the denominator of which consists ofthe taxpayer's gross sales for the taxable year, or period both within the Philippines andwithin the foreign country. The "gross sales of the taxpayer within the Philippines"means the gross sales made during the taxable year which were principally secured,negotiated, or effected by employees, agents, offices, or branches of the taxpayer'sbusiness resident or located in the Philippines. The term "gross sales" as used in thisparagraph refers only to the sales of personal property produced (in whole or in part) bythe taxpayer within the Philippines and sold within a foreign country or produced (inwhole or in part) by the taxpayer within a foreign country and sold within thePhilippines, and the term "property" includes only the property held or used to produceincome which is derived from such sales. Such property should be taken at its actualvalue, which in the case of property valued or appraised for purposes of inventory,depreciation, depletion, or other purposes of taxation shall be the highest amount atwhich so valued or appraised, and which in other cases shall be deemed to be its bookvalue in the absence of affirmative evidence showing such value to be greater or lessthan the actual value. The average value during the taxable year or period shall beemployed. The average value of property as above prescribed at the beginning and endof the taxable year or period ordinarily may be used, unless by reason of materialchanges during the taxable year or period such average does not fairly represent the

average for such year or period, in which event the average shall be determined upon amonthly or daily basis. Bills and accounts receivable shall (unless satisfactory reason fora different treatment is shown) be assigned or allocated to the Philippines when thedebtor resides in the Philippines. HCIaDT

CASE 3. Applications for permission to base the return upon the taxpayer's books ofaccount will be considered by the Commissioner of Internal Revenue in the case of anytaxpayer who, in good faith and unaffected by considerations of tax liability, regularly



employs in his books of account a detailed allocation of receipts and expenditures whichreflects more clearly than the processes or formulas herein prescribed, the incomederived from sources within the Philippines.

Section 163. Foreign steamship companies. — (REPEALED by Section 12 of RRNo. 8-75)

―Section 1. Definition of gross Philippine Billing – ―Section 2 (b) (1) of Revenue Regulations No. 875 is hereby amended to read asfollows: International carriers shall pay a tax of 2 ½ of their gross Philippine billings.For the purpose of section 24 (b) (2) of the National Internal Revenue Code, ―gross Philippine billings‖ means the gross revenue realized from uplifts anywhere in the worldby any international carrier doing business in the Philippines of passage documents soldtherein, whether for passenger, excess baggage, cargo or mail, provided the cargo ormail originates from the Philippines. The gross revenues realized from the said cargo ormail shall include the gross freight charges up to the final destination. The gross freightcharges in the airway bills, bills of lading and/or value of tickets sold by each

international carrier doing business in the Philippines shall be prima facie evidence of itsgross lifted revenue. For the purpose of this definition, the phrase ―doing business in thePhilippines‖ include the regular sale of tickets in the Philippines by offline internationalairlines either by themselves or through its agents. In the case of offline airlines, thegeneral sales agents (GSA) or duly authorized representatives in the Philippines arehereby constituted as withholding agents pursuant to section 53 of the National InternalRevenue Code. Revenue Regulations No. 376 amending RR No. 875, dated March 15,1976.

Section 164. Telegraph and cable service. — A foreign corporation carrying on thebusiness of transmission of telegraph or cable messages between points in thePhilippines and points outside the Philippines derives income partly from sources withinand partly from sources without the Philippines.(1) GROSS INCOME. — The gross income from sources within the Philippines derived

from such services shall be determined by adding (a) its gross revenues derivedfrom messages originating in the Philippines and (b) amounts collected abroad oncollect messages originating in the Philippines and deducting from such sumamounts paid or accrued for transmission of messages beyond the company's owncircuit. Amounts received by the company in the Philippines with respect to collectmessages originating without the Philippines shall be excluded from gross income.

(2) NET INCOME. — In computing net income from sources within the Philippines thereshall be allowed as deductions from gross income determined in accordance withparagraph (1): (a) all expenses incurred in the Philippines (not including any general

overhead expenses), incident to the carrying on of the business in the Philippines;(b) all direct expenses incurred abroad in the transmission of messages originatingin the Philippines (not including any general overhead expenses or maintenance,repairs, and depreciation of cable and not including any amount already deducted incomputing gross income); (c) depreciation of property (other than cables) located inthe Philippines and used in the trade or business therein; and (d) a proportionatepart of the general overhead expenses [not including any items incurred abroadcorresponding to those enumerated in (a), (b), and (c)], and of maintenance,



repairs, and depreciation of cables of the entire cable system of the enterprise basedon the ratio which the number of words originating in the Philippines bears to thetotal words transmitted by the enterprise.

Section 165. Computation of income. — If a taxpayer has gross income fromsources within or without the Philippines as defined by Section 37 (a) or (c) togetherwith gross income derived partly from sources within and partly from sources withoutthe Philippines, the amounts thereof, together with the expenses and investmentapplicable thereto, shall be segregated, and the net income from sources within thePhilippines shall be separately computed therefrom. TcHCIS (Section 38 of the Code)

Form Sources Within the Philippines

o Sec 42 (A, B), NIRC

SEC. 42. Income from Sources Within the Philippines.-

(A)

Gross Income From Sources Within the Philippines. - The followingitems of gross income shall be treated as gross income from sourceswithin the Philippines:

(1) Interests. - Interests derived from sources within thePhilippines, and interests on bonds, notes or other interest-bearing obligation of residents, corporate or otherwise;

(2) Dividends. - The amount received as dividends:(a) from a domestic corporation; and(b) from a foreign corporation, unless less than fifty percent

(50%) of the gross income of such foreign corporation forthe three-year period ending with the close of its taxable

year preceding the declaration of such dividends or forsuch part of such period as the corporation has been inexistence) was derived from sources within the Philippinesas determined under the provisions of this Section; butonly in an amount which bears the same ration to suchdividends as the gross income of the corporation for suchperiod derived from sources within the Philippines bears toits gross income from all sources.

(3) Services. - Compensation for labor or personal servicesperformed in the Philippines;

(4) Rentals and royalties. - Rentals and royalties from propertylocated in the Philippines or from any interest in such property,

including rentals or royalties for – (a) The use of or the right or privilege to use in the Philippines

any copyright, patent, design or model, plan, secretformula or process, goodwill, trademark, trade brand orother like property or right;

(b) The use of, or the right to use in the Philippines anyindustrial, commercial or scientific equipment;

(c) The supply of scientific, technical, industrial or commercial



knowledge or information;(d) The supply of any assistance that is ancillary and

subsidiary to, and is furnished as a means of enabling theapplication or enjoyment of, any such property or right asis mentioned in paragraph (a), any such equipment as ismentioned in paragraph (b) or any such knowledge orinformation as is mentioned in paragraph (c);

(e) The supply of services by a nonresident person or hisemployee in connection with the use of property or rightsbelonging to, or the installation or operation of any brand,machinery or other apparatus purchased from suchnonresident person;

(f) Technical advice, assistance or services rendered inconnection with technical management or administrationof any scientific, industrial or commercial undertaking,venture, project or scheme; and

(g) The use of or the right to use:

i.

Motion picture films;ii. Films or video tapes for use in connection with

television; andiii. Tapes for use in connection with radio

broadcasting.(5) Sale of Real Property. - gains, profits and income from the sale

of real property located in the Philippines; and(6) Sale of Personal Property. - gains; profits and income from the

sale of personal property, as determined in Subsection (E) of thisSection.

(B) Taxable Income From Sources Within the Philippines. – (1)

General Rule. - From the items of gross income specified inSubsection (A) of this Section, there shall be deducted theexpenses, losses and other deductions properly allocated theretoand a ratable part of expenses, interests, losses and otherdeductions effectively connected with the business or tradeconducted exclusively within the Philippines which cannotdefinitely be allocated to some items or class of gross income:Provided, That such items of deductions shall be allowed only iffully substantiated by all the information necessary for itscalculation. The remainder, if any, shall be treated in full astaxable income from sources within the Philippines.

(2)

Exception. - No deductions for interest paid or incurred abroadshall be allowed from the item of gross income specified insubsection (A) unless indebtedness was actually incurred toprovide funds for use in connection with the conduct or operationof trade or business in the Philippines.

o RAMO Nos. 1-86, 4-86, and 1-95



REVENUE AUDIT MEMORANDUM ORDER NO. 1-86

Subject: Procedure for tax audit of Philippine branches of foreign corporationsTo: All internal revenue officers and others concerned.

