a study on retailing mobile phone credits by electronic loading and its implications

A STUDY ON RETAILING MOBILE PHONE CREDITS BY ELECTRONIC LOADING AND

ITS TAX IMPLICATIONS

Danilo N. Napalinga, Rachel P. Follosco,

Horacio B. Yalung, Jr. Nestor Michael C. Tiglao

Ma. Vida A. Gomez Alfred Adel A. Ables

October 2006

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 In 2004, there were 33 million mobile phone subscribers in the Philippines, equivalent to 40 out of every 100 population. This is expected to increase to 58 million subscribers, or 61 subscribers for every 100 population, by 2009. In 2002 to 2004, revenues for wireless or mobile phone service increased from P70 billion to P102 billion, or 21 percent annually. This study examines the retailing of mobile phone credits through electronic loading, or e-loading and its tax implications. In general, the study can serve as a benchmark of the tax collection situation in the Philippine telecommunications industry, and can pave a roadmap for the Bureau of Internal Revenue on how to tax other business transactions that use emerging technology applications. This study documents the mechanics and intricacies of e-loading in the mobile phone industry in the Philippines, and the taxes involved in e-loading. Analysis consists of straightforward identification of challenges posed by the e-load business and their impact on tax enforcement and administration. The study estimated that the tax due the e-load business in 2005 was P2.7 billion, but that about P1.9 billion of this was forgone government revenues since it was not cost-efficient for the BIR to directly run after the retailers, which comprise mostly of unsophisticated or very small businesses who may not even be aware of their tax obligations. It is therefore recommended to impose advance percentage tax on e-load, to be collected by the telecommunications companies. This is estimated to bring about an additional government revenue collection of P1.8 billion. The study also gives other recommendations that are meant to ascertain taxable transactions and to institute behavioral changes in tax compliance.

A Study on Retailing Mobile Phone Credits by Electronic Loading and Its Tax Implications

FINAL REPORT

List of Tables List of Figures Acronyms Glossary Executive Summary i I. INTRODUCTION 1

A. Rationale 1 B. Objectives 3 C. Structure of the Report 3

II. BACKGROUND AND DOCUMENTATION

A. The Mobile Telephone Network in the Philippines 4 Technology 4 Networks and Protocols in General 4 Cellular Networks 5 Mobility and Data Rates 7 Fixed-Mobile Convergence 8 Mobile Phone Applications 8 The Telecommunications Sector in the Philippines 10 Market and Revenues 12

B. E-Load Distribution Network 16

Mobile Phone Subscription Modes: Post-Paid and Pre-paid 16 E-Loading Mechanism 17 The Retailers 18 E-Load Distribution Chain 19 E-Load Value Chain 22

The Mobile Phone as Electronic Wallet, and the Electronic Wallet in Buying and Selling E-Loads 24

C. Current Taxation of E-Loading Business 27 Income Tax 27 Business Tax 33

III. ANALYSIS 39

A. Challenges Presented By E-Load Business to Tax Enforcement and Tax Administration 39 B. Impact/Consequence Of The Peculiarities Of The E-Load Business On Collection

Efficiency And Effective Tax Collection And Administration 43 C. Other Relevant Findings/Observations 55

IV. RECOMMENDATIONS 57 A. Statutory Initiatives 60 B. Regulatory Enhancements 64 C. Enhancements of Operational Methodologies and Capacity Building 69 D. Technology-Based Solutions 81 E. Areas for Further Study 85

References 89 Annexes

A. Pro-forma Agreement of a SMART Wholesaler with Retailers and Information Sheet for SMART Retailers

B. Sample Flyers for SMART Retailers C. Summary of Findings in Financial Statements of Selected E-Load Wholesalers of SMART

Communications D. Draft Revenue Regulations on Taxation of Telecommunications Transactions E. Comparison of Basic Financial Statements of the Telcos F. Comparative Account Headings in Consolidated Balance Sheets G. NTC Chart of Accounts for Telecommunications

List of Tables

Table 1. Cellular Network Characteristics by Generation

Table 2. Units of Bandwidth

Table 3. Telecom Industry Structure, 2002-2004

Table 4. Number of Mobile Phone Subscribers per Operator, 2002-2004.

Table 5. Revenues of SMART and Globe from Wireless Service, 2002-2004.

Table 6. Breakdown of Revenues of SMART and Globe from Wireless Service

Table 7. Average Revenue per User, 2002-2004

Table 8. Discount Rates for SMART E-Load Retailers

Table 9. Summary Observations on Financial Statements of Selected E-Load Distributors/Wholesalers Table 10. Illustrative Example of Functions of a SIM Card as E-Wallet, Retailer SIM, and End-user

SIM

Table 11. Assumptions in Estimating Government Revenues Due the E-Load Distribution Network

Table 12. Sales and Profits of Each Merchant Type, 2005

Table 13. Taxes Due Each Merchant Type, 2005

Table 14. Estimated Foregone Government Revenues in E-Load Retailing, 2005

Table 15. Summary of Recommendations

Table 16. Business Tax Due for Every P1,000,000 Worth of E-load (at Street Value), at Current and

Proposed Tax Schemes

Table 17. Business Tax Due on Estimated 2005 E-Load Sales, at Current and Proposed Tax

Scheme

Table 18. Additional Business Taxes to be Collected from 2005 E-load Sales Using the Proposed

Scheme

List of Figures

Figure 1. Fixed and Mobile Telephone Subscribers per 100 Inhabitants, Philippines.

Figure 2. Current and Projected Number of Mobile Phone Subscribers, per 100 Population

Figure 3. Samples of End-user devices

Figure 4. Examples of Network Devices

Figure 5.a Diagramatic Description of Bandwidth

Figure 5.b Service and Data Rates

Figure 6. Mobility vs. Bandwidth

Figure 7. Philippine Telecom Sector

Figure 8. Current and Projected Number of Mobile Phone Subscribers, in ‘000, 2002-2009

Figure 9. Wireless Service Revenues of SMART Communications and Globe Telecom, in

Thousand Pesos, 2002-2004.

Figure 10. Telecommunications Price Curve: The Hockey Stick Curve

Figure 11. Post-Paid and Pre-paid Mobile Phone Subscribers, SMART Communications, 2001-2005

Figure 12. E-Loading Mechanism

Figure 13.a Three-Level E-Load Distribution Chain

Figure 13.b Two-Level E-Load Distribution Chain: The Wholesaler as Retailer

Figure 13.c. E-Load Distribution Chain: End-User Directly Buying from Telco

Figure 14. E-Load Value Chain

Figure 15.a. Retailer’s Purchase of E-load for Reselling through E-wallet

Figure 15.b End-User’s Purchase of E-load for Personal Use through E-wallet

Figure 16. E-Load Value Chain with Imposition of Advance Percentage Tax

Figure 17. Suggested Random Check of the Financial Recording System Using the CDR.

Figure 18. Suggested Random Sampling of Period Sales and Usage Using the CDR

Acronyms

AMPS Advanced Mobile Phone Service

ARPU Average Revenue per User

ASC Accounting Standards Council

BPI Bank of the Philippine Islands

bps bits per second

BIR Bureau of Internal Revenue

BITF Business Intelligence Task Force

CDMA Code Division Multiple Access

CDR Call Detail Record

CMTS Cellular mobile Telephone Subscriber

CSET Computer System Evaluation Team

D-AMPS Digital-Advanced Mobile Phone Service

DOTC Department of Transportation and Communications

EDGE Enhanced Data Rates for GSM Evolution

EPRA Economic Policy Reform and Advocacy

Evat Expanded Value Added Tax

FCC Federal Communications Commission

Gbps Gigabits per second

GSM Global System for Mobile Communications

GPRS General Packet Radio Service

HDSPA High-speed Downlink Packet Access

HSCSD High-Speed Circuit-Switched Data

IDD International Direct Dial

IP Internet Protocol

IMS IP Multimedia Core Network Subsystems

ITU International Telecommunications Union

Kbps Kilobits per second

LAN Local Area Network

Mbps Megabits per second

MMS Multimedia Messaging Service

NDD National Direct Dial

NIRC National Internal Revenue Code

NMT Nordic Mobile Telephone

NTC National Telecommunications Commission

OCT Overseas Communications Tax

PAS Philippine Accounting Standard

PDC Personal Digital Cellular

PFRS Philippine Financial Reporting Standards

PLDT Philippine Long Distance Telephone Company

POS Point-of-Sale

PPC Pre-paid Phone Card

SEC Securities Exchange Commission

SIM Subscriber Identification Module

SMS Short Message Service

TACS Total Access Communication System

Tbps Terabits per second

Telco Telecommunications Company

TIN Tax Identification Number

UMTS Universal Mobile Telecommunications System

USAID United States Agency for International Development

NSO National Statistics Office

VAT Value Added Tax

VOIP Voice Over Internet Protocol

WCDMA Wideband Code-Division Multiple Access

Glossary

AutoloadMax Globe Telecom’s commercial brand for electronic pre-paid loading.

Bandwidth The maximum achievable data rate, or amount of information or data that can be sent or

transmitted over a network connection or channel in a given period of time

(www.whatis.com, 2005).

Broadband As in “Broadband connection” is faster than 56Kbps connection.

chikka.com Filipino website dedicated to giving free sms services.

E-Load Smart Telecom’s commercial brand for electronic pre-paid loading; also used in this

study as a general term for electronic loading.

E-Wallet Smart Telecom’s value added service that allows subscribers to utilize electronic money

storage and use it for any business transaction.

G-Cash Globe Telecom’s E-wallet counterpart.

Pasaload Smart Telecom’s value added service that allows electronic pre-paid loading by

transferring pre-paid credits between two subscribers.

PayPal An e-commerce business allowing payments and money transfers be made

through the internet (www.wikipedia.org).

Peak hours Hours in a day when most calls and texts are made

Shareaload Globe Telecom’s version of the “Pasaload”

Smart Padala Money remittance service of Smart Telecom

Tingi Filipino word meaning “to sell products by piece”

A STUDY ON RETAILING MOBILE PHONE CREDITS BY ELECTRONIC LOADING AND ITS TAX IMPLICATIONS

EXECUTIVE SUMMARY SCOPE AND OBJECTIVES OF THE STUDY This study was commissioned to further investigate the observation of the Bureau of Internal Revenue’s (BIR’s) Business Intelligence Task Force that there is an underreporting by retailers of mobile phone credits in their tax returns. This study will focus on retailing credits through electronic loading, or e-loading. In general, the study can serve as a benchmark of the tax collection situation in the telecommunications (telecom) industry, and can pave a roadmap for the BIR on how to tax other business transactions that use matured and emerging technology applications. In particular, the study has the following objectives:

1. Examine the process of e-load retailing and estimate the magnitude of tax revenues generated in the chain;

2. Analyze tax revenue regulations governing retailers of prepaid airtime and assess whether at present there are adequate and sufficiently clear revenue regulations in place to cover taxable e-load retailing transactions; and

3. Recommend concrete measures for the effective collection of taxes from the e-load retailing business.

The study documents the mobile phone industry in the Philippines, the mechanics and intricacies of e-loading, and the taxes involved in e-loading. Analysis consists of straightforward identification of challenges posed by the e-load business and their impact on tax enforcement and administration. Most of the information were solicited by the BIR through the National Telecommunications Commission (NTC) from the three major providers of mobile phone services – SMART Communications, Globe Telecom, and Sun Cellular. Only SMART Communications and Sun Cellular complied and provided some of the information requested. Other information regarding the telecommunications companies (telcos) and their e-load wholesalers were obtained from there financial statements as provided by the BIR, the NTC, and the Securities Exchange Commission (SEC). The Growing Mobile Phone Industry For the two largest telecommunications companies, SMART Communications and Globe Telecom, total revenues for wireless or mobile service steadily increased by about 21 percent annually from P70 billion in 2002 to P102 billion in 2004. Total revenues for mobile phone service is a function of number of users and the average revenue per user (ARPU). ARPU, on the other hand, is a function of usage per user and price of services.

Total Revenues = No. of Users * ARPU = No. of Users * (Usage per User * Price of Services) The trends in the three factors suggest that total revenues will continue to increase at least in the next decade.

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With regards to number of users, there were 33 million mobile phone subscribers in 2004, and is expected to increase to 58 million by 2009. This translates to an increase in density from 40 subscribers to 61 subscribers for every 100 population from 2004 to 2009. The market is therefore far from saturation. In other countries such as the United Kingdom, penetration rate is as high as 99 percent. As to the ARPU, this factor decreased by about 17 percent per year in 2002-2004, but the trend is expected to reverse in the next few years due to new value-added services (VAS). The declining ARPU in 2002-2004 can be attributed to the fact that during this period, the increase in usage was in data services, in particular short message service (SMS, more popularly known as text messaging) which costs much less than voice calls. The price of mobile phone services will likely continue to exhibit downward drifts over time. The current and forecasted VAS, however, are expected to bring about an increase in ARPU, because these applications are heavy in content and consequently high in bandwidth requirement. New technologies like GPRS, EDGE and CDMA have increased the capacity of cell phones. In general, mobile phone usage can be measured in terms of bandwidth used, and the greater the bandwidth, the higher the ARPU. Bandwidth is the maximum achievable data rate or amount of information or data that can be sent or transmitted over a network connection or channel in a given period of time (whatis.com, 2005). It is usually measured in bits per second (bps), kilobits per second (kbps), or megabits per second (mbps). The higher a channel’s bandwidth, the more information it can carry. SMS requires very little bandwidth to be transmitted compared to voice calls, thereby explaining its affordability and the observed decrease in ARPU in the early 2000s. Recent and emerging applications such as multimedia messaging (MMS) adds images and audio clips to the SMS text messaging format and therefore require considerably more bandwidth than an SMS. Bandwidth usage is expected to further increase significantly, given the technology forecasts on fixed-mobile convergence (FMC). In general, stationary end-user devices (e.g. desktop or laptop computers) can support more bandwidth or higher data rates, while more mobile devices (e.g. cell phones) are expected to support less bandwidth. Fixed-mobile convergence, made possible by internet protocol (IP), brings together mobility and services that require more bandwidth. That is, FMC leads to empowering the cellular phone to carry more bandwidth and therefore support such applications as internet browsing that is as fast as when using broadband connections in stationary computers. The more bandwidth subscribers use, the greater the ARPU, and the more revenues for the telecommunications companies. Mobile Phone Credits Distribution Network A mobile phone subscriber’s usage is measured in terms of airtime credits used. In general, the more bandwidth used, the more credits used. There are two modes of mobile phone subscriptions: post-paid and pre-paid. Post-paid subscriptions are paid monthly, and the amount to be paid depends on the usage or the number of credits used per month. For pre-paid subscriptions, on the other hand, airtime credits are bought and credited (or loaded) into the mobile phone units and can be consumed with a certain period of time (i.e. pre-loaded credits have an expiration date.). The pre-paid amount of credits available is stated in terms of its peso equivalent and is commonly referred to as load (e.g. a P50 load). Pre-paid subscription is by far the more popular mode of subscription. For SMART Communications, for instance, 98 percent of subscriptions are pre-paid.

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The sales of pre-paid credits, similar to “goods” or “commodities,” pass through a chain of distribution channels. The figure below shows at least three levels of distribution for pre-paid credits: telco to wholesaler, wholesaler to retailer, and retailer to end-user. This is a simplistic representation of the distribution network because at present, there may be several more layers of merchants or resellers in between the wholesaler and the retailer. Some wholesalers also sell credits on retail (wholesaler-retailer).

Figure 1. Three-Level E-Load Distribution Chain

Pre-paid credits come in two forms: in card and in electronic form. Pre-paid cards contain numeric codes to be entered into the mobile phone to obtain credits. The card comes in denominations of at least P100. In the electronic form, which this paper shall refer to as e-load, credits are transferred electronically from the retailer to the end-user. E-load comes in denominations of as low as P15. The following figure illustrates the mechanism by which e-loading takes place:


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In e-loading, three steps occur in the following order:

1. The end-user pays the retailer to purchase e-load. The retailer obtains the customer’s/end-user’s cell phone number.

2. The retailer sends an SMS to the telco requesting that load be credited to the end-user, indicating the end-user’s number and the amount to be loaded. The retailer has a SIM that is programmed as a retailer SIM. That is, the retailer SIM can store load credits for reselling, and contains pre-set commands or functions that enables the retailer to send an SMS to the telco requesting that load credits be transferred from the retailer SIM to the end-user’s SIM. The retailer SIM should contain credits at least worth the amount being requested to be loaded to the customer. This function is available only in retailer SIMs and not in ordinary end-consumer SIMs.

3. The telco sends an SMS to the end-user’s cell phone informing the end-user that his phone has been loaded airtime credits worth the particular amount purchased. The telco also sends an SMS to the retailer SIM to confirm that the amount requested has been loaded to the customer, and that the same amount has been deducted from the retailer SIM.

E-load Retailing – A Low Entry Barrier Business To become an e-load retailer, one only needs a mobile phone unit, a retailer SIM card, and an accomplished application form which requires the disclosure of basic information such as name and address of the applicant. This oversimplification of requirements and the reported high revenues from e-load retailing has created a new class of entrepreneurs that include sari-sari stores, housewives, students, and other roving agents. Bigger establishments such as 7-Eleven and other large retail chain stores and groceries also sell pre-paid credits, both in pre-paid cards and e-load. Moreover, the very nature of electronic loading also allows electronic payments for e-load. This is made possible through banks, credit card issuers, and other electronic payment facilities. In both instances, the entities act both as wholesaler and retailer. In these cases, the distribution chain is reduced to two levels: telco to the wholesaler-retailer, and the wholesaler-retailer to end-user. In some cases, the distribution channel is further reduced to only one level: telco to end-user. This is made possible when an end-user purchases load in the business centers of the telcos, or purchases electronic money through the e-wallet. The e-wallet is a cell phone subscription’s ability to hold money denominations, making the cell phone a virtual wallet. Money is remitted to the business center, and the corresponding amount is loaded in the e-wallet as “electronic money.” This electronic money can then be used to electronically purchase e-load directly to the telco whereby the purchase amount is deducted from the e-wallet. Electronic money can also be used in purchasing commodities from participating stores. Moreover, electronic money up to P10,000 can also be remitted from one mobile phone to another. The foregoing descriptions show that e-load retailing is very different from retailing pre-paid cards in terms of distribution channels and payment methods. The greater flexibility afforded by e-load retailing makes it increasingly popular and is foreseen to ultimately lead to the phase-out of prepaid cards.

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Moreover, the electronic nature of e-loading has been leading to various VAS other than reselling mobile phone credits. It is due to these and other intricacies of e-loading that this study is focusing on e-load retailing of mobile phone credits. The Value Chain The figure below depicts the values involved in the distribution chain for pre-paid credits with a street value of P100.

Figure 3. E-Load Value Chain/1

Margin of P14 Gross Profit of 14% (i.e. P14 is 14% of P100)

Margin of P4 Gross Profit of 4.65% (i.e. P4 is 4.65% of P86)

1/ The case of Globe Telecom The figure above depicts the case for Globe Telecom wherein a retailer gets an outright discount of P14, i.e., he purchases the load for P86 and resells it for P100. The wholesaler obtains a discount of about 5 percent, although this can vary depending on the volume of load purchased. SMART Communications has a more complicated scheme where retailers get varying discounts for different amounts of e-load sold. Verification of Value Chain with Financial Information from Wholesalers A list of e-load wholesalers or distributors with direct purchases from the telcos was provided by the BIR through the NTC. Only SMART Communications and Sun Cellular complied. The study then made an examination of the financial statements of the first-level wholesalers or distributors with over P500 million purchases from SMART Communications. A verification of registration status of these entities with the SEC in the case of corporations and business partnerships, and the Department of Trade and industry (DTI) in the case of sole proprietorships, indicates that not all of them have the requisite registration or are at least in good standing or compliant with reporting requirements of these agencies, particularly in the case of those registered with the SEC. The audited financial statements of three SEC-registered wholesalers indicate that their gross profit rates ranged from 0.3 percent to 1.2 percent, or an average gross profit rate for the three of 0.65 percent. This is way below the 4.65 percent gross profit rate that they should be reporting if the gross profit is to be based on the value chain of e-load distribution as presented in Figure 3 above. Moreover, the net income

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rate before tax is also very low at 0.05 percent to 0.19 percent. This suggests a very high overhead, which is also inconsistent with the low overhead description of the operations of e-load merchants. The findings from the audited financial statements of the three major wholesalers are summarized below. Table 1. Summary Observations on Financial Statements of Selected E-Load Distributors/Wholesalers

Wholesaler

Sales Per SMART

Communications Record (Feb-Dec

2005)

Remarks

Wholesaler 1 P767,320,455

(derived annual: P837,076,860)

Latest available audited F/S with SEC is 2002, thus it may not include any e-load sales but its sales includes prepaid card sales of P608,935,415. It is engaged in other businesses such as sale of units and services but has itemized Sales figure in its F/S. It is possible that it is also selling prepaid or e-load for Globe, in which case, its audited F/S Sale from Cards/E-load should be significantly higher than PhP 837 million. However, the Cost of Sales figure is already a lump sum amount rather than itemized per type of business activity. Gross profit (P4,373,443) rate is 0.52% and net income (before tax – P576,223) rate is 0.069%.

