May 31, 2019

ITAD BIR RULING NO. 008-19

Articles 5 (Permanent
Establishment) and 7 (Business
Profits) Philippines-Indonesia tax
treaty

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Madam :

This refers to your tax treaty relief application filed on December 10, 2018
requesting confirmation that income payments made by Philippine National
Railways ("PNR") to PT Industri Kereta Api (Persero) ("PT Inka") are exempt
from income tax pursuant to the Convention between the Government of the
Republic of the Philippines and the Government of the Republic of Indonesia
for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion
with Respect to Taxes on Income ("Philippines-Indonesia tax treaty").

FACTS

PT Inka is a corporation organized and existing under the laws of

Indonesia and a resident thereof based on its amended Articles of Association and
Certificate of Taxpayer Residency issued by the Directorate General of Taxes of
Indonesia. The business purpose of PT Inka is to implement and support the
Indonesian government's programs and policies in the field of economics and
national development, particularly in railways and the transportation industries,
and to optimize utilization of resources to produce high quality goods and services.
It is engaged in producing railway facilities such as carriages, passenger trains,
locomotives, infrastructure equipment railways, and railway engineering parts. It is
a state-owned enterprise established on May 18, 1981 by the Ministry of
Transportation and the Ministry of Finance of Indonesia. It is supervised by the
Ministry of State-Owned Enterprises of Indonesia.

Based on its License to Transact Business in the Philippines, PT Inka is

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 licensed by the Securities and Exchange Commission on August 31, 2018 to
establish a representative office in the Philippines under the name PT Industri
Kereta Api (Persero) ("PT Inka Representative Office"), which shall act as its
liaison and shall disseminate information about its products and services. The
representative office is located at 18V Legaspi Towers 300, Malate, Manila. PT
Inka's resident agent in the Philippines is BBB, who is authorized to accept
summons and legal processes in all legal proceedings and notices affecting the
company.

On the other hand, PNR is a governmental instrumentality in the

Philippines operating an extensive intra-island railway in Metro Manila and the
Bicol Region. 1(1)

In 2018, PNR and PT Inka entered into three (3) contracts for the purchase
and delivery of trainsets as described below:

First contract
Contract date: January 8, 2018
Description: Purchase of diesel multiple unit
Contract price: Php485,312,600
Expected completion and Within two (2) years from the issuance of notice to proceed by
delivery by PT Inka: PNR or until January 12, 2020

Second contract
Contract date: May 29, 2018
Description: Purchase of four (4) diesel-multiple unit trainset
Contract price: Php1,071,112,296
Expected completion and Within twenty (20) months from the issuance of notice to proceed
delivery by PT Inka: by PNR or until January 18, 2020.

Third contract
Contract date: May 29, 2018
Description: Purchase of three (3) diesel hydraulic locomotive trainset
Contract price: Php1,306,051,922
Expected completion and Within twenty-four (24) months from the issuance of notice to
delivery by PT Inka: proceed by PNR or until May 18, 2020

The contracts were all signed and notarized in the Philippines. CCC,
General Manager of PNR, and Budi Noviantoro, President and Director of PT

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 Inka, signed the contracts respectively on behalf of their principals.

Based on a certification issued by PNR, the trains will be manufactured in

Indonesia, and the employees of PT Inka will be in the Philippines only during
the delivery and testing of the trainsets and not during the whole completion
period.

Based on a sworn statement issued by PNR, the income subject of this

ruling is not under investigation, on-going audit, administrative protest, claim for
refund or issuance of a tax credit certificate, collection proceedings, or judicial
appeal.

