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The best of regs, the worst of regs

(Article published in the Mar 24,2003 issue of TODAY, Business Section)

Revenue Regulations No. 12-2003, issued only recently albeit dated January 2, 2003, shows how our revenue authorities, in implementing the value-added tax (VAT) on banks, non-bank financial intermediaries and finance companies, have sought to collect the tax in a manner consistent with its inner logic.  At the same time, however, it mercilessly shows how Congress was terribly mistaken when it decided to impose the VAT on financial institutions long after other countries which had flirted with the idea had abandoned the concept.

Our VAT is a 10- percent tax, based on the value of the goods and services rendered, intended to be paid in full only by the consumer.  However, in order to enhance the efficiency of the collection and thereby augment the cash flow to the government, it is collected in various stages of production and distribution even before the goods or services are finally purchased by the consumer.

This is how our VAT is supposed to work: A manufacturer sells his product to a wholesaler for P100 and adds P10, for a total of P110.  He keeps the P100 and remits the P10 to the government. The wholesaler, who has paid P110 for the product, puts a mark up of P20, and sells it to the retailer for P120 plus the VAT of P12 for a total selling price of P132.  He keeps the P120 for himself and from the VAT of P12 that he passed on to the retailer, he reimburses himself for the P10 that he shouldered when he paid the manufacturer and remits the remaining P2 to the government.  The retailer then adds his own mark up of P30 and thus sells the product to the consumer for P150 plus the VAT of P15 for a total cost to the consumer of P165.  He keeps the P150 for himself, like the wholesaler, reimburses himself for the P12 that was previously passed on to him and remits the P3 to the government.  The consumer keeps the product and bears the economic burden of entire P165.

The result is that the consumer is made to pay P15 in the form a 10-percent tax on the product that he consumed which had accumulated a value of P150 by the time it reached his hand.  Notice, however, that the P15 tax was paid, in advance and by installments, by those who were responsible for bringing the product to him.  Thus, the manufacturer remitted P10 to the government when he sold the product to the wholesaler; the wholesaler remitted an additional P2 when he sold it to the retailer; and the retailer remitted the final P3 when he sold it to the consumer.

What is crucial to the understanding of the VAT is the fact that the manufacturer, the wholesaler, and the retailer are mere collectors of the tax that is supposed to be shouldered by the consumer as well as the fact that from each collector, the tax that is remitted corresponds only 10 percent of the value that he adds to the product.  Thus, in our illustration, the manufacturer created value worth P100 and thus remitted P10.  The wholesaler added P20 and remitted P2 and the retailer added P30 and thus remitted P3.  That is why the tax is called the value-added tax.  Not that the tax added value; but the portion of the tax to be remitted by a taxpayer is on the value that he added at the stage of production and distribution he directly involved himself in.

Finding out how much value a manufacturer, wholesaler and retainer adds to a product is relatively easy in the case of goods sold to consumers.  It gets a bit messy when it comes to services. Although it is clear how a plumber adds value to pipes and faucets, it is not as simple to identify the value added by some professionals, such as lawyers, for instance.  Judging from the resistance clients have to paying our fees, one would think the common sentiment is that lawyers do not add value. 

At any rate, the difficult becomes a nightmare when one tries to identify just how much value is added by banks and other financial institutions whose main function is to play the role of an intermediary between those who have funds and those who use funds.  As earlier noted, most countries had dropped the idea.  Our legislators stubbornly want nevertheless to do it. How Revenue Regulations No. 12-2003 addresses this question is material for a b-school case study.

The general method of determining how much VAT is to be remitted to the government is seemingly simple:  Step one is to multiply the selling price by 10 percent.  That is known as the Output Tax.  Step two is to add up all the VAT that had been previously passed on to the tax payer.  The short cut is to get the cost price of the inputs and multiply it by 1/11.  The fraction of 1/11 will give you the 10-percent tax that was imbedded in the purchase price of the inputs.  That is why that is called the Input Tax.  Deduct the Input Tax from the Output Tax and the difference is the tax that has to be remitted to the government.

Revenue Regs. No. 3-2003 correctly approaches the base on which the 10-percent Output Tax to be imposed by recognizing that banks receive compensation for bringing money from the moneyed to the moneyless in many ways.  And for each category of service, it indicates the base of the Output tax.  The main categories are (a) straight forward service for which fees are charged; (b) gains from the sale of property; and (c) income from financial intermediation or, in less daunting terminology,  interest charged to the user of funds.

