Tax residency issues: Gateway to tax assessments

Through the years, countries have developed a network of tax treaty agreements which provide tax residents of treaty countries income tax exemption or preferential tax treatment on foreign-sourced income. As a minimum requirement to avail of tax treaty benefits, an income earner must prove that it is a tax resident of the treaty country. This is done by presenting a tax residency certificate (TRC) issued by the tax authority of the home country.

In 2019, the Bureau of Internal Revenue (BIR) issued Revenue Memorandum Order (RMO) No. 51-2019 providing guidelines and procedures for Philippine taxpayers who wish to secure a TRC. Among the objectives of the RMO is to monitor the reporting and declaration of foreign-sourced income in the tax returns of the applicant-taxpayers since they are taxable on their worldwide income. In 2020, the BIR issued RMO No. 43-2020 to further streamline the process of securing TRCs. Under these rules, domestic corporations or resident citizens requesting a TRC must submit their annual income tax return (ITR) for the immediately preceding year. In practice, Audited Financial Statements (AFS) and VAT returns are also requested by the tax authority.

According to the RMO, the International Tax Affairs Division (ITAD) acts as the repository of documents, substantiating the foreign-sourced income of Philippine taxpayers and furnishing the Revenue District Office (RDO) or Large Taxpayers Division (LTD) with all documents submitted by the applicant. The RDO or LTD is tasked to verify whether the foreign-sourced income was properly declared by the taxpayer and if the corresponding tax was paid. If not, the RDO or LTD, following the procedures for conducting tax investigation, must assess the deficiency tax and enforce its collection, including penalties. This is where the challenge comes in. Assessment of deficiency tax solely on the basis that the foreign-sourced income was not reported in the tax returns or AFS submitted during the application was filed seems unjustified primarily because of the chronology of events as well as different rules for declaring the revenue.

The ultimate purpose of requesting a TRC is for the Philippine taxpayer to avail of treaty benefits for its foreign-sourced income. Without a TRC, the foreign income payor may not be able to apply the reduced withholding tax rate or exemption to its payment to the Philippine income earner. To ensure compliance with the TRC requirements of the foreign tax authority and considering the usual processing time for TRC issuance by the BIR, Philippine taxpayers prudently opt to file the TRC application much earlier than the date the income is expected to be earned and/or received. Consequently, the AFS and the tax returns available at the time the application is filed with the BIR may not yet reflect the foreign-sourced income.

For instance, take the case of anticipated dividend income from a foreign company by a Philippine taxpayer. The foreign company may hold off declaration and payment of dividends until the TRC is secured. The TRC is necessary for the foreign company to be able to apply the preferential tax rate to which the Philippine taxpayer is eligible. Until the dividends are declared and received, the Philippine taxpayer may have no basis to report such foreign-sourced dividend income in its AFS and tax returns.

On the other hand, in the case of foreign-sourced service income, following the VAT rules, such income should only be reported upon collection of the payment. Thus, while the income may have already been earned, the gross receipts would not be reflected in the VAT returns until the TRC is secured and the service fees can be remitted to the Philippines.

In both scenarios, the AFS and tax returns do not reflect the foreign-sourced income, but this should not warrant issuance of an assessment notice to the taxpayer. Instead, the rules can be adjusted to recognize such timing/reporting discrepancies, or at the very least, to give the taxpayer an opportunity to clarify its side before responding with a full regular tax audit and eventual assessment of deficiency taxes which may only be refuted by the taxpayer with factual and legal basis.

In addition, assessment issues that sprout from a Philippine taxpayer’s request for TRC to avail of tax treaty benefits negate, to some extent, the purpose of the tax treaty — to avoid double taxation and give relief to the taxpayer from paying the undue amount of taxes on foreign-sourced income.

The process and requirements may also leave taxpayers with little recourse but to forego the treaty benefit at the outset, so that the foreign income can be remitted (albeit without the benefit of the preferential treaty rate or exemption) and reported in the Philippines for tax and financial reporting purposes, and the TRC secured. Recovery of the overpaid tax may then be through a refund from the foreign tax office, which may or may not be feasible.

Supposedly, if the taxpayer does not secure a refund from the foreign tax authority, the taxpayer should be able to recover the foreign tax withheld as a foreign tax credit or deduction in its ITR which is allowed under the Tax Code. However, unfortunately, this also raises issues with the BIR during an audit as examiners are instructed to disallow the foreign tax credit claimed on the ground that the taxpayer should have availed of treaty relief. Instead of claiming a tax credit, RMO 43-2020 suggests that the taxpayer secure a TRC and file a claim for tax refund in the foreign country. Something that the current TRC procedures have made rather difficult. In fact, one could say, it has devolved into a chicken or egg situation.

It may also be a good time to revisit the rules given that under the recently enacted Corporate Recovery and Tax Incentives for Enterprises (CREATE) law, foreign-sourced dividends may already be subject to exemption provided conditions are met. At least for dividends, checking compliance with the conditions for exemption should now be considered before issuing any potential deficiency tax assessment.

One hopes that these procedural issues are revisited to make it easier to secure a TRC, so that the intention of entering tax treaties with other countries is not undermined and so the BIR can also achieve its objective of not losing out to other countries on its share of the international tax pie. I suspect that given the choice, Philippine taxpayers would choose to pay tax to the Philippine government instead of to a foreign country.

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.

Donabel M. Villegas is a tax manager at the Tax Services Department of Isla Lipana & Co., the Philippine member firm of the PwC network.

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