RULING

In reply, please be informed that paragraph 1, Article 7 and paragraphs 1

and 2, Article 5 of the Philippines-Indonesia tax treaty provide:

"Article 7

BUSINESS PROFITS

1. The profits of an enterprise of a Contracting State shall be

taxable only in that State unless the enterprise carries on
business in the other Contracting State through a permanent
establishment situated therein. If the enterprise carries on or
has carried on business as aforesaid, the profits of the
enterprise may be taxed in the other State but only so much of
them as is attributable to:

a) that permanent establishment; or

b) sales within that other Contracting State of goods or

merchandise of the same or similar kind as those sold
through that permanent establishment; or

c) other business activities carried on in that other State

of the same or similar kind as those effected through
that permanent establishment."

"Article 5

PERMANENT ESTABLISHMENT

1. For the purposes of this Agreement, the term 'permanent

establishment' means a fixed place of business through which
the business of the enterprise is wholly or partly carried on.

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 2. The term 'permanent establishment' includes especially:

a) a place of management;

b) a branch;

c) an office;

d) a factory;

e) a workshop;"

Under Article 7, the profits of an enterprise of a Contracting State shall be

taxable only in that State unless the enterprise carries on business in the other
Contracting State through a permanent establishment situated therein. If the
enterprise carries on or has carried on business as such, the profits of that
enterprise may be taxed in the other State but only so much of them as are
attributable to the permanent establishment, among others.

Under Article 5, a permanent establishment means a fixed place through

which the business of the enterprise is wholly or partly carried on, and includes
especially, a place of management, a branch, an office, a factory and a workshop.

The question of permanent establishment

The following commentaries of the Organisation for Economic

Cooperation and Development (OECD) Model Tax Convention on Income and on
Capital (Condensed Version 21 November 2017) provide conditions for the
existence of a permanent establishment, to wit:

"Paragraph 1

6. Paragraph 1 gives a general definition of the term

'permanent establishment' which brings out its essential
characteristics of a permanent establishment in the sense of
the Convention, i.e., a distinct 'situs,' a 'fixed place of
business.' The paragraph defines the term 'permanent
establishment' as a fixed place of business, through which the
business of an enterprise is wholly or partly carried on. This
definition, therefore, contains the following conditions:

— the existence of a 'place of business,' i.e., a facility

such as premises or, in certain instances, machinery
or equipment;

— this place of business must be 'fixed,' i.e., it must be

established at a distinct place with a certain degree of
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 permanence;

— the carrying on of the business of the enterprise

through this fixed place of business. This means
usually that persons who, in one way or another, are
dependent on the enterprise (personnel) conduct the
business of the enterprise in the State in which the
fixed place is situated.

7. It could perhaps be argued that in the general definition some

mention should also be made of the other characteristic of a
permanent establishment to which some importance has
sometimes been attached in the past, namely that the
establishment must have a productive character, i.e.,
contribute to the profits of the enterprise. In the present
definition this course has not been taken. Within the
framework of a well-run business organisation it is surely
axiomatic to assume that each part contributes to the
productivity of the whole. It does not, of course, follow in
every case that because in the wider context of the whole
organisation a particular establishment has a 'productive
character' it is consequently a permanent establishment to
which profits can properly be attributed for the purpose of
tax in a particular territory (see Commentary on paragraph
4)." (Pages 117-118)

In summary, the conditions for the existence of a permanent establishment

are as follows:

a) There must be a place of business (e.g., facility);

b) The place of business must be fixed or permanent; and

c) The business of the enterprise must be carried through the fixed

place of business.

Surely, PT Inka Representative Office constitutes a permanent

establishment because it is an office under paragraph 2 (c), Article 5 of the
Philippines-Indonesia tax treaty, and more importantly, it possesses the three
conditions laid down in the commentaries. The fact that the representative office's
business purpose is limited solely to acting as liaison of PT Inka and
disseminating information about PT Inka's products and services does not make
the representative office less or short of a permanent establishment because it is
not a requirement that the office must have a 'productive' character to qualify as a
permanent establishment (Item 7 of the commentaries). Therefore, this renders
immaterial whether the PT Inka Representative Office's resident agent has an
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 authority to conclude sales contracts for PT Inka, or such agent's authority is
limited to accepting summons and legal processes affecting the company.
Paragraph 2 of Article 5 lists down certain fixed places of business, which can be
regarded as constituting a permanent establishment (e.g., place of management,
branch, office, factory, workshop) regardless whether or not actual sales contracts
are conducted in these places of business.

