Zeroing in on the vetoed VAT provisions

When the Tax Reform for Acceleration and Inclusion (TRAIN) bill was signed into law, one of the more notable provisions was the shortening of the number of days within which the Bureau of Internal Revenue (BIR) should act on VAT refund claims from 120 days to 90 days, upon the successful establishment and implementation of an enhanced VAT refund system. While this may generally be considered as a step towards the government’s objective of making tax compliance and processes simpler for taxpayers, the same may not hold true for entities registered with the Philippine Economic Zone Authority (PEZA). Under TRAIN, the successful establishment and implementation of an enhanced VAT refund system is a condition that may trigger the imposition of VAT on constructive export sales to PEZA-registered entities by non-PEZA local suppliers.

LOOKING BACK AT TRAIN’S JOURNEY
In the House version of the TRAIN bill, a sunset provision was introduced on the VAT zero-rating of certain constructive export transactions including “Section 106(A)(2)(a)(5) or those considered as export sales under Executive Order No. 226, otherwise known as the Omnibus Investment Code of 1987, and other special laws,” which covers sales to PEZA entities. Accordingly, local sales to PEZA entities shall no longer be considered as VAT zero-rated once the enhanced VAT refund system is in place.

In the Senate and ultimately in the bicameral version of the TRAIN, an additional provision was introduced to expressly exclude the “sale and actual shipment of goods to special economic and freeport zones” from the coverage of the sunset provision on the VAT zero-rating. However, this provision was vetoed by the President because it goes against the principle of limiting the VAT zero-rating to direct exporters. As further explained in the veto message, the proliferation of separate customs territories, which include buildings, creates significant leakages in the tax system, which made it highly inequitable. The President’s veto effectively brought back the constructive export to PEZA entities under the above Tax Code provision; hence, covered by the sunset provision on VAT zero-rating.

Interestingly, there were no similar amendments to the VAT provisions on sale of services to PEZA entities. The successful implementation of an enhanced VAT refund system does not trigger the imposition of 12% VAT on these transactions.

UNDERSTANDING THE VETO MESSAGE
The President mentioned that zero-rating of local sales to PEZA entities creates “significant tax leakages in the tax system.” To fully analyze this statement, feel free to pick up your pens and run the numbers through a simple illustration. Let us assume that a local supplier (i.e., Supplier A) sold goods to a PEZA entity amounting to P100. Let us further assume that purchases of Supplier A from lower-tier local suppliers amounted to P80. At present, the BIR would be able to collect output VAT of P9.60 from the lower-tier local suppliers; however, the same amount of input VAT can be refunded by Supplier A since it is attributable to its zero-rated sale to the PEZA customer.

However, using the same illustration, after the successful implementation of the enhanced VAT refund system under the TRAIN law, Supplier A should already pass on 12% VAT to its PEZA customer. Under this scenario, the BIR may be able to collect a total amount of P12: (a) the initial P9.60 from the lower-tier local supplier; and (b) the net amount of P2.40 that will be remitted by Supplier A, which is calculated by deducting the P9.60 input VAT from the output VAT of P12 on the sale to the PEZA customer (i.e., P100 x 12%).

The next question that now comes to mind is whether or not the PEZA entity can recover the P12 input VAT passed on by Supplier A once the enhanced VAT refund system kicks in. The answer would depend on whether the said input VAT can be attributed to its VAT zero-rated sale.

A PEZA entity is generally entitled to the following fiscal incentives: (a) income tax holiday (ITH); and (b) 5% gross income tax (GIT), in lieu of all national and local taxes, after the lapse of the ITH period. For VAT purposes, export sales under the ITH regime are VAT zero-rated while those under the 5% GIT regime are VAT-exempt. Going back to the illustration, the PEZA entity may only recover the passed-on input VAT from Supplier A while under the ITH regime. Please note that although refundable, this would still distort the cash flow and entail additional costs (e.g., additional manpower to file and monitor the refund claims, among others) to the business. On the other hand, if the PEZA entity is already under the 5% GIT regime, the refund option is no longer available. Accordingly, the passed-on VAT becomes part of the cost that would ultimately impact profitability.

