Tax Articles

Service Fees Vs. Royalties

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

Both service fees and royalties are generally subject to tax in the Philippines. As such, there is no need to distinguish between the two. However, there are certain taxation aspects that differ for these two types of income, making it necessary to identify whether the income involved is a compensation for service or payment of royalty.

These differences are more pronounced when the income earners are non-resident foreign individuals and corporations. Hence, I will limit this discussion to service fees and royalties earned from sources within the Philippines by these types of taxpayers.

Source of Income Under Domestic Rules. Based on our domestic law, foreign individuals and corporations are taxable in the Philippines only on income derived from sources within the country. It follows that our tax authority may not impose tax on the income of foreign individuals and corporations if the income is considered derived from sources without the Philippines. That rule applies also to service fees and royalties. But for these types of income, there are respective rules in the determination of the source of income.

To be more precise, compensation for services is considered income derived from sources within the Philippines if the related 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. In short, the place of performance matters in identifying the source of income.

That requirement is not present in royalties. For royalties, it’s the presence of property or property rights in the Philippines or their use in the Philippines that matters. The underlying activity that may have resulted in the creation of those property or property rights may have been done outside the Philippines. That does not have an impact on taxation purposes.

Application of Tax Treaties. The Philippines has existing tax treaties with more than 40 countries. More treaties are also currently being negotiated. These treaties govern the income taxation of income derived by a resident of the other country from the Philippines. The income taxation based on these different treaties for business profits (service fees fall under this category of income) and royalties are almost the same, with differences only in rates.

For business profits, the income earned by a non-Philippine resident (resident of a treaty partner) from the Philippines will be subject to tax in the Philippines only if the non-resident income earner has a permanent establishment (PE) in the Philippines. If there is no Philippine PE, the income, even if considered income sourced from the Philippines under domestic rules, will not be taxable in the Philippines. On the other hand, if the non-resident has PE in the Philippines, the income derived from Philippine sources should be subjected to Philippine income taxes, unless there is other basis for exemption.

For royalties, the absence or presence of PE of the non-resident income earner is not a factor in determining the taxability of the related income. The treaties allow the Philippines to tax royalties arising from the Philippines, without regard to the presence or absence of PE in the Philippines.

These two factors are just among the instances where the characterization of the income into service fee/business profit or royalty becomes necessary. Some types of royalties can be easily distinguished from service fees. But there are situations where distinction is blurred or confusing. Our Tax Code itself includes in the categories of royalties “the supply of scientific, technical, industrial or commercial knowledge or information” and “technical advice, assistance or services rendered in connection with technical management or administration of any scientific, industrial or commercial undertaking, venture, project or scheme.” Tax treaties also define royalties as including “payment of any kind received as a consideration for information concerning industrial, commercial or scientific experience.”

These types of transactions giving rise to royalties are often confused with provisions of services. Nonetheless, there are guidelines to be observed for proper characterization. While the Philippines is not a member of the Organization for Economic Cooperation and Development (OECD), we often cite its commentaries and interpretations on the model tax convention as reference.

Based on the said commentaries and as adopted by our tax authorities, transactions giving rise to royalties refer to the supply of “know-how”. Contracts for the supply of know-how usually concern information that already exists or concern the supply of that type of information after its development or creation and include specific provisions concerning the confidentiality of that information. In the supply of know-how, there would generally be very little more which needs to be done by the supplier other than to supply existing information or reproduce existing material. On the other hand, for the provision of services, the supplier undertakes to perform services which may require the use of special knowledge, skill, and expertise but not the transfer of such special knowledge, skill, or expertise to the other party. It usually involves a very much greater level of expenditure by the supplier in order to perform his contractual obligations.

Our courts had also provided some parameters – in distinguishing between compensation for service and royalty payments, one must inquire on whether the payee has proprietary interest in the property giving rise to the income. If the payee has none, then the payment is a compensation for personal services, if the payee has proprietary interest then the payment is royalty.

It may be tempting to treat an income as royalty instead of service fee. But that would result in improper taxation. If the transaction involves the provision of service, it should be treated as such. Accordingly, these should still enjoy the exemption from tax if the service is rendered outside the Philippines or if the service provider does not have PE in the Philippines. Both the taxpayer and the tax authority should therefore properly characterize payments into service fees or royalties so that the proper taxes may also be properly applied.

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