The importance of having an agent with authority to conclude sales

contracts is given in paragraph 4 of Article 5, to wit:

"4. A person acting in a Contracting State on behalf of an

enterprise of the other Contracting State (other than an agent
of an independent status to whom paragraph 6 applies) shall
be deemed to be a permanent establishment in the
first-mentioned State if:

a) he has, and habitually exercises in that State, an

authority to conclude contracts on behalf of the
enterprise, unless his activities are limited to the
purchase of goods or merchandise for that enterprise;
or

b) he has no such authority, but habitually maintains in

the first-mentioned State a stock of goods or
merchandise from which he regularly delivers goods
or merchandise on behalf of the enterprise; or

c) in so acting, he manufactures or processes in that

State for the enterprise goods or merchandise
belonging to the enterprise."

Here, such an agent constitutes a permanent establishment if he habitually

exercises such authority for his principal-enterprise. However, this alternative
definition of a permanent establishment is resorted to only if the enterprise does
not have a fixed place of business in the concerned territory. In the instant case,
the need to determine whether or not PT Inka has a dependent agent with
authority to conclude contracts on its behalf is set aside because it already has in
the Philippines a fixed place of business which constitutes a permanent
establishment.

The question of preparatory or auxiliary activities

Paragraph 3, Article 5 provides an exception where a fixed place of

business does not constitute a permanent establishment if the activities carried out
therein are merely of preparatory or auxiliary character, to wit:

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 "3. Notwithstanding the preceding provisions of this Article, the
term "permanent establishment" shall be deemed not to
include:

a) the use of facilities solely for the purpose of storage

or display of goods or merchandise belonging to the
enterprise;

b) the maintenance of a stock of goods or merchandise

belonging to the enterprise solely for the purpose of
storage or display;

c) the maintenance of a stock of goods or merchandise

belonging to the enterprise solely for the purpose of
processing by another enterprise;

d) the maintenance of a fixed place of business solely for

the purpose of purchasing goods or merchandise or of
collecting information, for the enterprise;

e) the maintenance of a fixed place of business solely for

the purpose of carrying on, for the enterprise, any
other activity of a preparatory or auxiliary character;

f) the maintenance of a fixed place of business solely for

any combination of activities mentioned in
sub-paragraphs (a) to (e), provided that the overall
activity of the fixed place of business resulting from
this combination is of a preparatory or auxiliary
character."

The question then arises if PT Inka Representative Office, by reason of its

representation that it merely acts as liaison of PT Inka and disseminates
information about the latter's products and services, is performing preparatory or
auxiliary activities. In relation thereto, the following commentaries of the OECD
Model Convention mention:

"59. It is often difficult to distinguish between activities which

have a preparatory or auxiliary character and those which
have not. The decisive criterion is whether or not the activity
of the fixed place of business in itself forms an essential and
significant part of the activity of the enterprise as a whole.
Each individual case will have to be examined on its own
merits. In any case, a fixed place of business whose general
purpose is one which is identical to the general purpose of
the whole enterprise does not exercise a preparatory or

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 auxiliary activity.

60. As a general rule, an activity that has a preparatory

character is one that is carried on in contemplation of the
carrying on of what constitutes the essential and significant
part of the activity of the enterprise as a whole. Since a
preparatory activity precedes another activity, it will often be
carried on during a relatively short period, the duration of
that period being determined by the nature of the core
activities of the enterprise. This, however, will not always be
the case as it is possible to carry on an activity at a given
place for a substantial period of time in preparation for
activities that take place somewhere else. Where, for
example, a construction enterprise trains its employees at one
place before these employees are sent to work at remote work
sites located in other countries, the training that takes place
at the first location constitutes a preparatory activity for that
enterprise. An activity that has an auxiliary character, on the
other hand, generally corresponds to an activity that is
carried on to support, without being part of, the essential and
significant part of the activity of the enterprise as a whole. It
is unlikely that an activity that requires a significant
proportion of the assets or employees of the enterprise could
be considered as having an auxiliary character."