Based on the foregoing, the “tax leakage” that was referred to in the veto message could be the VAT component that the local suppliers (indirect exporters) are generally able to refund from the government even if the PEZA customer is under the 5% GIT regime.

In the past, however, the VAT zero-rating on constructive export sales to PEZA entities was not perceived as a tax leakage. Under Section 8 of the PEZA Law, economic zones are managed and operated as separate customs territories. On this basis, the Supreme Court declared that economic zones are regarded as foreign soil. Hence, applying the cross-border doctrine, no VAT shall be due on goods that are destined to these economic zones.

IMPLEMENTING REGULATIONS
Currently, there are varied interpretations as regards the imposition of VAT on sale of goods to PEZA entities by local suppliers. The BIR, in the public consultation held on Jan. 12, also opted to defer answering questions on the matter pending the scheduled meeting with PEZA officials. Unlike the equally controversial vetoed provisions of the TRAIN on the 15% employee tax incentives of regional operating headquarters (and similar taxpayers) where the implementing rules are likely to adopt the intent of the veto message, it seems the BIR may not yet have a final take on the VAT issue at the moment. This could be a good indication that the tax authorities are really taking into consideration the potential impact of the VAT veto, not only in terms of the additional cost or administrative burden of refunding on the part of PEZA entities, but also the billions worth of sale transactions of local suppliers, which could be at risk should these entities opt to limit their local purchases.

There are also a number of other considerations that the author hopes would be addressed in the implementing regulations:

• Whether or not another VAT provision left untouched by the TRAIN can be used as basis to retain the VAT zero-rating of constructive exports to PEZA entities. Under Section 106(A)(2)(c) of the Tax Code, “sales to persons or entities whose exemption under special laws or international agreements to which the Philippines is a signatory effectively subjects such sales to zero rate.” The PEZA Law, which entitles PEZA entities to the 5% GIT, in lieu of all national and local taxes, is a special law that technically falls under this provision.

• Whether or not the Supreme Court decisions that regard economic zones as foreign territories based on Section 8 of the PEZA Law could still be used as basis for the VAT zero-rating following the cross-border doctrine since the PEZA Law was not included in the repealing clauses of the TRAIN.

•  The TRAIN law provides that to determine the effectivity of the enhanced VAT refund system which will trigger the imposition of VAT on local sales to PEZA entities, “all applications filed from 1 January 2018 shall be processed and must be decided within 90 days from the filing of the VAT refund application. It is unclear whether or not a single instance of failure to decide on a refund claim within 90 days would mean that the enhanced VAT refund system has not been successfully implemented. And if so, would the transactions then revert to their previous zero-rated status?

Pending the issuance of the revenue regulations, it may be prudent for the affected entities to make an assessment of the potential cash flow impact of the VAT that will be passed on. More importantly, these entities must ensure that stricter controls are in place so that purchase transactions from non-PEZA entities are supported by VAT-registered invoices and official receipts that contain all the required information under the Tax Code and to ensure that VAT refund applications are filed on time.

On the part of the BIR, it must ensure that the enhanced VAT refund system would be able to accommodate the expected surge in recurring VAT refund applications. Based on the latest information from PEZA’s website, there are more than 300 economic zones nationwide with several registered entities in each economic zone. The objectives of the government to enhance the current tax system, provide equitable relief to a greater number of taxpayers by improving disposable income levels, and ensure sources of funds to maintain the general welfare of the people, will be achieved only through effective implementation of the tax reforms.

The views or opinions 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.

Eileen Flor C. Abalos is a senior manager at the Tax Services Department of Isla Lipana & Co., the Philippine member firm of the PwC network.

eileen.flor.l.chavez@ph.pwc.com