1.

Background1.1 Some branches of foreign corporations engage in business in the

Philippines by soliciting orders from local importers. These branches arecalled ―liaison offices or branches‖. Sales made from such solicitations arenot reported to these branches as their own sale purportedly because thebranch office merely relays to its head office abroad purchase ordersfrom local importers and it is purportedly its head office that actuallyconsummates the sale. At the end of the taxable period, the branch officesimply reports for income tax purposes its purported share of the incomegenerated from sales but the allocation of this purported share is leftentirely at the discretion of the head office. The revenue service is

completely at the mercy of multinational companies.1.2 Some branches engage in business in the Philippines by soliciting orders

from local importers and relay this information to its head office abroad.The head office in turn solicits prospective exporters for compensation. Atthe end of the taxable period, the head office allocates a certain portionof the compensation to its branch in the Philippines. The branch in turnreports its purported share for income tax purposes but does not pay thecommercial broker’s tax thereon purportedly because the compensationwas received from its head office and purportedly because the branchcannot be legally considered a commercial broker in relation to its headoffice since the branch and its head office possesses only a single legalpersonality (Philipp Brothers Oceanic, Inc. v. CIR, CTA Case No. 3140,March 8, 1984).

Again, in this second situation, allocation of the compensation is left asthe discretion of the head office – the revenue service also left at themercy of these multinational companies.

2. Legal Consequences2.1 The foregoing scope of activities of these branch offices is considered

under R.A. 5455 as business acts. ―Doing business‖ shall include solicitingorders, purchases, service contracts, opening offices, whether called

―liaison‖ offices or branches… any other act or acts that imply a continuity

of commercial dealings or arrangements, and contemplate to that extentthe performance of acts or works, or the exercise of some of thefunctions normally incident to, and in progressive prosecution of,commercial gain or of the purpose and object of the businessorganization. (Sec 1(1), RA 5455).

2.2 These branch offices, like any other businesses, are required by law toaccount for their business operations in accordance with generallyaccepted accounting practices (NIRC). Thus a branch office although not



possessing a separate and distinct juridical personality is, however,considered under generally accepted accounting practices as a distinctcharacter, a separate business unit and should be ―supplied by the homeoffice with cash and merchandise and other such assets as may beneeded‖ (Advance Accounting by Simons and Korrenbrock, 4th ed., p.202). Generally accepted accounting practices also dictate that incomeand expenses of the branch shall be segregated from those of the homeoffice in order to clearly reflect their respective operating results (ibid).

2.3 The doctrine of corporate fiction is not absolute – the veil of corporatefiction may be legally pierced should it be used to subvert just applicationof laws. ―…Where the corporate form of organization is adopted or acorporate entity is asserted in an endeavor to evade a statute or tomodify its intent, courts will disregard the corporation or its entity. Thishas been applied to violations of tax laws‖ (Fletcher, 170171, Commentaries and Jurisprudence on the Commercial Laws of thePhilippines by Agbayani, Vol. 3, 1970 ed., p.21). ―…Where the corporationis a dummy, is unreal or a sham and serves no business purposes and is

intended only as a blind, the corporate form may be ignored for the lawcannot countenance a form that is bald and a mischievous fiction.‖ (Id.page 20). ―…To allow a taxpayer to deny tax liability on the ground thatthe sales were made through another and distinct corporation when it isproved that the latter is virtually owned by the former or that they arepractically one and the same is to sanction a circumvention of our taxlaws.‖ (Id.)

Corporate fiction may be inquired upon where there is ―inadequacy ofcapital…, confusion of affairs… and direct intervention in managementcausing inequitable results (Ballantine, 314, Rorhlick, 417422).

3.

Branch Operation and Consequences3.1 The Philippine branch solicits purchase orders from local buyers, relays

the information to its home office abroad, and the home officepurportedly directly makes the sale.

In this type of operation,: (i) Sales purportedly consummated abroad bythe home office shall be treated as sales constructively consummated inthe Philippines and made by the branch office, hence, income therefromshall be considered income from sources within the Philippines; (ii) thebranch shall record and report the gross selling price of commodities soldthru its home office; and (iii) report for income tax purposes its net

income therefrom. (iv) since under this situation the import taxes, dutiesand charges have already been paid by the local buyers, the same shallnot anymore be chargeable against the branch. Under this paragraph,these transactions are treated sales constructively consummated by thebranch office in accordance with the generally accepted accountingpractices required under section 38 of the Tax Code since the branchsolicitations are actually trading acts. Accordingly, the home office isobligated to supply its branch with merchandise in pursuing its trading



business in the Philippines. Hence, sales purportedly made directly by itshome office shall be considered no more than merely constructivesupplying of the merchandise to its branch which eventuallyconstructively sells the same to Philippine buyers.

3.2 The branch solicits purchase orders from local buyers, relays theinformation to its home office, the home office solicits prospective sellersabroad and eventually receives compensation for services rendered.

In this second type of operation: (i) the branch shall be considered ―acommercial broker‖ or indentor; (ii) its share from compensation asallocated by its home office shall be subject to commercial broker grossreceipts tax; (iii) the branch shall provide itself with corresponding fixedtax as a commercial broker; and (iv) pay income tax on its share of compensation.

Under this paragraph, the branch office shall be considered a commercialbroker since its activities are well within the ambit of the term ―broker‖.

Brokers are ―… those who are engaged for others in the negotiation ofcontracts relative to property with custody of which they have noconcern. They act as negotiators in bringing other persons together tobargain; generally, they ought not to sell in their own names, have noimplied authority to receive payment, are not entrusted with the physicalpossession of the principal’s goods when engaged to buy and sell, andhave no special property therein or lien thereon.‖ (Philipi Brothers, Id.)

4. Audit procedure …xxx…


Subject: Audit Guidelines in the Allocation of Home Office Overhead ExpensesUnder Section 37(b) of the NIRC

In order to avoid delay and conflict in the determination of Philippine sourcestaxable net income of foreign taxpayers for purposes of Philippine Income tax,this RAMO is issued.

1. Background1.1 In computing net income from sources within the Philippines, Section

37(b) provides that from the gross income from sources within thePhilippines ―x x x there shall be deducted the expenses, losses and other

deductions properly allocated thereto and a ratable part of any expenses,interests and losses and other deductions effectively connected with thebusiness or trade conducted exclusively within the Philippines whichcannot be definitely allocated to some items or class of gross income x xx.‖

1.2 These deductions are difficult to verify because substantial amountsthereof are incurred in the head office or elsewhere and thecorresponding supporting documents and books of accounts are not



accessible to local taxing authorities.1.3 Heretofore only an audit certificate is presented to substantiate the

deductions incurred abroad which are allocated and prorated to Philippinesource gross income.

1.4 In implementing the above provision of the NIRC, there is a need foradequate and satisfactory proof and explanations in order that theclaimed deductions of the foreign taxpayer may be allowed for incometax purposes.

2. Audit Procedure2.1 Functional Analysis – At the start of investigation there should be a

detailed examination of the functions performed both by the Home Officeand the Local Branch. For this purpose, an organization and functionalchart of the home office and local branch should be secured.

2.1.1 The functions should be determined and then listed. Who does what?What is required to do it? Who needs who from what?

2.1.2 After having listed the functions performed by each entity, the functions

themselves must be analyzed. Could anyone else perform thesefunctions? How difficult are they? What skill, equipment and processesare needed?

2.2. On the basis of the functional analysis, the claimed deduction properlyallocable can now be determined by applying the tests of (a) relevance(necessary) to the local branch and (b) reasonable (ordinary) charges,keeping always in mind the arm’s length principle in transactions betweenrelated parties.

2.3. As to the deductions which cannot be definitely allocated, the followingare required:

2.3.1 Breakdown or Schedule of Home or Foreign Office expenses beingprorated, together with an explanation of the nature of each expense.Take note of the deductions which are directly allocable to income earnedoutside the Philippines.

2.3.2 Basis of proration(a) Determine if the basis and method of proration are being applied

consistently from year to year.(b) is the same amount of Home Office expense being allocated

worldwide?


Subject: Audit guidelines and procedures on the proper determination of the

income tax liability of Philippine branches and liaison offices, of MultiNationalEnterprises (MNEs) engaged in soliciting orders, purchases, service contracts,trading, construction and other activities in the Philippines.

