Commissioner of Internal Revenue vs. Smart Communication, Inc.

A withholding agent is a "taxpayer" within the meaning of the National Internal Revenue Code and possesses the legal right to file a claim for refund of erroneously or illegally withheld taxes, regardless of whether it is related to the principal taxpayer, provided it remits the amount recovered to that principal taxpayer. Corollarily, payments made to a non-resident enterprise for software development are taxable as royalties only where the payor does not acquire the intellectual property rights over the resulting program; where the intellectual property rights belong to the payor, the payments constitute business profits taxable only if attributable to a permanent establishment in the Philippines.

Respondent Smart Communications, Inc. is a corporation organized under Philippine law and duly registered with the Board of Investments. On May 25, 2001, it entered into three Agreements for Programming and Consultancy Services with Prism Transactive (M) Sdn. Bhd., a non-resident corporation organized under the laws of Malaysia. The transactions were governed by the Agreement between the Government of the Republic of the Philippines and the Government of Malaysia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, signed in Manila on April 27, 1982 and effective July 27, 1984, which allocates taxing rights over royalties and business profits and defines the concept of a permanent establishment.

Respondent Smart Communications, Inc., a corporation organized and existing under Philippine law and duly registered with the Board of Investments, entered into three Agreements for Programming and Consultancy Services on May 25, 2001 with Prism Transactive (M) Sdn. Bhd., a non-resident corporation organized and existing under the laws of Malaysia. Under these agreements, Prism was to provide programming and consultancy services for the installation of the Service Download Manager (SDM) and the Channel Manager (CM), and for the installation and implementation of the Smart Money and Mobile Banking Service SIM Applications (SIM Applications) and Private Text Platform (SIM Application).

On June 25, 2001, Prism billed Smart in the amount of US$547,822.45, broken down into US$236,000.00 under the SDM Agreement, US$296,000.00 under the CM Agreement, and US$15,822.45 under the SIM Application Agreement. Treating these payments as royalties, Smart withheld US$136,955.61, or ₱7,008,840.43, representing the 25% royalty tax under the RP-Malaysia Tax Treaty. On September 25, 2001, Smart filed its Monthly Remittance Return of Final Income Taxes Withheld (BIR Form No. 1601-F) for the month of August 2001. On September 24, 2003, or within the two-year period to claim a refund, Smart filed with the Bureau of Internal Revenue, through the International Tax Affairs Division, an administrative claim for refund of ₱7,008,840.43. Because the Commissioner of Internal Revenue failed to act on the claim, Smart filed a Petition for Review with the Court of Tax Appeals.

Smart claimed entitlement to a refund on the ground that the payments to Prism were not royalties but "business profits" within the meaning of the RP-Malaysia Tax Treaty and the pertinent Commentaries of the Organization for Economic Cooperation and Development Committee on Fiscal Affairs through the Technical Advisory Group on Treaty Characterization of Electronic Commerce Payments. It argued that since Article 7 of the Treaty taxes business profits in the Philippines only if attributable to a permanent establishment, and Prism, a Malaysian company, had no permanent establishment in the Philippines, the payments should not be taxed. In his Answer, the Commissioner countered that Smart, as withholding agent, was not a party-in-interest to file the claim and that, in any event, no showing had been made that the payments constituted business profits.

The intellectual property provisions of the three agreements supplied the factual core of the dispute. Under paragraph 1.3 of the Programming Services (Schedule A) of the SDM Agreement, the SDM was to be installed by Prism, including the SDM Libraries, the intellectual property rights over which were retained by Prism; Prism would provide the client the application programming interfaces at no cost, and the client was permitted to develop programs to interface with the SDM or the SDM Libraries using the related APIs. Under paragraph 1.4 of the Programming Services (Schedule A) of the CM Agreement, the intellectual property rights over all components of the CM belonged to the client, with the exception of an enumerated list of components provided without technical or commercial restraints or obligations. Under paragraph 1.3 of the Programming Services (Schedule A) of the SIM Agreement, the client owned the intellectual property rights over the Specifications and the Source Code for the SIM Applications; Prism was to develop an executable compiled code of the SIM Applications for use on the aSIMetric card, for the client's use only, and the executable version could not be provided to any third party without the client's prior written consent.