Wholesaler 2 P1,619,891,636 (derived annual: P1,767,154,152)

Minimal capitalization. There is no indication whether its sales consists solely of sale of prepaid card/e-load sales. Gross profit (P14,261,758) rate is 1.2% and net income (before tax P2,312,330)rate is 0.19%

Wholesaler 3 P1,311,322,238 (derived annual: P1,430,533,349)

The purpose clause of its Articles of Incorporation indicates authority to engage not only in trading but also performance of services. Thus, it is not clear how much of its sales is attributable to sale of prepaid card/e-load. It also needs to be determined if it is also selling Globe prepaid cards/e-load. Gross profit (P4,866,206) rate is 0.3% and net profit (before tax- P892,424) rate is 0.056%.

It must be noted that the computed gross profit and income rates of each of the three firms do not pertain only to the e-load business but to their entire business. Each is registered to be eligible to engage in other trading/business transactions, but the figures in their financial statements do not provide a breakdown of their revenue from each of the various types of trading/business transactions that they pursue. It must be noted, however, that the sales figures reported in the 2002-2004 financial statements are not very far from the SMART e-load sales to these firms in 2005. Moreover, it is highly likely that these companies also trade Globe and Sun Cellular e-load and pre-paid cards. These also suggest the need for scrutiny of the financial reporting of these companies. Taxes on E-Loading

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There are two applicable taxes in the e-loading business: income tax and business tax. The business tax can either be the value-added tax (VAT) or the percentage tax. All resellers or merchants in the distribution chain, from the telco to the retailer, are liable to income tax since each stands to earn revenue from the sale or resale of e-load. The timing of recognition of income, however, may differ among the players. For telcos, due to the fact that they are in the service business and have adopted the accrual basis of accounting, income is not recognized until the service is actually rendered, except in the case when the load expires, in which case, they are no longer obliged to render any further service. Accordingly, for telcos, cash receipts from e-load are treated as unearned revenue until such time when the load is used or expires. For the resellers, there is no categorical rule at this time whether the sale of e-load is treated as a sale of service or a mere sale of goods. In any case, there is more convincing basis to treat the sale of e-load by resellers as a sale of goods. The characterization of e-load sale as a sale of service or a sale of goods is important when there is a cross-border element, e.g., when the sale of e-load is done abroad. If treated as a sale of service, income is taxable in the Philippines because the income is deemed earned in the Philippines. On the other hand, if treated as a sale of goods, income is not taxable in the Philippines because income is not deemed earned in the Philippines. In terms of business tax, all resellers in the e-load distribution chain are also subject to VAT pursuant to Section 105 of the National Internal Revenue Code (NIRC) that stipulates that the sale of goods and service in the Philippines are subject to VAT which is now at the rate of 12 percent. However, if the e-load is used by a subscriber to call or send messages abroad, then the applicable business tax is the percentage tax in the form of overseas communication tax (OCT) at the rate of 10 percent of the amount of service. E-load resellers, on the other hand, may also be exempted from paying VAT if the annual gross revenue generated less than P1.5 million, in which case a percentage tax of 3 percent is instead imposed. The Challenges of Telecom Industry and E-Load Retailing to Tax Administration and Enforcement Challenges to tax administration and enforcement in the telecommunications industry can be traced to two factors: (1) technological innovation and convergence, and (2) rapid growth of e-commerce. To a large extent, the latter is also propelled by the rapid rate of technological innovation and development. Experts tend to categorize the issues brought about by technology into broad categories, to include:

Electronic money – Electronic commerce is still developing and no electronic money system has yet achieved widespread usage and acceptance. It is an issue whether the tax evasion potential of electronic money is manageable and what must be done to manage it.

Record keeping and identity verification for electronic transactions – Electronic transaction

creates the possibility for tax evasion and fraud because computerized records can be altered without a trace. Taxing authorities cannot restrain the practice of using electronic documentation, hence the need for a technology that will ensure that e-documents cannot be tampered with or which will allow the certification of electronic documents as well as establish the identities of persons involved in an electronic transaction to minimize the potential for tax evasion.

Disintermediation and information reporting – Tax reporting and compliance relies partly on

formal organizations and institutions as intermediaries to comply with information reporting and withholding requirements. Disintermediation refers to the elimination of these traditional

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intermediaries. With e-commerce, it is now possible for individuals and relatively unsophisticated taxpayers who are unfamiliar with their tax and tax withholding obligations to engage in business transactions without going through the traditional intermediaries which are also ordinarily constituted as tax withholding agents.

The challenges posed by the e-load business to tax enforcement and administration are but the subsets of the above. In particular, the following intricacies of the e-load business bring about these challenges:

Lack of paper trail – Beyond the level of telcos and wholesalers, there is hardly any paper involved to support or document the sale of e-load. Moreover, all purchases of e-load paid for from an e-wallet, by direct deduction from a depositor’s bank account, or by direct charge to a credit card account, can be consummated without any physical document being generated, making verification of the volume of e-load sales through these channels extremely difficult.

Lack of tangible object of sale – In the case of sale of physical goods, there are evident and

traditional indications of the level of business activity such as the physical stock of goods that it has in its warehouse and the rate of turnover of such goods, the number of delivery vehicles, and the size of its factory or warehouse. In the case of e-load business, one deals with intangible objects in the form of load credits. This also affords the seller to do business without a fixed base of operations.

Numerous unsophisticated and geographically dispersed retailers – With no major barriers to

engage in the e-load business, many e-load retailers are unsophisticated entrepreneurs who are unlikely to possess the requisite know-how on tax compliance requirements and even elementary bookkeeping. Moreover, the level of operations may also not justify the cost of maintaining accounting books. These retailers are also geographically dispersed and can be highly mobile.

Technology-driven – Increasingly, prepaid telephone service business is driven by technology

and the method of doing e-load business is in a constant flux. Technology has also enabled the entry of new participants such as banks and credit card issuers in the e-load sales network and marketing schemes. Moreover, telcos are also increasingly improving their own capability to sell on retail basis. This may ultimately lead to the elimination or at least diminished reliance of telcos on “traditional wholesalers” for the distribution and sale of e-load.

Broadening and expanding business of the telcos – Technology and demand have expanded

and broadened the service of telcos beyond just providing telecommunications service. The business of telcos is slowly becoming a subset of electronic commerce and creeping into the business domain of banks and money remittance. This opportunity opened to them because of technological advancement in wireless communications and IP-based applications, and the wide distribution network available to them.

Impact and Consequence of Peculiarities of E-Load Business on Efficiency of Tax Collection and Administration The following summarizes the impact and consequence of the above-enumerated peculiarities of the e-load business on collection efficiency and effective tax administration:

Lack of paper trail - To meet the challenges of not having paper trail in most levels of the e-load distribution chain and full opportunity of verification of revenue-generating transactions, the BIR should develop a method of verification that will allow it to ascertain that revenue from all potential revenue sources from the various types of transactions of the telcos are reported. This

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method should not be dependent on the traditional verification methods of tracing reported revenue against official receipts issued.

Dispersed and numerous mobile e-load resellers - Auditing the retailers at the bottom level of

the distribution chain will not be cost-efficient given that they are dispersed, numerous, and the limited value of the transactions of a good percentage of the retailers. There is therefore a strong incentive for the BIR to look into the possibility of loading all taxes at the level of the telco or the wholesaler.

Implications of Evolving Technology - The fast evolution of data communications technology

and wide variants of the e-load business makes it difficult for the BIR to react immediately and even reasonably anticipate changes in the e-load business. In general, the growing complexity of the business of telcos and the transactions and arrangements they have in conducting their business requires the BIR to continually change its audit procedures with respect to telcos, or design an audit/verification method that is effective and less sensitive to the changes in technology in the telco business.

Foregone Government Revenues - The documentation done by the study suggests that due to

the characteristics of the merchants in the e-load distribution network, a huge portion of the taxes or government revenues from e-load are foregone. For one, retailers are mostly unsophisticated or very small businesses who may not even be aware of their tax obligations. As with other businesses in the informal economy, it is both difficult and not cost-efficient for the BIR to directly run after the retailers to fulfill their tax obligations. On the other hand, although wholesalers are deemed more sophisticated businesses who are aware of tax obligations, a verification of the registration status of some of the biggest wholesalers (i.e., those with over PhP500 million in e-load purchases from SMART) with the SEC and DTI indicates that not all of them have the requisite registration or are at least in good standing or compliant with reporting requirements of these agencies.

Tables 3 and 4 present the estimated tax due the different merchants in the e-load distribution chain, and the estimated foregone government revenues. The following scenario is depicted: all telco sales are to wholesalers; 75 percent of wholesaler sales are to retailers; the remaining 25 percent of credits purchased by wholesalers are ratailed at street value by the wholesalers themselves. The scenario therefore deals with three merchant types: the wholesaler without retail operations, the wholesaler-retailer, and the retailer.

Two cases are considered. First, the case wherein the gross profit rate of the wholesaler is 4.65 percent, as documented in the value chain. Second, the case that uses a gross profit rate of 0.65 percent, which is the average gross profit rate of wholesalers based on the audited financial statements of three major wholesalers. The figures are computed based on an estimated P73.2 billion sales by the telecom companies in 2005, as derived from sales figures submitted by SMART Communications to the NTC. The sales figures are those sold to wholesalers, and therefore the P73.2 billion does not include any direct sales by telcos to end-users through the e-wallet or through conduits such as banks and credit card issuers. The income tax rate used is 35 percent for both the wholesaler and wholesaler-retailer, and 20 percent for the retailer. The business taxes considered were the remaining VAT payable (after deducting from the output VAT the input VAT) for the wholesaler and wholesaler-retailer, and the 3 percent percentage tax for the retailer.

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Table 2 summarizes the foregoing assumptions:


Case 1 Case 2 Players/Merchants/ Distribution Channels

Three types of merchants are considered after the level of the telco: wholesaler, wholesaler-retailer, and retailer. Wholesaler: Purchaser of 75% of the telco sales, and resells this to retailers. Has no own retail operation Wholesaler-retailer: Purchaser of 25% of the telco sales, and retails this on its own. Usually medium to large-scale businesses involved in institutional retailing, such as groceries/convenience stores Retailer: Purchaser of 100% of the sales of wholesaler, and retails this to the end-user.

Total E-Load Sales by the Telco (2005)

P73.2 billion - Assumed to be twice the value of load sold by SMART Communications in

2005 (P36.6 billion) to its wholesalers, which is justified by the fact that audited financial statements show that revenues for wireless services is almost the same for SMART and Globe in 2002-2004. This estimate is likewise conservative as it has not factored in the market share of Sun Cellular.

- The P36.6 billion for SMART was derived from record of sales for February-December 2005 to their wholesalers, as submitted to NTC. Thus, this necessarily excludes any direct e-load retail sales of SMART.

- SMART figure assumed to be inclusive of VAT, although it is more reasonable to assume that when sales amount is reported, the same should be deemed exclusive of VAT since for accounting purposes, the VAT component is required to be segregated from the gross sales figure. Thus, this is a conservative assumption.

Gross Profit Rate , computed as: [(Sales-Cost of Sales)/Sales]

Wholesaler: 4.65% (=3.57/76.79 =4/86) as computed from the value chain in study findings Wholesaler-Retailer: 18% (=16.07/89.29 = 18/100) as computed from the value chain in study findings Retailer: 14% (=14/100) as computed from the value chain in study findings

Wholesaler: 0.65% - the gross profit rate using figures in financial statements of three major wholesalers Wholesaler-Retailer: same as in Case 1 Retailer: same as in Case 1

Income Tax Rate Wholesalers and Wholesaler-Retailers, 35% Retailers: 20% (corresponding to a taxable income bracket of Php70,000 to Php140,000. The range being from 0% to 32%, depending on the amount of taxable income but as discussed, retailers are observed to be predominantly small retailers

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Case 1 Case 2

Business Tax – VAT for wholesaler (Case A and Case B examined in the full report)

Wholesaler and Wholesaler-Retailers: Case A - remaining VAT payable is output VAT less actual input VAT paid to telco. This applies the regulation that actual input VAT can be used so long as it does not exceed 100% of output VAT Case B - applies the law that maximum creditable input VAT is 70% of output VAT Retailer: 3% percentage tax on gross sales

Net Income, Taxable Income

Wholesaler, Wholesaler-Retailer, Retailer 50% of Gross Profit (thus, the other 50% corresponds to the provision for overhead, selling, and administrative expenses), which amount is also assumed to be equivalent to Taxable Income

The resulting tax due estimate for the base of P73.2 billion sold by the telco is P4.7 billion for Case 1 (Table 3), with P2.9 billion coming from the retailer and P1.8 billion coming from the wholesaler and wholesaler-retailer. Under Case 2, tax due is reduced to P4.0 billion, with P2.8 billion coming from the retailer and P1.2 billion from the wholesaler and wholesaler-retailer. It has to be noted again that these figures do not include direct e-load sales of telcos to end-users.

In Table 4, the foregone revenues are estimated in increments of 25 percent of tax due for the wholesaler, wholesaler-retailer, and the retailer. Given the characteristics underpinning poor tax remittance in the e-load business, the study deems that the scenario of uncollected taxes of 50 percent for wholesalers and wholesaler-retailers and 75 percent for retailers (shaded in the table) to be the most likely scenario.

The large percentage uncollected from the retailers, which is the largest source of taxes due, plus non-compliance by some wholesalers and wholesaler-retailers, bring the amount of foregone revenue to a staggering P3.1 billion (Table 4). Even if the assumed level of non-compliance for the wholesaler and the wholesaler-retailer is lowered from 50 percent to 25 percent, the estimated foregone revenue still amounts to a considerable P2.7 billion. Under Case 2, foregone revenue amounts to P2.7 billion. The full report also examines another VAT treatment wherein the input VAT credit against output VAT is capped at 70 percent of output VAT, in view of the 70 percent cap on input VAT provided under the NIRC, as amended by R.A. No. 9337. Using this VAT treatment, estimated foregone revenue amount to P4.0 billion and P3.7 billion for Case 1 and Case 2, respectively.

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Case 1. Gross Profit Rate of 4.65% for Wholesaler, Remaining VAT Payable for Wholesaler and Wholesaler-Retailer is Net of Input VAT

INCOME TAX BUSINESS TAX

Merchant Type Gross Sales Net Profit Income Tax /1 Output VAT Input VAT Remaining VAT

Payable Percentage Tax TOTAL TAX DUE

as a % of Total Tax

Due

Wholesaler 57,588,987,757 1,195,784,630 418,524,620 6,170,248,688 5,883,260,377 286,988,311 705,512,931 15.0% Wholesaler-Retailer 22,321,313,084 1,793,676,944 627,786,930 2,391,569,259 1,961,086,792 430,482,467 1,058,269,397 22.5% Retailer 66,963,939,252 4,687,475,748 937,495,150 - - - 2,008,918,178 2,946,413,327 62.6%

Total 1,983,806,700 8,561,817,947 7,844,347,170 717,470,778 2,008,918,178 4,710,195,656 100.0%

as a % of Total Tax Due 42.1% 15.2% 42.7% 100.0%



Gross Sales Net Profit Income Tax /1 Output VAT Input VAT Remaining VAT Payable Percentage Tax

TOTAL TAX DUE as a % of Total Tax

Due

Wholesaler 55,269,683,127 160,380,777 56,133,272 5,921,751,764 5,883,260,377 38,491,386 94,624,658 2.4% Wholesaler-Retailer 22,321,313,084 1,793,676,944 627,786,930 2,391,569,259 1,961,086,792 430,482,467 1,058,269,397 26.6%

Retailer 64,267,073,404 4,498,695,138 899,739,028 - - - 1,928,012,202 2,827,751,230 71.0%

Total 1,583,659,230 8,313,321,023 7,844,347,170 468,973,853 1,928,012,202 3,980,645,285 100.0%


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Table 4. Estimated Foregone Government Revenues in E-Load Retailing, 2005


Level of Taxes

Collected from Retailer

25% 50% 75% Level of Taxes

Collected from W/S and W/Sr-Retailer Wholesaler Wholesaler-

Retailer Retailer Total Wholesaler Wholesaler-Retailer Retailer Total Wholesaler Wholesaler-

Retailer Retailer Total

Income Tax 104,631,155 156,946,733 234,373,787 495,951,675 104,631,155 156,946,733 468,747,575 730,325,462 104,631,155 156,946,733 703,121,362 964,699,250

25%

Business Tax 71,747,078 107,620,617 502,229,544 681,597,239 71,747,078 107,620,617 1,004,459,089 1,183,826,783 71,747,078 107,620,617 1,506,688,633 1,686,056,328

Total 176,378,233 264,567,349 736,603,332 1,177,548,914 176,378,233 264,567,349 1,473,206,664 1,914,152,246 176,378,233 264,567,349 2,209,809,995 2,650,755,577

Income Tax 209,262,310 313,893,465 234,373,787 757,529,563 209,262,310 313,893,465 468,747,575 991,903,350 209,262,310 313,893,465 703,121,362 1,226,277,138

50%

Business Tax 143,494,156 215,241,233 502,229,544 860,964,933 143,494,156 215,241,233 1,004,459,089 1,363,194,478 143,494,156 215,241,233 1,506,688,633 1,865,424,022

Total 352,756,466 529,134,699 736,603,332 1,618,494,496 352,756,466 529,134,699 1,473,206,664 2,355,097,828 352,756,466 529,134,699 2,209,809,995 3,091,701,160

Income Tax 313,893,465 470,840,198 234,373,787 1,019,107,450 313,893,465 470,840,198 468,747,575 1,253,481,238 313,893,465 470,840,198 703,121,362 1,487,855,025

75%

Business Tax 215,241,233 322,861,850 502,229,544 1,040,332,628 215,241,233 322,861,850 1,004,459,089 1,542,562,172 215,241,233 322,861,850 1,506,688,633 2,044,791,716

Total 529,134,699 793,702,048 736,603,332 2,059,440,078 529,134,699 793,702,048 1,473,206,664 2,796,043,410 529,134,699 793,702,048 2,209,809,995 3,532,646,742

Case 2. Gross Profit Rate of 0.65% for Wholesaler, Remaining VAT Payable for Wholesaler and Wholesaler-Retailer is Net of Input VAT Level of Taxes


25% 50% 75% Level of Taxes Collected from W/S and W/Sr-Retailer Wholesaler Wholesaler-



Income Tax 14,033,318 156,946,733 224,934,757 395,914,808 14,033,318 156,946,733 449,869,514 620,849,564 14,033,318 156,946,733 674,804,271 845,784,321

25%

Business Tax 9,622,847 107,620,617 482,003,051 599,246,514 9,622,847 107,620,617 964,006,101 1,081,249,564 9,622,847 107,620,617 1,446,009,152 1,563,252,615

Total 23,656,165 264,567,349 706,937,807 995,161,321 23,656,165 264,567,349 1,413,875,615 1,702,099,129 23,656,165 264,567,349 2,120,813,422 2,409,036,936

Income Tax 28,066,636 313,893,465 224,934,757 566,894,858 28,066,636 313,893,465 449,869,514 791,829,615 28,066,636 313,893,465 674,804,271 1,016,764,372

50%

Business Tax 19,245,693 215,241,233 482,003,051 716,489,977 19,245,693 215,241,233 964,006,101 1,198,493,028 19,245,693 215,241,233 1,446,009,152 1,680,496,078

Total 47,312,329 529,134,699 706,937,807 1,283,384,835 47,312,329 529,134,699 1,413,875,615 1,990,322,643 47,312,329 529,134,699 2,120,813,422 2,697,260,450

Income Tax 42,099,954 470,840,198 224,934,757 737,874,909 42,099,954 470,840,198 449,869,514 962,809,666 42,099,954 470,840,198 674,804,271 1,187,744,423

75%

Business Tax 28,868,540 322,861,850 482,003,051 833,733,440 28,868,540 322,861,850 964,006,101 1,315,736,491 28,868,540 322,861,850 1,446,009,152 1,797,739,541

Total 70,968,494 793,702,048 706,937,807 1,571,608,349 70,968,494 793,702,048 1,413,875,615 2,278,546,157 70,968,494 793,702,048 2,120,813,422 2,985,483,964

Other Relevant Findings Other than what has been discussed above, below are other noteworthy observations and concerns which may not be directly related to taxation of e-load business but may be useful and of concern when designing the audit procedures for the telcos.

