On weekends, I travel from my workplace to my province for a quick break from my busy working life. Every time I travel to my home town, I always notice the expanding industry of Philippine Economic Zone Authority (PEZA) enterprises, with special economic zones and technoparks being established in almost every city of my province, wherever I go. In fact, our province is known for its numerous economic zones. This makes me realize the rise in demand for PEZA-registered entities.
The PEZA Law or Republic Act No. 7916 — also known as the Special Economic Zone Act of 1995 — was passed in February 1995. PEZA-registered entities enjoy numerous fiscal and nonfiscal incentives under the law as opportunities to build profits and minimize operational costs. However, in effectively administering the incentives set forth by PEZA, the Bureau of Internal Revenue (BIR), and other government agencies will always come into the picture. PEZA-registered entities are required to strictly adhere to the rules of PEZA, BIR, and other government agencies to completely enjoy their incentives. While compliance with PEZA is the primary objective, its tax compliance as a PEZA-registered entity should also be at the top of the to-do list. Otherwise, tax consequences due to noncompliance will always be a hurdle.
Consequently, what are the common tax issues PEZA-registered enterprises deal with?
Functional currency reporting. Many PEZA-registered entities are adopting foreign currencies other than the peso in their books of account for tax purposes. Under Revenue Regulations No. 06-2006, functional currency income and expenses needs to be translated into pesos monthly using the Philippine Dealing System (PDS) monthly average exchange rate (now the Banker’s Association of the Philippines exchange rate). However, some companies still use historical rates instead of monthly average exchange rates in translating their foreign currency income and expenses. Is this allowed? This was permitted in a BIR ruling, provided that the peso figures in the income tax return are reconciled with the peso amounts reflected in the tax returns other than income tax.
Hence, it is critical that the total figures in the income tax return for the year are reconciled with the total of the equivalent peso figures as converted from the functional currency figures in the maintained subsidiary ledgers to serve as the source of the figures reflected in tax returns other than income tax (i.e., tax returns for value-added tax, percentage tax, withholding tax, documentary stamp tax, etc.). For example, revenue reported under the VAT returns for the year should, likewise, be used as the revenue reported in the income tax return. Any difference due to currency translation is to be reported as reconciliations at the end of the year in the annual or final adjustment of income tax returns. For the sale of services, the foreign exchange rate may differ when accruing for income tax purposes and when recording the collection for VAT purposes.
Allocation basis. Some PEZA-registered entities, at any one time, are covered by different tax regimes. They have income from unregistered activities, which are subject to regular income tax. They may also have registered activities that are enjoying income tax holidays (ITH) or are subject to the five percent tax on gross income. Hence, they have to deal with the basis for allocation between registered to unregistered activities, between activities under ITH or the five percent regime, and from Cost of Sales to Operating Expenses.
The question is, what should be the basis? BIR Ruling [DA-608-06] provides that, if possible, segregation should be done through specific identification. Otherwise, allocation based on relevant data may be used, if applicable.
While some enterprises have secured rulings with the BIR to validate their basis of allocation, others plainly resort to their internal interpretations (e.g., sales related to registered and unregistered projects, floor areas and personnel headcount). Take note, however, that allocation basis is crucial during BIR assessments. It is the PEZA enterprises’ burden to prove that the allocation basis is reasonable and acceptable. Hence, PEZA enterprises should maintain documentation (e.g., memoranda, agreements, and BIR rulings) that can justify the basis of allocation. These should be further supported by billings/invoices issued to the company for them to be acceptable from the BIR’s perspective.
Direct costs. The computation of gross income subject to the five percent tax is still a major concern, even after more than 20 years of the PEZA Law. The basis of the five percent tax is the enterprises’ gross income, which should be Net Sales less Cost of Sales. RR No. 11-2005 has laid down the direct costs to be included as allowable deductions to arrive at the gross income as the basis of five percent gross income tax. The common question, though, is should this be treated as exclusive or not?