During the trial it was established that Prism does not have a permanent establishment in the Philippines. On these facts, the Court of Tax Appeals found that the payments for the CM and SIM Application Agreements constituted business profits and were therefore not subject to tax under the RP-Malaysia Tax Treaty, while the payment for the SDM Agreement was a royalty subject to withholding tax.

• Inapplicability of the Withholding-Agent Cases: Petitioner contended that the cases relied upon by the Court of Tax Appeals in upholding the right to claim a refund were inapplicable because the withholding agents therein were wholly owned subsidiaries of the principal taxpayers, unlike the present case where the withholding agent and the taxpayer are unrelated entities.
• Absence of Legal Standing: Petitioner claimed that since Smart did not file the claim on behalf of Prism, it had no legal standing to claim the refund, and that the real party-in-interest to file a claim for refund of the erroneously withheld taxes was Prism, citing Silkair (Singapore) Pte, Ltd. vs. Commissioner of Internal Revenue, where it was ruled that the proper party to file a refund is the statutory taxpayer.
• Unjust Enrichment: Petitioner argued that to allow the refund would result in the unjust enrichment of Smart, which never shelled out any amount to pay the royalty taxes.
• Characterization as Royalties: Assuming Smart was the proper party, petitioner countered that it was still not entitled to any refund because the payments made to Prism were taxable as royalties, having been made in consideration for the use of the programs owned by Prism.

• Statutory and Primary Liability: Respondent maintained that it was the proper party to file a claim for refund as it had the statutory and primary responsibility and liability to withhold and remit the taxes to the Bureau of Internal Revenue.
• Withholding Agent as Payee by Fiction of Law: Respondent pointed out that under the withholding tax system, the agent-payor becomes a payee by fiction of law because the law makes the agent personally liable for the tax arising from the breach of its duty to withhold, and that the fact that it is not in any way related to Prism is immaterial.
• Non-Royalty Character of the Payments: Respondent asserted that the payments made to Prism did not fall under the definition of royalties since the agreements were for programming and consultancy services only, wherein Prism undertook to perform services for the creation, development, or bringing into existence of software applications solely for the satisfaction of the peculiar needs and requirements of respondent.

• Right of the Withholding Agent to Claim Refund: Whether respondent has the right to file the claim for refund of the taxes it withheld from its payments to Prism.
• Characterization of the Payments under the RP-Malaysia Tax Treaty: Whether the payments made to Prism constitute "business profits" or royalties.

• Right of the Withholding Agent to Claim Refund: Yes. A withholding agent is a "taxpayer" under the National Internal Revenue Code, being personally liable for the withholding tax as well as for deficiency assessments, surcharges, and penalties, and as agent of the taxpayer it is impliedly authorized to file the claim for refund and to bring an action for its recovery.
• Characterization of the Payments under the RP-Malaysia Tax Treaty: Partly yes. The payments for the CM and SIM Application Agreements constitute "business profits" not subject to Philippine tax because Prism has no permanent establishment in the Philippines and the intellectual property rights over those programs belong to respondent; only the payment for the SDM Agreement is a royalty subject to the 25% withholding tax.