Lack of transparency of pricing strategy at various levels of the e-load distribution chain - It appears that the telcos do not fix the price at which resellers can sell e-load, nor is there a single discount rate for their distributors and retailers.

Lack of transparency of revenue-generating contractual arrangements entered into the by

the telcos - With the emergence of various types of arrangements with various entities such as content providers and players in the different payment options (e.g. banks, credit card issuers), it is becoming increasingly difficult to know and understand exactly the nature of the transactions that the telcos are entering into.

Financial statements of telcos present aggregate values - While the sources of revenues are

enumerated in the Notes to the audited financial statements of the telcos, the reported revenues are not broken down into these sources. Requiring the telcos to submit an itemized revenue report by source will give the BIR a good idea of the revenue sources it will need to concentrate its audit on.

Diversity in revenue source and other policies - Different revenue sources, applicable rates and

pricing policies, and types of transactions make verification of financial data extremely challenging.

No standard financial reporting - The audited financial statements of the three major telcos

show different levels of aggregation, different account titles, and different accounting policies adopted, notwithstanding the fact that all the telcos share one and the same auditing firm and the NTC has previously issued a uniform chart of accounts for use by telcos.

NTC-BIR partnership - It appears that the NTC actually receives a considerable amount of

financial information from the telcos. These reports are good sources of information which can be utilized by the BIR in auditing/verifying and obtaining the details of certain revenue accounts of the telcos reflected in their audited financial statements and income tax returns.

Foreign-sourced revenue from sale of prepaid cards and e-load - The telcos generate

considerable amount of revenue from the sale of prepaid cards and e-load abroad and it is not certain whether these are being fully recorded in the books of the telcos.

Verification of prompt revenue recognition - Considering that cash payments received from the

sale of e-load is initially recorded as unearned revenue for accounting income purposes, the BIR will need to verify whether this is promptly converted to realized income when the load is used or expires. However, one telco’s representation to the BIR is that it immediately recognizes proceeds of e-load sales for income tax purposes. Once verified that this is the case for all telcos, then this concern will be eliminated.

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RECOMMENDATIONS While the study examines the retail sales of e-load, a significant portion of the recommendations deals more with the telcos themselves rather than their e-load distribution network. This was inevitable given the circumstances observed in the e-load business which show that the role of the telcos will be most critical in the entire effort to enforce taxation at the various levels of e-load distribution. Moreover, the scope of recommendations was broadened beyond e-load since findings also show that e-loading cannot be completely isolated from the entire spectrum of telco services. The recommendations are summarized in Table 5, with an indication on the timeframe and revenue impact. Only one recommendation has a quantifiable impact on revenue collections. At the outset, the rest of the recommendations are only meant to ascertain taxable transactions and ensure that the taxes thereon are collected. Adoption of these recommended measures, however, is key to instituting behavioral changes in tax compliance, i.e., “cultural approach to tax collection”. The latter is the more valuable contribution that these actions will make. For comparability, the impact on ascertaining taxable transactions is expressed in varying degrees: moderate, high, and very high. Recommendations are grouped into four categories. The first category is statutory initiatives which include collecting business taxes upfront. This has a direct impact on revenue collection, estimated to be as much as P1.5 billion if already implemented in 2005. This can be done in the short-term. The three other categories are regulatory enhancements; enhancement of operational methodologies and capacity-building; and technology-based solutions. The study also presents recommendations that are not directly related to taxing e-load, but can be used in designing the audit procedures for the telcos and related players. All recommendations are for BIR’s action, except for the recommended technology-based solution to engage a third party to monitor control channels of cell sites, which is for the NTC to implement and share information with the BIR.


RECOMMENDATIONS

Timeframe (immediate: within one year;

short term: in 1 to 3 years; medium term: more than 3

years)

Revenue implication

Statutory Initiatives

Impose advance percentage tax Short-term

Considering 2005 figures, about P1.8 billion, on conservative

assumptions

Unify business taxes on telco Short to medium term

Not quantifiable at this time, but main impact is cost-efficiency of

tax collection, which also still needs to be quantified

Regulatory Enhancements Issue revenue regulation

specifically addressing Immediate Not quantifiable at this time, but with high impact in ascertaining

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RECOMMENDATIONS



years)

Revenue implication

telecommunications industry tax issues: e.g. Characterization of e-load sale transaction (whether goods or service) and prescription of timing of income recognition

taxable transactions

Amend or expand information

disclosure and reporting requirements of telcos

Short-term Not quantifiable at this time, but with very high impact in ascertaining taxable transactions

Enhancement of operational methodologies and capacity-building Obtain sufficient understanding

and knowledge of the telco business and full understanding of telco accounting system

Immediate Indirect

Enhance and strictly implement the prescribed procedure for the grant to telcos of authority to use computerized accounting system

Immediate Indirect

Maximize the use of third party information

Utilize domestic sources (information on wholesalers and other parties with revenue inflow implications)

Immediate Not quantifiable at this time, but with moderate impact in ascertaining taxable transactions

Strengthen and institutionalize linkage and data sharing between the NTC and the BIR


Utilize foreign-sourced information Immediate

Not quantifiable at this time, but with moderate to high impact in ascertaining taxable transactions

Institutionalize coordination of Revenue District Office with the Large Taxpayers Service in the audit of major wholesalers


Audit wholesalers to determine reason behind the erosion of their income tax base

Immediate

Not quantifiable at this time, but with very high impact in ascertaining taxable transactions

Technology-based solutions

Access and use information from Call Detail Records (CDR)

With political will, immediate


Engage third party services for monitoring call traffic


Areas for Further Study Examine:

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RECOMMENDATIONS



years)

Revenue implication

Transactions involving credit card companies

Transactions involving banks Revenue sharing with content

providers Magnitude of income earned by

telcos from providing their own content

Pursuit by telcos of other business activities

Statutory Initiatives The study recommends some amendments on the taxation of telcos, which amendments should be adopted pursuant to an amendatory law to the National Internal Revenue Code (NIRC). The mere issuance of revenue regulations by the Secretary of Finance, as recommended by the BIR Commissioner, would not suffice. These recommended amendments are:

Impose advance percentage tax Given that retailers of e-load are numerous and geographically dispersed and that the number of sublayers in the distribution or sale of e-load is not fixed and cannot be possibly monitored, there is tremendous pressure as well as incentive for the BIR to concentrate tax collection effort at the higher levels of the distribution chain. Ideally, the business tax should be collected up front, at the level of the telcos. The telcos are already identified and the level of their tax compliance is comparatively high, considering that they are under the close monitoring of the Large Taxpayers Service. With respect to the type of business tax, it would appear that a percentage tax would be the simplest to collect and impose. Being computed on the gross amount and there being no offsetting, as in the case of input VAT against output VAT, the likelihood of erosion of the tax base as well as the tax payable is eliminated. The recommendation contemplates not the regular percentage tax which is directly remitted by the seller subject to percentage tax but an advance percentage tax, i.e., it is collected in advance of the resale of the e-load and will be computed at 3 percent of the ultimate selling price to the end-user (street value). The percentage tax will be added to the telcos’ selling price in computing the total invoice price to the wholesaler. The telcos will continue to recognize output VAT based on their actual selling price.

Hence, as shown in the following figure, for every P100 worth of e-load in the street, there is a P3 percentage tax due from the distribution chain. The said percentage tax will be withheld by the telcos and remitted to the BIR on a monthly basis, instead of waiting for the wholesalers and retailers to declare their sales and pay the business tax thereon, assuming they actually declare and pay their taxes. The tax burden will have to be shared by the players in the distribution chain. Market forces should be able to ultimately dictate how the tax will be shared among the players in the distribution chain through a corresponding adjustment in the selling price/mark-ups within the distribution chain. In any case, the street value should be unaffected.

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Figure 4. E-Load Value Chain with Imposition of Advance Percentage Tax

The table below compares the tax due for the 2005 e-load sales under the prevailing tax system and the proposed advanced percentage tax scheme.

Table 6. Business Tax Due on Estimated 2005 E-Load Sales, at Current and Proposed Tax Scheme

Current Tax Scheme Proposed Tax Scheme Distribution Level Business Tax Due Base Business Tax Due

Wholesaler to Retailer P286,988,311 (remaining VAT

payable) Wholesaler-Retailer to End-user

P430,482,467 (remaining VAT

payable) Retailer to End-user P2,008,918,178

(3% percentage tax)

P89,285,252,336

(gross sales of wholesaler-retailer and gross sales of

retailer)

P2,678,557,570 (3% percentage tax)

Total P 2,726,388,955 P 2,678,557,570

While it appears above that the present tax system yields a higher combined tax, it should be noted that the percentage tax of P2.01 billion supposedly collectible at the level of retailers is, to a large extent, uncollected for reasons already discussed. As shown in Table 7, since only P0.86 billion is estimated to be collected from the P2.73 billion due under the present tax system, the advance percentage tax worth P2.68 billion in fact brings about a net increase in collections by about P1.82 billion.

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Table 7. Additional Business Taxes to be Collected from 2005 E-load Sales Using the Proposed Scheme

Amount (PhP) (1) Tax Due Under Current Scheme (from Table 2) 2,726,388,955 (2) Tax Due Under Proposed Scheme (from Table 5) 2,678,557,570 (3) Estimated Foregone Revenues from Business Taxes (Table 3) 1,865,424,022 (4) Estimated Business Taxes Collected [Row 1 -Row 3] 860,964,933 (5) Additional Business Tax to be Collected Under New Scheme [Row 2- Row 4] 1,817,592,637

Unify business taxes on telco

The BIR may consider the possibility of imposing only VAT and dispensing with OCT or vice versa. There is a need, however, to evaluate the revenue implication of such shift against the efficiency of collection and the facility of auditing the tax obligations of telcos.

Regulatory Enhancements

Issue revenue regulation specifically addressing telecommunications industry tax issues The BIR has previously considered issuing such revenue regulations but failed to finalize the draft. It is recommended to push through with such regulations and in doing so, should address matters such as e-loading and the tax treatment of the sale of e-load by e-load resellers. The e-load retailers, at least wholesalers of e-load who deal directly with the telcos, should also be covered by the same revenue regulations as they play an integral role in the pursuit by the telcos of their business. Such consolidated telecommunications industry regulations should cover the characterization of an e-load sale transaction (i.e., whether it is to be classified as a sale of tangible good or a sale of service, at the level of the telcos and at the level of the resellers), and timing of income recognition. Moreover, it can also stipulate the penalties for any player that fails to comply with the BIR issuance.

Amend or expand information disclosure and reporting requirements of telcos

The details that the BIR needs are beyond what is contained in the audited financial statements of the telcos. The BIR cannot prescribe the level of detail in the preparation of the FS since these have to be consistent with certain standards, but the BIR may invoke the authority of the Commissioner of Revenue to prescribe additional reports to be submitted to the BIR. Among others, additional reports or attachments to existing documentary submissions should supply the BIR with details of the income of the telco from pre-paid subscribers. Itemization of all prepaid revenue sources should be required. The BIR should already identify the major categories of income sources, including, among others: banks and credit card issuers; direct sales to retailers; direct sales to subscribers; and sales through wholesalers/distributors.

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Enhancement of operational methodologies and capacity-building

Obtain sufficient understanding and knowledge of the telco business and full understanding of telco accounting system

With the increasing complexity of the way the telcos do business - the increasing variety of services that they are able to render; the myriad of transaction, arrangements, and agreements that telcos enter into; the increasing number of parties constitute the network of business partners of telcos in the conduct of their business; and the constantly evolving technology that drives significant change in the manner that telco services are delivered, marketed, and settled – it is indispensable for an effective enforcement of tax laws in the telecommunications industry for the tax authority and its agents to acquire a good understanding of the telco business and the significant factors affecting it.

Enhance and strictly implement the prescribed procedure for the grant to telcos of

authority to use computerized accounting system

Complementary to the previous recommendation, the BIR can obtain a better understanding of the accounting system by invoking its authority to audit automated/computerized accounting systems. The BIR should require a walk-through or flow audit of different types of transactions (e.g., sales orders, credit notes, and customer master file changes) and should cover the description of transaction, related control information and balancing procedures, and error correction procedures. It has to be emphasized that the Computer System Evaluation Team (CSET) that evaluates the applications to use a computerized accounting system should include a member who is knowledgeable about the telecommunications industry and is aware of its nuances. Moreover, while Revenue Memorandum Circular No. 71-03 already grants the BIR the authority to conduct of a post system evaluation of computerized accounting systems, the conduct of the same should be expressly made mandatory as well as periodic.


Utilize domestic sources. The BIR can invoke its right to third party information to obtain from telcos information about wholesalers, in particular, information on the identity of all major e-load distributors, the value of the transactions with these wholesalers, and all other information which the telcos are assumed to have on their e-load wholesalers. Also invoking its right to third party information or during the course of audit, the BIR should also be able to gain access or obtain copies of contracts with significant revenue inflow or cost implications on the telcos. Strengthen and institutionalize linkage and data sharing between the NTC and the BIR. The BIR also needs to be aware of the available financial and other relavant information that is lodged with the NTC by the telcos. Legally, the BIR could have access to such information, whether or not the same is in connection with an ongoing audit of a particular taxpayer. For benchmarking purposes, the financial information with the NTC may in fact be more useful to the BIR than the information from the audited financial statements, particularly upon the full implementation by the NTC of the use of uniform system of accounting. There is also a reason to strengthen the linkage between the BIR and the NTC in anticipation of the broadening of the authority of the NTC under House Bill No. 4942 which is now pending.

xx

Utilize foreign-sourced information. It may also prove fruitful for BIR to obtain the level of traffic and corresponding income actually earned by telcos from abroad. The BIR can specifically target the countries where there is considerable concentration of Filipino nationals and which have existing tax treaties with the Philippines. Telecommunications authorities of other countries also gather significant volume of detailed information to which the public may be given access. In any case, it is important to first know what information can readily be obtained from foreign telecommunications authorities without going through their bureaucratic process. The Federal Communication Commission (FCC) of the United States, for example, has information which can readily be accessed by the public under the Freedom of Information Act. Information from other countries, particularly from their respective telecommunications authorities, is beyond the control and influence of any of the local telcos. As such, foreign-sourced information can be assumed to be highly reliable and objective information.

Institutionalize coordination of Revenue District Office wit the Large Taxpayers Service in the audit of Major Wholesalers. It is best that information relating to the telcos’ sales to their e-load wholesalers be centrally obtained by the Large Taxpayers Service as it is the office within the BIR that already deals closely with the telcos. Relevant information obtained by the Large Taxpayers Service about the wholesalers such as the value of their e-load purchases from the various telcos can be summarized and furnished to the Revenue District Office (RDO) where these wholesalers are registered. A procedure can be put into place to require the RDOs to report to the Large Taxpayers Service or the appropriate office of the BIR, the specific action taken, the final findings of the audit of the wholesalers under their respective jurisdictions, and the amount of assessment issued, if any. Audit wholesalers to obtain reason behind the erosion of their income tax base. The BIR needs to audit the sales declared by the wholesalers. Detailed scrutiny is in order, to account for the noted erosion of their taxable base. Based on the limited financial information that the study was able to obtain on some major wholesalers of SMART Communications, it appears that their net income before tax is a very low percentage of 0.05% to 0.19% of their gross revenue considering the business of selling e-load should not require a significant amount of overhead cost. Moreover, it is difficult to understand why a gross profit rate equivalent to 3 percent to 4 percent of the street value or 4.9% of telco’s selling price is reduced to a measly 0.3% to 0.5% and ultimately further eroded to reflect a net income before tax rate of only 0.05% to 0.19%. If the official receipts issued by wholesalers tally with the reported audited sales, it remains to be further investigated if the amounts indicated on the official receipts are actual and the indicated buyers are not fictitious. It is possible that official receipts are not, in fact, being issued and do not correspond to actual sales transactions.


Access and use information from raw Call Detail Records (CDR)

The raw CDR constitutes the master data and transaction record minus the systems log. The BIR can do at least two things if given access to the CDR: i) conduct a random check of the recording system to ensure that all transactions are indeed recorded, and ii) process a sample data to produce empirical formula to make interpolations and trend projections on such information as usage and volume of phone credit sales.

The random check can be a solid basis for penalties for any underreporting that will be discovered.

xxi


The data and transaction records can also be obtained using monitoring mechanisms that can capture the information in the control channel of cell sites. The information can be of use similar to a CDR, with even less chance for alteration of information as monitoring is conducted by a third party. However, data to be obtained is limited to specific cell sites monitored.

Areas for Further Study Study findings make it imperative to also recommend that the following matters be examined by the BIR even if not directly related to taxation of e-load sales. These can be used in designing the audit procedures for the telcos, as well as for other players involved.

Transaction involving credit card companies. It has to be ascertained whether credit card

companies are functioning as merchants of e-load (i.e. obtaining discounts from reselling e-load) or are sticking to their business of only facilitating payment. The withholding tax a credit card company is subject to is different for the two cases.

Transaction involving banks. As with the credit card companies, it also has to be ascertained whether banks serve as merchants or merely as conduits of payment.

Revenue sharing with content providers. The financial statements of telcos do not indicate the amount of revenues earned from transactions involving content providers.

Magnitude of income earned by telcos from providing their own content. The FS also does not provide the amount of revenues earned by telcos from providing their own content.

Pursuit by telcos of other business activities. Together with relevant government agencies, there is a need to determine whether prudence requires that telcos be prohibited from engaging in the business of issuing electronic money other than what can subsequently be exclusively used for the purchase of e-load.

xxii

A Study on Retailing Mobile Phone Credits by Electronic Loading and Its Tax Implications

FINAL REPORT I. INTRODUCTION

A. RATIONALE

The growth of the mobile phone industry has been unprecedented in the last five years. In spite of the expansion of infrastructure for fixed lines in the 1990s, the number of mobile phone subscribers has surpassed that of fixed lines by the year 2000 (Figure 1).

Figure 1. Fixed and Mobile Telephone Subscribers per 100 Inhabitants, Philippines

0123456789

'91 '92 '93 '94 '95 '96 '97 '98 '99 '00

FixedMobile

8.4

4.0

Source: ITU, Geneva, Switzerland, 2002

By the end of 2004, about 40 out of every 100 population subscribed to mobile phone service. It is estimated that this will increase to 61 per 100 by 2009 (Figure 2).

Figure 2. Current and Projected Number of Mobile Phone Subscribers, per 100 Population

1

19.427.8

39.845.1 51.2 54.8

58.3 61.4

0

25

50

75

100

2002 2003 2004 2005 2006 2007 2008 2009YEARMobile Phone Subscribers per 100 Population

Sources: 2002-2004: NTC 2005 to 2009 Projections: The Economist Economic Intelligence Unit

The combined revenues for wireless service of the two largest mobile phone service providers increased from P70 billion to P102 billion from 202 to 2004. The revenue growth is expected to be sustained by evolving technologies and increasing demand for new applications. In spite of declining prices of services, more usage per user will translate to bigger average revenue per user (ARPU).

With the expected increase in both the number of users and the average revenue per user, a significant increase in the overall revenues from the mobile phone industry will follow at least in the next five years.

The new technologies available have also spurred innovations in the distribution channels of mobile phone subscription. Aside from the traditional postpaid subscription wherein payment is made after every monthly billing cycle and the amount billed depends on the usage, both fixed line and mobile subscriptions can now be pre-paid through advanced purchase of phone credits. Phone credits for mobile phones come either in the form of a card containing numeric codes to be entered to the mobile unit to obtain the credits (pre-paid card), or in electronic form wherein the “seller” sends the credits to the mobile unit electronically. The latter is thus commonly called “electronic loading,” or “e-loading.” Electronic loads can be purchased through various channels including merchants, banks, and credit card issuers. Once payment has been placed, the mobile unit receives an electronic message informing the user that credits have already been loaded to his subscription. Retailing mobile credits electronically leaves no paper trail and gives reason to doubt whether taxes for these are paid or whether the revenues are recorded so that revenues from these transactions could be tracked and reported for tax purposes. In 2004, the Benchmarking Group of the Business Intelligence Task Force (BITF) of the Bureau of Internal Revenue (BIR) observed that there exists a wide discrepancy between the revenues and income level that the retailers have reported with that of their tax payments. The BIR therefore expressed the need to source and analyze third party information to confirm whether there is underreporting of transactions, hence the lackluster tax collections. In response to this, the Economic Policy Reform and Advocacy (EPRA) Project contracted in October 2005 a study team to study the tax implications of the electronic loading of mobile credits. The EPRA is a USAID-funded project based in the Ateneo

2

de Manila University that works towards establishing a mechanism that will provide broad and cross-sectoral support to the formulation, implementation, enforcement, and monitoring of policy reforms.