II. ObjectivesThis Order is issued to:a) amend and supersede RAMO No. 1-86 dated April 25, 1986 which provides

for the procedures for tax audit of Philippine branches of foreign



corporations.b) Address the issue on the proper determination of the income tax liability of

Philippine branches and liaison offices of MNEs pursuant to Section 43 of theNIRC wherein the CIR is authorized to distribute, apportion or allocate grossincome or deduction among organizations in order to clearly reflect theincome of any such organization.

III. Coveragea) This order shall apply only to Philippine branches and liaison offices of

Japanese trading firms which are members of the Sogo Shosas andregistered with the Japanese Chamber of Commerce and Industry (JCCI),and also all other foreign trading companies similarly situated as determinedby the CIR.

b) Furthermore, the contents of this Order will apply only to income taxliabilities of Philippine branches and liaison offices of MNEs and will not affectthe withholding, including branch profit remittance, and business taxobligations of the same Philippine branches and liaison offices of MNEs which

shall be subject to the provisions of the NIRC.

IV. Guidelines1. The Philippine income tax due from soliciting orders, purchases, service

contracts, trading, construction and other activities of the Philippine branchesand liaison offices of MNEs will be ascertained using the following formula:For solicitation and trading activities:(Worldwide Operating Sales to the Philippines attribution to tax)(Income X Worldwide Sales X rate X rate)For construction and other activities:Plus (Net Income from Construction and other activities X tax rate)

2. In implementing the above formula, the following terms shall be construed tomean as follows:

i. Worldwide (W/W) shall include head office accounts and those ofbranches located in different countries but shall exclude subsidiaryaccounts.

ii. W/W Operating Income shall include the Gross Income minus Selling ,General & Administrative expenses. Operating Income does not includenonoperating and extraordinary items like interest expense, exchangeprofit/loss, capital gains/losses or other income/loss not related tooperation.

iii. Sales to the Philippines shall be defined as the aggregated amount ofexports and offshore transactions to the Philippines by the Head Office ,

all branches and liaison offices and shall include the amount of indenttransactions from which commissions are generated. These shall alsoinclude imported materials and equipment of construction projectsundertaken in the Philippines, but shall exclude local service income fromconstruction projects or onshore income from local construction.

iv. W/W sales shall consist of domestic, export, import and offshoretransactions which include not only principal transactions but also indenttransactions from which commissions are generated.



v. Attribution rate shall mean a rate of 75% to be applied against theformula

vi. The tax rate to be applied shall be in accordance with Section 25(a) ofthe NIRC which is 35%.

vii. Net income on construction shall consist of local service income fromconstruction projects or onshore income from construction projects oronshore income from construction projects including the cost of locallypurchased materials and equipment, if any.

viii. Net income on all other activities shall consist of income such asmanagement consultancy services and other undertakings that Philippinebranches and liaison offices of MNEs are engaged in, net of costs andexpenses associated with such income.

3. In the application of the formula, no offsetting of losses from one line ofbusiness to the detriment of the other line of business shall be allowed. Thiswould mean that the tax due from each line of business shall be computedindependently from the other line of business.

V. Procedures

1. Request documents containing information of the nature of the businesstransactions of the taxpayer as follows:(a) the structure of the Philippine branch or liaison office, the Home Office,

other branches or more than 50% owned or controlled subsidiarieslocated outside the Philippines dealing with the local branch;

(b) the ownership, relationship, extent of control, directors and officers of thePhilippine branch or liaison office or Home Office;

(c) the business activity of the MNE and how it relates to the activity of thelocal branch or liaison office and other branches or more than 50%owned or controlled subsidiaries dealing with the local company.

o Revenue Regulation No. 2-2013, January 2, 2013

SUBJECT: Transfer Pricing GuidelinesTO: All Internal Revenue Officers and Others Concerned

BACKGROUND. – The dramatic increase in globalization of trade has also led toharmful tax practices that have resulted in tremendous losses of tax revenues forgovernments. The most significant international tax issue emerging fromglobalization confronting tax administrations worldwide is transfer pricing.

Transfer pricing is generally defined as the pricing of cross-border, intra-firmtransactions between related parties or associated enterprises.1 Typically, atransfer price occurs between a taxpayer of a country with high income taxesand a related or associated enterprise of a country with low income taxes. In thePhilippines, ―intra-firm / inter-related‖ transactions account for a substantialportion of the transfer of goods and services, however, the revenue collectionfrom related-party groups continue to go on a downtrend.



The revenues lost from intra-related transactions can be attributed to the factthat related companies are more interested in their net income as a whole(rather than as individual corporations), as such there is a desire to minimize taxpayments by taking advantage of the loopholes in our tax system.

While transfer pricing issue typically occurs in cross-border transactions, it canalso occur in domestic transactions. One context where transfer pricing issueoccurs domestically is where one associated enterprise, entitled to income taxexemptions, is being used to allocate income away from a company subject toregular income taxes. In the Philippines, there is a domestic transfer pricing issuewhen income are shifted in favor of a related company with special tax privilegessuch as Board of Investments (BOI) Incentives and Philippine Economic Zone

Authority (PEZA) fiscal incentives or when expenses of a related company withspecial tax privileges are shifted to a related company subject to regular incometaxes or in other circumstances, when income and/or expenses are shifted to arelated party in order to minimize tax liabilities.

SECTION 1. OBJECTIVE AND SCOPE. – Pursuant to the provision of Section244 in relation to Section 50 of the National Internal Revenue Code of 1997, asamended (―Tax Code‖) these regulations are hereby promulgated to:a. implement the authority of the Commissioner of Internal Revenue

(―Commissioner‖) to review controlled transactions among associatedenterprises and to allocate or distribute their income and deductions in orderto determine the appropriate revenues and taxable income of the associatedenterprises involved in controlled transactions;

b. prescribe guidelines in determining the appropriate revenues and taxableincome of the parties in the controlled transaction by providing for themethods of establishing an arm‟s length price ; and

c. require the maintenance or safekeeping of the documents necessary for thetaxpayer to prove that efforts were exerted to determine the arm‟s lengthprice or standard in measuring transactions among associated enterprises.

These Regulations apply to:(1) cross-border transactions between associated enterprises; and(2) domestic transactions between associated enterprises.

SECTION 2. PURPOSE OF THE REGULATIONS. – These Regulations seek toprovide guidelines in applying the arm‟s length principle for cross-border anddomestic transactions between associated enterprises.These guidelines are largely based on the arm‟s length methodologies as set out

under the Organisation for Economic Co-operation and Development (OECD)Transfer Pricing Guidelines.

SECTION 3. AUTHORITY OF THE COMMISSIONER TO ALLOCATEINCOME AND DEDUCTIONS. – Pursuant to Section 50 of the Tax Code, theCommissioner is authorized to distribute, apportion or allocate gross income ordeductions between or among two or more organizations, trades or businesses(whether or not incorporated and whether or not organized in the Philippines)



owned or controlled directly or indirectly by the same interests, if he determinesthat such distribution, apportionment or allocation is necessary in order to clearlyreflect the income of any such organization, trade or business.

Thus, the Commissioner is authorized to make transfer pricing adjustments, inline with the purpose of Section 50 to ensure that taxpayers clearly reflectincome attributable to controlled transactions and to prevent the avoidance oftaxes with respect to such transactions.

SECTION 4. DEFINITION OF TERMS. – As used in these Regulations, thefollowing terms shall have the following meaning:

Comparable transaction. A transaction that is comparable to the controlledtransaction under examination taking into consideration factors such as thenature of the property or services provided between the parties, functionalanalysis of the transactions and parties, contractual terms, and economicconditions.

Comparable uncontrolled transaction. A comparable uncontrolledtransaction is a transaction between two independent parties that is comparableto the controlled transactions under examination. It can be either a comparabletransaction between one party to the controlled transaction and an independentparty (―internal comparable‖) or between two independent parties, neither ofwhich is a party to the controlled transaction (―external comparable‖)

Associated enterprises. Two or more enterprises are associated if oneparticipates directly or indirectly in the management, control, or capital of theother; or if the same persons participate directly or indirectly in themanagement, control, or capital of the enterprises. These are also referred to asrelated parties.

Control refers to any kind of control, direct or indirect, whether or not legallyenforceable, and however exercisable or exercised. Moreover, control shall bedeemed present if income or deductions have been arbitrarily shifted betweentwo or more enterprises.

Controlled transaction means any transaction between two or moreassociated enterprises.

Independent enterprises or parties. Two enterprises are independent

enterprises with respect to each other if they are not associated enterprises.