• Right of the Withholding Agent to Claim Refund: Sections 204(c) and 229 of the National Internal Revenue Code provide that the person entitled to claim a tax refund is the taxpayer, but in case the taxpayer does not file a claim for refund, the withholding agent may file the claim. In Commissioner of Internal Revenue vs. Procter & Gamble Philippine Manufacturing Corporation, a withholding agent was considered a proper party to file a claim for refund of the withheld taxes of its foreign parent company. The term "taxpayer" refers to any person subject to tax imposed by the Title on Tax on Income; under the withholding provisions, the withholding agent required to deduct and withhold any tax is made personally liable for such tax and is subject to and liable for deficiency assessments, surcharges, and penalties should the amount withheld be finally found to be less than the amount that should have been withheld under law. A person liable for tax has been held to be a person subject to tax and properly considered a taxpayer, and by any reasonable standard should be regarded as a party in interest, or as a person having sufficient legal interest, to bring a suit for refund of taxes he believes were illegally collected from him. As pointed out in Philippine Guaranty Company, Inc. vs. Commissioner of Internal Revenue, the withholding agent is the agent of both the Government and the taxpayer — the Government's agent with respect to the collection and withholding of the tax, and the taxpayer's agent with respect to the filing of the necessary income tax return and the payment of the tax to the Government — and is no ordinary government agent, especially because it is held personally liable for the tax it is duty bound to withhold. Such authority may reasonably be held to include the authority to file a claim for refund and to bring an action for recovery of such claim. Petitioner's submission that this ruling applies only where the withholding agent and the taxpayer are related parties was rejected: although such relation is a factor that increases the withholding agent's legal interest, nothing in the decision suggests that the relationship is required or that its absence deprives the withholding agent of the right to file a claim for refund. Rather, two reasons sustain the withholding agent's legal right: first, it is considered a taxpayer under the Code because it is personally liable for the withholding tax as well as for deficiency assessments, surcharges, and penalties; and second, as an agent of the taxpayer, its authority to file the necessary income tax return and to remit the tax withheld impliedly includes the authority to file a claim for refund and to bring an action for recovery. It was significant to add, however, that while the withholding agent has the right to recover the taxes erroneously or illegally collected, it has the obligation to remit the same to the principal taxpayer; as an agent, it is its duty to return what it has recovered, otherwise it would be unjustly enriching itself at the expense of the principal taxpayer from whom the taxes were withheld and from whom it derives its legal right to file the claim. Silkair (Singapore) Pte, Ltd. vs. Commissioner of Internal Revenue, cited by petitioner, was held inapplicable because it involved excise taxes, not withholding taxes, the rule there being that the proper party to question or seek a refund of an indirect tax is the statutory taxpayer, the person on whom the tax is imposed by law and who paid the same even if he shifts the burden thereof to another.

• Characterization of the Payments under the RP-Malaysia Tax Treaty: Under the RP-Malaysia Tax Treaty, royalties are payments of any kind received as consideration for the use of, or the right to use, any patent, trademark, design or model, plan, secret formula or process, any copyright of literary, artistic or scientific work, or for the use of, or the right to use, industrial, commercial, or scientific equipment, or for information concerning industrial, commercial or scientific experience, as well as for the use of, or the right to use, cinematograph films or tapes for radio or television broadcasting; these are taxed at the rate of 25% of the gross amount. Under the same Treaty, the business profits of an enterprise of a Contracting State are taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment, defined as a fixed place of business where the enterprise is wholly or partly carried on, and an enterprise is deemed to have a permanent establishment even without a fixed place of business if it carries on supervisory activities in the other State for more than six months in connection with a construction, installation or assembly project being undertaken there. It was established during trial that Prism does not have a permanent establishment in the Philippines; hence, business profits derived from Prism's dealings with respondent are not taxable, and the only question was whether the payments under the three agreements were business profits rather than royalties. The provisions of the agreements are clear: Prism has intellectual property rights over the SDM program, but not over the CM and SIM Application programs, the proprietary rights over which belong to respondent. Out of the payments made to Prism, therefore, only the payment for the SDM program is a royalty subject to a 25% withholding tax, and a refund of the erroneously withheld royalty taxes pertaining to the CM and SIM Application Agreements is in order. The government has no right to retain what does not belong to it; no one, not even the State, should enrich oneself at the expense of another.

