Policy Issue Paper on Philppine Smes Tax Profile

POLICY ISSUE PAPER ON PHILIPPINE SMEs

TAX PROFILE

Gerlin Catangui

July 2005

DISCLAIMER

“The views expressed in this report are strictly those of the authors and do not necessarily reflect those of the United States Agency for International Development (USAID) and the Ateneo de Manila University”.

Abstract

This issue paper presents a profile of small and medium enterprises as well as the issues surrounding tax policy, administration and compliance of SMEs. It summarizes findings of the World Bank/International Finance Corporation ‘Doing Business 2006: Creating Jobs’ that are relevant to SMEs and enumerates reforms to be considered for improved SME tax compliance.

ATENEO-ECONOMIC POLICY REFORM & ADVOCACY TAX ADMINISTRATION SECTOR TIERG-USAID

Not for publication, quotation & distribution 1 of 10 without the written consent of EPRA July 2005

Policy Issue Paper on Philippine SMEs Tax Profile Gerlin Catangui, MBA, MPP

A. SME Characteristics in the Philippines

Operational Definition of SMEs Employment-based definition the most widely accepted. Asset-based is the official definition, as approved by the Small and Medium Enterprise

Development Council (SMEDC) Resolution No. 1, Series of 2003. SME Definition by Employment and by Asset Size

Current State of SMEs SMEs comprise 99.6% of all registered business in the Philippines, employ 70% of the

workforce, and contribute 32% to the economy. Number of Establishments: According to the 2001 statistics of business establishments

published by the National Statistics Office (NSO), there are 811, 589 business establishments in the country. Of total, micro-enterprises account for 743,949 (97.1%), small enterprises 61,759 (7.6%), medium enterprises 2, 923 (.4%), and large enterprises 2,958 (0.3%).

Geographic Distribution: The analysis of geographic distribution of enterprises throughout the country indicates a high concentration in the National Capital Region (NCR), which accounts for 24.4% of all establishments and 40.1% of all employees. The five regions subject to the present study (NCR, Regions 3, 4, 7 and 11) hold a combined share of 65.0% of total establishments. Similarly, the regions account for 72.1% of total employees. As a result, around two-thirds of SMEs are concentrated in the five regions.

Sales & Value Added: The recent trends in value added by SMEs in the country and their sales indicate a growing share. SMEs as a whole have been steadily growing year after year with the overall industrial growth, as indicated by relevant factors, including the number of establishments and the number of employees. Nevertheless, compared to the absolute number of establishments and employment, SMEs hold relatively small share of value added and sales, less than 30%.

The SMEDC had finalised the SME development strategy in 2000 that defined specific actions to address SME concerns. The strategies, however, made no mention on taxes and compliance.



Data/Statistical Deficiencies Statistics on the census of establishments (done every 5 years) and the annual survey of

establishments are usually released 15-24 months after the year. The scope and coverage of SME statistics are limited to 1) the number of establishments, 2)

employment contribution, 3) regional distribution, and 4) industry classification. There are confidentiality clauses in census for firm level data, which the NSO has to honour. The Philippines has a large section of small business constituting the so-called underground

or informal economy. This refers to the small-scale units in the national economy, which produce and distribute goods and services without the benefit of official sanction or control.

Most do not register, do not keep books and do not pay taxes. They operate beyond the reach of the law. The nature of this sector makes it very difficult to gather and process statistics on them.

B. SMEs and Tax Compliance Dilemmas Taxes SMEs Pay SMEs are subject to income taxes, including passive income items like capital gains tax,

dividend, interest, and royalties. Other national taxes levied are transaction taxes like VAT; gross receipts tax on certain

businesses; excise tax on certain products; percentage tax (on certain VAT-exempt transactions); documentary stamp tax; donor’s (gift) tax; estate tax; fuel tax; vehicle tax; and tariff and customs duties.

Local taxes imposed include graduated taxes on certain amounts of sales/gross receipts and percentage taxes; ad valorem tax on real property such as land, building, machinery, and other improvements, as well as on the sale, donation, barter, or on any other mode of transfer of real property; environmental tax; franchise tax; community tax; and overseas communications tax.

Labour taxes (such as payroll taxes and social security contributions). Problems in Tax Administration of SMEs Many small SMEs are hard to tax because of the large number of entities operating in

informal or underdeveloped economies. The identification and registration of SME-informal taxpayers is more difficult because sole

proprietorship and informal partnerships can be established, folded, or change identities with little or no formality by obtaining a new license from the local authorities.