Advance Pricing Arrangement (“APA”) is an arrangement that determines,in advance of controlled transactions, an appropriate set of criteria (e.g. method,comparables and appropriate adjustments thereto, critical assumptions as tofuture events) for the determination of the transfer pricing for those transactionsover a fixed period of time.



Mutual Agreement Procedure (MAP) is a means through which taxadministrations consult to resolve disputes regarding the application of doubletax conventions. This procedure, described in Article 25 of the OECD Model TaxConvention, can be used to eliminate double taxation that could arise from atransfer pricing adjustment.

SECTION 5. ARM’S LENGTH PRINCIPLE. – The Bureau of Internal Revenue(the ―Bureau‖) hereby adopts and the use of arm‟s length princ iple as the mostappropriate standard to determine transfer prices of related parties.

a. Background and Concept:

The arm‟s length principle is the internationally recognized standard for transferpricing between associated enterprises. Paragraph 1 of Article 9 of Philippine taxtreaties is virtually identical to paragraph 1 of Article 9 of the OECD Model TaxConvention on Income and Capital, which is considered, in the internationalarena, as the authoritative statement of the arm‟s length principle.

Paragraph 2 of Article 7 (Business Profits) of the OECD Model Tax Convention onIncome and on Capital specifies that, when attributing the profits to a permanentestablishment, the permanent establishment should be considered as „a distinctand separate enterprise engaged in the same or similar activities and under thesame or similar conditions‟. This corresponds with the application of the arm‟slength principle specified in paragraph 1 of Article 9 (Associated Enterprises) ofthe OECD Model Tax Convention on Income and on Capital.

The arm‟s length principle requires the transaction with a related party to bemade under comparable conditions and circumstances as a transaction with anindependent party. It is founded on the premise that where market forces drivethe terms and conditions agreed in an independent party transaction, the pricingof the transaction would reflect the true economic value of the contributionsmade by each entity in that transaction. Essentially, this means that if twoassociated enterprises derive profits at levels above or below the comparablemarket level solely by reason of the special relationship between them, theprofits will be deemed as non-arm‟s length. In such a case, tax authorities thatadopt the arm‟s length principle can make the necessary adjustments to thetaxable profits of the related parties in their jurisdictions so as to reflect the truevalue that would otherwise be derived on an arm‟s length basis.

b. Guidance on the Application of the Arm’s Length Principle:

The application of arm‟s length principle would, first and foremost, involve theidentification of comparable situation(s) or transaction(s) undertaken byindependent parties against which the associated enterprise transaction ormargin is to be benchmarked. This step is commonly known as ―comparabilityanalysis‖. It entails an analysis of the similarities and differences in theconditions and characteristics that are found in the associated enterprisetransaction with those in an independent party transaction. Once the impact of



these similarities or differences have on the transfer price have been determined,the arm‟s length price/margin (or a range) can then be established using anappropriate transfer pricing method.

In the application of the arm‟s length principle the following 3-step approach,discussed in detail in Sections 6, 7, and 8 of these Regulations, may beobserved.

Step 1: Conduct a comparability analysis.Step 2: Identify the tested party and the appropriate transfer pricing method.Step 3: Determine the arm‟s length results.These steps should be applied in line with the key objective of transfer pricinganalysis to present a logical and persuasive basis to demonstrate that transferprices set between associated enterprises conform to the arm‟s length principle.

SECTION 6. COMPARABILITY ANALYSIS.

a.

The Concept of ComparabilityThe arm‟s length principle is based on a comparison of the prices or marginsadopted or obtained by related parties with those adopted or obtained byindependent parties engaged in similar transactions. For such price or margincomparisons to be meaningful, all economically relevant characteristics of thesituations being compared should be sufficiently similar so that:(1) none of the differences (if any) between the situations being compared can

materially affect the price or margin being compared, or(2) reasonably accurate adjustments can be made to eliminate the effect of any

such differences.

b. Factors Affecting Comparability A comparability analysis should examine the comparability of the transactions in3 aspects:

(1) Characteristics of Goods, Services or Intangible Properties

i. The specific characteristics of goods, services or intangible properties playa significant part in determining their values in the open market. Forinstance, a product with better quality and more features would, ceterisparibus, fetch a higher selling price. Such product or servicedifferentiation affects the price or value of the product or service. Hence,the nature and features of the goods, intangible properties or services

transacted between related parties and those between independentparties must be examined carefully. The similarities and differences(which would influence the value of the goods, services or intangibleproperties) should be identified.

ii. Characteristics to be examined include, but are not limited to, thefollowing:- in the case of transfer of goods: the physical features, the quality andreliability, and the availability and volume of supply of the goods;



- in the case of provision of services: the nature and extent of theservices; and- in the case of intangible property: the form of transaction, the type ofintangible, the duration and degree of protection, and the anticipatedbenefits from the use of the property.

iii. Similarities in the actual characteristics of the product, intangible orservice, are most critical when one needs to compare prices of relatedparty transactions against independent ones, such as when theComparable Uncontrolled Pricing (CUP) method is adopted as the transferpricing method. On the other hand, comparisons of profit margins (usedin methods other than CUP) may be less sensitive to the features andcharacteristics of the product or service in question, as the marginsgenerally correlate more significantly with the functions performed, risksborne and assets used by the entity.

(2) Analysis of Functions, Risks and Assets

i.

Economic theory purports that the level of return derived by an entityshould be directly correlated to the functions performed, the assets usedand risks assumed. For instance, an entity selling a product with warrantyshould earn a higher return compared to another entity selling the sameproduct without the provision of warranty. The difference in margin is dueto the additional function performed and risk borne by the first entity.Likewise, a product with a reputable branding is expected to fetch ahigher return compared to that of a similar product without the branding,due to the additional asset (in this case, trademark) employed inenhancing the value of the product.

ii. Hence, a crucial step in comparability analysis must entail a comparison ofthe economically significant functions performed, risks assumed andassets employed by the related party with those by the independent party(which has been selected as the party against which the associatedenterprise‟s margin or transactions are to be benchmarked). This istypically known as conducting a ―functional analysis‖.

iii. The functions that should be compared include (but are not limited to)design, research and development, manufacturing, distribution, sales,marketing, logistics, advertising, financing, etc.

iv. It is also relevant and useful, when identifying and comparing thefunctions performed, to consider the assets that are employed or to beemployed. This analysis should consider the type of assets used, such asplant and equipment, valuable intangibles, etc. and the nature of the

assets used (i.e., the age, market value, location, availability ofintellectual property protections), etc.

v. An appraisal of risks is also important in determining arm‟s lengthprices/margins. The possible risks assumed that should be considered inthe functional analysis include market risks, risks of change in cost, priceor stock, risks relating to the success or failure of R&D, financial riskssuch as changes in the foreign exchange and interest rates, credit risks,etc.



vi. In practice, one cannot be expected to compare all functions, risks andassets employed. Hence, it must be emphasized that only functions, riskand assets that are economically significant in determining the value oftransactions or margins of entities should be identified and compared.

(3) Commercial and Economic Circumstancesi.

Prices may vary across different markets even for transactions involvingthe same property or services. In order to make meaningful comparisonsof prices or margins between entities/transactions, the markets andeconomic conditions in which the entities operate or where thetransactions are undertaken should be comparable. the economiccircumstances that may be relevant in determining market comparabilityinclude the availability of substitute goods or services, geographiclocation, the market size, the extent of competition in the markets,consumer purchasing power, the level of the market at which theenterprises operate (i.e., wholesale or retail), etc.

ii. Government policies and regulations (such as price controls, national

insurance, etc.) may have an impact on prices and margins. Hence, theeffects of these regulations should also be examined as part of theexamination for comparability of the market and economic conditions.

iii. Business strategies should also be examined in determining comparabilityfor transfer pricing purposes. Business strategies would take into accountmany aspects of an enterprise, such as innovation and new productdevelopment, degree of diversification, risk aversion, assessment ofpolitical changes and other factors bearing upon the daily conduct ofbusiness.

iv. An entity may embark on business strategies of temporarily charging alower price for its product compared to similar products in the market orincurring higher expenses in the short run (hence resulting in lower profitlevels). Such strategies are commonly used for market penetration andmarket share expansion or defense. The key issue with respect tobusiness strategies that temporarily reduce profits in anticipation ofhigher long-term profit is whether the adoption and outcome of suchstrategies produce an arm‟s length result. Hence, a claim that suchstrategies have been adopted ought to be demonstrated with evidencethat that an independent party would have been prepared to sacrificeprofitability for a similar period under similar economic circumstances andcompetitive conditions, so that a higher long-term profit can be realized.

