Tax arbitrage at 50%

In order to accelerate poverty reduction and to address the growing economic inequality between the rich and the poor, the government, over the last few years has prioritized undertaking a comprehensive tax reform program. The first package of the program which was known as Tax Reform for Acceleration and Inclusion (TRAIN) Law or Republic Act 10963 was passed during the last part of 2017. The impact of these recent changes has been felt by individuals and corporations alike. Two of the four remaining packages of the CTRP, Corporate Income Tax and Incentives Reform (CITIRA) and Passive Income and Financial Intermediary Taxes (PIFITA), are currently with the Senate for hearing and further deliberation. With all the clamor and news that the CITIRA has been into recently, let’s instead shed some spotlight to the PIFITA or House Bill 0304 (Package 4).

The aim of the amendment is to simplify the complicated passive income and financial intermediary tax system which causes arbitrage and unfairness. Philippines also has higher passive income tax rates compared to its ASEAN neighboring countries. Lowering these rates will make the country more competitive against the other countries. Thus, reforming the current tax system related to the financial sector is necessary to eventually encourage savings, develop our capital markets and increase financial inclusion.

The major proposed reforms of the PIFITA are the 15 percent uniform tax rate on most types of passive income such as interest income and dividends, reduction of Stock Transaction Tax (STT) from 0.60 percent to 0.10 percent, and reduction of rates and tax base of financial transactions subject to DST.

In addition to the above, the bill also proposed to increase of interest arbitrage from 33 percent to 50 percent starting 2020. This means that interest expense within the taxable year shall be allowed as deduction from gross income provided, that it shall be reduced by an amount equal to 50 percent (from 33 percent) of interest income subjected to final withholding tax. But why an increase to 50 percent?

To appreciate the reforms, it may be important to revisit the concept of the tax arbitrage scheme. In a general context, “arbitrage” can be defined as the process of exploiting differences in the price of an asset by simultaneously buying and selling it. In the Philippine tax landscape, this pertains to the proceeds of a taxpayer’s loan obtained in connection with the operations of his trade, business or exercise of profession which is afterwards invested, and the interest income derived from the said investment had been subjected to final withholding tax.

To illustrate, suppose ABC Corp borrowed from the bank P1 million with a rate 10 percent per annum or a P100,000 interest expense, then ABC Corp invested the same fund to purchase time deposits which will earn 10 percent per annum or a P100,000 interest income. For tax purposes, ABC Corp would gain a net benefit of P10,000 representing the difference between the income tax deduction on the interest expense of P30,000 (P100,000 x 30 percent) and the final tax on the interest income of P20,000 (P100,000 x 20 percent FWT). 

To address this issue, a reduction of the interest expense is necessary to equalize the tax liability on the interest income and the tax benefit on the interest expense, thus a 33 percent (P10,000/P30,000) reduction was implemented by the Tax Code.

Now that we have established the basis of the 33 percent interest expense limitation, where does the 50 percent increase of the limitation fit in the picture?

Let us consider the same illustrative example with the proposed amendments from the PIFITA, ABC Corp would now gain a benefit of P15,000 which represents the difference between the tax benefit on the interest expense of P30,000 (P100,000 x 30 percent) and the tax liability on interest income of P15,000 (P100,000 x 15 percent FWT). This means that the 50 percent (P15,000/P30,000) increased on interest expense limitation is a result of the proposed change of PIFITA to the final withholding rate for interest income from 20 percent to 15 percent.

Based on the above scenario, while the income tax rate for interest income is reduced, interest expense for corporate income tax deduction purposes would much be affected since the amount of disallowance would increase, leading to a higher taxable income.

It is also worthy to note that although this may neutralize the tax effect of the interest income and interest expense for tax arbitrage scheme purposes, this may not be beneficial to all taxpayers.

What if not all taxpayers did not engage in this type of tax avoidance? Are these taxpayers still bound to this limitation? Existing rules and regulations provide that the above interest expense limitation shall still apply regardless of whether tax arbitrage scheme was entered by the taxpayer so long as there is an interest expense incurred on one side and an interest income earned on the other side, which had been subjected to final withholding tax. So much for the phrase — “Innocent until proven guilty,” I suppose.

On a side note, CITIRA and PIFITA has similar and related provisions and after our comparison, we have noted that there are differences on the rates used, particularly on Section 34 (B) on the provisions of the Allowable Deduction on Interest Expense.

The interest arbitrage rate under the CITIRA is shown as a scheduled rate reduction (31 percent to 0 percent) while the PIFITA proposed a fixed rate of 50 percent starting 2020. While the CITIRA proposes a reduction in the corporate income tax rates which should subsequently affect the interest expense reduction rate, the PIFITA considers that the corporate tax rates will remain at 30 percent after its passage.

Since Congress intends to pass both the CITIRA and PIFITA before the year ends, it remains to be seen which of the above will make it to the final and substituted version for endorsement to the President. Will the PIFITA complement the CITIRA provisions or the recently passed TRAIN Law?

As we familiarize ourselves with the recent changes brought in by the passage of the Package 1 of the CTRP, our tax brain cells may not rest for a while as we paddle through the changes the PIFITA will bring. It’s an exciting and fun time for our tax system. It can be overwhelming, but we all have high hopes that this will help make the Philippine tax landscape attractive.

Frylen Y. Manacio  is an assistant manager from the Tax Group of KPMG R.G. Manabat & Co., the Philippine member firm of KPMG International. KPMG RGM&Co. has been recognized as a Tier 1 tax practice and Tier 1 transfer pricing practice by the International Tax Review.

This article is for general information purposes only and should not be considered as professional advice to a specific issue or entity.

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG International or KPMG RGM&Co. For comments or inquiries, please email [email protected] or [email protected].