Many SMEs do not register voluntarily and so widen the gap between actual and potential taxpayers at an early stage of the tax effort. Those who do register often fail to keep adequate accounting records, file tax returns, and settle their tax liabilities promptly.

Compliance costs are also higher for small entities, especially in relation to the amount of taxes they pay. SMEs have limited resources and technical capacity but, given their simple operations and structures, do not need complex rules and procedures to comply.



Evasion continues to be a major source of the leakage in revenues, however closer analysis

indicates that weaknesses in tax structure (non-indexation of excise taxes and proliferation of tax incentives) also contribute.

Lack of a comprehensive SME strategy by the tax agency result in weak processes, and hence high inefficiency and administration costs.

Small businesses face many different compliance obligations, but taxation is by far the most critical. It has been estimated by the WB/IFC Doing Business study that taxation accounts for roughly 94 hours per annum, involving 62 separate tax payments or interaction with tax administration.

Economic theory suggests that stricter enforcement would significantly affect the economic response of individuals in the underground economy - some firms would go bankrupt, taxpayers would modify their labour supply, prices and income would change, and so on. The tax base would clearly be altered because of stricter enforcement. Thus, even the imperfect measures of tax gaps must be interpreted cautiously. (Brooks, 2001)

Tax Compliance from the SME Sector Most SME-informal entities are typically small, unstructured entities like sole proprietorships

and loosely defined partnerships engaged in non-transparent cash transactions (hawkers and market stall/shop owners, etc.). They have genuine difficulty in keeping even simple records and make little or no use of banks and financial instruments.

In contrast, SME-formal entities may be reasonably well-structured entities like manufacturers, professional firms (doctors, accountants, and lawyers, etc.), producers (commercial farms, etc.), distributors and retail outlets. Many corporate SMEs in this category are already obliged to comply with several accounting rules under corporate and business laws.

SME non-compliance is also attributed to poor management and internal control practices. Owner-managers and a network of close family members, professional associates, friends, and employees usually control the common SME organisational forms (sole proprietorships and informal partnerships). The informal approach to setting up, dissolving and operating many SME businesses often creates mobility problems, inadequate record-keeping and non-separation of business and private transactions.

The generalisation of SMEs as incapable of keeping simple records and therefore unauditable has kept away professional accountancy firms from this sector. Some medium corporate entities may use accountants’ services but these are generally regarded as costly for most SMEs.

Audits provide another example of the SME compliance dilemma — the contrast between high default rates and the low fiscal yields.

Moreover, tax measures that put SMEs under severe liquidity pressure can lead to permanent loss of revenue because they can be folded up in an informal manner.

The slow and overburdened courts work in the favour of non-compliance because even if the government pursues cases against them, settlements are normally made at a compromise that could, in fact, result in savings for the firm.

Taxpayers take advantage of the weak compliance situation to further suppress turnover levels and stay out of the tax net.



The Size of the Tax Compliance Problem: The Tax Gap In general terms, the Philippines tax system does not segregate by size category (S/M/L). Most SMEs generally fall under the category of ‘hard-to-tax’ (HTT) groups (professionals,

self-employed) and ‘underground economy’ characterised by high delinquency rate and low revenue yields.

It is difficult to estimate the tax gap or estimate of the size of the underground economy with any certainty:

Reliable estimates of the underground economy are hard to come by, by their very nature these transactions are not meant to be measured. There are no direct methods for measuring its size.

An initial difficulty is even specifying what it is that needs to be measured. The popular term, “the underground economy”, is inexact, encompassing a wide range of economic activities.

Since businesses in the SME segment operate outside of the system, tax planning features characteristic of the large business market are not present and thus economic modelling tools and other techniques currently used within the large business market cannot be employed.

Publicised or Articulated Issues/Questions of SMEs over Tax Policies/Administration The “Survey of Enterprises on Corruption” is an annual project of the Social Weather Station

(SWS) and Transparent Accountable Governance (TAG) funded by The Asia Foundation-USAID.

The survey expanded from the National Capital Region (NCR) in 2000 to the five areas of NCR, Metro Cebu, Metro Davao, Cavite-Laguna-Batangas (CALABA), and Cagayan de Oro-Iligan City in 2005. In each area, two-thirds of the sample was allotted to small and medium enterprises, and one-third to large enterprises.

