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The VAT on Financial Intermediation Income  

(Article published in the Jun 16,2003 issue of TODAY, Business Section)

The newspapers reported over the long week-end that Sen. Ralph Recto, chair of the Senate Ways and Means Committee, maintained that banks should absorb half of the ten percent (10%) value added tax (VAT) on the interest collected on short-term loans.  Obviously in reaction to the public furor against being made to pay the VAT on interest from loans, the good senator, maybe trying very  hard to live up to the conflicting burden of being the spouse of the masa icon Vilma Santos and of being a kin of the great Claro M. Recto, apparently argued that since the interest on loans maturing in five years or less were, prior to the VAT, subject to the five percent (5%) gross receipts tax (GRT), which is “imbedded in the interest rates”, then the banks should pass on to its borrowers only the additional five percent (5%) which the government is collecting under the VAT regime.   

Niloloko nila tayo kung kokolekta sila ng 10 percent”, the senator was quoted as saying.  That pronouncement, of course, increases his pogi points for effort,  by showing how near he is to the masa, but at the same time it shows how very far away he is from intellect of his distinguished relative.  Aside from betraying an incredible failure to understand the fundamental distinction between the base of the two taxes, his statement shows he does not have a proper appreciation of the respective purposes of the GRT and the VAT as well as the true nature of a bank and the interest it receives.   

The base of the bank’s GRT is, as its name suggests, the taxpayer’s receipts without any adjustment or deductions.  It is imposed on the entire receipts for products sold or services rendered irrespective of what occurred before or what occurs after the taxpayer is subjected to it.  That is why it is, in senses more than one, called “gross”.  Some, including myself, prefer the name “very gross”. 

In contrast, the base of the VAT, if anyone wants to pay attention to its name, is the “value” that is from time to time added to the item bought or to the service availed of as it goes down the production (or, in the case of services, initiation) and distribution chain until it ends eventually in the hands of the ultimate consumer.  Thus, for a particular taxpayer who is subject to the VAT, the proper base of the tax that he must remit to the government is only the value that he has added at the stage where he is in. 


      The mechanism for achieving this, or rather for arriving at the proper tax base for any one particular VAT taxpayer, is to allow him to deduct from the entire ten percent (10%) that he collects from his buyer, the previous VATs that had already been paid to the government by those who had been before him.  The ten percent (10%) that a particular VAT taxpayer collects from his buyer is called “Output VAT” and the previous VATs that had been collected by the various taxpayers before him is called “Input VAT”.  The VAT that a particular taxpayer remits to the government is the difference between the Output VAT and the Input VAT.  That difference is equivalent, under ideal circumstances, to ten percent of the amount of value that that taxpayer added.   

Applying this analysis to the interest earned by banks on loans, the VAT that the banks ought to remit to the government must be, assuming that interest is subject to the VAT (an assumption I shall in a moment challenge), the ten percent (10%) of the interest received (the Output VAT) less the total of the Input VATs on those items that the banks themselves had bought from others in order to deliver the service which Input VATs had already been paid to the government by the previous sellers of goods and services to the banks. 

That difference is certainly less than the full ten percent (10%) VAT being collected from the banks and therefore to argue that since the five percent (5%) GRT tax is already in the interest paid on short-term loans, then the additional burden to the banks of the VAT regime and what the banks can legitimately pass on to its short term borrowers is the entire five percent (5%) differential, is to be too simplistic.  It fails to take into account the deduction of the Input VAT, no matter how minuscule when seen in the light of the greater scheme of things, from the Output VAT. 

Even the masa, however, realizes that his premise that the GRT is already imbedded in the interest is extremely dubious.  The GRT is part of doing business and, like other costs of doing business, often passed on to the buyer of the goods of services as part of the price.  To that extent, the good senator is correct.  However, passing on the cost of doing business to the customer is possible only if the customer will continue buying the goods or availing themselves of the service despite the increase in his price.  Economists call that elasticity of the demand.  However, if the customers will refuse to continue buying because of the increase in price, the businessman is forced either to (a) absorb it himself, or (b) recover the cost by reducing his expenses for other factors that went into his production.  In most cases, the likely absorber is labor; in others, it is other service providers. 

