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Should the banks be subject to the VAT?

(Article published in the Dec 30, 2002 issue of TODAY, Business Section)

Unless Congress acts very fast as soon as it returns from its Christmas break and addresses the question of whether, at least for the coming year, banks and other financial institutions ought to be subjected to the value-added tax or VAT (instead of the current and more traditional gross receipts tax), Revenue Regulations 18-99, with a few minor modifications, will most likely govern the imposition of the VAT banks. This is the same set of rules that were drafted in the waning days of 1999 when, like this year, our legislators were too busy to decide once and for all whether banks do "add value" and, if they do, how to measure and tax it.

The various organizations of banks and financial institutions have been working quietly to get, at least, another deferral of VAT on the compensation they receive for the services they render, although the finance department, on account of the projected short fall in its revenue collections, has been less than supportive. However, the sentiment in Congress, particularly of those who have not devoted themselves to Mark Jimenez telenovela, seems to be open to another deferral. It is thus possible that another reprieve will be won by the banks for this year. But, in this country of ours, you cannot take too much for granted, and thus, lest they be caught unprepared, it may be a good idea for banks and other financial institutions to examine this issuance and determine how they will be affected, just in case Congress acts true to form and does nothing.

Revenue Regulations 18-99 covered banks, non-bank financial intermediaries and finance companies. Section 2 attempted to define what these creatures are in accordance with their accepted meaning at that time, but since more recent legislation has been passed since December 1999, it is likely that the definitions will be modified. For example, "banks and financial institutions" will be probably defined the way the terms are understood under Section 3 of the General Banking Law of 2000.

The heart of Revenue Regulation 18-99, as far as the banks and other financial institutions are concerned, is found in Sections 3 on the computation of the Output Tax and in Section 5 on allowable input taxes. The hapless borrower, to whom the banks will obviously pass on the cost of the VAT, is covered by Section 4.

The output tax is computed in two ways, depending on whether the amount received by the bank or other financial institution is for "financial intermediation services", as in the case of interest earned from the institution’s borrowers or for "other services", like use of safe deposit boxes, trust and investment management fees, commissions, etc. The VAT on "other services" follows the general pattern of computing for the VAT on services rendered and needs no special attention. But the VAT on financial intermediation services need close scrutiny.

Recognizing that financial intermediation consists essentially from getting (and paying for) money from savers and investors and lending it, for compensation, to those the users of funds, subsection 3.1 computes the output tax, not on the entire amount of interest received, but only on the "gross receipts" which is in effect is just the spread between the "interest income" and the "interest expense". This meaning of "gross receipts" is a departure from the usual meaning of the concept in the case of other types of services rendered. Ordinarily, "gross receipts" is the total amount of money or its equivalent representing the contract price, compensation, service fee, rental or royalty. In effect, the regulations correctly acknowledge that part of the interest received by banks is in effect segregated from its general funds and, may be said to be held in trust, in a loose sense, for the institutions’ depositors and investors. Hence, that part is not to be treated as "gross receipts".

The crux of the problem, however, is in determining which part of the interest received in the course of financial intermediation is to be excluded from the gross receipts and which part is to be included. The difficulty lies specifically in pinning down the "interest expense" of a bank or financial institution which typically sources its funds through various products, each having its own interest cost. Thus, for, say, every million pesos lent out by the institution, a few hundred thousands may have come from checking accounts which yield no interest to a depositor, some hundred thousands from savings deposits which give minimal interest, still other sums from time deposits which cost the bank slightly higher interest, and, perhaps, the balance from bond offerings with interest varying from one repricing date to another. Tracking down the sourcing costs of every peso lent out is of course an operational nightmare both for the banks as well as the tax collector.

Simplicity of tax administration and enforcement demands a simple approach and the approach taken by the regulations is to adopt an arbitrary "proxy" for the cost of funds. That proxy is 91-day Treasury Bill rate. In other words, it is assumed that the interest cost which the bank had to pay to its depositor is equivalent to the current 91-day T-bill rate. Thus, the "gross receipts" is simply the interest earned less the assumed interest cost computed at the prevailing 91-day T-bill rate.

This proxy input tax, a term which further clutters the already confusing jargon of the value added tax, would not have been necessary if the depositors and investors of a bank charged VAT on the interest paid by the financial institutions to them. In such a case, the banks can be simply asked to base the output tax on the whole amount of interest paid and credit against the output tax the VAT they pay as part of the interest they pay to their depositors. The process would be tedious, but not any more tedious than what merchants are expected by law to do now, i.e. keep records of the VAT passed on to them. However, by a quirk of law, the definition of "sale of services"includes the interest earned by the banks when they lend to their clients but not the interest earned by the depositors when they lend to the banks. Everyone gets entangled on the questions of whether the depositors are subject to the VAT. Hence, the need for the proxy input tax to cut the Gordian knot.

At any rate, this method of computing for the "gross receipts" results in further complicating compliance with the law. Because "gross receipts" excludes the proxy financial intermediation expense, the interest paid on the use of the funds generates no input tax. Regardless of whether it is so in fact, the input tax is simply ten percent of the 91-day T-bill rate. Moreover, a VAT-registered borrower can claim as his own input VAT not the ten-percent of the interest he paid, but only what he can prove the bank collected from him. This means the borrower must require a VAT receipt issued by the financial institution.

This almost forced resort to the proxy cost of financial intermediation is just one of many other manifestations of the fundamental error in putting banks and other financial institutions within the VAT net. Members of Congress, by simply amending the VAT law to exclude banks and other financial institutions, would be making good amends for the aggravation they had recently inflicted on us when they allowed some of their colleagues to turn a simple extradition case into a pseudo-constitutional issue.