In the two strata of (a) large and (b) small-and-medium enterprises, random sampling drew enterprises from manufacturing, miscellaneous private services, trade, transportation, communication and storage, finance, construction, ownership of dwellings and real estate, agriculture and fishery, food, hotels and restaurants, electricity, gas and water, mining and quarrying, etc. In the 2005 survey, one-third of the enterprises do business with government, in the process generating about 10% of their income.

Relevant findings from the “2005 SWS Survey of Enterprises on Corruption” found that: There appears to be a slight decline in the reported solicitation of bribes in relation

to income taxes in particular: in NCR alone, there was already a decline from 52% in 2000 to 43% in 2003; when Cebu and Davao are included, reported solicitation declines from 39% in 2004 to 31% in 2005.

The respondents were asked to rate 26 separate agencies in terms of sincerity or insincerity in fighting corruption, giving rise to an agency-ranking in terms of Net Sincerity. Net scores worse than –50 are Very Bad: both the Bureau of Customs and the Bureau of Internal Revenue received this rating.

The three agencies most cited for a bad reputation for being corrupt are the same in 2005 as in 2004: Bureau of Customs (65%), Bureau of Internal Revenue (64%), and



Department of Public Works and Highways (46%). Incidentally, 71% say that it is the tax collectors who tempt citizens to cheat, and not the other way around.

What enterprise managers are most eager (45%) to monitor is public infrastructure and the private construction industry as having a relatively bad reputation. Other government activities they would like to monitor are BACs (12%), general procurement (12%), tax collection (9%), education services (9%), and health services (8%).

The private sector could stand much improvement in practicing honest business. Whereas 90% say that, in their line of business, most or all companies always demand receipts, only 78% say that most/all always issue receipts, only 66% say that most/all keep only one set of accounts, and only 54% say that most/all pay taxes honestly.

Among the ways of helping to fight corruption, 75% of managers are interested in donating funds, 62% would volunteer staff members to help monitor government projects on company time, 58% would help pay for program expenses, and 57% would send staff to join Bids and Awards Committees (BACs) of government agencies on company time. Three-fourths of those willing to assign staff members for project monitoring and BACs would also shoulder the costs of specialised training needs.

C. Findings of the WB/IFC “Doing Business 2006: Creating Jobs” Study Relevant Findings for the Philippines The effective tax that a medium size company in the Philippines must pay or withhold within

a year is shown below (Table 1). The business would make 62 payments, spend 94 hours doing so, and pay 46.4% of gross profit in taxes. This complexity and the high taxes make the Philippines’ tax system burdensome and susceptible to evasion and corruption.

Looking at business taxes, a medium size company in the Philippines is overtaxed compared to the regional average, which imposes the lowest total tax payable in the world. Sub-Saharan African businesses are taxed the highest.

In terms of measures of administrative burden (number of payments, time spent to comply with requirements), Philippine businesses spend relatively few hours preparing and filing tax payments, but this advantage is eroded by the number of payments entrepreneurs must make. In fact, the Philippines have one of the most payments, and are very high compared to each of the regions’ averages. This increases compliance cost for businesses.

Indeed the two indicators (‘payments’ and ‘total tax payable’) show that the Philippines is severely lagging behind its East Asia & Pacific neighbours, as an entrepreneur, on average, must make 28 payments and pay 31.2% of gross profit in tax only.

Table 1: Paying Taxes (2005), by Indicator & Regions

Indicator Philippines East Asia & Pacific

OECD Europe &

Central Asia

Latin America

& Caribbean

Middle East & North Africa

South Asia

Sub-Saharan

Africa

62 28.2 16.9 46.9 48.2 27.3 25.8 41.4



Payments (number per year)

Time to comply (hours per year)

94 249.9 197.2 431.5 529.3 241.9 331.7 394

Total tax payable (% gross profit)

46.4 31.2 45.4 50.2 52.8 35.1 35.3 58.1

How the Philippines Fare Compared to ASEAN6 + 4 Doing Business provides a global ranking of 155 economies on key business regulations and

reforms, with ‘payment of taxes’ as one of the indicators. The result of the study is a comparative ranking of countries.

The Philippines ranked 80th in ‘ease of paying taxes’ across 155 economies. Over-all, the country ranked 113th among 155 economies, as measured by the doing business indicators.