The general rule is that the banks’ Output Tax is 10-percent of the “gross receipts”.  That is what the law says.  Essentially, “gross receipts” is equivalent to the contract price, compensation, service fee, rental or royalty.  Thus, the Output tax on straight forward services such as rentals on properties, real or personal, royalties, commissions, trust fees, estate planning fees, services fees and all other charges or fees received as compensation for services (Yes, Virginia, banks do give service) as well as any other income is 10-percent of what the banks charge for them.  In this category of a bank’s activity, the bank is basically in the same position as a mortician and is taxed accordingly.

However, the regulations recognize that in the pursuit of its business a bank also buys and sells products, just like a wholesaler or retailer.  Sometimes it sells products, like desks and computers, it bought from some retailer.  And, more in keeping with its vocation, it buys dollars and sells them to its clients who need them (heaven knows, no bank speculates on foreign exchange), it sells securities, commercial papers, and other financial instruments that it likewise bought from other players in the financial market; and it sells the assets it had acquired, when the debtor defaults, through foreclosure of mortgages, pledges and other security arrangements. 

There is no problem when a bank sells desks and computers because those items, when bought by the bank, must have had the VAT factored into the price.  Thus, the computation of the tax falls neatly into the general rule.  However, when a bank trades in foreign exchange or in financial instruments, these trades, are, in reality, simply a proxy method for its getting funds from those who have to those who have not.  The spreads, which represent the only payment for value that the bank brings to the exercise, are very thin (unless the bank speculates in foreign exchange) and, mercifully, the regulations impose the 10-percent VAT only on the spread.  Thus the Output Tax on foreign exchange gains and net trading gains is respectively, as the text says, on “the difference between the value of the foreign currencies sold and purchased” and “the spread between the yield or selling price from trading…and the cost …of obtaining the same”. 

Similarly, when a bank forecloses on a property, the base of the ten percent (10%) tax is “the difference between the amount realized at the time of sale and …the bid price or unpaid loan value, whichever is lower”.  The theory is that the bank acquired the foreclosed property from the debtor at the cost of the unpaid loan value or at the bid price in the foreclosure proceedings” and then sold it to the winning bidder.  The value that the bank added in the process is simply that of liquefying the foreclosed asset and thus the base of the bank’s Output Tax ought to be limited to the extent of that value. 

This approaches is completely consistent with the inner logic of the VAT which was explained earlier.  And that is what makes it an excellent regulation.  But, unfortunately, the text of the VAT law does not justify it.  Congress dropped the ball, as it were, when, under Section 108 of the Tax Code, it imposed the VAT, without making any qualification recognizing the function of the financial institutions, “on gross receipts derived from the sale or exchange of services” and defined “gross receipts” as “the total amount of money or its equivalent representing the contract price, compensation, service fee, rental or royalty, including the amount charged for materials supplied for services and deposits and advanced payments actually or constructively received …for services performed or to be performed for another person, excluding the value-added tax”.  It would be exciting to bring this point to court because on the one hand the regulations conform to the spirit of the law but on the other is clearly contrary to it.

Suprisingly, when it came to financial intermediation and financial leasing (that financial legerdemain that makes a transaction which is truly a sale masquerade as a lease), Revenue Regulations No. 3-2003 strictly adhered to the text of the law.  I suspect this was done on purpose to provoke what is similar to, if I may use the vernacular of decades past, a “revolutionary situation”.  By hewing close to the law, the regulations brutally expose the folly of imposing the VAT on financial institutions and hopefully move Congress to amend the law by imposing a more suitable exaction.

Banking is essentially borrowing from Peter and lending to Paul.  When Paul pays back with interest, the interest is subjected to VAT on the theory that the service sold by the bank to  Paul was the use of money.  Interest is payment for the use of money; hence, a VATable item.  Since the VAT is imposed on the consumer, i.e. the user of the service, it is Paul who shoulders it.  The bank simply will add 10 percent to the interest it will charge to Paul.

The VAT law does not recognize any distinction among consumers.  Paul could be a manufacturer who in turn will simply deduct the VAT he paid on his business loan as an Input Tax from the Output Tax that he will pay when he sells his goods.  But Paul could also be borrower for his low-cost home, for his micro-finance business, for his small or medium scale industry, or other forms of activity which the government is encouraging.  He too will have to pay the additional 10 percent since no way will the banks be willing to absorb it.  After all, their stockholders did not invest their money in a charitable institution.

In effect, the VAT on financial institutions, to the extent that it indiscriminately imposes the tax burden on all borrowers, goes in direct contradiction of avowed policies of the government and subverts whatever progress is being achieved by pro-poor legislation and measures.  Not to mention the administrative nightmare that the implementation of the tax will cause.  But the likelihood of Congress realizing this and acting soon enough is as strong as George Bush realizing that he has no business bringing the world to the brink of an economic disaster by purportedly liberating the people of Iraq.