Tax Articles

Foreign Corporations and Individuals: Basic Taxation Rules

By Atty. Fulvio D. Dawilan

Fulvio D. Dawilan Managing Partner   +632 8403 2001 loc.310 This email address is being protected from spambots. You need JavaScript enabled to view it. View Profile

A recent issuance supposedly clarified the taxation of cross-border services, referring to a Supreme Court decision as a basis. A number of experts had already expressed their views on the matter. I need not dwell on that circular and the decision on which it is based as I believe the discussions already made on the issue are sufficient. More importantly, our laws and jurisprudence provide sufficient rules to be followed. So let me provide a basic guide on the income taxation of foreign individuals and corporations in this country, especially on the source of taxable income.

Countries impose income taxes on foreign individuals and entities only on income derived by these individuals and entities within the borders of the country imposing the tax. That is almost a universal rule. And based on its domestic laws, the Philippines follows the same system. A deviation from this rule is a disregard of this universal rule and our own laws.

The wordings of our tax laws are in fact very explicit. An alien individual, whether considered resident or not of the Philippines, is taxable only on income derived from sources within the Philippines. Similarly, a foreign corporation, whether engaged or not in trade or business in the Philippines, is taxable only on income derived from sources within the Philippines. Incidentally, this had been the rule since our first tax law was crafted more than a century ago. There had been modifications but the basic principles remain unchanged up to the present Tax Code. Certainly, there are deviations from this rule, but those are exceptions rather than the general rule.

Clearly then, our tax authority can impose tax on the income of foreign individuals and corporations only if the income is derived from sources within the country. Since the source of income is an essential element in the taxation of income of foreign corporations and individuals, there is a need to identify the source of the income before including or excluding them from the coverage of taxation. And our tax law is not wanting it that respect – as it supplies the rules for classifying income as to its source. Specifically, Section 42 of the current Tax Code defines the different types of income that are considered derived from sources within and from without the Philippines. One needs to refer to that provision for guidance when in doubt as to the source. Specific rules are provided for interests, dividends, services, rentals and royalties, sale of real properties and sale of personal properties.

Zeroing in on the services, the related income shall be considered derived from sources within the Philippines if the service is performed in the Philippines. On the other hand, income for services performed without the Philippines shall be considered income derived from sources without the Philippines. Jurisprudence had also repeatedly emphasized and made clear that the place of performance of the service is the source of income. It follows that for services rendered in the Philippines, the related service fee is income from sources within the Philippines, regardless of the residence of the payor, the place where the contract for services was made or the place of payment. On the other hand, the income from services rendered outside the Philippines is considered income from sources outside the Philippines.

Thus, in determining the taxability of a service income, we refer solely to the place where the service is actually rendered. The basic and general rule therefor is: income from services shall be considered derived from sources within the Philippines if the service is performed in the Philippines and taxable in this country. Income for services performed without the Philippines shall be considered income derived from sources without the Philippines and not taxable in this country. Unless a specific law provides a different scheme for the taxation of an income or transaction, this rule should govern.

For the traditional types of services, the place of performance can be easily determined. It is simply where the service provider physically does the service. Surely, there are types of transactions where there is difficulty in the determination of the place of performance, and precedents are still scarce. And perhaps, for some types of services, a number of factors may need to be considered. But certainly, the residence of the payor, the place where the payment is made, or the source of payment affect the taxation of service fees. The place where the service contract is entered into wouldn’t also matter. And neither should the determination of the source of the income depend on the place where the recipient of the service resides or does its business.

In fact, even for digital services or those services availed electronically where the identification of the place of performance used to be a challenge, there are emerging applicable precedents. In fact, our own tax authority had issued rulings holding that if the servers, websites and other related facilities are located outside the country, the income generated from the activity should be treated as sourced from outside the Philippines and therefore not taxable in the Philippines. This applies even if the user is based in the Philippines.

Now, the question many are asking – should they impose final withholding tax on income payments to non-residents? My answer: Stick to the basic rule. As long as it can be sufficiently established that the service is rendered outside the Philippines, the final withholding tax should not apply. If the service is rendered here, then as a rule, the payor should impose the applicable final withholding tax. In the case of the latter, if there is an applicable tax treaty, the exemption or preferential tax rates provided in such treaty may also apply.