The Philippines is overtaxed comparative to other countries in the East Asia and Pacific region:

Among the Top 10 (overall) ‘easiest in paying taxes’ are the country’s neighbours, Hong Kong, Singapore and Malaysia.

In the Asian region (see Table 2), the Philippines have the second highest total tax payable (46.4%). China imposes the highest total tax payable (46.9%). In ASEAN-6, Indonesia (38.3%) follows the Philippines with the highest tax payable. Malaysia has the lowest at 11.6%. Vietnam (31.5%), a transition economy, levies lower total tax payable than some of the more established economies in the region.

Again, in ‘payments’, the Philippines have the most with 62 payments per year followed by India (59 payments). Within ASEAN, Singapore have streamlined tax payments the most with only 16 payments, followed by Malaysia (28 payments) and then Thailand and Vietnam (both 44 payments).

Only in ‘time to comply’ did the Philippines fare slightly better compared to the other Asian countries. Singapore (30 hours) and Thailand (52 hours) lead the Asian countries in the least time to pay taxes. In fact, both these countries are in the Top 10 (overall) on this specific indicator of paying taxes.

Vietnam’s figures are instructive for the Philippines. Medium size businesses there are taxed less and make fewer payments than their Philippines counterparts. This has implications especially on the competitiveness of SME-exporting companies and those in the sub-contracting business.

Indian medium size companies are also taxed less and make fewer payments than their Philippines counterparts. This has implications especially on the software, ICT-enabled businesses and off-shore/call centre operations.

The complexity of tax compliance matters. In Norway, tax authorities collect 60% of companies’ gross profit using 3 taxes filed electronically. In contrast, it takes 14 taxes and 62 interactions with the tax authorities to collect 46.4% of gross profit in the Philippines.



Despite having high tax rates and fees the government still suffered from weak tax revenue

and a chronic fiscal deficit. This suggests that the government should strongly pursue initiatives to improve tax collection efficiency, widen the tax base and plug tax leakages.

The Doing Business study suggests four ways to start reform: Consolidate the number of taxes; Cut back special exemptions and privileges; Simplify filing requirements; and, Broaden the tax base by keeping rates moderate.

Table 2: Paying Taxes (2005), by Country: ASEAN6 + 4

Country Payments (number per year)

Time to comply (hours per year)

Total tax payable (% gross profit)

Philippines 62 94 46.4

Indonesia 52 560 38.8

Malaysia 28 … 11.6

Singapore 16 30 19.5

Thailand 44 52 29.2

Vietnam 44 1050 31.5

China 34 584 46.9

India 59 264 43.2

Japan 26 315 34.6

South Korea 26 290 29.6

Relevant Findings – International Conclusions Middle Eastern and East Asian countries make paying taxes the easiest. Latin American

countries impose the heaviest burdens, mainly because of compliance costs. Africa follows, largely because of high taxes. OECD countries impose the smallest administrative burdens and charge moderate tax bills.

However, East Asian economies lagged in introducing reforms to help small and medium businesses generate jobs relative to most other regions.

Rich countries tend to have lower business taxes and make them less complex. Simple, moderate taxes and fast, cheap administration mean less hassle for business - as well as higher revenues. In contrast, poor countries tend to use business as a collection point, charging higher business taxes.

High taxes create strong incentives to evade driving many firms into the underground economy, and do not translate to higher revenues.



Burdensome taxes are associated with more informality, less investment. They breed

corruption. Every point of contact between a bureaucrat and an entrepreneur is another chance for a bribe. Confusion on voluminous, often contradictory rules creates room for discretion. Faced with this, many entrepreneurs avoid the system altogether, operating in the informal economy.

Firms in 90% of surveyed countries rank tax administration among the top five obstacles to doing business.

Arguments for business tax reform usually emphasise rates, especially corporate income tax rates. That is misleading on three counts:

1) Corporate income taxes are only a small share of the total business tax burden; 2) The complexity of tax compliance matters too; and, 3) Businesses care about what they get for their taxes.

Methodology of the Study The main indicators for ‘Paying Taxes’ address the taxes that a medium-size company must

pay or withhold in a given year, as well as measures of administrative burden in paying taxes. They include:

Total number of payments the business would have to make to tax authorities; Time it takes to prepare, file and pay (or withhold) the corporate income tax, the

value added tax and social security contributions (in hours per year); and, Total amount of taxes payable by the business, except labour costs (as a percentage of

gross profit). The total amount is the sum of all the different taxes payable after accounting for deductions and exemptions. The taxes withheld but not paid by the company are not included.

