A guide to navigating software licenses in light of recent tax developments

Software is a cornerstone of modern business innovation and efficiency. From streamlining operations to enhancing the customer experience, it enables organizations to scale, adapt, and thrive. The dynamic nature of software — whether through cloud-based solutions, enterprise applications, or specialized tools — has transformed industries and redefined how businesses operate. However, as software becomes increasingly integral to business strategy and continues to expand, so does the complexity of its taxation.

This article revisits the taxation of software licenses in light of recent tax developments, specifically Revenue Memorandum Circular (RMC) Nos. 5 and 38-2024, which covers cross-border transactions, and Republic Act (RA) No. 12023, or the VAT on Digital Services Act, along with its implementing rules and regulations (IRR).

To arrive at the correct taxation, it is crucial to first determine whether payments for software licenses qualify as business profits or royalties, according to guidelines established in RMC No. 44-2005. A common mistake by software purchasers is categorizing the payments as royalties even when no copyright rights are transferred — only the “right to use” the software is granted. This distinction is vital because, in the Philippines, cross-border royalty payments are typically subject to a 12% VAT and 25% Final Withholding Tax (FWT), unless a lower rate is applicable under a tax treaty. Conversely, business profits may be exempt from Philippine taxes.

In mixed contracts, where necessary, the total consideration payable should be broken down based on contract information or reasonable apportionment, with appropriate tax treatment applied to each part. If one part constitutes the principal purpose of the contract and other parts are ancillary, the treatment of the principal part should apply to the entire consideration.

Once the nature of the software payment is established, business profits should be further assessed to determine whether they are considered Philippine-sourced income, following the factors laid down by RMC Nos. 5 and 38-2025:

1. Whether an integral stage/s in the rendition of services occurred in the Philippines, without which, the transaction would not have been accomplished; or

2. Whether the foreign vendor used any facilities and/or equipment situated in the Philippines to deliver the service; or

3. Whether the foreign vendor’s accrual of income depends on the successful use, consumption or utilization of the services by the Philippine purchaser.

Based on the RMCs, meeting at least one of the above-mentioned factors will constitute the payment as Philippine-sourced income subject to 25% FWT, but exemption is available under applicable tax treaties.

The final step is to assess whether the transactions would qualify as digital services. If so, the full amount is subject to 12% VAT. Otherwise, only the portion corresponding to the service rendered in the Philippines is subject to VAT.

RA No. 12023 and its IRR provided a broad definition and non-exclusive list of what would qualify as digital services. As defined, digital services are those supplied over the internet or other electronic network with the use of information technology and where the supply of the service is essentially automated. On the other hand, digital goods are intangible goods that are delivered or transferred in digital form, such as digital content purchases, subscription-based supplies of content, supplies of software services and maintenance, among others.

This definition can lead to confusion, particularly regarding which types of services are considered supplied over the internet and when they are deemed automated. Typically, software payments are covered under mixed contracts, granting the right to use software combined with the provision of after-sale services. Often, these after-sale services include technical assistance via conference calls, potentially considered as supplied over the internet; or bug fixes, which might be deemed automated despite the involvement of IT personnel. This implies that all services related to the software license could qualify as digital services subject to the 12% VAT.

Pending further guidance from the tax authority, I believe that the active conduct of the service should be considered when making an assessment. This means that if the active conduct of the service is performed manually or a significant portion of the service requires human intervention, it should not qualify as a digital service, even if supplied over the internet.

Navigating the complexities of software license taxation requires planning and proactive compliance measures. Businesses can consider the following actions to optimize their tax position and ensure adherence to the new tax rules:

• Reassess the nature of the software payments for proper classification and imposition of tax.

• Discuss with the foreign vendors to include/clarify the scope and details of the delivery and specify them in the contracts, as necessary. These would include considerations such as: the place of rendition of the service, including the location of any facilities used; the party who will shoulder the applicable taxes; and the transactions which will be supplied over the internet or automated.

• Avail of tax treaty benefits, if applicable, and file an application with the BIR for a Certificate of Entitlement to Treaty Benefits.

As software continues to drive innovation, understanding and adapting to the evolving tax environment is crucial. By embracing these changes, businesses can ensure they remain compliant while leveraging the transformative power of software to propel their growth and success in the digital age.

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.

Adriel Joshua Zaki Sim is a manager at the Tax Services department of Isla Lipana & Co., the Philippine member firm of the PwC network.

adriel.joshua.zaki.sim@pwc.com