SENATE PLANS RADICAL REVISIONS TO INVESTOR INCENTIVES

UNCLAS SECTION 01 OF 02 MANILA 003718 SIPDIS SIPDIS SENSITIVE STATE FOR EAP/MTS SCHAUDHARY STATE PASS TO USTR FOR DKATZ USDOC FOR 4430/ITA/MAC/ SBERLINGUETTE E.O. 12958: N/A TAGS: ETRD EINV ECON RP SUBJECT: SENATE PLANS RADICAL REVISIONS TO INVESTOR INCENTIVES -------------- SUMMARY -------------- ¶1. (SBU) Following up on President Arroyo's 2004 promise to increase government revenue, the Philippine Congress is poised to reduce and reform investment incentives. The Senate proposal under discussion draws from a USAID-funded study that recommends eliminating income tax holidays as inefficient and expensive. Foreign investors, including American companies, argue that incentives are needed to compensate for the risks and costs of doing business and complain that delayed refunds of tax payments may deter new investment. END SUMMARY. -------------- STREAMLINING INVESTMENT INCENTIVES -------------- ¶2. (U) The Philippine Congress is poised at last to reduce and rationalize investor incentives - the final measure from President Arroyo's 2004 plan to increase government revenue. The GRP presently gives reduced income tax rates to firms located in an area administered by the Philippine Economic Zone Authority (PEZA). A PEZA firm may concurrently register with the Board of Investment (BOI) to qualify for income tax holidays. Although certain incentives are reserved for exporters, the GRP has granted eligibility and special tax breaks to a wide array of domestic industries through 140 different laws. According to a study funded by USAID, the GRP lost $21 billion in revenue from its incentives regime in 2004. ¶3. (U) The Lower House responded quickly to Arroyo's call for incentives rationalization by passing a bill in December 2004 repealing some of the special incentives laws, but expanding income tax holidays. Rather than streamlining the current incentives program, critics argue that the House proposal further complicates the system and will not result in increased tax revenue. By contrast, the Senate bill recently released from the Ways and Means Committee chaired by Ralph Recto, repeals nearly all special incentives laws and consolidates and reconstitutes PEZA and BOI as the Philippine Investment Promotion Administration (PIPA). Only exporters and enterprises located in 30 of the Philippines' poorest provinces would be eligible for incentives. The Senate bill also eliminates income tax holidays and requires firms to pay value added tax (VAT) on imported materials and capital equipment. Exporters can then apply for a refund of VAT paid on those imported materials if they can prove the materials were used to manufacture exports. New incentives in the Senate bill include reducing corporate tax rates to 15%. The Senate bill includes a grandfather clause which allows investors to continue to enjoy current incentives until they expire. -------------- INCENTIVES REDUNDANT AND EXPENSIVE -------------- ¶4. (U) The author of the USAID funded study, Professor Renato Recide, told Embassy officers that Senator Recto drew heavily from his research in drafting his bill although the change in VAT procedures goes beyond the measures he recommended. Recide concluded that most incentives in the Philippines do little to attract incremental investment, and carry a high cost for government. The majority of investors, especially those tapping domestic resources (e.g., mineral extraction industries) or appealing to a specific local market (telecoms) would choose to invest without incentives. Foreign investors base investment decisions on many factors, including political and economic stability, transparency, and infrastructure. When these factors are favorable, Recide argued, and the country's tax system is in line with international norms, incentives play a limited role if any in influencing an investor's decision. -------------- GOVERNMENT CONCERNS -------------- ¶5. (SBU) Elmer Hernandez, Undersecretary for Investment at the Department of Trade and Industry (DTI),admitted to econoffs that the investment incentives regime is complicated and lacks a central authority. Since incentives are managed by several agencies, DTI cannot track them to formulate policy, Hernandez added. Rationalization will bring transparency, he said, and that will improve the investment climate. Nonetheless, Hernandez said, the Senate version is too hard on investment. He speculated that Recto's priority is to raise revenue so he is less willing to grant incentives. DTI is concerned Recto's bill would discourage new investment or drive away existing investors. Hernandez said DTI MANILA 00003718 002 OF 002 wants to work with Congress on a law that is investor friendly, streamlined, and with clear rules and regulations. -------------- INVESTOR PERSPECTIVES -------------- ¶6. (U) The Joint Foreign Chambers of Commerce issued a recent statement supporting reduced investment incentives but cautioned the GRP to retain the flexibility and authority to grant tax deductions for "strategic" investments. The Chamber asked Congress to invite its members to Committee hearings and consult them on incentive reform plans. Amcham members argue the Philippines needs incentives to compensate for the country's poor infrastructure, high power costs, and widespread corruption. Major competitors in the region offering tax holidays include India, Thailand and Malaysia. ¶7. (U) The Semiconductor and Electronics Industries of the Philippines (SEIPI),which accounts for two-thirds of total exports, expressed particular concern about the Senate bill's change to the "zero VAT" system. SEIPI members import over $1 billion in materials each year VAT-free. Under the Senate bill, they must pay the VAT up-front and apply for refunds. Many of the member companies have had other types of tax credit claims pending for over five years and expressed concern that the VAT refund procedure would be similar. An Intel Corporation representative told Embassy officials this provision would cost the company tens of millions of dollars monthly. Intel has cautioned the GRP that it, together with other electronic companies, may direct new investments to China if this provision is passed. ¶8. (U) The International Monetary Fund (IMF) strongly supports the elimination of many tax incentives. Academic studies conclude that low corporate tax rates induce investment better than tax holidays. Preferred incentives also include accelerated depreciation and tax credits for capital investments. The IMF rep told Embassy officials that not one company representative had told him incentives such as income tax holidays were an important part of their investment decision. -------------- COMMENT -------------- ¶9. (SBU) The GRP's challenge is to implement tax reform legislation that increases revenue while improving the investment climate in the face of perceived political instability, corruption, inadequate infrastructure, and high power costs - not an easy task. JONES