Taxes are measured at all levels of government and include the corporate income tax, the personal income tax withheld by the company, the value added tax or sales tax, property taxes, property transfer taxes, the dividend tax, the capital gains tax, the financial transactions tax, waste collection taxes and vehicle and road taxes. All applicable deductions and exemptions are taken into account to calculate the total burden.

Rankings on the ‘ease of paying taxes’ are the average of the country rankings on total taxes, number of payments and time required to comply.

It should be pointed out that the Doing Business study used a hypothetical case of a standardised firm; therefore the results of this study are not based on actual transactions or of a survey of actual establishments’ tax payments and compliance.

To measure the tax paid by a standardised business and the complexity of a country’s tax law, a case study was prepared with a set of financial statements and assumptions about transactions made over the year. Experts in each country compute the taxes owed for their jurisdiction based on the standardised case facts.

The standardised case fact assumes that the business: is a limited liability, taxable company, performs general industrial or commercial activities, does not participate in foreign trade and does not handle products subject to a special tax regime, has 60 employees, has a start-up capital of 102 times per capita, has a turnover of 1,050 times income per capita, and



distributes 50% of its profits as dividends to the owners at the end of the second year, among others. D. Other Reforms Consider classifying SMEs as formal or informal on the basis of their potential ability to

comply with administrative procedures, and be subject to formal accounting and enforcement principles.

Because SMEs are not homogeneous and non-compliance is not always synonymous with size, a rigid grouping of taxpayers as small, medium, and large on the basis of income may be deceptive from an enforcement viewpoint.

Indeed, some small taxpayers like corporate and professional entities are capable of complying with the law. They are structured and have the capacity to keep the records that conform to the accounting standards and corporate or tax laws.

SME-formal entities can be assisted to comply with voluntary or self-assessment programs for all taxes.

Semiskilled staff in many small offices can be upgraded to implement simplified audits and enforcement programs.

The task is to take the VAT record-keeping and simple control or audit programs beyond the invoicing stage and apply them to a simple set of financial records for all taxes and all taxpayers, especially SME-formal entities.

Consider using a well-managed presumptive tax regime for vulnerable SMEs to improve compliance. Presumptive taxes are policy measures but may also be used as a feasible administrative option for controlling SMEs. A summary of approaches to improving SME administration and compliance is appended as Annex 1.

Consider using modified procedures or simple accounting, audit and enforcement rules to SME-formal entities. This will make SMEs comply better and improve procedures in tax offices.

Consider developing clear SME tax accounting guidelines to decrease compliance costs and encourage them to meet their tax obligations.

SOURCES: Berry, A., and Rodriguez, E. (2001) ‘Dynamics of Small and Medium Enterprises in a Slow-

Growth Economy: The Philippines in the 1990s’. Washington, D.C.: The International Bank for Reconstruction and Development/The World Bank. www.worldbank.org/wbi/publications/wbi3718.pdf

Brooks, N. (2001) ‘Key Issues in Income Tax: Challenges of Tax Administration and

Compliance’. ADB 2001 Tax Conference. Manila: Asian Development Bank.



Chan Robles Virtual Law Library Republic Act No.8289 Amending Republic Act No.6977; R.A. 6810. The ChanRobles Group.

http://www.chanrobles.com/republicactno8289.htm Lagua, B. ‘SME Characteristics and Statistical Needs in the Philippines’. Powerpoint Presentation. <www.oecd.org/dataoecd/3/49/15004719.ppt> PricewaterhouseCoopers (2005) Doing Business and Investing in the Philippines. Makati City:

PricewaterhouseCoopers. (www.pwc.com.ph) Social Weather Station (2005) ‘2005 SWS Survey of Enterprises on Corruption’. Quezon City:

Social Weather Station. Tamangan, R., Josef, F and Habito, C. (2004) ‘Small and Medium Enterprise Development

Experience and Policy in Japan and the Philippines: Lessons and Policy Implications’. PIDS Discussion Paper Series: 2004(30).

Terkper, S. (2003) ‘Managing Small and Medium-Size Taxpayers in Developing Economies’.

Tax Notes International: 211-234. World Bank/International Finance Corporation (2005) Doing Business 2006: Creating Jobs.

Washington, DC: The International Bank for Reconstruction and Development/The World Bank.

Policy Issue Paper on Philppine Smes Tax Profile

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