SECTION 7. IDENTIFICATION OF THE TESTED PARTY AND THE

APPROPRIATE TRANSFER PRICING METHOD.a. Determination of the Tested Party

The tested party is the entity to which a transfer pricing method can be mostreliably applied to and from which the most reliable comparables can be found.For an entity to become a tested party, the Bureau requires sufficient andverifiable information on such entity.



b. Selection and application of Transfer Pricing Methodologies (TPM)(1) The specific methods to be used in determining the arm‟s length price are

discussed in Section 10 of these Regulations.(2) The selection of a transfer pricing method is aimed at finding the most

appropriate method for a particular case. Accordingly, the method thatprovides the most reliable measure of an arm‟s length result shall be used.For this purpose, the selection process should take into account thefollowing:

i. the respective strengths and weaknesses of each of the transferpricing methods;

ii. the appropriateness of the method considered in view of the nature ofthe controlled transaction, determined in particular through afunctional analysis;

iii. the availability of reliable information (in particular on uncontrolledcomparables) in order to apply the selected method and/or othermethods; and

iv. the degree of comparability between controlled and uncontrolled

transactions, including the reliability of comparability adjustments thatmay be needed to eliminate material differences between them.

(3) The Bureau does not have a specific preference for any one method.Instead, the TPM that produce the most reliable results, taking into accountthe quality of available data and the degree of accuracy of adjustments,should be utilized.

(4) In exceptional circumstances where there may not be comparabletransactions or sufficient data to apply the above-described methods theBureau may use the following approaches to verify whether the controlledtransactions comply with the arm‟s length principle:

i. Extension of the transfer pricing methods. The comparable may bewith enterprises in another industry segment or group of segments;and

ii. Use of a combination or mixture of the transfer pricing methods orother methods or approaches.

(5) In all cases, taxpayers should be able to explain why a specific TPM isselected or used in recording controlled transactions through properdocumentation.

c. Selection of Profit Level Indicator (PLI)(1) In applying the TPM, due consideration must given to the choice of PLI which

measures the relationship between profits and sales, costs incurred or assetsemployed. The use of an appropriate PLI ensures better accuracy in the

determination of the arm‟s length price of a controlled transaction. PLI ispresented in the form of a generally recognized or utilized financial ratio. Theselection of an appropriate PLI depends on several factors, including:

i. characterization of the business;ii. availability of comparable data; andiii. the extent to which the PLI is likely to produce a reliable measure of

arm‟s length profit. (2) Commonly used PLI include:



i. Return on costs: cost plus margin and net cost plus margin.ii. Return on sales: gross margin and operating margin.iii. Return on capital employed: return on operating assets.

SECTION 8. DETERMINATION OF THE ARM’S LENGTH RESULTS. - Oncethe appropriate transfer pricing method has been identified, such is applied onthe data of independent party transactions to arrive at the arm‟s length result.

In some cases, it will be possible to apply the arm‟s length principle to arrive ata single figure or specific ratio (e.g. price or margin) that is the most reliable toestablish whether the conditions of a transaction are arm's length. However, it isgenerally difficult to arrive at a specific ratio or range of deviation that may beconsidered as arm‟s length. More likely, the transfer pricing analysis would leadto a range of ratios. Hence, the use of ranges to determine an arm‟s lengthrange shall be applied, provided that the comparables are reliable.

a. If the relevant condition of the controlled transaction (i.e. price or margin) is

within the arm‟s length range, no adjustment should be made. If therelevant condition of the controlled transaction (e.g. price or margin) fallsoutside the arm‟s length range asserted by the Bureau, the taxpayer shouldpresent proof or substantiation that the conditions of the controlledtransaction satisfy the arm‟s length principle, and that the result falls withinthe arm‟s length range (i.e. that the arm‟s length range is different from theone asserted by the tax administration). If the taxpayer is unable to establishthis fact, the Bureau must determine the point within the arm‟s length rangeto which it will adjust the condition of the controlled transaction.

b. In determining this point, where the range comprises results of relativelyequal and high reliability, it could be argued that any point in the rangesatisfies the arm‟s length principle. Where comparability defects remain, itmay be appropriate to use measures of central tendency to determine thispoint (for instance the median, the mean or weighted averages, etc.,depending on the specific characteristics of the data set), in order tominimise the risk of error due to unknown or unquantifiable remainingcomparability defects.

SECTION 9. COMPARABILITY ADJUSTMENT. - Differences between thetransaction of the comparables and that of the tested party must be identifiedand adjusted for, in order for the comparables to be useful as basis fordetermining the arm‟s length price. Comparability adjustments includeaccounting adjustments and function/risk adjustments.

a. Comparability adjustments are intended to eliminate the effects ofdifferences that may exist between situations being compared and thatwhich could materially affect the condition being examined in themethodology (e.g. price or margin). These should not be performed tocorrect differences that have no material effect on the comparison, asthese adjustments are neither routine nor mandatory in a comparabilityanalysis. When proposing a comparability adjustment, a resultant



improvement or increase in the accuracy in the comparability should bedemonstrated.

b. The following adjustments should be avoided as they do not improvecomparability:(1) adjustments that are questionable when the basis for comparability

criteria is only broadly satisfied;(2)

excessive adjustments or adjustments that too greatly affect thecomparable as such indicates that the third party being adjusted is inactually not sufficiently comparable;

(3) adjustments on differences that do not materially affect thecomparability;

(4) highly subjective adjustments, such as on the difference in productquality.

SECTION 10. ARM’S LENGTH PRICING METHODOLOGIES. – Indetermining the arm’ s length result, the most appropriate of the followingmethods may be used.

a. Comparable Uncontrolled Price (CUP) Method – The CUP Methodevaluates whether the amount charged in a controlled transaction is at arm‟slength by reference to the amount charged in a comparable uncontrolledtransaction in comparable circumstances. Any difference between the twoprices may indicate that the conditions of the commercial and financialrelations of the associated enterprises are not arm‟s length, and that theprice in the uncontrolled transaction may need to be substituted for the pricein the controlled transaction.

The use of the CUP Method to determine transfer price entails identificationof all the differences between the product or service of the associatedenterprise and that of the independent party. If these differences have amaterial effect on the price, adjustment of the price of products sold/servicesrendered by the independent party to reflect these differences shall be madeto arrive at the arm‟s length price. A comparability analysis under the CUPMethod shall take into account the following:(1) Product characteristics such as physical features and quality;(2) If the product is in the form of services, the nature and extent of such

services provided;(3) Whether the goods sold are compared at the same points in the supply or

production chain;(4) Product differentiation in the form of patented features such as

trademarks, design, etc.;(5) Volume of sales if it has an effect on price;(6) Timing of sale if it is affected by seasonal fluctuations or other changes in

market conditions;(7) Whether cost of transport, packaging, marketing, advertising, and

warranty are included in the deal;(8) Whether the products are sold in places where the economic conditions

are the same; and



(9) Whether a business strategy is adopted in the controlled transaction thatwould produce material difference on the price of the controlledtransaction as against the price in an uncontrolled transaction.

b. Resale Price Method (RPM) - RPM is applied where a product that hasbeen purchased from a related party is resold to an independent party.Essentially, it seeks to value the functions performed by the reseller of aproduct. The resale price method evaluates whether the amount charged in acontrolled transaction is at arm‟s length by reference to the gross profitmargin realized in comparable uncontrolled transactions. This method isgenerally appropriate where the final transaction is made with anindependent party. The usefulness of the method largely depends on howmuch added value or alteration the reseller has done on the product before itis resold, or the time lapse between purchase and onward sale. Thus, RPM ismost appropriate in a situation where the reseller adds relatively little valueto the properties. The greater the value added to the properties by thereseller, for example, through complicated processing or assembly with other

products or, the longer the time lapse – to the extent that market conditionsmight have changed – before it is resold or, when the reseller contributessubstantially to the creation or maintenance of an intangible property that isattached to the product, such as trademarks or tradenames, the moredifficult it is to use RPM to arrive at the arm‟s length price.

