Tax-free Provisions on Agreements in the Philippines

In some contracts, especially, with non-resident foreign corporations and entities, a provision on taxes is almost always included. This provision normally mentions who among the parties would shoulder the applicable taxes in the Philippines. Some scenario on such contracts and agreements would provide that any and all applicable taxes in the Philippines shall be shouldered by the Philippine company or entity. This would mean that the foreign party will receive the agreed consideration, net of applicable taxes. This is what we call as “tax – free covenant” or “tax-free provision” in the  agreement or contract in the Philippines.

Under such scenario, the critical part is the determination of the taxable base because some taxes are chargeable to the payee (the non-resident or foreign party), while some are chargeable to the (resident of Filipino party). This scenario is covered by Section 57(C) and hereunder we quote:

Section 57(C). Tax-free covenant Bonds – In any case where bonds, mortgages, deeds of trust or other similar obligations of domestic or resident foreign corporations, contain a contract or provision by which the obligor agrees to pay any portion of the tax imposed in this Title upon the oblige or to reimburse the oblige for any portion of the tax or to pay the interest without deduction for any tax which the obligor may be required or permitted to pay thereon or to retain therefrom under any law of the Philippines, or any state or country, obligor shall deduct bonds, mortgages, deeds of trust or other obligations, whether the interest or other payments are payable annually or at a shorter or longer periods, and whether the bonds, securities or obligations had been or will be issued or marketed, and the interest or other payment thereon paid, within or without the Philippines, if the interest or other payment is payable to a nonresident alien or to a citizen or resident of the Philippines. (Emphasis supplied)

To illustrate the tax-free covenant above, let us assume that foreign party (say, A Co. Ltd.) bills the equivalent of PhP1.5M for the lease of a specific machinery for use of a Philippine local company (say, PhilCoy) under the contract. If the contract would provide that the PhP1.5M PhilCoy will pay A Co. Ltd. is net of taxes, then, the above tax free covenant rule would apply. Under the rules, lease of machinery by a non-resident foreign lessor is subject to a final tax of 7.5% (Section 28(B)(4) of the Tax Code, as amended) so the final withholding tax (FWT) on such lease payments may be applied as follows:

  • Amount remittable to A Co., Ltd.                                         PhP1,500,000.00
  • Divided by equivalent percentage (100% less 7.5%)                         92.5%
  • Grossed-up amount                                                                    PhP1,621,621.62
  • Multiply by FWT rate                                                                                        7.5%
  • FWT due to BIR                                                                        PhP 121,621.62

Tax computation that simply multiplies the 7.5% by the lease payment of p1.5M that is net of taxes is unjustified and is not in compliance with the tax-free covenant provision. The reason is that the final withholding tax on lease payments to non-resident lessor of the machinery is the income tax liability of the non-resident foreign lessor so in effect, the local company is not only paying the P1.5M, but the P1.62M plus. As such the final withholding ta in the Philippines should be 7.5% of the P1.62M plus.


Disclaimer: This article is for general conceptual guidance only and is not a substitute for an expert opinion. Please consult your preferred tax and/or legal consultant for the specific details applicable to your circumstances. For comments, you may please send mail at info@taxacctgcenter.org.)


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