• Withholding Agent as "Taxpayer" — A withholding agent is itself a "taxpayer" under the National Internal Revenue Code because it is statutorily made personally liable for the tax it is duty bound to withhold, as well as for deficiency assessments, surcharges, and penalties should the amount withheld be finally found to be less than the amount that should have been withheld. A person "liable for tax" is a person "subject to tax," and by any reasonable standard should be regarded as a party in interest, or as a person having sufficient legal interest, to bring a suit for refund of taxes it believes were illegally collected from it. In this case, the Court applied the doctrine to uphold Smart's standing to claim the refund notwithstanding that it was not a wholly owned subsidiary of, or otherwise related to, the principal taxpayer Prism.
• Withholding Agent as Agent of Both the Government and the Taxpayer — The withholding agent is constituted the agent of both the Government and the taxpayer: with respect to the collection and/or withholding of the tax, it is the Government's agent; with respect to the filing of the necessary income tax return and the payment of the tax to the Government, it is the agent of the taxpayer. It is no ordinary government agent, especially because it is held personally liable for the tax it is duty bound to withhold, whereas the Commissioner and his deputies are not made liable by law. The Court used this doctrine to hold that the withholding agent's authority to file the return and remit the tax impliedly includes the authority to file a claim for refund and to bring an action for recovery.
• Duty to Remit the Recovery to the Principal Taxpayer — The right of a withholding agent to claim a refund of erroneously or illegally withheld taxes comes with the responsibility to return the same to the principal taxpayer. As an agent of the taxpayer, it is the withholding agent's duty to return what it has recovered; otherwise, it would be unjustly enriching itself at the expense of the principal taxpayer from whom the taxes were withheld and from whom it derives its legal right to file the claim. The Court expressly qualified its recognition of the withholding agent's standing with this obligation.
• Royalties vs. Business Profits under a Tax Treaty — Under the RP-Malaysia Tax Treaty, royalties are payments received as consideration for the use of, or the right to use, intellectual property, and are taxed at 25% of the gross amount, whereas business profits of an enterprise of a Contracting State are taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment. The Court held that the characterization turns on who owns the intellectual property rights over the resulting program: where the service provider retains the intellectual property rights, the payment is a royalty; where the client owns them, the payment is a business profit not taxable absent a permanent establishment.
• Non-Taxability of Business Profits Absent a Permanent Establishment — An enterprise of a Contracting State is taxable in the other Contracting State on its business profits only if it carries on business through a permanent establishment situated therein, and then only on so much of the profits as is attributable to that permanent establishment. A permanent establishment is a fixed place of business in which the business of the enterprise is wholly or partly carried on, and is deemed to exist even without a fixed place of business where the enterprise carries on supervisory activities in the other State for more than six months in connection with a construction, installation or assembly project undertaken there. Because Prism was established at trial to have no permanent establishment in the Philippines, its business profits were held not taxable.
• No Enrichment at Another's Expense — No one, not even the State, should enrich oneself at the expense of another. The Court invoked this principle to justify the refund of withholding taxes paid on payments that did not in law constitute royalties, holding that the government has no right to retain what does not belong to it.

• "The right of a withholding agent to claim a refund of erroneously or illegally withheld taxes comes with the responsibility to return the same to the principal taxpayer." — This opening pronouncement of the Decision states the ratio decidendi in compressed form, coupling the withholding agent's standing with the correlative duty of remittance and framing the entire disposition of the first issue.
• "A 'person liable for tax' has been held to be a 'person subject to tax' and properly considered a 'taxpayer.' The terms 'liable for tax' and 'subject to tax' both connote legal obligation or duty to pay a tax. It is very difficult, indeed conceptually impossible, to consider a person who is statutorily made 'liable for tax' as not 'subject to tax.' By any reasonable standard, such a person should be regarded as a party in interest, or as a person having sufficient legal interest, to bring a suit for refund of taxes he believes were illegally collected from him." — Quoted from Procter & Gamble and adopted by the Court, this passage supplies the canonical formulation of the doctrine that a withholding agent is a taxpayer with sufficient legal interest to sue for a refund.
• "In this connection, it is however significant to add that while the withholding agent has the right to recover the taxes erroneously or illegally collected, he nevertheless has the obligation to remit the same to the principal taxpayer. As an agent of the taxpayer, it is his duty to return what he has recovered; otherwise, he would be unjustly enriching himself at the expense of the principal taxpayer from whom the taxes were withheld, and from whom he derives his legal right to file a claim for refund." — This is the Court's own qualification of the withholding agent's standing, and it explains why the dispositive portion ordered the tax credit certificate issued in favor of the principal taxpayer rather than the withholding agent.
• "Indeed, the government has no right to retain what does not belong to it. 'No one, not even the State, should enrich oneself at the expense of another.'" — The closing rationale for the partial refund, resting on the principle against unjust enrichment and confirming that the State may not retain taxes collected on payments that do not in law constitute taxable royalties.