The starting point in RPM is the price (the resale price) at which a productthat has been purchased in a controlled sale is then resold to an independentthird party (uncontrolled resale). This price (the resale price) is then reducedby an appropriate gross margin (the resale price margin) representing theamount out of which the reseller would seek to cover its selling and otheroperating expenses and, in the light of functions performed (taking intoaccount assets used and risks assumed), make an appropriate profit. Anarm‟s length price for the original transfer of property between theassociated enterprises (controlled transaction) is obtained after subtractingthe gross margin (resale price margin) from the resale price, and adjustingfor other costs associated with the purchase of the product, such as customsduties.

The following are factors which may influence the resale price margin andother considerations when performing a comparability analysis for purposesof the resale price method:(1) Functions or level of activities performed by the reseller and the risks

undertaken (e.g., whether the reseller is merely a forwarding agent or, adistributor who assumes full responsibility for marketing and advertisingthe product by risking its own resources in these activities);

(2) Whether similar assets are employed in the controlled and uncontrolledtransactions, (e.g., a developed distribution network);

(3) Although broader product differences are allowed as compared to theCUP method, product similarities are still significant to some extentparticularly when there is a high value or unique intangible attached to



the product;(4) If the resale price margin used is that of an independent enterprise in a

comparable transaction, differences in the way business is managed mayhave an impact on profitability;

(5) The time lapse between original purchase and resale of the product as alonger time lapse may give rise to changes in the market, exchangerates, costs, etc.;

(6) Whether the reseller is given exclusive rights to resell the products;(7) Differences in accounting practices where adjustments must be made to

ensure that the components of costs in arriving at gross margins in thecontrolled and uncontrolled transactions are the same;

(8) Whether cost of transport, packaging, marketing, advertising, andwarranty are included in the deal;

(9) Whether the products are sold in places where the economic conditionsare the same; and

(10) Whether a business strategy is adopted in the controlledtransaction that would produce material difference on the resale gross

margin of the controlled transaction as against the resale gross margin inan uncontrolled transaction.

As gross profit margins represent the gross compensation (after cost ofsales) for specific functions performed, assets used and risks assumed,product differences are less critical than under the CUP Method. Therefore,where the related and independent party transactions are comparable in allaspects except for the product itself, RPM might produce a more reliablemeasure of arm‟s length conditions than the CUP Method. Nonetheless, itcan be expected that the more comparable the products, the more likely it isthat the RPM will produce better results.

c.

Cost Plus Method (CPM) - CPM focuses on the gross mark-up obtained bya supplier who transfers property or provides services to a related purchaser.Essentially, the method attempts to value the functions performed by thesupplier of the property or services. CPM is most useful where semi-finishedgoods are sold between associated enterprises or where the controlledtransaction involves the provision of services.

CPM indirectly measures whether the price for the property or service in thecontrolled transaction is an arm‟s length price by assessing whether themark-up on the costs incurred by the supplier of the property or service inthe controlled transaction meets the arm‟s length standard. This method is

often useful in cases involving the manufacture, assembly, or otherproduction of goods that are sold to related parties or where controlledtransaction involves the provision of intra-group services.

The starting point in CPM is the cost incurred by the supplier of property orservices in a controlled transaction for property transferred or servicesprovided to a related purchaser. An appropriate mark-up is added to this costto find the price that the supplier should be charging the buyer.



The cost base used in determining costs and the accounting policies shouldbe consistent and comparable between the controlled and uncontrolledtransaction, and over time in relation to the particular enterprise. The costsreferred to in CPM are the aggregation of direct and indirect costs ofproduction.

Comparability, when applying CPM, should take into account the similarity offunctions performed, assets used and risks assumed, contractual terms,market conditions and business strategies as well as any adjustments madeto account for the effects of any differences in the aforementioned factorsbetween the controlled and uncontrolled transactions.

A comparability analysis under CPM shall take into account the following:(1) Functions or level of activities performed by the seller and the risks

undertaken;(2) Whether similar assets are employed in the controlled and uncontrolled

transactions;(3) Although broader product differences are allowed as compared to the

CUP method, product similarities are still significant to some extent;(4) If the gross margin used is that of an independent enterprise in a

comparable transaction, differences in the way business is managed mayhave an impact on profitability;

(5) Differences in accounting practices where adjustments must be made toensure that the components of costs in arriving at gross margins in thecontrolled and uncontrolled transactions are the same;

(6) Whether cost of transport, packaging, marketing, advertising, andwarranty are included in the deal;

(7) Whether the products are sold in places where the economic conditionsare the same; and

(8) Whether a business strategy is adopted in the controlled transaction thatwould produce material difference on the cost plus mark-up of thecontrolled transaction as against the cost plus mark-up in an uncontrolledtransaction.

As in RPM, fewer adjustments may be necessary to account for productdifferences under CPM than the CUP Method, and it may be appropriate tofocus on other factors of comparability (such as the functions performed andeconomic circumstances). Where the associated enterprise and independentparty transactions are not comparable in all aspects and the differences have

a material effect on the margin, taxpayers are expected to make appropriateadjustments to eliminate the effects of these differences.

d. Profit Split Method (PSM). PSM seeks to eliminate the effect on profits ofspecial conditions made or imposed in a controlled transaction (or incontrolled transactions that are appropriate to aggregate) by determining thedivision of profits (or losses) that independent enterprises would haveexpected to realize from engaging in the transaction or transactions.



This method provides an alternative in cases where no comparabletransactions between independent parties can be identified. This is truenormally in a situation where transactions are very interrelated that theycannot be evaluated separately, or in situations involving a unique intangible.The method is based on the concept that profits earned in a controlledtransaction should be equitably allocated among associated enterprisesinvolved in the transaction(s) on an economically valid basis thatapproximates the allocation of profits that would have been anticipated andreflected in an agreement made at arm‟s length.

Generally, the profit to be split is the operating profit, but it may beappropriate to carry out a split of the gross profit and then deduct theexpenses incurred by or attributable to each relevant party.

The allocation of profit or loss under the profit split method shall be made inaccordance with the following approaches:

(1) Residual Profit Split Approach. –The combined profits from thecontrolled transactions under examination are split in two stages.

i. In the first stage, each participant is allocated sufficient profit toprovide it with a basic return appropriate for the type oftransactions in which it is engaged. Ordinarily, this basic returnwould be determined by reference to the market return achievedfor similar types of transactions by independent parties. Thus, thebasic return would generally account for the value, with referenceto comparable independent market data, of the contribution orfunctions performed by each party and not account for the returnthat would be generated by any unique and valuable assetspossessed by the participants.

ii. In the second stage, any residual profit (or loss) remaining afterthe first stage division would be allocated among the partiesbased on an analysis of the facts and circumstances that mightindicate how this residual would have been divided betweenindependent parties (i.e. taking into consideration the value ofunique assets used by the parties, usually intangible assets). Theremaining profit which is attributable to such unique assets isallocated between the parties based on the relative contributionsof the parties to the creation of such assets, taking intoconsideration how independent parties would have divided such

residual profits in similar circumstances.(2) Contribution Profit Split Approach. – The combined profits, which are

the total profits from the controlled transactions under examination, aredivided between the associated enterprises in a single stage based uponthe parties‟ relative contribution to the profit or the relative value of thefunctions performed by each of the associated enterprises participating inthe controlled transactions, supplemented as much as possible byexternal market data that indicate how independent enterprises would



have divided profits in similar circumstances.

e. Transactional Net Margin Method (TNMM) – TNMM operates in amanner similar to the cost plus and resale price methods in the sense that ituses the margin approach. This method examines the net profit marginrelative to an appropriate base such as costs, sales or assets attained by themember of a group of controlled taxpayers from a controlled transaction.

TNMM compares the net profit margins attained by an entity from a relatedparty transaction to those attained by the same entity in uncontrolledtransactions or, by comparable independent entities involved in similartransactions, relative to some appropriate base such as costs, sales, orassets.

In short, TNMM evaluates whether the amount charged in a controlledtransaction is arm‟s length by reference to the operating profit earned incomparable uncontrolled transactions.

Being a transactional profit method that is typically applied to only one of theparties involved in the transaction, the TNMM is closely aligned to the resaleprice and cost plus methods.

This similarity means that this method requires a level of comparabilitysimilar to that required for the application of the two traditional transactionmethods (the resale price method, and the cost plus method).

The primary difference between TNMM and RPM or CPM is that the formerfocuses on the net margin instead of the gross margin of a transaction.However, one of the weaknesses of using net margin as the basis forcomparison is that it can be influenced by many factors that either do nothave an effect, or have a less substantial or direct effect, on price or grossmargins. Examples of such factors include the efficiency of plant andmachinery used, management and personnel capabilities, competitiveposition, etc. Unless reliable and accurate adjustments can be made toaccount for these differences, TNMM may not produce reliable measures ofthe arm‟s length net margins.