The commentaries proceed that the decisive criterion whether or not the
activity of the fixed place of business is preparatory or auxiliary is that such
activity in itself forms an essential and significant part of the activity of the whole
enterprise, and each individual case will have to be examined on its own merits.

Moreover, as a general rule, an activity that has a preparatory character is

one that is carried on in contemplation of the carrying on of what constitutes the
essential and significant part of the activity of the whole enterprise. Since a
preparatory activity precedes another activity, it will often be carried on during a
relatively short period, the duration of which is determined by the nature of the
core activities of the enterprise. On the other hand, an activity that has an
auxiliary character corresponds to an activity that is carried on to support, without
being part of, the essential and significant part of the activity of the whole
enterprise as a whole.

Accordingly, considering that PT Inka Representative Office is

established a few months after PT Inka has concluded sales contracts with PNR
for the purchase and delivery of the trainsets, whereby PT Inka has committed to
manufacture the trainsets in Indonesia and deliver them to the Philippines within a
period of two years, any activity performed and that will be performed by PT Inka
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 Representative Office cannot be regarded as preparatory. Moreover, since the
License to Transact Business issued to PT Inka is not time-bound, PT Inka
Representative Office will not carry on activities in the Philippines during a
relatively short period of time, thereby making those activities not preparatory.

Similarly, those activities are not auxiliary. As defined, an activity is

auxiliary if carried on to support, without being part of, the essential and
significant part of the activity. Considering the long period of time to manufacture
the trainsets and the need for PT Inka to have a representation in the Philippines
pursuant to existing government procurement laws, the representative office's
function of acting as liaison of PT Inka to PNR while the trainsets are being
manufactured cannot be disregarded and be deemed as not forming part of PT
Inka's contractual obligations to PNR to deliver the trainsets in due time.

Moreover, in determining whether a foreign corporation's activity in the

Philippines is auxiliary or not, we must take into account that a foreign corporation
which does not derive income in the Philippines, and which does not have an
office or an agent in the Philippines is not doing business in the country. In
Cargill, Inc. vs. Intra Strata Assurance Corporation, G.R. No. 168266 dated
March 15, 2010, the Supreme Court held that:

"The determination of whether a foreign corporation is doing business in the

Philippines must be based on the facts of each case. In the case of Antam
Consolidated, Inc. v. CA, in which a foreign corporation filed an action for
collection of suns of money against petitioners therein for damages and loss
sustained for the latter's failure to deliver coconut crude oil, the Court
emphasized the importance of the element of continuity of commercial
activities to constitute doing business in the Philippines. The Court held . . .

xxx xxx xxx

Most of these activities do not bring any direct receipts or profits to the
foreign corporation, consistent with the ruling of this Court in National
Sugar Trading Corp. v. CA that activities within Philippine jurisdiction that
do not create earnings or profits to the foreign corporation do not constitute
doing business in the Philippines. In that case, the Court held that it would
be inequitable for the National Sugar Trading Corporation, a state-owned
corporation, to evade payment of a legitimate indebtedness owing to the
foreign corporation on the plea that the latter should have obtained a
license first before perfecting a contract with the Philippine government.
The Court emphasized that the foreign corporation did not sell sugar and
derive income from the Philippines, but merely purchased sugar from the
Philippine government and allegedly paid for it in full.

In this case, the contract between petitioner and NMC involved the purchase

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 of molasses by petitioner from NMC. It was NMC, the domestic corporation,
which derived income from the transaction and not petitioner. To constitute
doing business, the activity undertaken in the Philippines should involve
profit-making. Besides, under Section 3(d) of RA 7042, soliciting purchases
has been deleted from the enumeration of acts or activities which constitute
doing business.