This study will focus on the electronic loading of mobile telephone credits. In general, the study will serve as a benchmark of the tax situation in telecommunications retailing by electronic loading, in particular, the amount of taxes paid and the mechanisms used in collecting the taxes. This study, however, can also pave a roadmap for BIR on how to tax other electronic business transactions, as well as other business transactions using other emerging technology applications.

B. OBJECTIVES

The study has the following objectives:

1. Examine the process of e-load retailing and estimate the magnitude of tax revenues

generated in the chain, 2. Analyze tax revenue regulations governing retailers of pre-paid airtime and assess

whether at present there are adequate and sufficiently clear revenue regulations in place to cover taxable e-load retailing transactions, and

3. Recommend concrete measures for the effective collection of taxes from the e-load

retailing business.

C. STRUCTURE OF THE REPORT The report has four major sections. First is an introduction to give the rationale and objectives of the study, and to describe the organization of the rest of the report. The next major section documents three aspects to be able to make the necessary analysis in the next section. The first is a simplistic background on the mobile phone industry in the Philippines that establishes the revenue growth trend in the next decade; documents some technologies involved in mobile phones; and describes the telecommunications sector in the Philippines, its and market, and revenues. Next is a documentation of the distribution network for mobile phone subscription, focusing on sale and value chain of pre-paid credits by electronic loading or e-load. The third aspect discussed is the taxes involved in electronic loading.

The third section is an analysis from the findings in the background. The framework for analysis is a straightforward identification of challenges posed by the e-load business and their corresponding impact on tax enforcement and administration.

Finally, recommendations are given. These consist of statutory initiatives, regulatory enhancements, enhancement of operational methodologies, and technology-based solutions.

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II. BACKGROUND AND DOCUMENTATION

This section contains three parts: a background on the mobile phone network in the Philippines, a documentation of the e-load distribution network, and a documentation of the taxes involved in selling e-load.

A. THE MOBILE PHONE NETWORK IN THE PHILIPPINES

Three aspects are discussed in this part: the technology in mobile phones, the telecommunications sector in the Philippines, and the trends in revenues from mobile phone subscriptions.

Technology

Cellular telephone technology can be discussed in terms of the different generations of cellular network technology.

Networks and Protocols in General

Basically, a network is composed of complementary nodes and links, or a group of devices, that are linked so that information can travel from one point to another. The crucial defining feature of networks is the complementarity between the various nodes and links (Dictionary of Terms in Network Economics, 2005).

Below are examples of end-user devices that provide users with a connection to the network. These are also referred to as hosts, which allow users to share, create, and obtain information. The mobile phone, more commonly known in the Philippines as cell phone, is one example of an end-user device.

Figure 3. Samples of End-user devices

On the other hand, below are examples of network devices. These devices transport data between end-user devices. These are also responsible for conversion of data formats (e.g. voice inputted in an end-user device are transformed to other data formats while traveling in the network and then transformed back to voice format prior to reaching the final destination).

4

Figure 4. Examples of Network Devices

End-user and network devices can be in the same room and linked by copper cables, or located in different countries linked by satellites, phone lines, or transmit information over public airwaves, such as that used by television, radio, and cell phones.

An example of a network is the Internet, which is one of the world’s largest networks.

Cellular Networks

Cellular networks evolved into generations, with each generation characterized by an increasing range of bandwidth (Table 1).

Table 1: Cellular Network Characteristics by Generation

NETWORK GENERATION

DATA RATES/BANDWIDTH DESCRIPTION STANDARDS

1G Separate 9.6 kbps external modem

Analog cell phones designed for voice

NMT TACS AMPS

2G 64.0 kbps Digital voice plus messaging, voice

mail, and caller ID

GSM D-AMPS

PDC CDMA

2.5G 115.2 kbps Data enhancements to 2G

GPRS HSCSD

3G 144.0 kbps to 2.0 Mbps Broadband data and VoIP

EDGE WCDMA

CDMA2000 Source: An Introduction to Multimedia Services (an Intel White Paper, 2005)

Bandwidth is the maximum achievable data rate, or amount of information or data that can be sent or transmitted over a network connection or channel in a given period of time (whatis.com, 2005). It is usually measured in bits per second (bps), kilobits per second (Kbps), or megabits per second (Mbps). The higher a channel’s bandwidth, the more information it can carry.

The last column of Table 1 indicates standards created by organizations and consortiums of providers of mobile phone services to ensure interoperability and interconnectivity among

5

cellular phone networks. In the Philippines, GSM and GPRS are the predominant cellular technology standards.

Figure 5.a Diagramatic Description of Bandwidth

Table 2. Units of Bandwidth

UNIT OF BANDWIDTH ABBREVIATION EQUIVALENCE

Bits per second bps 1 bps = fundamental unit of bandwidth Kilobits per second Kbps 1 Kbps = ~1,000 bps = 103 bps

Megabits per second Mbps 1 Mbps = ~ 1,000,000 bps = 106 bps

Gigabits per second Gbps 1 Gbps = ~ 1,000,000,000 bps = 109 bps

Terabits per second Tbps 1 Tbps = ~ 1,000,000,000,000 bps = 1012

bps Earlier cellular networks (1G) are analog cell phones designed for voice (Table 1). We are currently in the 2G generation and moving towards 2.5G. The 64 kbps bandwidth of 2G networks enable digital voice plus other services such as messaging, voice mail, and caller ID. On the other hand, 2.5G has bandwidth of up to 115.2 kbps that allows enhancements from those of 2G networks. 3G networks are a big leap as they have a bandwidth of up to 2 Mbps that can carry broadband data and voice-over internet protocol (VOIP). Figure 5.b below is another diagrammatical representation of data transmission rates and available applications under each generation. It shows that GSM and HSCSD standards during the 2G generation can carry only data rates of up to 768 kbps which generally can be used only for messaging. 3G application of the future will have very large bandwidths that can carry multi-media services on real-time basis, similar to satellite networks for television. The figure also shows that the quality of service for the same application increases as bandwidth increases.

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Figure 5.b Service and Data Rates

Source: Mobile Data Network Solution: A Tellabs Business Solutions Briefing, September 2005

Data Rates and Mobility

In general, the more stationary an end-user device is, the more bandwidth or higher data rates the network can support; the more mobile a device is, the less bandwidth it is expected to be able to support (Figure 6).

Figure 6. Mobility vs. Bandwidth

Source: P.R. Chevillat, W. Schott, Broadband Radio LANs and the Evolution of Wireless Beyond 3G, IBM Journal of Research and Development Journal of Research and Development

7

This can be observed, for instance, in internet browsing: one can browse the internet using the cell phone, but the speed is not as fast as that when browsing in a personal or a laptop computer using broadband connections.

Fixed-Mobile Convergence

On the assumption that the market wants both mobility and services requiring bigger bandwidth, technologies have been and continue to be developed to marry the two. This sets off the discussion on convergence, which is currently a buzzword in the telecommunications industry. The many manifestations of convergence in telecommunications do not fit into neat categories. There is convergence between networks, among various devices, and between and among services/service providers. Fixed-mobile convergence connects the mobile phone to the infrastructure of fixed lines. With the convergence between the mobile and fixed line networks, telecommunications operators can provide services to users irrespective of their location, access technology, and terminal (commil.com, 2006). This is made possible by internet protocol (IP). The IP Multimedia core network subsystem (IMS) is the architecture for wrapping a “telephony standard” infrastructure around IP services that evolves into a future replacement for circuit switched voice, and can be used by wired and wireless networks; the standard/network is independent of the access technology (VON Magazine, 2005). With fixed-mobile convergence, all parties are expected to benefit: the fixed-line operators which own the backbone networks and local loops but which have been losing revenues over wireless operators can get back a share of the revenue pie; the wireless providers which have the bandwidth can link up with wirelines to provide coverage that is less patchy and with better overall quality of service; the subscribers get mobility, bandwidth, and good quality of service.

Mobile Phone Applications

Currently, there are three mobile phone applications in the Philippines: voice, short message service, and multimedia service.

Voice

Voice is the oldest service available for telephone networks, wherein one can speak on his network device (the telephone receiver), and the other end can hear his voice, and vice versa.

SMS

Short message service (SMS), more popularly known as “texting” in the Philippines, can be considered a serendipitous application discovered almost by accident. The capability to send some 160 or so characters was included in the original specification of the GSM (or global system for mobile communication) digital mobile standard that was developed in the 1980s (ITU, 2002). It was not considered to be a viable application and was originally given away free of charge. However, it has since found many uses, and has become a way of life in the Philippines, now considered the texting capital of the world. Around Christmas in 2001, the volume of messages reached around 90 million per day, or about 10 messages per user, creating a considerable source of revenues for mobile operators.

8

The popularity of SMS is largely due to its affordability, costing only P1 per message, or about 8 messages at the cost of one minute of a local call from a mobile telephone.

On top of personal message sending, SMS is used in many other ways that have further boosted the revenues of the providers. Some of the other revenue-generating SMS are:

• Games; • Daily quotes, jokes, and other message downloads; • Downloads of ringtones and mobile phone wallpaper; • Voting for TV competitions; and • Sending in raffle entries (e.g. one can text in a code found in a product as proof of

purchase, and entitles a sender to a raffle entry).

For the above types of SMS, content providers and mobile service providers split the revenues from the SMS.

SMS has also found practical applications. Requiring very little bandwidth, it is easier to send through an SMS than get a voice call through heavy traffic. In natural calamities, for instance, SMS is sometimes a more viable means of communication than voice calls.

It has to noted that not all SMS generate revenues. The mobile phone service providers send notifications to subscribers using SMS, or a subscriber can make some inquiries without being charged. These SMS are not charged to the subscriber, and hence non-revenue generating.

MMS

Multimedia messaging service (MMS) adds images and audio clips to the SMS text messaging format (Intel, 2005). Wireless service providers in Europe and the Far East see MMS as a natural evolution from SMS for their large user bases. Bandwidth is key because of the “real time” nature of MMS. Large 3G cellular phones promise to provide a multimedia user experience that is always on, easily transported, and universally reachable.

One popular use of MMS worldwide, including the Philippines, is for sending pictures taken with a mobile device’s camera. Other MMS applications currently deployed include: Weather reports sent with map images; Stock quotes with trending information in graph form; Key moments from the day’s sporting event sent as a “slide show”; and Text messages with animations.

Other multimedia services formerly carried only by broadband computer networks are also becoming increasingly popular in other countries and it is only a matter of time before these become available in the Philippines, i.e., video mail, video caller ID, video portal, and contact center enhancements.

Triple Play

The term “triple play” became a catchphrase referring to telcos becoming providers of “voice, video, and data.” Technically, both voice and video are also data, as well as other

9

applications that can be handled as data in a broadband network. It is therefore a matter of how much bandwidth is available (TechDirt, 2004).

The Telecommunications Sector in the Philippines

Policymaking and Regulatory Bodies

The Department of Transportation and Communications (DOTC) is the government body responsible for telecommunications policy (Figure 7). The National Telecommunications Commission (NTC), an agency of the DOTC, is the industry regulator. Republic Act 7925, “Public Telecommunications Policy Act of the Philippines,” passed in March 1995, is the main legislation of the telecommunications sector. The law sets out the duties and obligations of public telecommunications operators as well as interconnection rules. The Act endorses the policy of private ownership, instructs the government to sell remaining publicly-held telecommunications assets and also calls for operators to list up to 20 per cent of their shares to encourage citizen ownership. It also entrusts the NTC with the right to establish tariffs for telecommunications services (ITU, 2002).

Figure 7. Philippine Telecom Sector

Source: DOTC

Telecommunications Operators and Services

Table 3 enumerates the composition of the players in the telecommunications industry and shows the number of licenses issued by the NTC for the different telecommunications services. As of 2004, there were 73 local exchange carriers and seven licensed mobile phone service operators.

10

Table 3. Telecom Industry Structure, 2002-2004

2002 2003 2004 Local Exchange Carrier Service 74 73 73 Inter-Carrier carrier service 14 14 14 International Gateway Facility 11 11 11 Radio Mobile Cellular mobile Telephone Subscriber (CMTS) 7 7 7 Public Trunk Repeater Service 11 11 10 Radio Paging Service 11 11 8 Value-Added Service With Networks Coastal 12 13 18 Broadband 19 19 19 Without Networks 186 249 292

Source: NTC

The telephone market was virtually a monopoly of the Philippine Long Distance Telephone Company (PLDT) which provided 95 percent of the fixed telephone lines until 1993 when the industry was opened up to other players and deregulated.

The cellular mobile phone, on the other hand, is dominated by Globe Telecom and SMART Communications, each having an almost equal share in 82 percent of the market in 2004 (Table 4). SMART currently has the biggest share, having acquired Piltel. SMART is a subsidiary of PLDT. Digitel’s Sun Cellular phone is picking up in the market, getting popular with its unlimited Sun-to-Sun calls and texts for a fixed rate.

Table 4. Number of Mobile Phone Subscribers per Operator, 2002-2004

Operator 2002 2003 2004

Bayantel Not operational Not operational Not operational Digitel Not operational 732,467 1,200,000 Extelcom 29,896 29,896* 13,670 Globe 6,572,185 8,800,000** 12,513,973** Islacom 181,614 - - Piltel 1,773,620 2,867,085 4,612,450 SMART 6,825,686 10,080,112 14,595,782 Total 15,383,001 22,509,560 32,935,875

Source: NTC, 2005. * no report submitted, based on old report ** Globe and Islacom subscribers combined under Globe

Another milestone in 1993 was Executive Order 109 (EO 109) that mandated the then nine mobile cellular and international telephone service providers to also install a total of four million fixed telephone lines, or more than quadruple than the number that existed at the end of 1993. Operators were assigned to different regions of the country to ensure even roll-out. In addition, at least ten per cent of the lines were to be installed in rural areas.

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As a result, more than six million lines were in fact installed by 2000, but only 52 percent were in use by 2004, with PLDT still holding more than 60 percent of the local fixed line subscribers. A major reason for the slow take-up is a mismatch between supply and demand: the lines were installed in places where people could either not afford them or did not want them (ITU, 2002). Moreover, by mid-1990s, the Filipino’s appetite was greater for mobile telephones, and the growing competition for mobile phone caused its subscription prices to drop. The popularity of the mobile phone was generally unforeseen when EO 109 was crafted. Eventually, it was the fixed line services that adopted features of the mobile phone services such as pre-paid services and texting messages.

Market and Revenues

As expected, the market prefers what is “faster, cheaper, and better”. As discussed, this is the trend for mobile phone technologies and applications. In spite of prices getting cheaper, the increasing number of users and applications is foreseen to increase revenues from mobile phone subscriptions. Table 5 shows a significant 21 percent annual increase in revenues from mobile phone use for the period 2002 to 2004 for SMART and Globe, and this trend will likely continue in the next decade.

Table 5. Revenues of SMART and Globe from Wireless Service, 2002-2004 2002 2003 2004

Amount in P ‘000

% Change

Amount in P ‘000

% Change

Amount in P ‘000

% Change

SMART Communications

/1

28,524,971 39,929,992 40.0% 52,268,859 30.9%

Globe Telecom

/2 41,161,222 44,464,953 8.0% 49,903,246 12.2%

Total 69,686,193 84,394,945 21.1% 102,172,105 21.1% 1/ Source: SMART Communication Annual Reports 2003 and 2004 submitted to NTC

2/ Source: Globe Telecom Consolidated Financial Statements 2002, 2003, 2004, submitted to Securities Exchange Commission (SEC)

Total revenues from mobile phone use is a function of 1) number of users and 2) average revenue per user (ARPU). ARPU, on the other hand, is a function of 1) usage per user, and 2) prices of services.

Total Revenues = No. of Users * ARPU

= No. of Users * (Usage per User * Price of Services)

As will be discussed below, the number of users is still far from saturation and hence is still expected to increase. On the other hand, while prices tend to drop, with increased variety of bandwidth-heavy applications being made available to mobile phone subscribers, the overall usage per user is still expected to bring about increasing ARPU and corresponding continuous increase in the revenues for the mobile phone industry.

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Trends in Number of Users

Figure 8 shows that there are 33 million mobile phone subscribers in 2004, and is expected to increase to 58 million by 2009. Going back to Figure 2, this translates to 61 mobile phone subscribers for every 100 population in 2009. This is on the assumption that one person has only one subscription. While figures are not available, it is common knowledge that many subscribers have more than one mobile phone subscriptions. The market, therefore, is still far from saturation and it can be expected that the trend will continue to rise beyond 2009. In some countries such as the United Kingdom, penetration rate is as high as 99 percent.

Figure 8. Current and Projected Number of Mobile Phone Subscribers, 2002-2009.

15,383

22,510

32,93639,643

45,77949,923

54,04457,853

0

15,000

30,000

45,000

60,000

75,000

2002 2003 2004 2005 2006 2007 2008 2009YEAR

Mobile Phone Subscribers ('000)

Sources: 2002-2004: NTC 2005 to 2009 Projections: The Economist Economic Intelligence Unit Trends in Usage

On top of voice services, SMS and MMS are increasing the revenues gained from mobile services. In fact, for SMART, revenues from SMS and MMS alone already exceed revenues from voice calls (Table 6).

13

Table 6. Breakdown of Revenues of SMART and Globe from Wireless Service 2002 2003 2004

AMOUNT IN P ‘000

% CHAN

GE

AMOUNT IN P ‘000

% CHAN

GE

AMOUNT IN P ‘000

% CHAN

GE SMART Communications Cellular mobile Service Revenues /1

Airtime Fees 13,294,579 18,257,067 37.3% 20,392,331 11.7% International Roaming 665,942 1,007,768 51.3% 1,985,876 97.1%

Text Messaging 14,258,380 20,217,468 41.8% 29,370,381 45.3% Registration Fees (4,831) 181 -

103.8% 46 -74.9%

Subscription Revenues 310,900 447,508 43.9% 520,225 16.2%

Total 28,524,971 39,929,992 40.0% 52,268,859 30.9%

Globe Telecom Net Operating Revenues from Wireless Services /2 Voice 22,611,293 27,820,688 23.0% 27,722,035 -0.4% Data 12,574,267 14,772,873 17.5% 19,332,387 30.9% Others 5,975,662 1,871,392 -68.7% 2,848,824 52.2% Total 41,161,222 44,464,953 8.0% 49,903,246 12.2% 2002 2003 2004V Total Revenues /3

Amount in P ‘000

% Share

Amount in P ‘000

% Share

Amount in P ‘000

% Share

for Voice Calls 35,905,872 57.2% 46,077,755 56.8% 48,114,366 49.7% for SMS and MMS 26,832,647 42.8% 34,990,341 43.2% 48,702,768 50.3%

Total 62,738,519 100.0% 81,068,096 100.0

% 96,817,134 100.0%

1/ Source: SMART Communication Annual Reports 2003 and 2004 submitted to NTC 2/ Source: Globe Telecom Consolidated Financial Statements 2004, 2003, 2002, submitted to Securities Exchange Commission (SEC) 3/ Assumes airtime fees of SMART and voice of Globe constitute voice calls; and text messaging revenue of SMART and data revenue of Globe constitute SMS and MMS.

For Globe, revenues from data have not yet exceeded revenue from voice calls, but the combined revenues of both Globe and SMART for data has already exceeded that from voice calls, as shown in Table 6 and illustrated in Figure 9.

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Figure 9. Wireless Service Revenues of SMART Communications and Globe Telecom, in

Thousand Pesos, 2002-2004

-20,000,00040,000,00060,000,00080,000,000

100,000,000120,000,000

2002 2003 2004

Voice Data

Source: Derived from Globe Telecom Consolidated Financial Statement, 2002, 2003, 2004 The increasing revenues from data (or SMS and MMS) can be attributed both to the volume of SMS, as well as to the sizeable bandwidth that is used by MMS applications. MMS is therefore charged much more than the SMS that uses very little bandwidth. As the volume of MMS usage also increases, significant increases in revenues can also therefore be expected.

The same trend is observed in some saturated mobile markets in Europe, where revenues from SMS and MMS already almost exceed revenues from calls and monthly fees (Intel, 2005). The Philippines is expected to follow this trend.