TNMM is usually appropriate to use when the gross profit of the business isnot easy to determine such that either CPM, in case of amanufacturer/service-provider, or RPM, in case of a distributor, cannot be

used. Since the net margin figure is always available, TNMM may be usedinstead, applying the same formula as those for CPM (formanufacturer/service provider) or RPM (for distributor) but rather using netmargin in lieu of the gross margin/profit. 21

SECTION 11. ADVANCE PRICING ARRANGEMENTS and MUTUAL AGREEMENT PROCEDURE. – An Advance Pricing Arrangement (APA) is afacility available to taxpayers who are engaged in cross-border transactions. It is



an agreement entered into between the taxpayer and the Bureau to determine inadvance an appropriate set of criteria (e.g. method, comparables andappropriate adjustments thereto) to ascertain the transfer prices of controlledtransactions over a fixed period of time. The purpose of an APA is to reduce therisk of transfer pricing examination and double taxation.

There are two kinds of APA: (i) Unilateral APA; and (ii) Bilateral or Multilateral APA. A unilateral APA is an agreement involving only the taxpayer and BIR, whilea bilateral/multilateral APA is an agreement involving Philippines and one ormore of its treaty partners. A Bilateral or Multilateral APA is authorized under theMutual Agreement Procedure (MAP) Article of the 37 Philippine tax treaties.

It is not a mandatory requirement for taxpayers to avail of an APA for theircontrolled transactions. If a taxpayer avails of an APA, it may choose freelybetween a unilateral and bilateral/multilateral APA. If a taxpayer does not chooseto enter into an APA and its transactions are subject later on to transfer pricingadjustments, it may still invoke the MAP Article to resolve double taxation issues.

The Philippine tax treaties‟ article on MAP provides a mechanism for thePhilippine competent authority to mutually arrive at satisfactory solution with thecompetent authority of the treaty partner to eliminate double taxation issuesarising from transfer pricing adjustments.

The Bureau shall issue separate guidelines on the application of APA and MAPprocesses.

SECTION 12. DOCUMENTATION. – Taxpayers must demonstrate that theirtransfer prices are consistent with the arm‟s length principle. The main purposeof keeping adequate documentation is for taxpayers to be able to (i) defend theirtransfer pricing analysis, (ii) prevent transfer pricing adjustments arising from taxexaminations, and (iii) support their applications for MAP. Taxpayers who havenot prepared adequate documentation may find their application for MAPrejected or that the transfer pricing issue would be much more difficult toresolve.

a. Retention Requirement - The BIR does not require transfer pricingdocuments to be submitted when the tax returns are filed. However, suchdocuments should be retained by the taxpayers and submitted to BIR whenrequired or requested to do so.

b. Retention Period - In general, transfer pricing documents must be retained

preserved within the period specifically provided in the Tax Code as theretention period, unless a different period is otherwise legally provided.However, it is to the best interest of the taxpayer to maintain documentationfor purposes of MAP and possible transfer pricing examination.

c. Contemporaneousness - The transfer pricing documents must becontemporaneous. It is contemporaneous if it exists or is brought intoexistence at the time the associated enterprises develop or implement anyarrangement that might raise transfer pricing issues or review these



arrangements when preparing tax returns.d. Documentation Details – the details of transfer pricing documents include,

but are not limited to, the following:(1) Organizational structure(2) Nature of the business/industry and market conditions(3) Controlled transactions(4)

Assumptions, strategies, policies(5) Cost contribution arrangements (CCA)(6) Comparability, functional and risk analysis(7) Selection of the transfer pricing method(8) Application of the transfer pricing method(9) Background documents(10) Index to documents

SECTION 13. PENALTIES. – The provisions of the Tax Code and otherapplicable laws regarding the imposition of penalties and other appropriatesanctions shall be applied to any person who fails to comply with or violates the

provisions and requirements of these regulations.

SECTION 14. TRANSITORY PROVISION. – Transactions entered into prior tothe effectivity of these Regulations shall be governed by the laws and otheradministrative issuances prevailing at the time the controlled transactions wereentered into.

SECTION 15. SEPARABILITY CLAUSE. – If any part or provision of theseRegulations shall be held to be unconstitutional or invalid, other provisionshereof which are not affected thereby shall continue to be in full force and effect.

SECTION 16. REPEALING CLAUSE. – All existing rules, regulations and otherissuances or portions thereof inconsistent with the provisions of theseRegulations are hereby modified, repealed or revoked accordingly.

SECTION 17. EFFECTIVITY. – This Regulations shall take effect after fifteen(15) days following publication in a newspaper of general circulation.

o Revenue Regulations No. 16-86

REVENUE REGULATIONS NO. 16-86

Subject: Amendment to Section 160 of Income Tax Regulations (RR2) regardingthe basis of determining ratable part of overseas overhead expenses apportionedunder section 37(b) of the NIRC. Pursuant to Sections 4 and 277 of the NIRC,the first paragraph of Section 160 of RR2, otherwise known as the Income TaxRegulations, is hereby amended as follows:

Section 160.(a) Apportionment of deductions. From the items specified in Section37(a) as



prosecution of commercial gain or for the purpose and object of thebusiness organization

Sales proceeds from tickets and reservations for cargo spaces throughsaid local agents constitute taxable income from sources within thePhilippines

o

CIR v BOAC, 149 SCRA 395

BOAC is a 100% owned British corporation organized under British law. Itis engaged in international airline business. It (1) operates transportationservice and (2) sells tickets. But because it did not have landing rights inthe Philippines, it carried neither passengers nor cargo from thePhilippines. It did, however, sell BOAC tickets covering passengers andcargoes through a general sales agent in the Philippines.

In order that a foreign corporation may be regarded as doing businesswithin a State, there must be continuity of conduct and intention toestablish a continuous business, such as the appointment of a local

agent, and not one of a temporary character. The source of an income is the property, activity, or service that

produced the income (Howden and Co., Ltd. v. CIR [1965]). For thesource of income to be considered as coming from the Philippines, it issufficient that the income is derived from activity within the Philippines.

In BOAC's case, the sale of tickets in the Philippines is the activity thatproduces the income. The tickets exchanged hands here and paymentsfor fares were also made here in Philippine currency. The site of thesource of payments is the Philippines. The flow of wealth proceededfrom, and occurred within, Philippine territory, enjoying the protectionaccorded by the Philippine government. In consideration of suchprotection, the flow of wealth should share the burden of supporting thegovernment.

o NDC v CIR, 151 SCRA 395

NDC contracts with several shipbuilding companies in Japan to constructtwelve ocean-going vessels. NDC paid these companies in Japan, had allthe vessels constructed in Japan, and accepted the same in Japan. Theyargue that their interest payments on the balance of the purchase pricefor the vessels are non-taxable since all relevant activities were doneoutside of the country.

The law, however, does not speak of activity but of "source," which in

this case is the NDC – a domestic and resident corporation with principaloffices in Manila.

NDC, for its failure to withhold taxes from its Japanese contractors, willbear the liability as a penalty under Section 53 of the old NIRC

o Air Canada v CIR, CRA EB No. 86. Aug. 25, 2005



The principal issue is whether or not the revenue derived by aninternational air carrier from sales of tickets in the Philippines for airtransportation, while having no landing rights in the country, constitutesincome of said international air carrier from Philippine source, andaccordingly, taxable under Section 24(b)(2) of the NIRC.

The CTA en banc reiterated the ruling in CIR v BOAC and found AirCanada as a resident foreign corporation whose income from sourceswithin the Philippines as subject to income tax. Again, our tax laws aresource-oriented not activity.

The tax treaty between RP and Canada notwithstanding, Air Canada’sincome from within the Philippines as evidenced in the treaty which treatspremises used as a sales outlet as a permanent establishment in thecountry, and therefore, income derived through such manner is taxable.

o CIR v CTA, 127 SCRA 9

Smith Kline & French Overseas Company is a multinational firm domiciled

in Philadelphia, licensed to do business in the Philippines. It is engagedin the importation, manufacture, and sale of pharmaceutical drugs andchemicals.

