Most-favored nation clause: Tax credit limitation clarified

The Philippines has about 44 bilateral tax agreements to eliminate or mitigate double taxation of crossborder transactions involving certain types of income (e.g., service fees, dividends, interest, royalties). In eliminating double taxation, the 2017 Organisation for Economic Co-operation and Development (OECD) Commentaries on the Model Tax Convention on Income and on Capital provide two leading principles — the principle of exemption and the principle of credit.

One of the oldest tax treaties we have is with the US, which grants US residents the lowest Philippine tax rate that may be imposed on a resident of a third State or what we call the “most-favored nation (MFN)” clause for royalty income. Further, the US allows a credit against the US tax equivalent to the taxes paid or accrued in the Philippines, provided that the tax credit does not exceed the limitations set by US law for the taxable year.

How can the reduced withholding tax rates for royalties under any of the other existing tax treaties of the Philippines be applied for the enjoyment of the MFN clause?

In G.R. No. 127105 dated June 25, 1999, the Supreme Court (SC) held that for the MFN clause to apply, the royalties derived by the resident of the US and of the third State (Germany in this case) must be of the same kind and that the same mechanism for eliminating double taxation must be employed by the US and Germany. The Court ruled that the taxpayer is not entitled to the concessional tax rate of 10% under the Philippines-West Germany Tax Treaty as the Philippines-US Tax Treaty does not give a matching credit of 20% for the taxes paid on royalties as allowed under the former tax treaty.

In 2002, the Bureau of Internal Revenue (BIR) issued Revenue Memorandum Circular No. 46-02 which confirmed that the method for elimination of double taxation under the Philippines-China Tax Treaty is similar to the method employed under the Philippines-US Tax Treaty. Thus, the tax on royalty payments to residents of the US and China are paid under similar circumstances and the MFN clause would apply.

While there are no similar BIR circulars confirming the application of the MFN clause for other tax treaties, there are several BIR rulings issued prior to 2020 confirming the applicability of the MFN clause using the tax treaties between the Philippines and the Czech Republic and the Philippines and the United Arab Emirates, among others. However, it is worth noting that in 2020, the SC ruled otherwise as regards the Czech Tax Treaty.

In G.R. No. 203346 dated Sept. 9, 2020, the taxpayer filed a claim for refund of overpaid withholding tax on royalty income paid to a US entity after securing a 2007 BIR ruling, which confirmed the US entity’s entitlement to the reduced withholding tax rate under the Czech Tax Treaty pursuant to MFN clause. However, both the Court of Tax Appeals and the SC denied the application for refund since the taxpayer failed to show evidence that the Czech and US Tax Treaties grant similar tax reliefs on royalty payments.

In determining whether Czech and US Tax Treaties employ similar methods of tax relief, the Court laid down the provisions in the tax treaties regarding the elimination of double taxation. While the Court agreed that both countries adopt the credit principle, the treaty provisions showed that the Czech Tax Treaty is more specific as to how the tax credit is computed as compared with the US Tax Treaty. The US Tax Treaty simply states that the allowable tax credit may not exceed the limitations set under US law. Thus, without pertinent evidence of the specific credit that the US law allows, the claim for refund was denied.

Following this SC case, the subsequent rulings issued by the BIR where the Czech Tax Treaty (and even the UAE Tax Treaty) was invoked in relation to the MFN clause were denied by the BIR for failure to submit a copy of the internal tax laws of the US.

It thus appears that submission of a copy of the US tax laws, specifically Section 904 of the US Tax Code providing the tax credit limitation (as adopted in our tax laws), will suffice for purposes of confirming that the Czech Tax Treaty satisfies the condition that the tax is paid under similar circumstances.

While the BIR may consider issuing updated guidelines which expressly requires a copy of the US tax laws as part of the requirements to be submitted for purposes of filing a request for confirmation or a tax treaty relief application for those invoking the MFN clause, my hope is that the BIR can work directly with the tax authorities of relevant treaty countries to confirm the application of the MFN clause and just issue a circular for everyone’s guidance. That will be a great service to the taxpaying public, as it will remove limitations in their ability to avail of treaty benefits, and will bring to life the intention of the parties when they wrote the MFN clause.

The views or opinions expressed in this article are solely those of the author and do not necessarily represent those of Isla Lipana & Co. The content is for general information purposes only, and should not be used as a substitute for specific advice.