Trends in Prices of Services

The telecommunications price curve is dubbed as the hockey stick curve for its shape (Figure 10). It typically exhibits a significant price drop followed by continuing slower downward drifts (IT Pro, 2005). The deployment of new technology – a platform change – enables the initial price drop. Market factors, such as competition, then allow the ensuing slower downward price drift.

Figure 10. Telecommunications Price Curve: The Hockey Stick Curve

P r i c e

T i m e

Source: Adopted from IT Pro, 2005

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The prices of the different applications generally follow the same trend. Per minute prices of voice calls, for instance, was P14 in the late 1990s, P8 in the early 2000s, and now can be as low as P4 for off-peak hours.

Overall Trend in ARPU For the period 2002-2004, the ARPU in fact exhibited a decreasing trend (Table 7). This can be attributed to the fact that the increase in usage during this period was due to SMS, which costs little, while the growth in usage of the more expensive voice calls slowed down. However, with the advent of bandwidth-heavy applications as discussed above, the overall ARPU is expected to increase soon, if it has not done so yet after 2004. Table 7. Average Revenue per User, 2002-2004

2002 2003 2004 Revenues from Wireless Service 69,686,193 84,394,945 102,172,105 No. of Users 15,383,000 22,510,000 32,936,000 Ave. Revenue per User (ARPU) 4.53 3.75 3.10

Source: From Tables 5 and 6

B. E-LOAD DISTRIBUTION NETWORK

Mobile Phone Subscription Modes: Post-Paid and Pre-paid

End-users may avail of mobile phone services in two modes of subscription: post-paid and pre-paid. Post-paid subscriptions are paid monthly and the amount to be paid depends on the usage for the month. For pre-paid subscriptions, on the other hand, airtime credits or load is bought and credited/loaded into the mobile phone units and can be consumed within a certain period of time (i.e. pre-loaded credits have an expiration date).

Pre-paid subscription is by far the more popular mode of subscription. For the past five years, 98 percent of SMART subscribers have been pre-paid subscribers (Figure 11).

Figure 11. Post-Paid and Pre-paid Mobile Phone Subscribers, SMART Communications, 2001-2005

0

3,000,000

6,000,000

9,000,000

12,000,000

15,000,000

2001 2002 2003 2004 2005

PostpaidPrepaid

Total

Source: SMART Communications

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Pre-paid credits were originally sold through load cards which contained numeric codes to be entered into the mobile phone to obtain credits. The card came in denominations of P500, P300, and P100.

It was in May 2003 when Smart Communications introduced sale of credits through the electronic transfer of load from the retailer to the end-user. The loads came in denominations as low as P30. This adoption to the sachet or “tingi” mentality of the Filipinos proved to be a success and enticed even the poorest population to participate in the market. Not long after, Globe and Sun Cellular also sold credits through electronic loading in denominations as low as P15. This paper shall refer to this electronic manner of providing airtime credits to a consumer or end-user as e-loading, and the load or airtime credits sold or received by end-user as e-load1. E-loading Mechanism

Figure 12 illustrates the mechanism by which e- loading takes place.


Three steps occur in the following order (refer to Figure 12):

4. The end-user pays the retailer to purchase e-load. The retailer obtains the customer’s/end-user’s cell phone number.

5. The retailer then sends an SMS to the telco requesting that load be credited to the

customer, indicating the customer’s number and the amount to be loaded.

The retailer has a SIM that is programmed as a retailer SIM. That is, the retailer SIM can store load credits for reselling, and contains pre-set commands or functions that enables the retailer to send an SMS to the telco requesting that load credits be transferred from the retailer SIM to the end-user’s SIM. The retailer SIM should contain credits at least worth the amount being requested to be loaded to the customer.

This function is available only in retailer SIMs and not in ordinary end-consumer SIMs.2

1 The pre-paid card had a variation wherein codes were printed on sealed paper. Globe also referred to this as Globe Eload, but the term e-load is now more commonly used to refer to sending of phone credits through electronic transfer, as it is defined and used in this study.

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6. The telco sends an SMS to the end-user’s cell phone informing that it (the end-user’s

phone) has been loaded airtime credits worth the amount purchased.

The telco also sends an SMS to the retailer SIM to confirm that the amount requested has been loaded to the customer, and that the same amount has been deducted from the retailer SIM.

The Retailers

We shall qualify retailers according to the method that they receive payments from end-consumers.

Retailers Paid in Cash

In Step 1 in Figure 12, the end-user usually pays the retailer in cash. The value of e-load bought can be as low as P15.

To become this type of retailer of e-load, one only needs a mobile phone unit, a retailer SIM card, and to provide basic information such as name and address. The SMART application form asks for the Tax Identification Number; Globe does not. This oversimplification of requirements and the reported high revenues from e-load retailing has created a new class of entrepreneurs that included, among others, sari-sari stores, housewives, students, and other roving agents. Bigger establishments such as 7-Eleven and other large retail stores likewise retail pre-paid phone credits including e-load.

Retailers Paid Electronically

The very nature of electronic loading also allows electronic payments for cashless purchase of e-load. This is made possible through banks, credit card companies, and other electronic payment facilities such as PayPal. These entities, in effect, function as retailers and the e-loading mechanism follows that shown in Figure 12. The only differences with the ordinary retailers are that no physical cash is transferred during the time of transaction, and amounts to be loaded come in bigger denominations of at least P300.

For banks, an end-user enters the necessary information – cell phone number and amount to be loaded - through the automated teller machine (ATM). For credit cards, the information is sent via an SMS with a charge of P2.50, higher than ordinary SMS. For PayPal, the information is sent through partner web services, such as Chikka.com.

It is assumed and has to be verified whether these entities have deposits with the telcos where payments for the load credits they resell are charged against.

2 This is different from Share-a-Load of Globe or Pasa-Load of SMART, wherein an end-user can transfer load credits to another end-user. In the example above, the retailer loads were obtained at a discount (as will be discussed in the succeeding paragraphs) and therefore transferring the credits is in fact reselling the credits at a profit. The retailer is not billed for the SMS that he or she sends for the transfer of loads to take place. In Share-a Load and Pasa-Load, the amount of load transferred was bought for the same price, hence no reselling takes place. Moreover, the person sending load is charged a fee of P1 for the transaction, deducted from the current credits in his or her phone. Therefore, Share-a-Load and Pasa-Load is an SMS application for convenience of end-users, and not for selling phone credits.

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Special Case: The Telco as the Retailer

In some instances, an end-user purchases pre-paid phone credits directly from the telco. Payments are made either in cash at the telco’s business center or electronically through an electronic wallet or e-wallet, a facility wherein an end-user can store money credits in his or her cell phone. The e-wallet mechanism will be discussed in greater detail at the latter part of this section.

E-Load Distribution Chain

In discussing the e-loading mechanism, there are three parties involved: the telco, the retailer, and the end-user. Like many “goods” or “commodities,” pre-paid credits usually pass through a chain of distribution channels.

Figure 13.a shows at least three levels of distribution of pre-paid phone credits, whether in the form of card or e-load: telco-to-wholesalers, wholesalers-to-retailers, and retailers-to-end-user. This can be a simplistic representation of the distribution network because at present, there may be several more layers of merchants in between the wholesaler and retailer levels. For purposes of discussion, we shall use the following terminologies for the players in the chain:

1. telco – the provider of the telecommunications service. 2. wholesalers – those directly purchasing from the telcos and reselling either to sub-dealers

or directly to retailers. They usually purchase in bulk amounting to hundreds of thousands to millions of pesos.

3. retailers - those directly selling to the end-users. They usually purchase in much less

bulk than the wholesalers, about a few thousands or a few hundreds of pesos at a time.

4. wholesaler-retailers - those directly purchasing from the telcos and reselling directly to end-users.

5. sub-dealers (not shown in figure) – those purchasing pre-paid phone credits from a

wholesaler or from another sub-dealer, and reselling to retailers or another sub-dealer. They do not purchase directly from the telcos and do not resell directly to end-users; hence, they constitute the distribution channels in between the wholesalers and retailers.

We shall refer to the wholesalers, sub-dealers, and retailers collectively as merchants.

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Figure 13.a Three-Level E-Load Distribution Chain

In many instances, wholesalers also sells directly to end-users, thus , they act both as wholesalers and retailers (Figure 13.b). This is usually the case for retailers that are paid electronically (credit card companies, banks, etc.) Retailers which receive cash payments may of course also do this. On the same note, many retailers who do not make bulk purchases can also obtain their load directly from the telcos.

Figure 13.b Two-Level E-Load Distribution Chain: The Wholesaler as Retailer

Wholesaler-Retailer

Still in some instances, selling of pre-paid credits do not pass through any merchant, but is a direct transaction between the telco and the end-user (Figure 13.c). As mentioned, this transpires when the end-user pays the telco directly in the business centers or uses e-wallet to purchase the e-load.

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Figure 13.c E-Load Distribution Chain: End-User Directly Buying from Telco

Telco

End-user

End-user

End-user

Proximity and affordability are major determinants of where retailers and end-users obtain their load for reselling and for use, respectively. Retailers with relatively easy access to the business centers of telcos in the urban centers deal directly with the telcos. On the other hand, some other retailers find it easier to deal with wholesalers or subdealers.

As for the end-users, some end-users may find electronic payments convenient. Most users, however, do not have access to banks, credits cards, and other electronic payment facilities and thus buy pre-paid credits from stores or individual retailers as they would with any other merchandise. The observed end-user preference is to purchase load in small denominations and to pay in cash rather than pay electronically.

Telco Agreements with Wholesalers and Retailers Wholesalers Wholesalers are especially useful to telcos in signing up retailers who will not likely go directly to the business centers, such as sari-sari store owners who do not have the luxury of going to the business centers as often as the credits for reselling need replenishing. Potential wholesalers are usually required to provide a list of potential retailer-clients and are imposed a quota or minimum amount of credits to be purchased every month, although special concessions can be made. Wholesalers are provided a wholesaler SIM which is also programmed to receive discounted credits. Retailers As mentioned, retailers are recruited proactively by wholesalers. On the other hand, any interested entity, whether a business or an individual, can also go directly to the telco business centers to apply as retailer. For Globe, one can immediately register as a retailer by purchasing a retailer SIM and the first tranche of load for reselling. For SMART, interested parties usually first undergo a group orientation conducted by in-house sales managers in various locations. Flyers with details of benefits for retailers are also available in the business centers and given out during orientation sessions. Samples of these information materials and a pro-forma agreement with a retailer are provided in Annexes A and B, respectively. With this active recruitment, the telco-retailer transactions are very transparent, whether conducted directly or passing through layers of merchants.

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E-Load Value Chain Figure 14 below depicts the values involved in the distribution chain for pre-paid load credits with a street value (i.e. the amount that an end-user pays) of P100, assuming a 14 percent discount rate for the retailer and 5 percent for the wholesaler. Figure 14. E-Load Value Chain/1

1/ The case of Globe Telecom The example above is the case for Globe wherein retailers get an outright 14 percent discount while wholesalers may obtain varying discount levels depending on agreements with the telco and the volume of load purchased for reselling. As shown, when the retailer pays the dealer (or the telco directly, as the case may be) P86, the retailer SIM gets P100 worth of credits, which he can then sell for P100.

SMART has a more complicated scheme wherein retailers get varying discounts for different amounts of e-load sold, as follows:

Table 8. Discount Rates for SMART E-Load Retailers

DENOMINATION

AMOUNT DEBITED

FROM RETAILER

(INCLUSIVE OF EVAT),

(PHP)

ACTUAL AIRTIME AMOUNT

LOADED TO SUBSCRIBER

(PHP)

TOTAL FREE SMS

LOADED TO SUBSCRIBER

DAYS VALID

30 26.5 26 4 3 60 53 52 8 6

115 102 100 15 12 300 290 300 33 60 500 483.5 500 83 60

1000 967 1000 250 60 200 193.5 190 40 30 10 8.75 1 10 1

Source: SMART Communications

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Verification of Value Chain with Financial Information from Wholesalers A list of e-load wholesalers or distributors with direct purchases from the telcos were solicited through the NTC from the three major telcos. Only SMART Communication and Digitel complied. The study then made an examination of the financial statements of the first-level wholesalers or distributors with over P500 million purchases from SMART Communications. A verification of the registration status of these entities with the Securities Exchange Commission (SEC) in the case of corporations and business partnerships, and the Department of Trade and Industry (DTI) in the case of sole proprietorships, indicates that not all of them have the requisite registration or are at least in good standing or compliant with reporting requirements of these agencies, particularly in the case of those registered with the SEC The audited financial statements of three SEC-registered wholesalers which were submitted to the SEC indicate that their gross profit rates ranged from 0.3 percent to 1.2 percent, or an average gross profit rate for the three of 0.65 percent (Table 9). This is way below the 4.65 percent gross profit rate that they should be reporting if the gross profit is to be based on the value chain of e-load distribution. Moreover, the net income rate before tax is also very low at 0.05 percent to 0.19 percent. This suggests a very high overhead (i.e., general, administrative, and selling expenses), which is also inconsistent with the description of the operations of e-load merchants. The findings from the audited financial statements of the three major retailers is summarized below. Table 9. Summary Observations on Financial Statements of Selected E-Load Distributors/Wholesalers

Wholesaler

Sales Per SMART

Communications Record (Feb-Dec

2005)

Remarks

Wholesaler 1 P 767,320,455 (derived annual: P 837,076,860)

Latest available audited F/S with SEC is 2002, thus it may not include any e-load sales but its sales includes prepaid card sales of P608,935,415. It is engaged in other businesses such as sale of units and services but has itemized Sales figure in its F/S. It is possible that it is also selling prepaid or e-load for Globe, in which case, its audited F/S Sale from Cards/E-load should be significantly

Wholesaler 2 P 1,619,891,636 (derived annual: P 1,767,154,152)

Minimal capitalization. There is no indication whether its sales consists solely of sale of prepaid card/e-load sales. Gross profit (P14,261,758) rate is 1.2% and net income (before tax P2,312,330)rate is 0.19%

Wholesaler 3 P 1,311,322,238 (derived annual: P 1,430,533,349)

The purpose clause of its Articles of Incorporation indicates authority to engage not only in trading but also performance of services. Thus, it is not clear how much of its sales is attributable to sale of prepaid card/e-load. It also needs to be determined if it is also selling Globe prepaid cards/e-load. Gross profit (P4,866,206) rate is 0.3% and net profit (before tax- P892,424) rate is 0.056%.

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It must be noted that the computed gross profit and income rates of each of the three firms do not pertain only to the e-load business but to their entire business. Each is registered to be eligible to engage in other trading/business transactions, but the figures in their financial statements do not provide a breakdown of their revenue from each of the various types of trading/business transactions that they pursue. It must be noted, however, that the sales figures reported in the 2002-2004 financial statements are not very far from the SMART e-load sales to these firms in 2005. Moreover, it is highly likely that these companies also trade Globe and Sun Cellular e-load and pre-paid cards. These also suggest the need for scrutiny of the financial reporting of these companies.

The Mobile Phone as Electronic Wallet Used in Buying and Selling E-Load

Electronic transactions are now not only limited to selling and transferring airtime credits. The ability to hold money denominations has made the cell phone a virtual wallet, holding amounts of money that can be used in purchasing commodities from participating stores and transferable from one phone to another similar to sending “money.” This is called SMART Money and G-Cash, respectively, by SMART and Globe, and will be referred to as virtual wallet or electronic wallet or e-wallet in this paper. With e-wallet, the phone subscriber initially registers as an e-wallet user. He or she can then remit an amount in a telco business center, afterwhich the amount will be loaded by the telco in his virtual wallet3.

The e-wallet can then be used to purchase commodities in participating commercial establishments. Moreover, this can be used in sending “money” electronically between two geographically-distant persons by sending value/credit from one’s e-wallet to the other party’s e-wallet. This can have a huge impact in commerce, but in this study, the focus of discussion is the way it is used in purchasing load credits. SMART Money and G-Cash can be used to purchase airtime credits both for retailer SIMs and end-user SIMs.

Purchasing Credits for Retailer SIMs A retailer may load money in his e-wallet so that he need not have to go to the business center everytime he needs to replenish load credits to his retailer SIM. As depicted in Figure 15.a, the retailer loads money in his e-wallet by paying the equivalent amount to the telco business center, in addition to a nominal transaction fee. In buying e-load for his retailer SIM, he prompts the telco to credit him a certain amount of credits at street value, to which the telco responds by deducting the discounted amount from his e-wallet and then loading his retailer SIM with the amount of load purchased. He can then resell these credits to end-users, including himself. Load credits intended for resale by retailers have to be sold within a prescribed number of days. The expiry date for the resale of the load credits is reckoned from the date the same was credited/loaded to the retailer SIM. Hence, it is prudent for the retailer to load money in the e-

3This has a transaction cost of 1 percent of the amount loaded, or P10, whichever is higher.

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wallet and to load his retailer SIM only when necessary. The e-wallet option therefore, eliminates the need for the resellers to physically visit a telco office or a wholesaler to purchase load for resale, making the purchase of e-load credits significantly more convenient. Figure 15.a. Retailer’s Purchase of E-load for Reselling through E-wallet

Purchasing Credits for Personal End-user SIMs The convenience of having an e-wallet can also be enjoyed by end-users. An end-user may also load money in his e-wallet so that he need not have to go to the business center everytime he needs to load credits to his personal SIM.

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Figure 15.b End-User’s Purchase of E-load for Personal Use through E-wallet

In Figure 15.b, the same process takes place as in Figure 15.a except that the street value is deducted from the end-user’s e-wallet instead of a discounted value.

Illustration of Multi-functions of a SIM Card

A single SIM card can simultaneously function as an e-wallet, a retailer SIM, and an end-user SIM. In the example below, Pedro is a Globe AutoLoadMAx retailer. He uses his retailer SIM also as his personal cell phone and as his G-cash wallet. The table traces the flow of money among these three functions of the SIM.

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Table 10. Illustrative Example of Functions of a SIM Card as E-Wallet, Retailer SIM, and End-user SIM

Pedro’s G-Cash Account

Pedro’s Retailer SIM

Pedro’s End-User

Account

John’s end-user Account

Pedro’s Cell Phone/SIM Number 0917-1234567 0917-1234567

0917-1234567

0917-1434424

RESULTING CREDITS Current Credits: P 0 P 0 P 0 P 0 Transaction 1:

Pedro goes to Globe Center to load P500 in his G-Cash wallet (pays P500 in cash to Globe)

P500 P 0 P 0 P 0

Transaction 2: John buys P25 worth of load from Pedro

Not possible because Pedro’s retailer SIM has 0 credits

Transaction 3: Pedro buys P200 worth of load though his G-cash wallet

P328 (Pedro gets a P28 discount, i.e. only P172 is deducted from his G-Cash wallet))

P200 P 0 P 0

Transaction 4: John Buys P25 worth of load from Pedro

P328 P175 P 0 P 25

Transaction 5: Pedro buys P50 worth of e-load from himself

P328 P125 P50 P25

Transaction 6: Pedro buys a cell phone case worth P100 from a store and pays through his G-Cash (Assumes store is a participating establishment)

P228 P125 P50 P25

Transaction 7: Pedro sends five text messages worth P1/text

P228 P125 P45 P25

C. Current Taxation of E-Loading Business

There are two applicable taxes in the e-loading business: income tax and business tax. The business tax can either be the value-added tax (VAT) or the percentage tax.

Income tax

Taking off from the foregoing discussion on e-load distribution channels, it is clear that the following are the taxable participants in the sale of e-load: 1. the telephone companies; 2. the major wholesalers who have direct dealings with the telephone companies;

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3. the subdealers who deal with the major wholesalers and have no direct dealings in respect of the e-load business with the telephone companies; and

4. the retailers who may either deal directly with the telephone companies or deal with any of the wholesalers.

All of the foregoing participants in the e-load distribution chain stand to earn revenue from their sale and resale of e-load. Thus, to the extent that they realize taxable income, they are liable for income tax on such income. Income Tax on Telephone Companies Certainly, telephone companies selling their services on pre-paid basis actually pay income taxes. However, it is not clear from their audited financial reports as well as their income tax returns how much of their declared revenue is attributable to services sold on pre-paid basis. It is to be noted that revenue of the telephone companies is presented as an aggregate figure in their audited financial statements, as well as in their income tax returns. Thus, it is not also specified how much of their revenue from wireless service is attributable to pre-paid subscribers and how much is attributable to postpaid subscribers. Aside from the fact that revenues of telephone companies from pre-paid services is not presented separately, the related costs to render the said services are likewise not identified nor allocated in the financial statements and income tax returns of the telephone companies. Thus, this state renders it impossible to isolate the taxable income and the resulting income tax due on the pre-paid services being rendered by the telephone companies. Suffice it to say that, while revenue from wireless and wireline services are presented separately in some instances, the costs are never allocated into wireline service costs and wireless service costs. It may also need to be pointed out that for purposes of this study, we are assuming the completeness and accuracy of the revenue reported by the telephone companies in their financial statements and income tax returns. In a subsequent discussion, however, we point out revenue sources which may be difficult to track or monitor, and which therefore opens opportunities for non-declaration or under declaration of income.