Smith Kline claims overpayment of tax arising from under-deduction ofthe overhead expense. The overhead expense made on the basis of thepercentage of gross income in the Philippines to gross income of thecorporation as a whole. CTA granted refund. CIR maintains that suchright to deduction is not absolute and that there exists a serviceagreement which Smith has entered into with its home office, prescribingthe amount that a branch can deduct as its share of the main office’soverhead.

SC affirmed CTA. Smith Kline is entitled to a refund. From the itemsspecified in section 37(a), as being derived specifically from sourceswithin the Philippines there shall be deducted the expenses, losses, andother deductions properly apportioned or allocated thereto and a ratablepart of any other expenses, losses or deductions which cannot definitelybe allocated to some item or class of gross income. The remainder shallbe included in full as net income from sources within the Philippines. Theratable part is based upon the ratio of gross income from sources withinthe Philippines to the total gross income. (RR No. 2)

o CIR v. Marubeni, December 18, 2001

Marubeni is a Japanese corporation which has engaged with NDC andPhilphos (both Philippine entities) to construct and build for the latter twoa wharf/port complex and an ammonia storage complex, respectively.

EO 41 and EO 61 (expanding EO 41) were issued which granted taxamnesties.

Marubeni applied for tax amnesties pursuant to these EOs and was ableto avail of the same.



CIR assessed Marubeni for tax deficiencies, namely, income tax, branchprofit remittance tax, and contractor’s tax.

Insofar as income tax and branch profit remittance tax areconcerned, although these were derived from sources within thePhilippines, EO 41 specifically grants amnesty for these kinds of taxesand Marubeni was able to comply with all the requirements. Contrary toCIR’s ratiocination, Marubeni is NOT excepted from the tax amnestybecause EO 41 is clear that exceptions apply to those who file cases afterits effectivity. Marubeni applied for tax amnesty before the effectivity dateof the EO 41.

With respect to contractor’s tax, it is imposed upon the privilege ofengaging in business. It is generally in the nature of an excise tax on theexercise of a privilege of selling services or labor rather than a sale onproducts; and is directly collectible from the person exercising theprivilege. Being an excise tax, it can be levied by the taxingauthority only when the acts, privileges or business are done orperformed within the jurisdiction of said authority. CIR

erroneously assessed Marubeni when it taxed the latter for deficiencycontractor’s tax for services made and completed in Japan. Not thewhole project was taxable, but just those that could be pointed to havebeen performed in the Philippines. The service contract and therefore therespective payments for the phases in that contract were divisible andMarubeni is only liable to tax for those services performed in thePhilippines --- which, in fact, Marubeni had already paid.

o Alexander Howden v Collector, Apr. 14, 1965

The source of an income is the property , activity or service thatproduced the income. The reinsurance premiums remitted to AlexanderHowden by virtue of the reinsurance contracts, accordingly, had for theirsource the undertaking to indemnify Commonwealth Insurance Co.against liability. Said undertaking is the activity that produced thereinsurance premiums, and the same took place in the Philippines.

Taxpayers however, should not confuse activity that creates incomewith business in the course of which an income is realized. An activitymay consist of a single act; while business implies continuity oftransactions. An income may be earned by a corporation in thePhilippines although such corporation conducts all its businessesabroad. Precisely, Section 24 of the Tax Code does not require a foreigncorporation to be engaged in business in the Philippines in order for itsincome from sources within the Philippines to be taxable. It subjects

foreign corporations not doing business in the Philippines to tax forincome from sources within the Philippines.

o Manila Electric v Yatco, 69 Phil 89

The Collector of Revenue assessed herein Manila Electric Company forinsurance premiums it paid to a foreign company organized under USlaw.



The Court held that where a foreign company, by making and carryingout insurance policies covering risks located in the Philippines, andcertain incidents of the insurance contract are to be attended to in thePhilippines, such as payment of dividends when received in cash, andsending an adjuster to the Philippines on proving of claims of loss, didbusiness in the Philippines and subjected itself to the jurisdiction of thecountry, and therefore can be taxed by the government.

It would be discrimination against domestic insurance corporations to betaxed but not foreign corporations.

o Phil. Guaranty v CIR, April 30, 1965 Phil. Guaranty entered into several liability-sharing contracts with several

foreign insurance companies that among others, obliges Phil. Guaranty toremit a portion of the premiums in consideration for the assumption ofthe foreign companies of an equivalent portion of the risks involved.

Phil. Guaranty did not withhold any taxes on the premiums it ceded to theforeign insurers.

The Court held that then Section 24 of the Tax Code subjects foreigncorporations to tax on their income from sources within the Philippines.The word "sources" has been interpreted as the activity,property or service giving rise to the income. The reinsurancepremiums were income created from the undertaking of the foreignreinsurance companies to reinsure Philippine Guaranty Co., Inc., againstliability for loss under original insurances. Such undertaking took place inthe Philippines. These insurance premiums, therefore, came from sourceswithin the Philippines and, hence, are subject to corporate income tax.The foreign insurers' place of business should not be confused with theirplace of activity. Business should not be continuity and progression oftransactions 2 while activity may consist of only a single transaction. Anactivity may occur outside the place of business. Section 24 of the TaxCode does not require a foreign corporation to engage in business in thePhilippines in subjecting its income to tax. It suffices that the activitycreating the income is performed or done in the Philippines. What iscontrolling, therefore, is not the place of business but the place of activitythat created an income.

From Sources Without the Philippines

o Sec. 42 (C), NIRC


(C) Gross Income From Sources Without the Philippines. - Thefollowing items of gross income shall be treated as income from sourceswithout the Philippines:

(1) Interests other than those derived from sources within thePhilippines as provided in paragraph (1) of Subsection (A) of thisSection;



(2) Dividends other than those derived from sources within thePhilippines as provided in paragraph (2) of Subsection (A) of thisSection;

(3) Compensation for labor or personal services performed withoutthe Philippines;

(4) Rentals or royalties from property located without the Philippinesor from any interest in such property including rentals or royaltiesfor the use of or for the privilege of using without the Philippines,patents, copyrights, secret processes and formulas, goodwill,trademarks, trade brands, franchises and other like properties;and

(5) Gains, profits and income from the sale of real property locatedwithout the Philippines.

Partly Within/ Without the Philippines

o

Sec. 42(E), NIRC


(E) Income From Sources Partly Within and Partly Without thePhilippines.- Items of gross income, expenses, losses and deductions,other than those specified in Subsections (A) and (C) of this Section, shallbe allocated or apportioned to sources within or without the Philippines,under the rules and regulations prescribed by the Secretary of Finance,upon recommendation of the Commissioner. Where items of grossincome are separately allocated to sources within the Philippines, there

shall be deducted (for the purpose of computing the taxable incometherefrom) the expenses, losses and other deductions properlyapportioned or allocated thereto and a ratable part of other expenses,losses or other deductions which cannot definitely be allocated to someitems or classes of gross income. The remainder, if any, shall be includedin full as taxable income from sources within the Philippines. In the caseof gross income derived from sources partly within and partly without thePhilippines, the taxable income may first be computed by deducting theexpenses, losses or other deductions apportioned or allocated theretoand a ratable part of any expense, loss or other deduction which cannotdefinitely be allocated to some items or classes of gross income; and theportion of such taxable income attributable to sources within the

Philippines may be determined by processes or formulas of generalapportionment prescribed by the Secretary of Finance. Gains, profits andincome from the sale of personal property produced (in whole or in part)by the taxpayer within and sold without the Philippines, or produced (inwhole or in part) by the taxpayer without and sold within the Philippines,shall be treated as derived partly from sources within and partly fromsources without the Philippines.



Gains, profits and income derived from the purchase of personal propertywithin and its sale without the Philippines, or from the purchase ofpersonal property without and its sale within the Philippines shall betreated as derived entirely form sources within the country in which sold:Provided, however, That gain from the sale of shares of stock in adomestic corporation shall be treated as derived entirely form sourceswithin the Philippines regardless of where the said shares are sold. Thetransfer by a nonresident alien or a foreign corporation to anyone of anyshare of stock issued by a domestic corporation shall not be effected ormade in its book unless:

a. the transferor has filed with the Commissioner a bond conditionedupon the future payment by him of any income tax that may bedue on the gains derived from such transfer, or

b. the Commissioner has certified that the taxes, if any, imposed inthis Title and due on the gain realized from such sale or transfer

have been paid. It shall be the duty of the transferor and thecorporation the shares of which are sold or transferred, to advisethe transferee of this requirement.

Tax - SITUS (Supporting Laws and Doctrines)

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