• Commissioner of Internal Revenue vs. Procter & Gamble Philippine Manufacturing Corporation, G.R. No. 66838, December 2, 1991, 204 SCRA 377 — The controlling precedent relied upon by the Court; it held that a withholding agent is a "taxpayer" under the National Internal Revenue Code, being directly and independently liable for the correct amount of tax that should have been withheld, and is impliedly authorized to file a claim for refund and to bring an action for its recovery. The Court quoted it at length and rejected petitioner's attempt to confine it to subsidiary-parent relationships.
• Philippine Guaranty Company, Inc. vs. Commissioner of Internal Revenue — Cited within Procter & Gamble and relied upon by the Court for the doctrine that a withholding agent is the agent of both the Government and the taxpayer, and is no ordinary government agent because it is personally liable for the tax it is duty bound to withhold.
• Silkair (Singapore) Pte, Ltd. vs. Commissioner of Internal Revenue, G.R. No. 173594, February 6, 2008, 544 SCRA 100 — Cited by petitioner for the rule that the proper party to seek a refund of an indirect tax is the statutory taxpayer; distinguished by the Court on the ground that it involved excise taxes, not withholding taxes.
• Commissioner of Internal Revenue vs. Wander Philippines, Inc., 243 Phil. 717 (1988) — One of the cases cited by the CTA Second Division in upholding the withholding agent's right to file the claim for refund.
• Commissioner of Internal Revenue vs. The Court of Tax Appeals, G.R. No. 93901, February 11, 1992 (Minute Resolution) — Also cited by the CTA Second Division in support of the withholding agent's right to claim a refund.
• BPI-Family Savings Bank, Inc. vs. Court of Appeals, 386 Phil. 719, 721 (2000) — Cited for the principle that no one, not even the State, should enrich oneself at the expense of another, invoked to justify the refund of taxes the government had no right to retain.

• Section 204(c), National Internal Revenue Code — Authorizes the Commissioner to credit or refund taxes erroneously or illegally received, and requires that no credit or refund be allowed unless the taxpayer files a written claim within two years after payment of the tax or penalty, a return showing an overpayment being considered a written claim. The provision supplied the statutory basis for the refund claim and the two-year period within which Smart filed its administrative claim on September 24, 2003.
• Section 229, National Internal Revenue Code — Governs the recovery of tax erroneously or illegally collected, requiring that a claim for refund or credit be duly filed with the Commissioner before any suit or proceeding may be maintained, and barring such suit after the expiration of two years from the date of payment. The Court cited it, together with Section 204(c), for the rule that the person entitled to claim a tax refund is the taxpayer, but that where the taxpayer does not file a claim, the withholding agent may do so.
• Section 57 (formerly Section 53(c)), National Internal Revenue Code — Requires the withholding agent to deduct and withhold the tax and makes it personally liable for such tax, and indemnifies it against claims and demands the stockholder might wish to make in questioning the amount of payments effected. This provision is the statutory foundation of the holding that the withholding agent is a "taxpayer" subject to tax and therefore a proper party to claim a refund.
• Article 12, Paragraph 4(a), RP-Malaysia Tax Treaty — Defines royalties as payments of any kind received as consideration for the use of, or the right to use, any patent, trademark, design or model, plan, secret formula or process, any copyright of literary, artistic or scientific work, or for the use of, or the right to use, industrial, commercial, or scientific equipment, or for information concerning industrial, commercial or scientific experience, and for the use of, or the right to use, cinematograph films or tapes for radio or television broadcasting. The Court applied this definition to hold that only the SDM payment, over which Prism retained intellectual property rights, was a royalty.
• Article 12, Paragraph 2(b)(ii), RP-Malaysia Tax Treaty — Fixes the tax on royalties at 25% of the gross amount, the rate Smart applied when it withheld ₱7,008,840.43.
• Article 7, RP-Malaysia Tax Treaty (Business Profits) — Provides that the profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein, in which case only so much of the profits as is attributable to that permanent establishment may be taxed. The Court applied this provision to hold that the CM and SIM Application payments, being business profits of Prism, were not taxable in the Philippines.
• Article 5, RP-Malaysia Tax Treaty (Permanent Establishment) — Defines a permanent establishment as a fixed place of business in which the business of the enterprise is wholly or partly carried on, enumerates specific inclusions such as a place of management, branch, office, factory, workshop, mine, farm or plantation, and building site or construction, installation or assembly project existing for more than six months, and deems a permanent establishment to exist where the enterprise carries on supervisory activities in the other State for more than six months in connection with a construction, installation or assembly project, or where substantial equipment is used or installed there. The finding that Prism had no permanent establishment in the Philippines under this provision removed its business profits from Philippine taxation.
• Section 13, Article VIII, 1987 Constitution — Cited in the certification accompanying the Decision, confirming that the conclusions reached had been arrived at in consultation before the case was assigned to the writer of the opinion of the Court's Division.

• Chief Justice Renato C. Corona (Chairperson)
• Associate Justice Presbitero J. Velasco, Jr.
• Associate Justice Teresita J. Leonardo-De Castro
• Associate Justice Jose Portugal Perez