Tax Articles

Fiscally Transparent Entities

By Atty. Fulvio D. Dawilan

In my previous article in this column, I discussed the modified guidelines, procedures and other significant changes in the application and processing for the availment of tax treaty benefits as mandated by Revenue Memorandum Order No. 14-2021. That article was dedicated to a review as to whether there should even be a need for confirmation or application for TTRA in the first place.

Perhaps, one thing that is worth mentioning is the reference to “fiscally transparent entity”. The new guidelines note that the recipients of income payments made to a foreign fiscally transparent entity are the owners or beneficiaries thereof. The provision of the tax treaty is applicable only to the portion that is treated as income of members who are residents of the other contracting state where the fiscally transparent entity is a resident. A member who is a resident of a third state may be given treaty benefits pursuant to the treaty between the Philippines and that third state. Apparently, the Philippines is adopting the “fiscally transparent approach” in the determination of the entitlement to tax treaty benefits. And for that, additional information and documents are required.

Ordinarily, the required information is limited to those of the recipient of the income - the seller, shareholder, creditor or licensor. And one wonders why in the case of a “fiscally transparent entity”, additional information is required that goes beyond that of the entity-recipient of the income. And while its appears that this is the very first time that this phrase is mentioned in our local tax rules and literature, there was no definition or further description made in the memorandum order. So what is this so-called “fiscally transparent entity”?

In most tax treaties, to qualify for the benefits, one must be a person and a resident in one of the parties/states concluding the treaty. This is true in the case of most of the tax treaties concluded by the Philippines with other countries. As so provided in these treaties, the same shall apply to persons who are residents of one or both of the contracting states. The term resident of a contracting state means any person who, under the law of that state, is liable to taxation therein by reason of his domicile, residence, place of management or any criterion of similar nature.

An entity may therefore be considered a resident of a state for purposes of the application of the tax treaties only if its liable to taxation in that state. This is notwithstanding that it is already considered resident in that state for other legal purposes, such as by reason of establishment or registration.

For further guidance, we refer to the Commentaries on the Articles of the Model Tax Convention. There are aggrupation of persons or entities and even legally established entities which, under the laws prevailing in the place of their establishments, are legally allowed to transact business with outside parties, yet are not considered taxable persons in their place of establishment. An example is a partnership which, based on the local laws of some jurisdictions, are not treated as a taxable person. Groups, associations or entities of these nature are ignored for tax purposes. Consequently, these entities are not treated as residents in their place of establishment based on the definition int the treaty. Instead, the beneficiaries, owners, members, partners, trustors or shareholders are taxed at their levels on their respective share in the income.

No benefits will be available under the tax treaty between the state where the entity is established and the source of the income. Simply put, when an entity is treated as fiscally transparent in its state of establishment, it is not liable to tax in that state. Not being a resident of that state for tax purposes, the treaty between the state of source of the income and the state of establishment cannot be invoked. However, the member/partner/shareholder may invoke the treaty between his state of residence and the state of source of the income. The entity is deemed to be a “flow-through”. And the income is deemed to have been earned directly by the members of the “fiscally transparent entity” from the state of source. This is what is referred to as the “fiscally transparent approach” in invoking tax treaty benefits.

Following the fiscally transparent approach now included in our rules, if a Philippine customer, investee, debtor or licensee is dealing with a fiscally transparent entity in a foreign country, neither of the parties may invoke the tax benefits available under the tax treaty between the Philippines and the state of that entity. However, the same treaty may still be invoked for the tax treaty benefits by the members, partners or shareholders of that foreign entity who are considered residents for tax purposes of that same state. If they are residents of a third state, the benefits under the treaty between the Philippines and the third state may be availed.

Note, however, of the principle of non-allocation of partnership income. No benefit will be available under the treaty between the state of residence of the partner and the state of source if the income of the partnership is not allocated to the partner under the taxation law of the state of residence. In this case, if the partnership is regarded as transparent for tax purposes by the state in which it is established and the income of the partnership is not allocated to the partner under the taxation law of the state of residence of the partner, the state of source may tax the partnership income allocable to the partner without the benefit of the treaty.

Lastly, note that the application of the “fiscally transparent approach” is different from the application of the “beneficial ownership” concept. In a “fiscally transparent entity”, treaty benefits may still be invoked at the level of the owners/members/partners. This is not the case when the beneficial ownership rule is applicable.