Cutting incentives: The sequel to the tax reform agenda

House Bill 7214, the first bill to contain package 2 of the government’s Tax Reform for Acceleration and Inclusion (TRAIN) program was filed last week by Sultan Kudarat Rep. Horacio P. Suansing, Jr. and Nueva Ecija Rep. Estrellita Suansing. This will now start the official period of deliberation in the House for package 2.

There are three major policy changes sought in the bill:

1. Reduction of corporate income tax rate from 30 percent to not lower than 25 percent conditioned upon the reduction of tax investment cost;

2. Overhaul of the tax incentive system to one that is performance-based, targeted, time-bound and transparent; and

3. Adoption of stricter rules on intercompany transactions and arrangements.

Let me discuss these three reforms in brief.

Reduction of corporate
tax rate

The bill proposes to reduce the corporate tax rate by 1 percent for every reduction in the cost of tax investment incentives by 0.15 percent of gross domestic product. But overall, the rate should not be lower than 25 percent and there is no definite timeframe for the reduction.

In short, the tax reduction is conditional and dependent upon the government’s efficiency in being able to reduce the cost of tax incentives. There is no certainty.

This quid pro quo proposal may be fiscally prudent, making sure there is no dip in revenue at any point in time while trying to fix the system. Understandably, because of the proliferation of various incentives and exemptions that narrowed thinly the tax base overtime, it makes it more difficult and sensitive to reduce the tax rate without accompanying discipline in revenue.

But uncertainty is the worst nightmare of those in business as it makes everything unstable. It makes one incapable of planning, projecting and making solid business decisions. Investors, when looking for a country to invest in, look for certainty in the business environment, certainty in policies and rules. That is lacking in this quid pro quo proposal.

While there is a brighter future being hoped for, the idea of a reduced tax rate remains just an idea floating on air, until and after it happens.

Scouring the landscape of the corporate taxation of our neighboring Asean countries, I note that the dominant tax rate now is 20 percent and the average is 21-22 percent. Singapore is at 17 percent, Cambodia, Vietnam and Thailand at 20 percent, Malaysia and Laos at 24 percent and Indonesia at 25 percent.

At 30 percent, we are the highest, and even if we successfully reduce it to 25 percent, we still remain to be the highest, together with Indonesia. However, I heard Indonesia may soon reduce its rate, too—thus making us still the lone country with the highest tax rate. Uncompetitive!

With that as background, a tax reform that offers certainty in rules, a competitive one that would put the country within regional range even if it takes a longer period to achieve it, is something to be considered.

For example, a reduction in corporate tax leaning towards the Asean dominant rate of 20 percent over a period of six years with a fixed yearly rate adjustment would be best. It could be a gradual reduction, say 1 percent for the first three years, 2 percent in the next two years and 3 percent on the sixth year. This transition period of six years would give the government sufficient time to fix an entire gamut of tax collections, both tax policies and tax administration, to assure a steady revenue flow, until we achieve the ideal system.

With a 20-percent corporate tax rate, we need not give incentives anymore. Foreign investment will flow naturally, for as long as other nontax considerations are improved and are competitive as well.

Overhaul of the investment tax incentives

There are 14 investment promotion agencies, 123 laws granting various types of investment tax incentives, another 192 laws granting various noninvestment tax incentives, and the Tax Code also granting several tax incentives and tax preferences.

That is how generous our country is to investors. That is how big those in the regular tax regime have given as a subsidy to the lucky ones. And that is how serious the tax base has narrowed. Yet, for years, we lagged very much behind in attracting foreign investments.

We failed, despite that generosity.

Package 2 wants to fix all that. How? By scrapping all the various tax incentives and replacing them with a single menu of incentives that is performance-based, time-bound, targeted and transparent. To emphasize, it will be time-bound. There will be a gradual phasing out of holders of existing incentives allowing them to continue for a number of years more before sunset applies based on a recent presentation of the Department of Finance (DOF).

In HB 7214, a whole new chapter (Title XII) containing the general provisions on tax incentives is proposed to be incorporated in the Tax Code, rather than in a separate investment law. Perhaps, this move will institutionalize fiscal discipline in the grant of incentives and prevent the trigger-happy sporadic giving out of incentives by legislators or by incentive-giving bodies. Due to lack of space, I will discuss this separately in another article.

Likewise, the preferred tax rates and exemptions contained in the Tax Code are rationalized and streamlined. HB 7214 proposes to remove the tax exemptions and tax preferences given to certain entities, such as local water districts, offshore banking units, regional headquarters (ROHQs), nonresident cinematographic film owners and lessors of vessels and aircraft, among others.

Special deductions such as those given to private educational institutions are removed and the Optional Standard Deduction (OSD) has been reduced to 20 percent of gross income, for both individuals and corporations.

Intercompany transactions and arrangements

The purpose of the bill is to guard base erosion and profit shifting in transactions between related companies, putting a stricter scrutiny to sweetheart deals by strengthening the transfer pricing rules and enforcing arm’s length standards. However, the wordings are still vague and may need more clarity.