VAT PROPOSALS THREATHEN POWER SECTOR REFORMS

UNCLAS SECTION 01 OF 03 MANILA 001839

SIPDIS

SENSITIVE

STATE FOR EB/IFD/OIA, EB/ESC AND EAP/PMBS
STATE PASS USAID FOR AA/ANE, AA/G
STATE PASS EXIM, OPIC AND USTR
DOE FOR TOM CUTLER
TREASURY FOR JVELTRI
TREASURY ALSO FOR OASIA
USDOC FOR 4430 ITA/MAC/ASIA & PAC/KOREA & SE ASIA/ASEAN

E.O. 12958: N/A
TAGS: ECON ENRG PGOV EAID RP
SUBJECT: VAT PROPOSALS THREATHEN POWER SECTOR REFORMS

SENSITIVE BUT UNCLASSIFIED - NOT FOR INTERNET - PROTECT
ACCORDINGLY


1. (U) Summary: Value Added Tax (VAT) proposals filed
in both Houses of Congress contain provisions detrimental
to the government's efforts to strengthen and restructure
the power sector. In particular, replacing the current
"zero rating" for power generating firms with a value
added tax (VAT) and preventing firms from passing the tax
onto consumers would violate contracts, discourage new
investments into the sector, and derail the National
Power Corporation's (NPC) plans to privatize generation
and transmission assets. A bicameral conference
committee is deliberating the appropriate VAT treatment
of the power sector. Although Congress will probably
impose a VAT on electricity generation and fuel, the
final bill is unlikely to require producers or fuel
purchasers to absorb the tax. End Summary.

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VAT Bills Target Power Sector
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2. (U) The Congressional Bicameral Conference Committee
is currently deliberating on bills increasing the value
added tax (VAT) and expanding its coverage to increase
government revenue and address the Philippines'
burgeoning budget deficit. Both bills remove the "zero
rating" currently enjoyed by power producers, which
entitles them to a refund or tax credit if their input
taxes exceed their output taxes. The House bill imposed
a VAT rate of 4% for the initial year of implementation,
rising to 6%, 8% and 12% in succeeding years, and
prohibited power generators from passing this tax to
consumers. The House bill also exempts the import and
sale of coal and natural gas, and the sale of power from
biomass, wind and solar energy from VAT coverage.
Meanwhile, the Senate bill proposes a 10% VAT on power
generation, transmission and distribution, and prohibits
passing this new tax to residential consumers and the
National Power Corporation (NPC). The Senate bill levies
a zero VAT rate on the import and sale of renewable
sources of energy.

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No Pass-Through Unfairly Taxes Power Producers...
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3. (SBU) The no pass-through provisions found in both
the House and Senate bills effectively turns the VAT, a
consumption tax, into a tax on producers' earnings.
Independent power producers (IPPs) have warned that this
provision would slash their profitability and constitute
a breach of covenant with international and multilateral
lenders. This would force IPPs to nullify their
contracts with the NPC, which guarantee complete pass-
through of any taxes, and trigger contract buy-outs that
several newspapers estimated would cost NPC about $27
billion.


4. (SBU) In discussions with us, House Committee on
Ways and Means Chair Jesli Lapuz and House Committee on
Trade and Industry Chair Junie Cua said that there is
perception that IPPs make windfall profits as a result of
their contract's "take or pay" provisions and their
entitlement to tax credits. Although as members of the
bicameral committee were concerned about the provision's
impact on power sector investment, they wanted to hear
directly from IPPs on the damage the "no pass-through"
provision would have on their profitability. U.S. IPPs
estimated that the inability to pass on the VAT would
wipe out the bulk of their profits and set in motion the
need for calling in their contracts.

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...Further Clouds the Investment Climate
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5. (U) Requiring power generation companies to pay and
absorb the VAT would not only make their business
unprofitable, but would also deter any new investments in
the power sector. The Senate proposal to increase
corporate income taxes from 32%, already the highest in
ASEAN, to 35% provides another disincentive for private
investment. In addition, provisions exempting self-
generation of power and the generation of electricity
from indigenous and/or renewable energy systems from VAT
coverage are discriminatory, giving favored sectors undue
competitive advantage over other existing power
producers. The power industry considers these proposals
contrary to standard business practice that could
adversely affect the government's ability to attract much
needed investments to stave off electricity shortages
already present in the Visayas and Mindanao, and looming
in Luzon.

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...And Could Derail Power Sector Reform
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6. (U) New uncertainties in the investment climate could
further delay the government's target to privatize at
least 70% of the NPC's generating capacity and
transmission assets within the year. The delay may mean
additional national government borrowing just to operate
NPC's plants. Privatization, which is central to the
Electric Power Industry Reform Act (EPIRA),is a key
prerequisite to achieving open access and retail
competition in the electricity sector by June 2006 in the
Luzon grid.


7. (SBU) Imposing a VAT on power generation,
transmission and distribution at this time may be
detrimental to the government's effort to increase
electricity rates to reflect the true cost of power. The
Energy Regulatory Commission's rate-setting process would
become even more politically difficult as the ERC will
have to impute new cost items in the determination of
electricity rates. The ERC is expected to announce its
decisions shortly on NPC's final generation rate and the
Manila Electric Company's (Meralco) distribution rate
increases. These rate increases are crucial in steering
the NPC and Meralco to sound financial footing. In a
meeting April 19, Energy Secretary Lotilla said the ERC's
final determination of the NPC rate (provisionally
increased by a country-wide average of 98 centavos per
kilowatt hour in September 2004, but expected to increase
further) will not be affected by any increases in
electricity rates from the VAT bill.

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Comment
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8. (SBU) The treatment of the power sector has emerged
as among the most contentious issues in Congress'
deliberations on the VAT bill, now under consideration in
the bicameral conference committee (septel). There is a
need to balance the government's revenue generation goals
with investor and business sentiments. Finance Secretary
Purisima gave assurances at a meeting with econoffs, U.S.
IPP firms and American Chamber representatives April 19
that while the bicameral committee will impose a VAT on
fuel and electricity generation, it would eliminate the
"no pass-through" provision, and commented that the
President would veto this provision if necessary. In
view of his reassurances and the strong concerns
expressed by various business groups, including the
foreign chambers of commerce, we believe that the final
bill will not contain the controversial "no pass-through"
provision.

RICCIARDONE