Pacta Sunt Servanda

By Tesi Lou S. Guanzon

First Published in Business World (9/23/ 2013)

The Latin title used for this article translates to “agreements must be kept.” It is a term used in understanding the spirit of treaties and executive agreements among nations, including double taxation agreements (DTAs) or what are otherwise known as tax treaties. This is important for foreign corporations or individuals doing business in other countries. The recent decision of the Supreme Court in Deutsche Bank AG Manila Branch vs. CIR ( G.R. No. 18850 promulgated August 19, 2013) reminds us of this time-honored Latin maxim.

In the Philippines and under our Tax Code, non-resident foreign corporations or individuals are generally subject to Philippine income tax on Philippine-sourced income. This rule, however, yields to the DTA between the Philippines and the home country of the foreign corporation or individual, particularly where the DTA provides preferential tax rates, or in some cases, tax exemption, on Philippine-sourced income.

Claiming the benefit of any DTA is, however, subject to certain procedural requirements. In Revenue Memorandum Order (RMO) No. 01-2000 dated November 25, 1999, which was later modified by RMO No. 72-10, dated August 25, 2010, the BIR declared that “it is to the best interest of both the taxpayer and the Bureau of Internal Revenue that any availment of the tax treaty provisions be preceded by an application for treaty relief with the International Tax Affairs Division (ITAD) [of the BIR]. In this way, the consequences of any erroneous interpretation and/or application of the treaty provisions (i.e., claim for tax refund/credit for overpayment of taxes, or deficiency tax liabilities for underpayment) can be averted before proceeding with the transaction and or paying the tax liability covered by the tax treaty.” Thus, RMO 1-2000 required that such application for tax treaty relief (TTRA) “be made at least 15 days before the transaction i.e. payment of dividends, royalties, etc., with all the supporting documents justifying the relief sought.”

In October 2003, Deutsche Bank AG Manila Branch (DB Manila Branch) remitted its 2002 and prior years’ after-tax profits to its home office in Germany, and withheld and remitted to the 15% Branch Profit Remittance Tax (BPRT) rate prescribed under the Tax Code. In October 2005 and on the belief that it overpaid the BPRT, DB Manila Branch filed a claim for refund or issuance of tax credit certificate (TCC) with the BIR, and at the same time filed with the ITAD a request for confirmation of its entitlement to the 10% BPRT rate prescribed under the Philippines-Germany DTA. Due to the BIR’s inaction on its claim, DB Manila Branch elevated its claim for refund to the Court of Tax Appeals (CTA).

The CTA denied DB Manila Branch’s claim for refund on the basis that DB Manila Branch’s TTRA was “not filed prior to its payment of the BPRT and actual remittance of its branch profits to DB Germany . . . thereby violating the 15-day period mandated under Section III paragraph (2) of RMO 01-2000.” The CTA relied on the earlier case of Mirant (Philippines) Corporation vs. CIR (CTA En Banc Case No. 40, June 7, 2005) wherein the CTA held that a ruling from the ITAD must be secured prior to the availment of a preferential tax rate under a tax treaty. Unsatisfied with the CTA decision, DB Manila Branch filed an appeal with the Supreme Court which upheld DB Manila Branch’s position and granted the refund. The Supreme Court determined that the “crux of the controversy lies in the implementation of RMO No. 1-2000,” and to this end, disagreed with the CTA’s decision that the prior filing of a TTRA is mandatory, and that non-compliance with this prerequisite is fatal to the taxpayer’s availment of the preferential tax rate.

According to the Supreme Court, “[t]he time-honored international principle of pacta sunt servanda demands the performance in good faith of treaty obligations on the part of the states that enter into the agreement.” The Supreme Court pointed-out that “there is nothing in RMO No.1-2000 which would indicate deprivation of entitlement to a tax treaty relief for failure to comply with the 15-day period”, and while the Court recognizes the clear intention of the BIR in implementing RMO No. 1-2000, the CTA’s outright denial of a tax treaty relief for failure to strictly comply with the prescribed period is not in harmony with the objectives of the contracting state to ensure that the benefits granted under tax treaties are enjoyed by duly entitled persons or corporations. Bearing in mind the rationale of tax treaties, the period of application for the availment of tax treaty relief as required by RMO No. 1-2000 should not operate to divest entitlement to the relief as it would constitute a violation of the duty required by good faith in complying with a tax treaty. The denial of the availment of tax relief for the failure of a taxpayer to apply within the prescribed period under the administrative issuance would impair the value of the tax treaty. At most, the application for a tax treaty relief from the BIR should merely operate to confirm the entitlement of the taxpayer to the relief.

The SC regarded the obligation of the Philippines to comply with a tax treaty to be paramount over the objectives of RMO No. 1-2000. Such failure to abide with its tax treaty obligations would have “negative implications on international relations, and unduly discourage foreign investors. Non-compliance of RMO No. 1-2000 could be remedied through imposition of a fine or penalty, rather than the deprivation of a treaty benefit simply for failing to comply with an administrative issuance.

Indeed, when the Philippines became a signatory to the Vienna Convention on January 27, 1980, it bound itself to honor its contracts in good faith with the international community. The principle of pacta sunt servanda stresses that these pacts and clauses are the law between the parties, and implies that the non-fulfilment of respective obligations is a breach of the pact.

Since pacta sunt servanda is based on good faith, this entitles States to require that obligations be respected and to rely upon the obligations being respected. A State that is a party to the treaty cannot invoke provisions in its Constitution or its domestic laws as an excuse or justification for failure to perform its duty. As a signatory of the Philippines-Germany DTA, the Philippines is required to honor its obligations to provide exceptions to the BPRT rate to DB Manila Branch.

Moreover, Section 2 Article III of the Constitution provides that the Philippines adopts the generally accepted principles of international law as part of the law of the land. By the doctrine of incorporation, the generally accepted principles of international law are automatically part of the laws of the Philippines. Therefore, such failure of the Philippines to uphold the provisions of the Philippines-Germany DTA may have negative economic results, in addition to being a violation of Section 3, Article II of the Constitution.

The pacta sunt servanda rule is the cornerstone of the law of treaties and the Supreme Court, in this latest decision , took the opportunity to reiterate that fulfillment of treaty obligations is essential to stable international relations and promote trust and cooperation between States. It now remains to be seen whether the BIR will review its current policy on tax treaty relief availments, considering that RMO No. 72-2010 (which amended RMO No. 1-2000) specifically provides that all TTRAs should be filed before the occurrence of the first taxable event, and “[f]ailure to properly file the TTRA with ITAD within the period prescribed herein shall have the effect of disqualifying the TTRA.”

Tesi Lou S. Guanzon is a Tax Senior Director of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.