In many instances, the BIR disallows certain direct costs that are not on the list asserted under RR No. 11-2005. However, a Court of Tax Appeals (CTA) decision issued in 2014 has ruled that the list under RR No. 11-2005 is not meant to be all-inclusive, but merely enumerates the expenses that can be considered direct costs. PEZA-registered enterprises may be allowed to deduct expenses that are in the nature of direct costs, even though the same is not included on the list. It was stated that the criteria for determining if the item of cost or expense should be part of the direct cost are the direct relation of such item in the rendition of the PEZA-registered services.
Despite this CTA interpretation, the BIR still continues to disallow expenses and to assess deficiency taxes based on the rules under RR No. 11-2005.
VAT zero-rating. For the sale of services to PEZA-registered entities to be subject to VAT at zero percent, the BIR, in several rulings, takes the position that it should be under these two circumstances: (1) services are rendered within the ecozone, and (2) services are rendered in relation with the registered activities of the PEZA-registered buyers.
A CTA ruling issued in 2017 rendered this invalid. The CTA ruled that sales of services should be zero-rated when the following requisites are met:
1. Sale of service is performed in the Philippines;
2. Service is performed by a VAT-registered person; and
3. Service is rendered to persons or entities exempted under special laws or international agreements to which the Philippines is a signatory.
The CTA considered unarguable the BIR’s position that a sale of services should be rendered within the ecozone and should be directly connected to the activities of PEZA-registered enterprises to qualify for VAT zero-rating. Such a position is not only contrary to the plain wording of the law, but also to established jurisprudence and even to BIR’s own revenue issuance.
The CTA decided that, as long as the PEZA-registered buyer is located and operating within the ecozone, sellers from the Customs territory cannot pass on any output VAT for any sale of goods or services destined for consumption within the ecozone. Proving its tax situs and connection with the registered activities will not be of importance.
Nevertheless, some BIR examiners still insist on a different interpretation during tax audits.
Local government impositions. The five percent special gross income tax is in lieu of all national internal revenue taxes and local government taxes, except for real property taxes. However, it is still a question up to now if the exception should be treated as encompassing all national and local taxes, including regulatory fees and charges.
While PEZA entities’ exemption from payment of local business taxes is being honored, many local government units impose local business taxes on unregistered activities. Most PEZA entities are also being required to pay the regulatory fees imposed by local government units (LGUs). While the exemption states that this should be in lieu of all national and local taxes under the PEZA law, certain local government units still specifically proceed with their own LGU Memoranda of Agreement with PEZA.
Expiration of income tax holiday. PEZA-registered entities can be entitled to an extension of the Income Tax Holiday up to eight years from the start of commercial operations. However, the Income Tax Holiday extension requires compliance with specific terms and conditions; thus, securing approval for the extension can take time. Some PEZA enterprises whose ITH applications are still pending with PEZA already use the ITH exemption as the basis of their annual income tax. Will this be accepted? Ideally, they should already be under the five percent gross income tax if the ITH has expired. The proof of approval of the ITH extension is crucial before an enterprise can apply the exemption in its annual income tax returns.
The above common issues are a few of what PEZA entities deal with. Indeed, the growth of PEZA economic zones is no doubt instrumental to an economy: making the country attractive to foreign investors, creating millions of job opportunities, and improving export activities. From the PEZA-registered entities’ perspective, however, tax compliance is not a walk in the park.
With the PEZA Board now in support of the Corporate Income Tax and Incentive Rationalization Act or (CITIRA) Bill, PEZA-registered entities may be faced with a new set of incentives and new rules if the bills are passed. Let us hope for easier compliance with a clearer and more consistent interpretation of the rationalized tax incentives.
In addition, the passage of Republic Act No. 11032 or the Ease of Doing Business Act of 2018, which aims to make it easier to start and operate businesses, should also support taxpayers’ concerns in dealing with tax compliance: simplicity of rules, transparency, and promotion of efficiency. Therefore, how do you deal with the dilemmas of complying with the BIR and LGU regulations?
In the meantime, PEZA enterprises still bear the burden of proving that their practices are reasonable and not contrary to what regulations provide.
Let’s Talk Tax is a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
Jasmine D. Abaygar is a senior of Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.