Thus, my favorite banana cue sidewalk vendor forced by sanitary inspector from City Hall to pay his daily tong can, it is true, increase his price and imbed the tong in the price.  But if he cannot, and he still wants to stay in that business, he can either decide to be content with lesser profits, or, pay his helpers a bit less.  In either case, the masa full well knows, the tong, which in our illustration is functionally equivalent to the GRT of the banks, is not necessarily imbedded in the price of the banana cue.  It depends, my Jesuit teachers used to say. 

But what the good senator ought to think about, and for this he needs to put on hard drive all the genes he may have inherited from the great Don Claro, is that interest on loans paid to banks is not, in its entirety, proper objects of the VAT.  Only a small portion of the interest, that which corresponds to the banks’ fundamental function of financial intermediation, should be subject to the VAT. 

This suggestion is, of course, outrageous to those who would be guided only by what appears, in this case, by what appears in the text of the law, particularly the Tax Code.  Undoubtedly, the VAT, as we know it, covers not only the sale of goods but also the sale of services.  Interest, the law and the decisions tell us, is what is paid for the use or forbearance of money.  It is thus like rental for the use of property.  Hence, the argument goes, like rentals, it is a proper object of the VAT.  

This kind of thinking, however, fails to discern the particular nature of bank interest.  Banks do business primarily by putting together those who have funds with those who need to use funds.  Thus, banks accept deposits from savers and lend the money to their clients who  use it.  In high falluting language, banks are financial intermediaries.  Deposits are, of course, borrowings by the banks from their depositors and they, for the most part, pay interest on the deposits.   

This means that when the banks charge their borrowing clients, say, twelve percent (12%) interest, part of that, say, nine percent (9%) will paid to their depositors and only the three percent (3%) remains with the banks.  Therefore, the total of twelve percent (12%) is only part “interest” (in the sense of payment for the use or forbearance of money) to the extent of nine percent (9%); the remaining three percent (3%) is really payment for bringing saver and user together.  Put another way, the value-added attributable to the banks is only the three percent (3%). That only should be the object of the VAT to be collected from the banks. 

When they were drafting the current regulations (Rev. Regs. No. 12-2003) to cover the VAT to be collected from the banks, those who understood the rationale of the VAT included a provision allowing for the deduction of a “presumptive input tax” fixed at the arbitrary figure of fifty percent (50%) of the interest received.  The idea, however, did not see the light of day since the VAT law did not make a provision of such a “presumptive input tax”.  In contrast, the VAT under Section 111(B) of the Tax Code expressly permitted the “presumptive input tax” for firms engaged in the processing of certain primary agricultural products, such as sardines, milk, sugar and cooking oil, and for contractors with respect government contracts.   

The obvious purpose of the presumptive input tax is to allow the “flow-through” to the consumers of the benefits of the special treatment accorded the products in their initial state.  For instance, sale of agricultural products in the original state is exempt from the VAT.  That exemption is rendered useless when the same products are manufactured or processed substantially before being sold to the public.  To preserve the benefit of the exemption with respect to certain products which are usually purchased by the poor (otherwise, the poor would have to shoulder the VAT), the law permits the processor to claim a “presumptive input tax”.  In effect, the ten percent (10%) VAT on the processor is limited to the value he added to the agricultural product.  

A similar situation actually arises in the case of interest received by banks.  Interest on bank deposits, for some reason or another, have never been considered as subject to the VAT.  You do not find any depositor claiming from his bank an additional ten percent (10%) on his interest.  Yet, if one were to be strictly consistent about the reason why interest earned by banks is subject to the VAT, i.e. because it is money paid for the use or forbearance of money, then the interest earned by depositors should also be subjected to the VAT.  But that would be political suicide for our lawmakers and elective officials in the executive branch.  Hence, the government re-coups what it failed to get from the depositors by pouncing on the hapless banks.