In the arena of international transactions, management and service agreements between interrelated companies within a multinational corporation is an inevitable consequence of globalization. The diversity of cultures among different nations necessitates the proliferation of management and service agreements between a domestic corporation and its parent or affiliate Non-Resident Foreign Corporation (NRFC). Management services are advantageous to groups of companies, as member companies or affiliates will benefit from the expertise of these groups and, in the process, they can ensure the quality and uniformity of practices among all the subsidiaries. They can also be a catalyst for taking advantage of the efficiencies and economies in maintaining resource centers among the member companies.
Management services agreements are agreements entered into between two corporations, in which a party (usually a related party) will provide management, consulting or other services for a fee (“management fees or service fees”). Usually, management agreements between a domestic corporation and the parent or affiliate NRFC involve human resource functions, marketing and sales, finance, and IT services, among others.
The tax treatment of the management fees received by the NRFC is one of the challenging facets of this business set-up. As with any cross-border transaction, the examiner, during a tax audit, would normally assess the withholding tax and leave it to the taxpayer to prove that the transaction is not subject to withholding tax.
When are payments for management services to an NRFC subject to final withholding tax?
Under the tax code, an NRFC shall be subject to Philippine income tax only on its income sourced within the Philippines. In the doctrinal case of CIR v. British Overseas Airways Corp., the Supreme Court ruled that the source of income is the property, activity, or service that produced the income; the test of taxability is the “source” and the source of income is that activity which produced the income. The situs of the income derived from services is determined solely by the place where service is rendered. Thus, the taxability of fees received by the NRFC from the performance of management services depends on where the services are performed. If performed outside the Philippines, the income is not taxable here. However, should there be any service performed in the Philippines, the same shall be subject to Philippine taxes.
Nevertheless, even if there are management services being performed within the Philippines, management fees can still enjoy exemption under a tax treaty. An NRFC, who is a resident of a contracting state in a tax treaty with the Philippines, may be exempt from income tax on the business profits derived within the Philippines. As a condition for the tax exemption, all Philippine tax treaties require that the NRFC must not carry on transacting business in the Philippines through a permanent establishment. In the case of management services, the most common risk of creating a permanent establishment is the length of period that the service is performed in the host country. Most Philippine tax treaties provide a 180-day threshold for the duration of the services.
Current rules, however, require that a Tax Treaty Relief Application (TTRA) be filed to avail of the exemption.
Despite the prevalence of jurisprudence and BIR rulings, resolving the issue of situs of management or service fees is a challenge to both taxpayers and tax authorities. Proving that the services were performed by an NRFC is easy. The company can show the Articles of Incorporation as well as a certification from Securities and Exchange Commission that the NRFC is not registered to do business in the Philippines. However, proving that the services were performed abroad is the bigger challenge.
Hence, even if the income tax exemption is provided under the Tax Code, many companies opted to secure further confirmation under tax treaties by filing a TTRA. Numerous BIR International Tax Affairs Division (ITAD) rulings stated that since services which the parent NRFC will perform for the benefit of the Philippine affiliate will be done entirely outside the Philippines, the management fee, being an income not derived from sources within the Philippines, is therefore exempt from Philippine income tax.
Proving that the NRFC or its employees did not render any services within the Philippines is a very difficult challenge. In the case of a tax audit, the burden of proof is upon him who claims the exemption in his favor and he must be able to justify his claim by the clearest grant of organic or statute law. Even BIR rulings contain a disclaimer that, if upon investigation it shall be disclosed that the actual facts are different, then the ruling shall be without force and effect insofar as the parties are concerned. Hence, a BIR ITAD ruling approving the exemption will not preclude a subsequent investigation or audit. Thus, during an audit, the taxpayer may still be required by the examiner to prove that services were performed outside the Philippines.
The taxpayer must be able to present proper evidence to the BIR to avoid assessments and other tax liabilities. To resolve whether the service fees and reimbursement are not subject to income tax on the grounds that the services are performed outside of the Philippines and reimbursement pertaining to such services rendered, the Court of Tax Appeals, in the case of Oakwood Management Services (Philippines), Inc. vs Commissioner of Internal Revenue, considered the following documents -- list of officers of the NRFC providing management services to the domestic corporation; Bureau of Immigration Certification on the Travel Schedule of the officers listed; and Certificate of Employment of the employees of the NRFC.
If the company is claiming that the services are performed abroad, the services enumerated should be of a nature that can be reasonably performed abroad. If the services are to be performed within the country under the TTRA, it is advisable that the parties in a management agreement specify the services which must be performed within and outside the Philippines.
If the management, supervision, or HR functions (hiring, selection, interview, and training of staff) were to be done online, will the situs be considered within the Philippines or without?
At present, there is no clear and categorical ruling by the courts or by the BIR which can answer the question. However, some BIR rulings may be used as basis to argue that services performed online may be considered as performed outside the Philippines. In ITAD Ruling No. 014-01, the BIR ruled that if the editing, programming, designing and dissemination of the advertisement are done using facilities located abroad, the situs of the income is abroad. On the other hand, in several rulings, the BIR held that services done through electronic means such as through telephone calls and e-mails may be considered rendered outside of the Philippines.
If it is discovered during audit that there are management services being performed in the Philippines, can the company still insist on the exemption under the tax treaty even without a TTRA? In the case of Deutsche Bank AG Manila Branch v. Commissioner of Internal Revenue, the Supreme Court declared the failure to apply for tax treaty relief within the prescribed period should not operate to divest the entitlement to the relief as it would constitute a violation of the duty required in good faith in complying with a tax treaty.
Notwithstanding, this doctrinal pronouncement of the Supreme Court is a proactive measure, so it is prudent to file a TTRA to confirm that the management fees are exempted from Philippine tax. This process will not only aid the tax authorities in their tax investigation but it will also help the NRFC and the withholding agent in case of a tax audit.
Transfer pricing issues may also be raised on the management services. Among others, there may be issues on whether the fees were set on an arm’s length basis, or whether the services were needed by and benefit the Philippine affiliate. Transfer pricing documentation should be able to support these.
Taxing the management fee depends upon a variety of factors; much will depend upon the wording of the contract and the actual performance of the service. The evidentiary aspect is extremely critical; thus, it is imperative on the part of the taxpayer to ensure that they are not exposed to deficiency tax assessment considering the complexity of the rules affecting the tax treatment of the management fees.
Gerald P. Mesina is an associate with the Tax Advisory and Compliance division of P&A Grant Thornton.
As published in BusinessWorld, dated 08 August 2017.