Other factors which support the finding that petitioner is not doing business
in the Philippines are: (1) petitioner does not have an office in the
Philippines; (2) petitioner imports products from the Philippines through its
non-exclusive local broker, whose authority to act on behalf of petitioner is
limited to soliciting purchases of products from suppliers engaged in the
sugar trade in the Philippines; and (3) the local broker is an independent
contractor and not an agent of petitioner." (Underscoring supplied)

On the other hand, in Hutchison Ports Philippines Limited vs. Subic Bay
Metropolitan Authority, International Container Terminal Services, Inc., Royal
Port Services, Inc. and the Executive Secretary, G.R. No. 131367 dated August 31,
2000, the Supreme Court held that a foreign corporation participating in any
bidding process is already doing business in the Philippines, thus:

"The maelstrom of this issue is whether participating in the bidding is a

mere isolated transaction, or did it constitute engaging in or transacting
business in the Philippines such that petitioner HPPL needed a license to do
business in the Philippines before it could come to court.

"There is no general rule or governing principle laid down as to what

constitutes doing or engaging in or transacting business in the Philippines.
Each case must be judged in the light of its peculiar circumstances. Thus, it
has often been held that a single act or transaction may be considered as
doing business when a corporation performs acts for which it was created or
exercises some of the functions for which it was organized. The amount or
volume of the business is of no moment, for even a singular act cannot be
merely incidental or casual if it indicates the foreign corporations intention
to do business.

Participating in the bidding process constitutes doing business because it

shows the foreign corporations intention to engage in business here. The
bidding for the concession contract is but an exercise of the corporations
reason for creation or existence. Thus, it has been held that a foreign
company invited to bid for IBRD and ADB international projects in the
Philippines will be considered as doing business in the Philippines for which
a license is required. In this regard, it is the performance by a foreign
corporation of the acts for which it was created, regardless of volume of
business, that determines whether a foreign corporation needs a license or
not." (Underscoring supplied)

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 In the instant case, PT Inka has participated in a bidding process in the
Philippines for the manufacture and delivery of trainsets to PNR, has secured a
License to Transact Business in the Philippines, has an office in the Philippines,
and has appointed an agent in the country. These circumstances lead to no other
logical conclusion than that PT Inka is doing business in the Philippines.

The question of attributable profits

Under paragraph 1 of Article 7, the profits of an enterprise of a Contracting

State may be taxed in the other Contracting State but only so much of them as are
attributable to the permanent establishment situated in the other State. Article 7
proceeds on the basis that the other State as situs State has primary right to tax the
profits than the first-mentioned State where the enterprise is a resident.

In the instant case, the Philippines is considered the situs State by reason
that the contracts for the trainsets were signed and notarized in the Philippines and
the trainsets will be delivered and utilized in the Philippines. While the resident
agent of PT Inka Representative Office or any representative thereof did not sign
the sales contracts but the President and Director of PT Inka who travelled to the
Philippines to personally sign the three contracts in two occasions, this does not
imply that payments for the trainsets are not attributable to the representative
office. First, as explained above, the representative office's activities are not
preparatory or auxiliary, but essential and significant while the trainsets are being
manufactured by PT Inka in Indonesia until they are delivered to the Philippines
and accepted by PNR. Without this office, PT Inka will not effectively fulfill its
contractual obligations to PNR. Second, since the contracts are done in the
Philippines and not Indonesia, the latter is not deemed the primary situs State and
cannot have primary taxing right on the income under paragraph 1, Article 7 of the
tax treaty. As country of residence, Indonesia may tax PT Inka's income after the
same is taxed in the Philippines, but it shall allow relief on any income tax
imposed in the Philippines. This being so, income payments made by PNR to PT
Inka for the trainsets are attributable to PT Inka Representative Office and may
be taxed in the Philippines under paragraph 1 of Article 7.