Thus, as far as taxation of income from e-load is concerned, it would suffice to state that:

a. any income earned therefrom is subject to the regular corporate income tax of 35% of taxable

income, as increased by Republic Act No. 9337; and b. cash receipts from e-load are only recognized as revenue upon: (i) the actual use of the pre-

paid load to make calls, to send SMS or MMS, or passed on to another subscriber (as “pasaload”)4 or (ii) the expiry of the e-load three months from the date the e-load was credited to the telephone subscription.

Based on the foregoing, it is to be emphasized that, as far as the telephone companies are concerned, they treat the sale of e-load as a non-revenue generating event. Consistent with the fact that they are in the service business and they have adopted accrual basis of accounting,

4 Needs to be confirmed if pasaload is already deemed revenue upon the execution of the load transfer or it remains unearned revenue until the load is actually used by the recipient of the pasaload.

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income is not recognized until the service is actually rendered, except in the case when the load expires, in which case, they are no longer obliged to render any further service. This is consistent with the accounting rules on the matter. Under the Framework for the Preparation and Presentation of Financial Statements (PAS Framework) issued by the Accounting Standards Council (ASC), it is provided that—

Accrual Basis 22. In order to meet their objectives, financial statements are prepared on the accrual basis of accounting. Under this basis, the effects of transactions and other events are recognized when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. Financial statements prepared on the accrual basis inform users not only of past transactions involving the payment and receipt of cash but also of obligations to pay cash in the future and of resources that represent cash to be received in the future. Hence, they provide the type of information about past transactions and other events that is most useful to users in making economic decisions. X x x. (underscoring ours)

Paragraph 20 of Philippine Accounting Standard (PAS) 18 concerning revenue further provides the following on the timing of recognition of income:

When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognized by reference to the stage of completion of the transaction at the balance sheet date. The outcome of a transaction can be estimated reliably when all the following conditions are satisfied: (a) the amount of revenue can be measured reliably; (b) it is probable that the economic benefits associated with the transaction will

flow to the entity; (c) the stage of completion of the transaction at the balance sheet date can be

measured reliably; and (d) the costs incurred for the transaction and the costs to complete the

transaction can be measured reliably.

Simply stated, revenues should be considered earned when the entity has substantially accomplished what it must do or perform to be entitled to the benefits represented by the revenues.

A review of the audited financial statements of the telcos indicate that they uniformly recognize income from the sale of e-load when the service has been rendered, i.e., the load has been used or when the unused load expires. In the meantime that neither of these events has taken place, the proceeds of the sale of e-load is booked as unearned revenue. Based on a presentation made by Globe to the BIR, however, it is represented that Globe recognizes the proceeds from the sale of e-load as income for income tax purposes immediately upon the happening of the sale, irrespective of the date when the load credits sold are used or expire. Thus, it is represented that this difference between the accounting and tax treatment of the sale of e-load is one of the items reported in the reconciliation (of accounting income with tax

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income) portion in the annual income tax return (ITR). Globe further represents that VAT thereon is accrued at the time of sale. It is not certain, however, if this is true for all telcos as we had no access to the annual ITR of the telcos but this fact can easily be verified by the BIR. Assuming that the sale of e-load is actually being recognized by the telcos as part of gross revenue declared for income tax purposes in the quarter the sale was made, we note that there is really no categorical legal requirement for such treatment. It appears that this is rather a voluntary move on the part of the telcos to recognize it earlier. In fact, this may be the reason why the proposed regulations for telcos drafted in 20045 specifically included a provision requiring telcos to immediately reflect their pre-paid cards sales as taxable income at the time of sale. Section 8.3 of the proposed regulations on the telecommunications industry, provides:

SIM and Pre-paid Cards – Tax Treatment on Original Sale of SIM and Pre-paid Cards – Telecommunications companies shall recognize income and accrue the VAT liability upon transfer or at the point of sale of the cards. The output tax shall be computed by multiplying the sales amount with the factor 1/11.

Without any categorical regulation requiring the recognition of proceeds from the sale of e-load or pre-paid cards as part of taxable income in the quarter that the sale is consummated, existing regulations permit telcos to actually recognize the same at a later period, i.e., at the time they are actually recognized as earned for accounting purposes. As discussed above, it is within the bounds of generally accepted accounting practice, specifically under accrual accounting, to recognize income in this instance at the time the service is actually rendered rather than at the time cash is received. On the other hand, Revenue Regulations No. 2 (the Income Tax Regulations), as amended, a rather dated but still authoritative regulation, allows the time of reporting of income to be consistent with the time of recognition of income prescribed under an accrual method of accounting. This is clear when Revenue Regulations No. 2 expressly provides:

Section 51. When income is to be reported. - Gains, profits, and income are to be included in the gross income for the taxable year in which they are received by the taxpayer, unless they are included when they accrue to him in accordance with the approved accounting method of accounting followed by him. X x x.

Accordingly, even assuming the telcos are uniformly voluntarily recognizing income from the sale of pre-paid cards or e-load at the time of sale, such treatment should be made a legal requirement by the adoption of a categorical rule on the matter, by way of a revenue regulation specifically applicable to telcos. Income Taxation of the Wholesalers, Subdealers, Retailers There is no categorical rule at this time whether the sale of e-load by the participants in the distribution chain is treated as sale of service or a mere sale of goods. Even the 2004 draft revenue regulation intended to address telecommunications industry issues does not clarify whether the sale of pre-paid cards is to be deemed a sale of goods rather than a

5 This proposed revenue regulation referred to has not been finalized and it appears that the draft has actually been withdrawn as it has been taken out of the BIR webpage where it was previously posted for comments.

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sale of the underlying telecommunications service. The clear policy of the BIR on how such sales should be treated is necessary as it is crucial in determining the following— (a) where the income from the transaction is deemed earned; and

As provided under Section 42 of the NIRC, income from the sale of goods will be taxable in the place where the sale is consummated while income from the sale of services is deemed earned in the place where the service is rendered or performed. Sec. 42 provides, in part, as follows:

SEC. 42. Income from Sources Within the Philippines. — (A) Gross Income From Sources Within the Philippines. — The following items of gross income shall be treated as gross income from sources within the Philippines: (1) X x x X x x. (3) Services. — Compensation for labor or personal services performed in the Philippines; X x x. (6) Sale of Personal Property. — Gains, profits and income from the sale of personal property, as determined in Subsection (E) of this Section. X x x. Gains, profits and income derived from the purchase of personal property within and its sale without the Philippines, or from the purchase of personal property without and its sale within the Philippines shall be treated as derived entirely from sources within the country in which sold: x x x. (emphasis ours)

(b) the timing of the payment of VAT, which shall be further discussed below. Assuming there are no cross-border elements (e.g. the place of sale is abroad) in the e-load sale transactions of telcos, as is generally the case, the issue of characterization of the sale of e-load as either a sale of goods/personal property or service would be irrelevant. In such case, the income that the wholesalers and distributors will earn from the e-load business will be imposed income tax at the rate of 35% in the case of a corporate income earner and up to 32% in the case of individuals. On the other hand, a more complex situation arises in instances where there is a cross-border element which comes into play. For example, assuming the sale of e-load is done abroad, the following will be the consequences for income tax purposes, depending on the tax classification of the seller and the characterization of the e-load sale transaction:

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Classification of Seller/Tax treatment Characterization

of E-load Sale Domestic

corporation6/Resident Filipino

Foreign corporation7/alien (whether or not resident)/non-

resident Filipino

1. Sale of service Income is taxable in the Philippines

Income is taxable in the Philippines because the income is deemed earned in the Philippines

2. Sale of tangible good

Income is taxable in the Philippines

Income is NOT taxable in the Philippines because income is not deemed earned in the Philippines

While it appears that the characterization of e-load sale as sale of goods is more imaginable and appears more logical considering that the resellers are not telcos who are in the position to sell any telco service and neither are they mere agents of the telcos, this characterization issue is actually a legitimate issue that has been identified even in foreign jurisdictions as early as the era of phone cards. In fact, the issue is more complicated at this time because there is not even any a tangible representation of what is being sold, unlike in the case of sale of pre-paid phone cards. Thus, in the paper by David Meyer on “Taxation of Telecommunications in the District of Columbia”,8 on the topic of policy perspectives, he wrote:

Should pre-paid phone cards (PPCs) be taxed by a retail sales and use tax or like other telecommunications services? An issue of great interest to the telecommunications industry and the states in the last few years has been the taxation of pre-paid telephone cards. These cards allow a consumer to purchase “units” of telephone service in advance. Revenue from the sale of these cards is in excess of $1 billion per year nationally and growing. Some industry observers envision the use of these cards expanding beyond telephone service to include other products, services, or goods. There is no clear single national trend regarding the taxation of PPCs, although many industry advocates have urged the states to enact one standard. There appears to be two general policy options: (1) subject telecommunications services paid for through use of PPCs to telecommunications taxes on the value of the telecommunications service at the time of use or (2) Tax PPCs as tangible personal property, subjecting the value of PPCs to taxation through sales and use taxes. Several states, including the District, tax the cards as tangible personal property but a majority of the states require telecommunications taxes to be paid on the value of the telecommunications services at the time the card is used. Richard McHugh reported in 1996 that PPCs were taxed at the point of sale in 11 states at the time of use in 30 states, at the discretion of the seller in one state, and not at all in nine states.

6 The term 'domestic,' when applied to a corporation, means created or organized in the Philippines or under its laws. (Sec. 22, National Internal Revenue Code). 7 The term 'foreign,' when applied to a corporation, means a corporation which is not domestic. (Sec. 22 of the NIRC) 8 Authored by David Meyer, Tax & Economic Policy Administration, Office of Tax and Revenue, Washington, D.C. and presented to the Committed on State Taxation.

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It was noted that while the 2004 proposed regulations on the telecommunications industry laid down the proposed policy on the timing of recognition of income from original sale of pre-paid cards by the telcos, it is silent on the timing of recognition of income from subsequent sale of pre-paid cards, which could have been applied by analogy to the subsequent sale of e-load.

Business tax 1. Value-added tax

Pursuant to Section 1059 of the NIRC, the sale of goods and services in the Philippines are subject to VAT which is now at the rate of 12 percent. Telcos are generally subject to VAT on their sale of telecommunications services, regardless of the terms of their payment, i.e., postpaid or pre-paid. Likewise, all the distributors, wholesalers, and retailers are subject to VAT on their sale of e-load, except if they have basis to invoke exemption from VAT. On both the level of the telcos and the retailers, the characterization of the sale of e-load as either sale of goods or sale of services, as discussed above, is not initially critical for purposes of concluding that their e-load transactions would attract VAT. This is not to say that the characterization of e-load sales does not have any significance as far as VAT is concerned. The characterization of e-load sales as sales of goods or sale of the underlying services will be determinative of the timing of the accrual of VAT on the sale.

VAT at the Telco Level At the telco level, there is no question that telco sale of e-load constitutes sale of the underlying service rather than a mere sale of tangible goods. Accordingly, VAT on service as imposed under Section 108 of the NIRC is the relevant provision. As such, VAT on e-load sales should attach from the moment the cash is received. The pertinent provision of the NIRC provides:

SEC. 108. Value-added Tax on Sale of Services and Use or Lease of Properties. – (A) Rate and Base of Tax. - There shall be levied, assessed and collected, a value-added tax equivalent to ten percent (10%) of gross receipts derived from the sale or exchange of services, including the use or lease of properties: Provided, That the President, upon the recommendation of the Secretary of Finance, shall, effective January 1, 2006, raise the rate of value-added tax to twelve percent (12%), after any of the following conditions has been satisfied:

9 SEC. 105. Persons Liable. — Any person who, in the course of trade or business, sells, barters, exchanges, leases goods or properties, renders services, and any person who imports goods shall be subject to the value-added tax (VAT) imposed in Sections 106 to 108 of this Code. X x x.

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X x x. The term 'gross receipts' means the total amount of money or its equivalent representing the contract price, compensation, service fee, rental or royalty, including the amount charged for materials supplied with the services and deposits and advanced payments actually or constructively received during the taxable quarter for the services performed or to be performed for another person, excluding value-added tax. (underscoring ours)

Thus, whether or not the income has been earned, as long as the cash payment for services still to be rendered has been received, the same should already be subjected to VAT. Thus, unlike in income taxation where the receipt of cash may not necessarily have an impact on the amount of taxable income, for VAT, the receipt of cash immediately triggers the obligation to report the same for VAT purposes. The VAT treatment of the proceeds of e-load sales as gross receipts from the sale of services is consistent with the position of the telcos for accounting income purposes that until the service is rendered, e-load sales are not recognized as income. However, although the proceeds of e-load sales should immediately be reported for VAT purposes, there may be a need to subsequently make adjustments on the amount of sales properly subject to VAT if the e-load credits purchased are subsequently partially used for overseas communication, whether it consists of an international call, SMS, or MMS. For overseas calls, SMS and MMS originating from the Philippines, the revenue is subject to Overseas Communications Tax under Section 120 of the NIRC (see discussion under percentage tax on telcos). Thus, under Section 8.3 and 8.4 of the 2004 proposed regulations governing telcos, it is provided that—

SIM and Pre-paid Cards – a. Tax Treatment on Original Sale of SIM and Pre-paid Cards – Telecommunications companies shall recognize income and accrue the VAT liability upon transfer or at the point of sale of the cards. The output tax shall be computed by multiplying the sales amount with the factor 1/11

. a. Overseas Communications Tax on Pre-paid Cards – The applicable ten percent (10%) overseas communications tax on international toll calls made using the pre-paid card shall be paid by the telecommunications company by effecting an adjustment to the output VAT liability which was recognized on the original sale of the cards. X x x.

8.4 Short Messaging Services (SMS) or Multimedia Messaging Service (MMS). –

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A) Local SMS/MMS – Income from local SMS (i.e., text message) or MMS (i.e., image or audio, or combination of both), which is sent to a subscriber of the same or another local PTE, is subject to the 10% VAT, unless they are bundles in other services that are already subject to the 10% VAT. B) International SMS/MMS – Income from international SMS/MMS, which is sent to a subscriber of an FA shall be subject to the 10% OCT.

The materials from the Globe presentation to the BIR indicate that such adjustment to output VAT and the recognition of OCT payable is actually being done if the pre-paid load is subsequently used to send SMS or MMS or call overseas. We had no access to the VAT declarations and quarterly declarations of the telcos, but in any case, it would not be ascertainable from the VAT returns/declarations whether they are in fact paying VAT on their sale of pre-paid load. In preparing VAT returns and declarations, a taxpayer is not required to itemize the sources of the gross revenue/receipts on which it is paying VAT. Notwithstanding the indication in the audited financial statements of the telcos that they are paying OCT instead of VAT on outbound calls, SMS, and MMS, we note that there is actually an option under the NIRC for taxpayers subject to percentage tax under Title V of the NIRC (e.g., OCT) to opt to be subject to VAT instead.

SEC. 109. Exempt Transactions. - (1) Subject to the provisions of Subsection (2) hereof, the following transactions shall be exempt from the value-added tax: X x x; (E) Services subject to percentage tax under Title V; (2) A VAT-registered person may elect that Subsection (1) not apply to its sale of goods or properties or services: Provided, That an election made under this Subsection shall be irrevocable for a period of three (3) years from the quarter the election was made.

VAT on Distribution Channels As discussed above, it is not clear at this point whether the BIR treats the sale of e-load by the participants of the distribution channel as a sale of tangible goods or sale of services. There is no revenue regulation or other BIR issuance or ruling which provides or discusses how e-load sales should be characterized. It would seem odd for the sale of e-load by the wholesalers, sub-dealers, or retailers to be characterized as the sale of the underlying service. It is practically impossible for these participants in the distribution chain to determine whether the service has been rendered or not. Thus, should they classify their sale of e-load as a sale of service, they would never know when is the proper time to recognize the income.

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The telcos have the capacity to monitor the actual use and expiry of the e-load but not any of the resellers after the level of the telcos. Moreover, if the wholesaler/resellers of e-load will treat the sale as a sale of the underlying service, then they will have to make further distinction between the use of the e-load for local calls and services as against their use for outbound communication (which is not subject to VAT but to OCT). Given this, it would appear inevitable to characterize the sale of e-load at all levels after the telco as sale of tangible goods, although unlike the sale of pre-paid load which has a tangible representation in the form of a physical card, in this case, there is no equivalent physical/tangible representation. Thus, if the BIR confirms that the subsequent sale/resale of e-load by entities other than the telcos partakes of the character of a sale of goods, then the VAT thereon accrues from the time the wholesaler/resellers of e-load actually sell the same to third parties, regardless of the payment terms. As far as retailers are concerned, it is likely that they can claim exemption from VAT pursuant to Section 109 of the NIRC, as amended, which reads:

SEC. 109. Exempt Transactions. - (1) Subject to the provisions of Subsection (2) hereof, the following transactions shall be exempt from the value-added tax: X x x. (V) Sale or lease of goods or properties or the performance of services other than the transactions mentioned in the preceding paragraphs, the gross annual sales and/or receipts do not exceed the amount of One million five hundred thousand pesos (PI,500,000): Provided, That not later than January 31, 2009 and every three (3) years thereafter. the amount herein stated shall be adjusted to its present value using the Consumer Price Index, as published by the National Statistics Office (NSO); X x x.

As discussed above, except for a small percentage of institutional retailers such as 7-Eleven stores, Mini-Stop, and other convenience stores, the bulk of retailers are students, housewives, employees, or owners of businesses such as sari-sari stores and other types of retail stores. As such, we anticipate that at the level of retailers, a big bulk of them would be unable to meet the required threshold level of revenue to be subject to VAT, even assuming they declare all their sales, for tax purposes. Following the approval into law of RA No. 9337 the threshold value of revenue to be subject to VAT has been increased from Php550,000 to Php1,500,000. It should be further noted that for purposes of determining whether a particular business entity or businessman has reached the threshold of Php1,500,000, all the business activities of the taxpayer subject to VAT will have to be added. Thus, if in addition to engaging in e-load business a retailer also operates a sari-sari store, the revenue from the sari-sari store and from the e-load business will have to be added up to determine whether or not he has sales of Php1,500,000, which renders him subject to VAT.

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Lastly, to the extent that banks and credit card issuing companies are likewise merchants of e-load rather than mere payment facilities or conduits for e-load transactions, then they will not also be subject to VAT on their sale of e-load, as they are specifically exempt from VAT. Banks and other financial intermediaries are subject to gross receipts tax under Section 121 of the NIRC. Section 109 of the NIRC provides:

SEC. 109. Exempt Transactions. - (1) Subject to the provisions of Subsection (2) hereof, the following transactions shall be exempt from the value-added tax: X x x (U) Services of banks, non-bank financial intermediaries performing quasi-banking functions, and other non-bank financial intermediaries; and

2. Percentage Tax

Percentage Tax on Telcos A percentage tax is imposed on the value of e-load credits that is used for overseas (outbound) communication. Overseas communication tax (OCT) is imposed pursuant to Section 120 of the NIRC which provides—

SEC. 120. Tax on Overseas Dispatch, Message or Conversation Originating from the Philippines. — (A) Persons Liable. — There shall be collected upon every overseas dispatch, message or conversation transmitted from the Philippines by telephone, telegraph, telewriter exchange, wireless and other communication equipment services, a tax of ten percent (10%) on the amount paid for such services. The tax imposed in this Section shall be payable by the person paying for the services rendered and shall be paid to the person rendering the services who is required to collect and pay the tax within twenty (20) days after the end of each quarter. X x x.

Thus, if the e-load is used by a subscriber to call or send messages abroad, then the telco will have to pay OCT thereon rather than VAT. On the assumption that a telco previously paid VAT when it received payment for e-load sales, then it needs to reverse the output VAT paid on the e-load credits used for outbound services. Percentage Tax on Merchants As discussed above, if the merchant or distribution channel participant does not generate annual gross revenue subject to VAT in the amount of at least Php1,500,000, then it would not be subject to VAT but to percentage tax pursuant to Section 116 in relation to Section 109 of the NIRC.

