Philippine taxes in the digital space

The digital economy has come so far in such a short time — it’s hard to believe that it all started just over 30 years ago, but has now become pervasive in our everyday lives. They say a person is, on average, online at least seven hours a day. Whether for business or entertainment, the impact of digitization is undeniable.

With its phenomenal growth, digitization also poses non-stop challenges to regulators. There are multiple items that must continuously be considered, whether it is keeping information safe, protecting consumers from suspicious schemes, and of course, ensuring that the correct taxes are paid.

In the Philippines, there have been several rounds of discussions on how best to capture the growing economic gains in the digital realm. Last year, the House of Representatives passed a bill seeking to impose VAT on digital services. A couple of months ago, the Senate held a hearing with the Bureau of Internal Revenue (BIR) to further discuss possible measures to address the gaps in our VAT system and allow our tax authority to generate revenue from digital service providers, with the goal of drafting a bill appropriately responding to these gaps. But as of now, it appears that our country remains at the legislative stage and has yet to implement considerable tax policy changes. The concern is that current Philippine tax laws by themselves are not sufficient to properly tax digital services. But is this really the case?

Around this time last year, the Supreme Court (SC) issued a decision which may potentially affect the taxation of digital services. The decision involved the sale of satellite communications services by a non-resident foreign corporation (based in Bermuda) to a local corporation, for which the latter was assessed by the BIR for deficiency final withholding tax. The satellite communications services were part of a larger process which allowed overseas calls to and from the Philippines through the gateway facilities owned by the local corporation.

In the case, the BIR argued that the service fees earned by the Bermudan entity from the transaction arise from sources within the Philippines and are thus subject to Philippine income tax. However, the local entity argued otherwise, saying that the related services (act of transmission) by the Bermudan entity occurred in outer space where the satellites were located and in Indonesia where the control center was located, and that it had no equipment in the Philippines. Therefore, applying the general Philippine tax rules on services, the Bermudan entity had no Philippine-sourced income and the local corporation was not required to withhold tax on its payments thereto.Interestingly, the SC took the BIR’s position and ruled that the income arose in the Philippines. In its decision, the SC applied a two-tiered approach: (1) identifying the source of the income, and (2) identifying the situs of that source. For the first test, the SC explained that the income source is the Philippine gateways’ receipt of the transmission since it is only upon the successful delivery of the transmission thereto that services are completed, and the fees are earned by the Bermudan corporation. Given this, the second test (situs) was necessarily in the Philippines since it is where the gateway facilities are located.

It may be worth noting that the SC acknowledged that the Bermudan corporation’s services were rendered in two stages, i.e., first, outside the Philippines (outer space in the satellite and in the Indonesian control center), and second, in the Philippine gateway facilities owned by the local corporation. This notwithstanding, the SC did not mention any separation or bifurcation of revenue to the extent of the services performed for the first stage (outside the Philippines). Instead, the entire amount paid to the Bermudan entity was treated as revenue from Philippine sources and subjected to tax.

Personally, I am also curious whether, in the larger scheme of things, not subjecting the transmission fees would really mean that there were services in the country which were untaxed. Presumably, the local corporation reported tax on its own income representing the value of its own services as the gateway owner and operator when it then sold the satellite communication services to its Philippine subscribers.

Moreover, I am also wondering if the High Court would have reached a similar decision had the fee arrangement been different — for example, fixed, instead of on the basis of usage.

It will also be interesting to see how the above decision will be applied if the counterparty is a resident of a tax treaty country. In the SC case, the taxpayer’s arguments considered the Commentaries of the Organization for Economic Co-operation and Development (OECD) on tax treaties as reference. The OECD is the international standard-setting body that develops models for double tax agreements (i.e., tax treaties) and its commentaries are normally relied on in interpreting tax treaty provisions and even cited by the BIR in its rulings. However, since the Philippines does not have an existing tax treaty with Bermuda, the SC deemed the OECD Commentaries as irrelevant and applied the domestic tax laws in full. It appears then that the SC recognizes that tax treaty benefits can be validly considered if the non-resident counterparty is a resident of a treaty country.

But perhaps the one thing I am most curious about is how the above decision will affect the income taxation of digital services in the Philippines. Similar to the above case, some digital services providers are able to cater to Filipino consumers without any physical presence here. With this decision, the SC showed that our current tax laws can potentially reach the digital space as they are right now, if certain conditions are met. As a rule, SC decisions form part of the law of the land. While more formal implementing rules are pending, taxpayers and practitioners alike should nonetheless take note of this development in conducting their transactions moving forward.