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Taxation of software

Taxation of software by: Julius P. Babalcon

It is a given fact that a transaction may be taxed differently on varying conditions. For example, a sale on a parcel of land may be subjected to either capital gains tax (if the land is considered as capital asset) or normal tax (if the land is considered as an ordinary asset). This often leads to a problem on the part of the taxpayer on how to classify a transaction and apply the correct tax treatment.

One of the most common confusions today is the tax treatment on the sale of software. Software is defined by law as a program, or a series of programs, containing instructions for a computer required either for the operational processes of the computer itself (operational software) or for the accomplishment of other tasks (application software). It can be transferred through a variety of media:  in writing or electronically, on magnetic tape or disk, on a laser disk or CD-ROM, or it can even be downloaded through the internet or network. It can be standardized with a wide range of application or to be customized for specific users.  It can be transferred as an integral part of a computer hardware or an independent form available for use on a variety of hardware. The right over the software is an intellectual property; hence protected under the law on copyright.

Under Revenue Memorandum Circular 44-05, transactions involving software may include: the sale of the copy of the software, the granting or transfer of copyright rights, any provision for support and maintenance, and the provision of know-how relating to software programming techniques.  These categories of transactions are taxed differently depending on who the seller is and the characterization of the transaction. In cases where software payments are made under mixed contracts such as sales of computer hardware with built-in software and license to use software with provisions of services, the total consideration shall be apportioned with appropriate tax treatment being applied to each apportioned part. Moreover, payments made in consideration of transactions relating to software may either be royalty income or business income.

Royalty payments are received in consideration for the use of, or the right to use the software.  This includes the transfer of some of the copyright rights such as the right to make copies of the software for purposes of distribution to the public by sale or lease, or the right to prepare derivative computer programs based upon the copyrighted software, or the right to make a public performance of the software, or the right to publicly display the computer program, or any other rights of the copyright owner when exercised by another constitute infringement. This is exemplified by a sale granting the buyer/reseller the right to resell the property, or the licensor granting the licensee the right to use the software within a specific period.  As royalty payments, a local owner or licensor of copyright is subject to final tax of twenty percent (20%) on the gross amount of royalties or on the regular tax on net taxable income if received in the course of the registered business. Conversely, a nonresident foreign licensor shall be subjected to thirty percent (30%) final tax based on gross amount of payment or a reduced treaty rate if the foreign licensor is a resident of a country which has an existing treaty with the Philippines.    

On the other hand, payment received in consideration of sale or exchange of the software and its copyrights are treated as business income.  This includes the sale of a copy of a software itself, or a transfer of all substantial rights in the copyright, or any provision of services for the development or modification of the software. As an example, when a buyer purchases a copy of software for personal or internal use only, the seller payment is treated as business income which is subject to regular income tax. As business income, the payment shall form part of the copyright owner’s gross income from which his taxable income shall be computed. In that case the individual owner shall be subjected to graduated income tax rates of 5%-32%, or a corporation owner shall be subject to thirty percent (30%). A nonresident foreign corporation is subject to a final tax of thirty percent (30%) final tax based on gross income if the sale is made within the Philippines. The proceeds of the sale by the nonresident foreign corporation, however, is generally exempt from Philippine income tax if the sale is made outside or if the seller does not have a permanent establishment in the Philippines to which the sale can be attributed, and provided that the requirements set forth by the treaty has been complied with. The sale is, however, subject to value-added tax under the destination principle.

One of the common provisions in tax treaties that must be complied with in order to avail the reduced tax on royalties and tax exemption of business profit is that the nonresident foreign owner must not have a permanent establishment in the Philippines. A permanent establishment is generally defined as a fixed place of business in which the business of the enterprise is wholly or partly carried on. Failure to comply with the provisions on permanent establishment would mean that the owner of the copyright will be subjected to taxes as if there has been no treaty existing between the Philippines and the country of residence of the foreign owner.

An en banc Supreme Court decision enunciated that a foreign corporation wishing to avail of the benefits of tax treaty should invoke the provisions of the tax treaty and prove that indeed the provisions of tax treaty applies to it. In this regard, either of the contracting parties should apply for a tax treaty relief  with the International Tax Affairs Division(ITAD) of the Bureau of Internal Revenue(BIR) to prevent any erroneous interpretation and/or application of treaty provisions with which the Philippines is a signatory.

With the aforesaid considerations, the buyer and seller must have a clear understanding of the nature of the transactions they enter into.  Depending on the particular circumstance, the tax on payments relating to the software transaction may range from zero up until 30% on gross payments received. Hence, when entering into a transactions involving software, the parties may plan ahead taking into account the kind of transaction they will pursue and the tax implications of the transactions to both parties.