SEC. 116. Tax on Persons Exempt from Value-added Tax (VAT). - Any person whose sales or receipts are exempt under Section 109(V) of this Code from the payment of value-added tax and who is not a VAT-registered person

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shall pay a tax equivalent to three percent (3%) of his gross quarterly sales or receipts: Provided, That cooperatives shall be exempt from the three percent (3%) gross receipts tax herein imposed." (as amended by R.A. No. 9337)

As discussed above, to the extent that banks and credit card companies are likewise merchants of e-load rather than mere payment facilities or conduits for e-load transactions, their sale of e-load will have to be subject to the GRT ordinarily imposed on their revenues pursuant to Section 121 of the NIRC, which reads:

SEC. 121. Tax on Banks and Non-Bank Financial Intermediaries Performing Quasi-Banking Functions. - There shall be collected a tax on gross receipts derived from sources within the Philippines by all banks and non-bank financial intermediaries in accordance with the following schedule: (a) X x x (c) On royalties, rentals of property, real or personal, profits, from exchange and all other items treated as gross income under Section 32 of this Code - 7% X x x Provided, however, That in case the maturity period referred to in paragraph (a) is shortened thru pretermination, then the maturity period shall be reckoned to end as of the date of pretermination for purposes of classifying the transaction and the correct rate of tax shall be applied accordingly. Provided, finally, That the generally accepted accounting principles as may be prescribed by the Bangko Sentral ng Pilipinas for the bank or nonbank financial intermediary performing quasibanking functions shall likewise be the basis for the calculation of gross receipts. Nothing in this Code shall preclude the Commissioner from imposing the same tax herein provided on persons performing similar banking activities. (as amended by R.A. 9337)

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III. ANALYSIS

A. CHALLENGES PRESENTED BY E-LOAD BUSINESS TO TAX ENFORCEMENT AND TAX ADMINISTRATION

General

In various forums where the taxation of the telecommunications industry was discussed, the identified challenges to tax administration and enforcement in the industry could be traced to two factors: (1) technological innovation and convergence and (2) rapid growth of e-commerce. To a large extent, the latter is also propelled by the rapid rate of technological innovation and development. The pace of technological innovation and convergence is seen to continue to change the telecommunications industry itself. These developments suggest that governments everywhere will continue to face challenges in their telecommunications tax policy. Most tax reforms will be short term as they may have to be superseded as new types of services are brought to the market. On the other hand, growth of electronic commerce is anticipated to create new variations of old issues as well as new categories of issues in the areas of tax administration and compliance. Experts tend to categorize the issues brought about by technological developments into broad categories, to include:1

1. Electronic money. Admittedly, electronic commerce is still developing and no

electronic money system has yet achieved widespread usage and acceptance. Nonetheless, it is prudent to already consider these issues at this time since certain tax administration issues in relation to electronic commerce can already be identified.

In line with the development of e-commerce, the concept of electronic money has emerged and as it continues to evolve, it is also gradually gaining acceptance. In regards to tax administration, electronic money is seen to increase tax evasion potential similar to that created by paper money. This raises the issue of whether the evasion potential is manageable and what must be done to manage it.

2. Record keeping and transaction and identity verification for electronic

transactions. It is a basic requirement on taxpayers to keep accurate books and records which taxing authorities may need to examine for the purpose of verifying the income and expenses reported on taxpayer returns. Taxpayers are increasingly relying on computerized record keeping systems although many transactions still originate as paper records that can be used to verify the accuracy of the electronic records. However, in the realm of e-commerce, no paper record is likely to be created because customer orders are placed and fulfilled electronically and, therefore, the only record that exists of these transactions could be an electronic one. It is quite apparent that this creates the possibility for tax evasion and fraud because computerized records can be altered without a trace. Even in instances where the transaction involves or requires the physical delivery of goods, the transaction documents may be received and issued electronically.

1 Selected Tax Policy Implications of Global Electronic Commerce, U.S. Department of the Treasury Office of Tax Policy, November 1996.

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It appears that taxing authorities are helpless in restraining practice towards the use of e-documentation. Thus, tax authorities can only hope to ultimately have the technology that will ensure that e-documents could not be tampered with or which will allow the verification of electronic “documents” as well as establish the identities of persons involved in an electronic transaction to minimize the potential for tax evasion.

3. Disintermediation and information reporting. Tax reporting and compliance relies

partly on formal organizations and institutions to serve as intermediaries that can be used to comply with information reporting and withholding requirements. Thus, part of effective tax administration is the proper identification of “taxing points”. A significant amount of taxes are being collected through withholding agents who are generally sophisticated persons, such as financial institutions and other large taxpayers, who understand their obligations and can be identified and audited by tax authorities. With e-commerce, it is now possible for individuals and relatively unsophisticated taxpayers who are unfamiliar with their tax and tax withholding obligations to engage in business transactions without going through the traditional intermediaries which are also ordinarily constituted as tax withholding agents. Disintermediation refers to the elimination of these traditional intermediaries. For example, a payment made for the right to download and reproduce a digitized image may be subject to a royalty fee, depending on transferee’s rights. The parties to these transactions may be unfamiliar with their withholding obligations and have no access to technology which would allow them to compute and pay such taxes electronically. Moreover, the parties may be unfamiliar with applicable information reporting requirements and it is highly probable that they do not maintain accounting books. Lack of information reports jeopardizes effective tax administration and renders tax enforcement more difficult. In view of the foregoing issues, the challenge to tax authorities is how they can develop practical techniques to deal with these technological innovations as these technological developments are seen to touch on a wide range of issues affecting the administration of our tax laws. It is further foreseen that the products and techniques that will be required to address technology advancement in leaps and bounds cannot be developed independently or implemented unilaterally by the taxing authority of a particular taxing jurisdiction. It is becoming evident that the taxing authorities of countries will have to cooperate in developing techniques to cope with challenges.

Challenges Posed by the E-Load Business

The challenges that the e-load business poses to tax administration and enforcement are but the subsets of the challenges posed by e-commerce and technological innovation on the taxation of the telecommunications industry, in general.

Based on information gathered regarding the manner that e-load business is pursued, the following peculiarities/characteristics of the e-load business have been identified as posing challenges to tax administration and enforcement. 1. Lack of paper trail. In e-load transactions, except probably at the level of the telcos

and to a certain extent, the wholesalers, there is no longer any documentary proof that

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a transaction has in fact been completed from which the telco earned revenue or at least received cash or some form of payment. Beyond the level of the telcos and wholesalers, there is hardly any paper involved to support or document the sale of e-load. Probably the exceptions are the retailers who are likewise retailers of other tangible goods which have duly registered point-of-sale (POS) machines registered with the BIR, such as chain retailers like the known convenience stores. All purchases of e-load paid for from an e-wallet, by direct deduction from a depositor’s bank account, or by direct charge to a credit card account, can be consummated without any physical document being generated, making verification of the volume of e-load sales through these channels extremely difficult.

2. Lack of tangible object of sale. Unlike in the case of sale of physical goods where

the volume of the operations of a particular merchant would be evident on the physical stock of goods that it has in its warehouse and the rate of turnover of such goods, the number of delivery vehicles, the size of its factory or warehouse, among other evident and traditional indications of its level of business activity, in the case of e-load business, one deals with intangible objects in the form of load values/credits.

A person standing by his lonesome, without any office, vehicle, or other usual contraptions needed to pursue traditional businesses, may in fact be running an e-load business which is generating sales of over a million pesos annually. Also given that there is no physical product that is being sold affords the seller the facility to do business without a fixed base of operations. A person engaged in e-load business can thus be totally mobile as any ordinary person. This also makes it difficult for the BIR to spot, who are actually engaged in the e-load business.

3. Numerous unsophisticated and geographically dispersed retailers. In terms of

number (but not necessarily the value of transactions), there should be more retailers who are individuals consisting of housewives, ordinary employees, students, and owners of sari-sari stores, etc. who have no existing registrations with the BIR as businesses/self-employed taxpayers. Although they may have their personal TIN, the BIR is not informed, based on their TIN, whether they are actually also engaging in business. On the other hand, admittedly, these multitude of retailers are unlikely to possess the requisite know-how on tax compliance requirements and even elementary bookkeeping. Moreover, the level of their business operations may not also justify the cost of maintaining accounting books.

As already discussed, aside from the huge number of retailers and the fact that they are unsophisticated entrepreneurs, they are also widely geographically dispersed and can be highly mobile. The huge number of retailers is due to the fact that there are no barriers to entry to engage in this business. This is also the reason why there can be several levels of distribution. A new retailer level can still get in for as long as there remains a margin between the street value of the e-load and the price at which a retailer can purchase the load from his e-load supplier.

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4. Technology-driven. Increasingly, prepaid telephone service business is driven by technology. The method of doing e-load business is in a constant flux.

Previously, only pre-paid cards were available, but this method is fast being rendered obsolete by e-load. E-loading itself has undergone evolution. Initially, e-loading was only done through the traditional channels, i.e., essentially the same resellers as those who sold prepaid cards. But as early as now, in view of the capability afforded by enhanced technology, the entry of new and more sophisticated resellers such as banks and credit card issuers could be noted. Content providers like Chikka.com also sell e-load payable electronically for those who have accounts with PayPal, an electronic payment facility. Noticeably, a significant technological innovation has taken place in the payment system for e-load purchases. In fact, it is the advancement of technology in this regard that enabled banks and other new players to join the ranks of e-load resellers. Aside from actual cash payment, e-load can now be purchased using one’s credit card, by direct charge against the buyer’s bank account, or by transfer of value from a buyer’s electronic wallet or some other stored value with some electronic money issuing facility. These new payment modes do not only allow a person to e-load his personal phone but also the phones of other people. With the observed entry of new potentially big players in the e-load business such as banks and credit card issuers, focus of this study cannot be confined to the traditional wholesalers/distributors who were originally also involved in the distribution of prepaid cards. The reliance of telcos on “traditional wholesalers” for the distribution of e-load may in fact be gradually eliminated or at least diminished considering that—

• telcos are increasingly improving their capability to directly sell on retail basis to

the lower levels of the present distribution channels; and • as discussed above, there is an entry of new players who can potentially take a

significant volume of the business of the “traditional wholesalers” and these new players are the banks and credit card issuers.

5. Expansion of the business of telcos. Telcos are positioning to expand their

services far beyond just providing telecommunications service. In general, the business of telcos is slowly becoming a subset of electronic commerce. In fact telcos may even be considered as creeping into the business domain of banks and money remittance businesses in view of services they offer such as issuance of e-money and money remittance (e.g., Smart Padala). This opportunity opened to them because of advanced technology and wide distribution network available to them. This direction of expansion of telco business raises new challenges altogether—

(a) increased revenues from increasingly diverse sources of income/types of

transactions; and (b) increasing volume of cash received by telcos which do not necessarily represent

revenue or potential revenue of the telcos as part of the cash received now

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represent mere deposits with the telco for conversion into electronic money or for remittance to specified beneficiaries.

Previously, cash received by telcos can only be— (a) payment for services already rendered (as in the case of postpaid subscribers); (b) pre-payment for services still to be rendered (which is the case for proceeds of e-

load and prepaid card sales); and (c) to a limited extent, payment for certain tangible goods sold (e.g., mobile phone

units) or miscellaneous services rendered (e.g., mobile phone repairs). At present, cash received by a telco may simply be amounts which will pass through its hands but will not end up being revenue of the telco. Previously, only interconnection fees were of this nature. Thereafter, amounts collected on behalf of content providers added to the volume of cash receipts that passed through the hands of the telcos without full present/future revenue implications on their part. Now, the same is true for cash receipts for the purpose of loading value into electronic wallets or intended for remittance to third parties.

B. IMPACT/CONSEQUENCE OF THE PECULIARITIES OF THE E-LOAD BUSINESS ON COLLECTION EFFICIENCY AND EFFECTIVE TAX COLLECTION AND ADMINISTRATION

1. Lack of Paper Trail

To meet the challenge of not having paper trail in most levels of the e-load distribution chain and full opportunity of verification of revenue-generating transactions, there is pressure on the BIR to develop a method of verification that will enable it to ascertain that revenue from all potential revenue sources and from various types of transactions of the telcos are reported. This method should not be dependent on the traditional verification methods such as tracing reported revenue against official receipts issued. Such a verification system may not necessarily be equally useful in the audit of those in the distribution chain. However, once it is established that the revenue/financial declared by the telcos are fairly accurate, the BIR may they rely on the same for purposes of estimating the income of e-load resellers (from wholesalers, sub-dealers, to retailers) considering that the street value of the e-load sold as well as the indicative mark-up rates are available. The data and relevant information with the telcos can likewise serve as valuable inputs to the audit of the tax liabilities of major resellers of e-load, particularly those with direct transactions with the telcos.

2. Dispersed and Numerous Mobile E-load Resellers

The large number of e-load resellers, particularly as one goes further down the distribution/value chain, renders it very difficult for the BIR to audit and check the level of tax compliance of even a small segment of these bottom level resellers. Given the limited value of the transactions of a good percentage of the resellers, auditing the bottom level retailers will not be cost efficient.

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Granting that the small e-load retailers are not worth auditing, there is a strong incentive for the BIR to look into the possibility of loading all taxes at the level of the telcos or at the most, the resellers who have direct transactions with the telcos, i.e., the wholesalers.

3. Implications of Evolving Technology

The fast evolution of technology and different aspects of the e-load business (i.e. from payment methods and systems to distribution channels) makes it difficult for the BIR to react immediately (by adjusting/expanding the terms of applicable revenue regulations to address the emerging changes) and even reasonably anticipate changes in the e-load business. All these developments will inevitably muddle the financial transactions of telcos and will render it more difficult for the BIR to audit the telcos’ transactions and revenue account. The growing complexity of the business of telcos and the transactions and arrangements they have in conducting their businesses requires the BIR to continually change its audit procedures with respect to telcos or design an audit/verification method that is effective and less sensitive to the changes in the technology in the telco business. Reliable and complete revenue information on the magnitude of e-load business of telcos is critical to BIR’s ability to audit and assess the correct amount of taxes on wholesalers. In the absence of sufficient paper trail at the level of wholesalers, the BIR will have to rely more on third party information available with the telcos. Wholesalers will have difficulty refuting information furnished by the telcos they deal with.

4. Foregone Government Revenues

The documented features of the e-load distribution network – the players, characteristics of each player, applicable taxes– suggest that a huge portion of the taxes or government revenues from e-load are foregone. Moreover, the same documentation is used to estimate how much of these supposed government revenues are foregone largely due to the characteristics of the network and its players.

Assumptions

Two cases are examined:

Case 1 - The gross profit rate of the wholesaler is 4.65% as computed from the

documented value chain, and

Case 2 - The gross profit rate of wholesalers is only 0.65%, which is the computed gross profit rate of wholesalers based on the audited financial statements of three major wholesalers.

Within each case, two sub-cases are also studied:

Sub-Case A. The wholesaler’s VAT payable is net of the full amount of the input VAT absorbed from/passed on by the telcos;

Sub-Case B. The input VAT credit against output VAT is capped at 70% of output VAT, in view of the 70% cap on input VAT provided under the NIRC, as

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amended by R.A. No. 9337. Both sub-cases A and B are possible scenarios, depending on the amount of input VAT of the wholesaler relative to its output VAT. The first sub-case will be true if the wholesaler invokes the implementing rules and regulation that provide that the actual input VAT may be applied as long as this does not exceed 100% of the output VAT. The second sub-case will be true if the wholesaler will have input VAT greater than its output VAT for the particular taxable period.

The figures are computed based on an estimated P73.2 billion sales by the telecom companies in 2005, as derived from sales figures submitted by SMART Communications to the NTC. The sales figures are those sold to wholesalers, and therefore the P73.2 billion does not include any direct sales by telcos to end-users through the e-wallet or through conduits such as banks and credit card issuers. The income tax rate used is 35 percent for both the wholesaler and wholesaler-retailer, and 20 percent for the retailer. The business taxes considered were the remaining VAT payable for the wholesaler and wholesaler-retailer after deducting from the output VAT the input VAT paid to the telco, and the 3 percent percentage tax for the retailer. Table 11 summarizes the foregoing assumptions:


Case 1 Case 2 Players/Merchants/ Distribution Channels

Three types of merchants are considered after the level of the telco: wholesaler, wholesaler-retailer, and retailer. Wholesaler: Purchaser of 75% of the telco sales, and resells this to retailers. Has no own retail operation Wholesaler-retailer: Purchaser of 25% of the telco sales, and retails this on its own. Usually medium to large-scale businesses involved in institutional retailing, such as groceries/convenience stores Retailer: Purchaser of 100% of the sales of wholesaler, and retails this to the end-user.

Total E-Load Sales by the Telco (2005)

P73.2 billion - Assumed to be twice the value of load sold by SMART

Communications in 2005 (P36.6 billion) to its wholesalers, which is justified by the fact that audited financial statements show that revenues for wireless services is almost the same for SMART and Globe in 2002-2004. This estimate is likewise conservative as it has not factored in the market share of Sun Cellular.

- The P36.6 billion for SMART was derived from record of sales for February-December 2005 to their wholesalers, as submitted to NTC. Thus, this necessarily excludes any direct e-load retail sales of SMART.

- SMART figure assumed to be inclusive of VAT, although it is more reasonable to assume that when sales amount is reported, the same should be deemed exclusive of VAT since for accounting purposes, the VAT component is required to be segregated from the gross sales figure. Thus, this is a conservative assumption.

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Case 1 Case 2 Gross Profit Rate , computed as: [(Sales-Cost of Sales)/Sales]

Wholesaler: 4.65% (=3.57/76.79 =4/86) as computed from the value chain in study findings Wholesaler-Retailer: 18% (=16.07/89.29 = 18/100) as computed from the value chain in study findings Retailer: 14% (=14/100) as computed from the value chain in study findings

Wholesaler: 0.65% - the gross profit rate using figures in financial statements of three major wholesalers Wholesaler-Retailer: same as in Case 1 Retailer: same as in Case 1

Income Tax Rate Wholesalers and Wholesaler-Retailers, 35% Retailers: 20% (corresponding to a taxable income bracket of Php70,000 to Php140,000. The range being from 0% to 32%, depending on the amount of taxable income but as discussed, retailers are observed to be predominantly small retailers

Business Tax – VAT for wholesaler

Wholesaler and Wholesaler-Retailers: Case A - remaining VAT payable is output VAT less actual input VAT paid to telco. This applies the regulation that actual input VAT can be used so long as it does not exceed 100% of output VAT Case B - applies the law that maximum creditable input VAT is 70% of output VAT Retailer: 3% percentage tax on gross sales

Net Income, Taxable Income

Wholesaler, Wholesaler-Retailer, Retailer 50% of Gross Profit (thus, the other 50% corresponds to the provision for overhead, selling, and administrative expenses), which amount is also assumed to be equivalent to Taxable Income

Sales and Profits

As stated in the assumptions table, the total sales (to wholesalers) including VAT by all telcos is assumed to be P73.2 billion. Of the P73.2 billion, 75 percent is assumed to be purchased by wholesalers who eventually pass this on to the retailers, while the remaining 25 percent is assumed to be bought by the wholesalers who also resell the load on retail basis themselves. We are therefore examining here three types of merchants: the wholesaler, the wholesaler-retailer, and the retailer.

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As discussed earlier, two cases are considered: one using a 4.65% profit rate and another using a 0.65% profit rate. These two cases are applied to the wholesaler without retail operations only. For the wholesaler-retailer, the gross profit rate of 18% is retained to be on the conservative side and considering that most institutional retailers are sophisticated businesses that are likely aware of and comply with tax obligations. For the retailer, the 14% gross profit rate is also retained in Case 2, but the cost of sales and the consequent selling price are different as a result of the adjustment in the gross profit rate of the wholesaler from which the retailer buys the load credits for reselling.

The resulting sales and profit figures for each merchant type are in Table 12. It can be seen that the drop in gross profit rate from 4.65% to 0.65% for the wholesaler reduces the gross profit from P2.4 billion to a mere P320 million, a difference of more than P2 billion, or a drop by 87 percent. This translates to a reduction in net profit from P1.2 billion to only P160 million. The resulting estimated decrease in gross profit and net profit for the retailer are P378 million and P189 million, respectively.