Consequently, PT Inka (through PT Inka Representative Office) shall be

considered a resident foreign corporation subject to income tax rate of 30% on its
taxable income under Section 28 (B) (1) of the National Internal Revenue Code of
1997, as amended ("Tax Code"), to wit:

"SEC. 28. Rates of Income Tax on Foreign Corporations. —

(A) Tax on Resident Foreign Corporations. —

(1) In General. — Except as otherwise provided in this Code, a

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 corporation organized, authorized, or existing under the laws
of any foreign country, engaged in trade or business within
the Philippines, shall be subject to an income tax equivalent
to thirty-five percent (35%) of the taxable income derived in
the preceding taxable year from all sources within the
Philippines: Provided, That effective January 1, 2009, the
rate of income tax shall be thirty percent (30%)."

Under Section 31 of the Tax Code, the term taxable income means
pertinent items of gross income less deductions authorized for such types of
income by this Code or other special laws. In the instant case, PT Inka's taxable
income is computed by deducting from the gross payments made by PNR the
pertinent costs in manufacturing the trainsets in Indonesia until they are delivered
to the Philippines and accepted by PNR, including the operational cost in
maintaining the representative office.

Since taxable, PNR, as government-owned or controlled corporation, shall

withhold a creditable income tax at the rate of 1% on all payments made to PT
Inka Representative Office or PT Inka, pursuant to Section 2.57.2 (N) of
Revenue Regulations No. 2-98, 2(2) as amended, thus:

"(N) Income payments made by the government to its

local/resident supplier of goods and local/resident supplier
of services other than those covered by other rates of
withholding tax. — Income payments, except any single
purchase which is P10,000 and below, which are made by a
government office, national or local, including barangays, or
their attached agencies or bodies, and government-owned or
controlled corporations, on their purchases of goods and
purchases of services from local/resident suppliers.

Supplier of goods — One percent (1%)

Supplier of services — Two percent (2%);

A government-owned or controlled corporation shall

withhold the tax in its capacity as a government-owned or
controlled corporation rather than as a corporation stated in
Subsection (M) hereof." (Underscoring supplied)

Finally, the importation of the trainsets is subject to value-added tax at the

rate of 12% under Section 107 (A) of the Tax Code, to wit:

"SEC. 107. Value-Added Tax on Importation of Goods. —

(A) In General. — There shall be levied, assessed and collected

on every importation of goods a value-added tax equivalent

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 to twelve percent (12%) based on the total value used by the
Bureau of Customs in determining tariff and customs duties,
plus customs duties, excise taxes, if any, and other charges,
such tax to be paid by the importer prior to the release of
such goods from customs custody: Provided, That where the
customs duties are determined on the basis of the quantity or
volume of the goods, the value-added tax shall be based on
the landed cost plus excise taxes, if any."

Please be guided accordingly.

Very truly yours,

(SGD.) CAESAR R. DULAY

Commissioner of Internal Revenue
Footnotes
1. http://pnr.gov.ph/about-contact-us/who-we-are/corporate-profile.
2. Implementing Republic Act No. 8424, "An Act Amending the National Internal
Revenue Code, as Amended" Relative to the Withholding on Income Subject to
the Expanded Withholding Tax and Final Withholding Tax, Withholding of
Income Tax on Compensation, Withholding of Creditable Value-Added Tax and
Other Percentage Taxes.

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 Endnotes

1 (Popup - Popup)
1. http://pnr.gov.ph/about-contact-us/who-we-are/corporate-profile.

2 (Popup - Popup)
2. Implementing Republic Act No. 8424, "An Act Amending the National Internal
Revenue Code, as Amended" Relative to the Withholding on Income Subject to
the Expanded Withholding Tax and Final Withholding Tax, Withholding of
Income Tax on Compensation, Withholding of Creditable Value-Added Tax and
Other Percentage Taxes.

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