Table 12. Sales and Profits of Each Merchant Type, 2005

TELCO WHOLESALER WHOLESALER-RETAILER RETAILER

% Per P82 Sales % Per P86

Sales % Per P100 Sales % Per P100 Sales

Sales w/VAT (%Tax for Retailer) 112% 82.00 112% 86.00 112% 100.00 100% 100.00

Output VAT 12% 8.79 12% 9.21 12% 10.71 0% -

Sales W/o VAT 100% 73.21 100% 76.79 100% 89.29 100% 100.00

Cost of Sales - - - 73.21 - 73.21 - 86.00

Gross Profit - - - 3.57 - 16.07 - 14.00

Gorss Profit Rate - - - 4.65% - 18.00% - 14.00%

TELCO % Amount Per P82 Sales Sales w/VAT 112% 73,213,906,916 82.00 Output VAT 12% 7,844,347,170 8.79 Sales W/o VAT 100% 65,369,559,746 73.21

WHOLESALER Case 1 Case 2 Difference % Amount % Amount Amount % Change

Sales w/VAT 112% 57,588,987,757 112% 55,269,683,127 2,319,304,630 -4% Output VAT 12% 6,170,248,688 12% 5,921,751,764 248,496,925 -4% Sales w/o VAT 100% 51,418,739,069 100% 49,347,931,363 2,070,807,705 -4% Cost of Sales 95.35% 49,027,169,810 99.35% 49,027,169,810 - 0% Gross Profit 4.65% 2,391,569,259 0.65% 320,761,554 2,070,807,705 -87% Operating Expenses 2.33% 1,195,784,630 0.33% 160,380,777 1,035,403,853 -87% Net Profit 2.33% 1,195,784,630 0.33% 160,380,777 1,035,403,853 -87%

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WHOLESALER - RETAILER Case 1 Case 2 % Amount % Amount

Sales w/VAT 112% 22,321,313,084 112% 22,321,313,084 Output VAT 12% 2,391,569,259 12% 2,391,569,259 Sales w/o VAT 100% 19,929,743,825 100% 19,929,743,825 Cost of Sales 82.00% 16,342,389,937 82.00% 16,342,389,937 Gross Profit 18.00% 3,587,353,889 18.00% 3,587,353,889 Operating Expenses 9.00% 1,793,676,944 9.00% 1,793,676,944 Net Profit 9.00% 1,793,676,944 9.00% 1,793,676,944

RETAILER

Case 1 Case 2 Difference % Amount % Amount Amount % Change

Sales w/ Percentage Tax 100% 66,963,939,252 100% 64,267,073,404 2,696,865,849 -4.0% Cost of Sales 86.00% 57,588,987,757 86.00% 55,269,683,127 2,319,304,630 -4.0% Gross Profit 14.00% 9,374,951,495 14.00% 8,997,390,276 377,561,219 -4.0% Operating Expenses 7.00% 4,687,475,748 7.00% 4,498,695,138 188,780,609 -4.0% Net Profit 7.00% 4,687,475,748 7.00% 4,498,695,138 188,780,609 -4.0%

Taxes Due

Using the foregoing figures, the taxes due the three merchant types are computed and shown in Table 12. For the wholesaler and wholesaler-retailer, the taxes due are income tax and the remaining VAT payable after input VAT is subtracted from the output VAT. For the retailers, the assumed taxes due are income tax and percentage tax.

As mentioned, two VAT treatments are considered within each of the two gross profit rate assumptions, resulting to four subcases. The resulting computation of taxes due for each subcase is shown in the tables.

Under Case 1.a, the total tax due from the three types of merchants is P4.7 billion. The bulk (63 percent) is due the retailers. The wholesaler-retailer, although assumed to be accounting for only 25 percent of the telco sales, accounts for 22 percent of the collectible taxes. This is relatively high as compared to the wholesaler with no retail operations which purchased 75 percent of telco sales but accounts to only 15 percent of taxes due. This is due to the much higher gross profit rate of 18 percent for the wholesaler-retailer, as compared to the 4.65 percent mark-up of the wholesaler.

In terms of type of tax, each of income tax and percentage tax accounts for more than 40 percent of the total taxes due, while the remaining VAT payable of the wholesaler and the wholesaler –retailer accounts for only 15 percent.

When a 0.65 percent gross profit rate is considered instead of 4.65 percent for the wholesaler (Case 2.a), the total tax due becomes P4.0 billion, a reduction by P700 million. The percentage share of the wholesaler also plummets to less than 3 percent, as a result of the drop in gross sales by P2.3 billion and in net profit by P1.0 billion. Consequently, among the three types of taxes, the percentage tax of the retailer becomes the highest contributor at 48 percent.

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Applying input VAT to only 70 percent of gross sales brings considerably increases the VAT payable and total tax due of the wholesaler by almost P2 billion from Case 1.a to Case 1.b. The wholesaler’s share in the total taxes due rises to 25 percent, and the three types of taxes take up almost equal shares in the taxes due. A similar pattern is observed in the shift from Case 2.a to Case 2.b.

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Case 1.a Gross Profit Rate of 4.65% for Wholesaler, Remaining VAT Payable for Wholesaler and Wholesaler-Retailer is Net of Input VAT


Gross Sales Net Profit Income Tax /1 Output VAT Input VAT Remaining VAT

Payable Percentage Tax TOTAL TAX DUE

as a % of Total Tax

Due

Wholesaler 57,588,987,757 1,195,784,630 418,524,620 6,170,248,688 5,883,260,377 286,988,311 705,512,931 15.0% Wholesaler-Retailer 22,321,313,084 1,793,676,944 627,786,930 2,391,569,259 1,961,086,792 430,482,467 1,058,269,397 22.5% Retailer 66,963,939,252 4,687,475,748 937,495,150 - - - 2,008,918,178 2,946,413,327 62.6%

Total 1,983,806,700 8,561,817,947 7,844,347,170 717,470,778 2,008,918,178 4,710,195,656 100.0%


Case 1.b Gross Profit Rate of 4.65% for Wholesaler, Input VAT only on 70% of Gross Sales (not including VAT)




Due

Wholesaler 57,588,987,757 1,195,784,630 418,524,620 6,170,248,688 5,883,260,377 1,851,074,606 - 2,269,599,227 34.6% Wholesaler-Retailer 22,321,313,084 1,793,676,944 627,786,930 2,391,569,259 1,961,086,792 717,470,778 - 1,345,257,708 20.5% Retailer 66,963,939,252 4,687,475,748 937,495,150 - - - 2,008,918,178 2,946,413,327 44.9%

Total 1,983,806,700 8,561,817,947 7,844,347,170 2,568,545,384 2,008,918,178 6,561,270,262 100.0%


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Table 13. Taxes Due Each Merchant Type, 2005 (cont’d.)





Due

Wholesaler 55,269,683,127 160,380,777 56,133,272 5,921,751,764 5,883,260,377 38,491,386 94,624,658 2.4% Wholesaler-Retailer 22,321,313,084 1,793,676,944 627,786,930 2,391,569,259 1,961,086,792 430,482,467 1,058,269,397 26.6% Retailer 64,267,073,404 4,498,695,138 899,739,028 - - - 1,928,012,202 2,827,751,230 71.0%

Total 1,583,659,230 8,313,321,023 7,844,347,170 468,973,853 1,928,012,202 3,980,645,285 100.0%






Due

Wholesaler 55,269,683,127 160,380,777 56,133,272 5,921,751,764 5,883,260,377 1,776,525,529 1,832,658,801 30.5% Wholesaler-Retailer 22,321,313,084 1,793,676,944 627,786,930 2,391,569,259 1,961,086,792 717,470,778 1,345,257,708 22.4% Retailer 64,267,073,404 4,498,695,138 899,739,028 - - - 1,928,012,202 2,827,751,230 47.1%

Total 1,583,659,230 8,313,321,023 7,844,347,170 2,493,996,307 1,928,012,202 6,005,667,739 100.0%


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Estimated Revenues That are Foregone

Again, the documentation done by the study suggests that due to the characteristics of the merchants in the e-load distribution network, a huge portion of the taxes or government revenues from e-load are foregone. For one, retailers are mostly unsophisticated or very small businesses who may not even be aware of their tax obligations. As with other businesses in the informal economy, it is both difficult and not cost-efficient for the BIR to directly run after the retailers to fulfill their tax obligations. On the other hand, although wholesalers are deemed more sophisticated businesses who are aware of tax obligations, a verification of the registration status of some of the biggest wholesalers (i.e., those with over PhP500 million in e-load purchases from SMART) with the SEC and the DTI indicates that not all of them have the requisite registration or are at least in good standing or compliant with reporting requirements of these agencies.

The following table provides the figures of government revenues at various levels of taxes due that are uncollected. The figures are in increments of 25 percent of tax due for the wholesaler and wholesaler-retailer; and the retailer. The study deems that the scenario of uncollected taxes of 50 percent for wholesalers and wholesaler-retailers and 75 percent for retailers, shaded in the table, to be the most likely scenario.

The large percentage uncollected from the retailers which is the largest source of taxes due plus non-compliance by some wholesalers and wholesaler-retailers, bring the amount of foregone revenues to a staggering P3.1 billion (Case 1.a). Even if the assumed level of non-compliance for the wholesaler and the wholesaler-retailer is lowered from 50 percent to 25 percent, the estimated foregone revenues still amount to a considerable P2.7 billion.

When a 0.65 pecent gross profit rate is used for the wholesaler (Case 2.a), the estimated foregone revenue of P3.1 billion becomes P2.7 billion. Under the Case b assumption, foregone revenues amount to P4.0 billion and P3.7 billion, respectively, for Case 1.b and Case 2.b.

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Table 14. Estimated Foregone Government Revenues in E-Load Retailing, 2005 Case 1.a Gross Profit Rate of 4.65% for Wholesaler, Remaining VAT Payable for Wholesaler and Wholesaler-Retailer is Net of Input VAT

Level of Taxes






Income Tax 104,631,155 156,946,733 234,373,787 495,951,675 104,631,155 156,946,733 468,747,575 730,325,462 104,631,155 156,946,733 703,121,362 964,699,250

25%

Business Tax 71,747,078 107,620,617 502,229,544 681,597,239 71,747,078 107,620,617 1,004,459,089 1,183,826,783 71,747,078 107,620,617 1,506,688,633 1,686,056,328

Total 176,378,233 264,567,349 736,603,332 1,177,548,914 176,378,233 264,567,349 1,473,206,664 1,914,152,246 176,378,233 264,567,349 2,209,809,995 2,650,755,577

Income Tax 209,262,310 313,893,465 234,373,787 757,529,563 209,262,310 313,893,465 468,747,575 991,903,350 209,262,310 313,893,465 703,121,362 1,226,277,138

50%

Business Tax 143,494,156 215,241,233 502,229,544 860,964,933 143,494,156 215,241,233 1,004,459,089 1,363,194,478 143,494,156 215,241,233 1,506,688,633 1,865,424,022

Total 352,756,466 529,134,699 736,603,332 1,618,494,496 352,756,466 529,134,699 1,473,206,664 2,355,097,828 352,756,466 529,134,699 2,209,809,995 3,091,701,160

Income Tax 313,893,465 470,840,198 234,373,787 1,019,107,450 313,893,465 470,840,198 468,747,575 1,253,481,238 313,893,465 470,840,198 703,121,362 1,487,855,025

75%

Business Tax 215,241,233 322,861,850 502,229,544 1,040,332,628 215,241,233 322,861,850 1,004,459,089 1,542,562,172 215,241,233 322,861,850 1,506,688,633 2,044,791,716

Total 529,134,699 793,702,048 736,603,332 2,059,440,078 529,134,699 793,702,048 1,473,206,664 2,796,043,410 529,134,699 793,702,048 2,209,809,995 3,532,646,742


Level of Taxes Collected from

Retailer 25% 50% 75%

Level of Taxes




Income Tax 104,631,155 156,946,733 234,373,787 495,951,675 104,631,155 156,946,733 468,747,575 730,325,462 104,631,155 156,946,733 703,121,362 964,699,250

25%

Business Tax 462,768,652 179,367,694 502,229,544 1,144,365,890 462,768,652 179,367,694 1,004,459,089 1,646,595,435 462,768,652 179,367,694 1,506,688,633 2,148,824,979

Total 567,399,807 336,314,427 736,603,332 1,640,317,566 567,399,807 336,314,427 1,473,206,664 2,376,920,897 567,399,807 336,314,427 2,209,809,995 3,113,524,229

Income Tax 209,262,310 313,893,465 234,373,787 757,529,563 209,262,310 313,893,465 468,747,575 991,903,350 209,262,310 313,893,465 703,121,362 1,226,277,138

50%

Business Tax 925,537,303 358,735,389 502,229,544 1,786,502,236 925,537,303 358,735,389 1,004,459,089 2,288,731,781 925,537,303 358,735,389 1,506,688,633 2,790,961,325

Total 1,134,799,613 672,628,854 736,603,332 2,544,031,799 1,134,799,613 672,628,854 1,473,206,664 3,280,635,131 1,134,799,613 672,628,854 2,209,809,995 4,017,238,463

Income Tax 313,893,465 470,840,198 234,373,787 1,019,107,450 313,893,465 470,840,198 468,747,575 1,253,481,238 313,893,465 470,840,198 703,121,362 1,487,855,025

75%

Business Tax 1,388,305,955 538,103,083 502,229,544 2,428,638,583 1,388,305,955 538,103,083 1,004,459,089 2,930,868,127 1,388,305,955 538,103,083 1,506,688,633 3,433,097,671

Total 1,702,199,420 1,008,943,281 736,603,332 3,447,746,033 1,702,199,420 1,008,943,281 1,473,206,664 4,184,349,365 1,702,199,420 1,008,943,281 2,209,809,995 4,920,952,697


Level of Taxes


25% 50% 75% Level of Taxes Collected from W/S and W/Sr-Retailer Wholesaler Wholesaler-



Income Tax 14,033,318 156,946,733 224,934,757 395,914,808 14,033,318 156,946,733 449,869,514 620,849,564 14,033,318 156,946,733 674,804,271 845,784,321

25%

Business Tax 9,622,847 107,620,617 482,003,051 599,246,514 9,622,847 107,620,617 964,006,101 1,081,249,564 9,622,847 107,620,617 1,446,009,152 1,563,252,615

Total 23,656,165 264,567,349 706,937,807 995,161,321 23,656,165 264,567,349 1,413,875,615 1,702,099,129 23,656,165 264,567,349 2,120,813,422 2,409,036,936

Income Tax 28,066,636 313,893,465 224,934,757 566,894,858 28,066,636 313,893,465 449,869,514 791,829,615 28,066,636 313,893,465 674,804,271 1,016,764,372

50%

Business Tax 19,245,693 215,241,233 482,003,051 716,489,977 19,245,693 215,241,233 964,006,101 1,198,493,028 19,245,693 215,241,233 1,446,009,152 1,680,496,078

Total 47,312,329 529,134,699 706,937,807 1,283,384,835 47,312,329 529,134,699 1,413,875,615 1,990,322,643 47,312,329 529,134,699 2,120,813,422 2,697,260,450

Income Tax 42,099,954 470,840,198 224,934,757 737,874,909 42,099,954 470,840,198 449,869,514 962,809,666 42,099,954 470,840,198 674,804,271 1,187,744,423

75%

Business Tax 28,868,540 322,861,850 482,003,051 833,733,440 28,868,540 322,861,850 964,006,101 1,315,736,491 28,868,540 322,861,850 1,446,009,152 1,797,739,541

Total 70,968,494 793,702,048 706,937,807 1,571,608,349 70,968,494 793,702,048 1,413,875,615 2,278,546,157 70,968,494 793,702,048 2,120,813,422 2,985,483,964

Case 2.b Gross Profit Rate of 0.65% for Wholesaler, Input VAT only on 70% of Gross Sales (not including VAT) Level of Taxes






Income Tax 14,033,318 156,946,733 224,934,757 395,914,808 14,033,318 156,946,733 449,869,514 620,849,564 14,033,318 156,946,733 674,804,271 845,784,321

25%

Business Tax 444,131,382 179,367,694 482,003,051 1,105,502,127 444,131,382 179,367,694 964,006,101 1,587,505,178 444,131,382 179,367,694 1,446,009,152 2,069,508,228

Total 458,164,700 336,314,427 706,937,807 1,501,416,935 458,164,700 336,314,427 1,413,875,615 2,208,354,742 458,164,700 336,314,427 2,120,813,422 2,915,292,550

Income Tax 28,066,636 313,893,465 224,934,757 566,894,858 28,066,636 313,893,465 449,869,514 791,829,615 28,066,636 313,893,465 674,804,271 1,016,764,372

50%

Business Tax 888,262,765 358,735,389 482,003,051 1,729,001,204 888,262,765 358,735,389 964,006,101 2,211,004,254 888,262,765 358,735,389 1,446,009,152 2,693,007,305

Total 916,329,401 672,628,854 706,937,807 2,295,896,062 916,329,401 672,628,854 1,413,875,615 3,002,833,869 916,329,401 672,628,854 2,120,813,422 3,709,771,677

Income Tax 42,099,954 470,840,198 224,934,757 737,874,909 42,099,954 470,840,198 449,869,514 962,809,666 42,099,954 470,840,198 674,804,271 1,187,744,423

75%

Business Tax 1,332,394,147 538,103,083 482,003,051 2,352,500,281 1,332,394,147 538,103,083 964,006,101 2,834,503,331 1,332,394,147 538,103,083 1,446,009,152 3,316,506,382

Total 1,374,494,101 1,008,943,281 706,937,807 3,090,375,189 1,374,494,101 1,008,943,281 1,413,875,615 3,797,312,997 1,374,494,101 1,008,943,281 2,120,813,422 4,504,250,804

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C. OTHER RELEVANT OBSERVATIONS/FINDINGS

Other than what has been discussed above, it may also be worthy to note the other incidental findings/observations gathered in the course of this study as listed below. Although some observations/findings may not be directly related to taxation of e-load business, these may still be useful when designing the audit procedures for telcos.

1. Lack of transparency of pricing strategy at various levels of the e-load distribution

chain

It appears from our study that the telcos do not fix the price at which the resellers can on-sell e-load, except that there is a quoted street value to the e-load credits that serves as the maximum price at which they can sell the load. As far as the telcos are concerned, they simply sell e-load credits in bulk to distributors or wholesalers and thereafter, it is up to the wholesalers how they ultimately allocate the discount between themselves and the next level of resellers through whom they sell. The same is true as one goes down the distribution chain. As discussed, the telcos also do not appear to have a single discount rate for their distributors or merchants. The telcos have a graduated scale of discounts which increases as the volume purchased increases. It should be noted that the discount scale of the telcos for e-load sales is not disclosed in their annual report submitted to the NTC. What is in the their annual report to the NTC are their per minute rates for various types of subscriber plan, types of service availed of, among others. This necessarily means that, in the course of auditing the telcos, it may be necessary for the BIR to actually check the applicable discount rates based on actual contracts signed or require the presentation of the discount scale in effect during the relevant period.

Aside from granting a discount, it appears that telcos also grant bonus loads. While the number of or rate at which bonus or free load is granted by the telcos is not known and is not currently reported out, the telcos certainly have a record of these bonus loads. These bonus loads in fact convert to additional revenue on the part of the distributors/merchants. On the part of the telcos, this converts to increased volume of transactions without commensurate revenue.

2. Lack of transparency of revenue-generating contractual arrangements entered into by

telcos

With the emergence of various types of arrangements with various entities, in addition to the development of a wide variety of new products, it is becoming increasingly difficult to know and understand exactly the nature of the transactions that the telcos are entering into. Contracts that are now being executed are clearly beyond the traditional contracts as they are premised on the availability of higher levels of technology. What used to be a straightforward sale of telecommunications service is becoming increasingly complex with the entry of new players such as content providers who undertake to perform a segment of the entire service to merit a share in the proceeds of the service sold. As also discussed, telco subscribers are also offered a mélange of payment options and for these options to be available, surely the telcos have previously entered into a myriad of contracts with various institutions. Access to contracts will give the BIR a means to verify the representations of telcos with respect to the amount of their revenues as well as their costs and expenses.

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The problem at this point is that no particular government authority receives a copy of these contracts being entered into, as a matter of course. Thus, while agencies such as the BIR could request for copies of these contracts, at the outset, it would not know what types of contracts have been entered into; hence, it would not know what contracts it will request the telco to provide in the course of audit.

3. Financial statements of telcos present aggregate values

Within the Notes to the audited financial statements, a brief description of the sources of the telcos’ revenues is ordinarily included. However, there is no breakdown of their revenue according to the enumerated sources of their revenue on their income statement. Considering that accounting standards do not necessarily require a detailed classification of revenue according to the specific types of transaction from which revenue is sourced, the BIR should nonetheless require the telcos to submit a detailed/itemized revenue report. This should also give the BIR a good idea of the revenue sources it will need to concentrate its audit on.

4. Diversity in revenue source and other policies

Verification of financial data is extremely challenging in view of different revenue sources, applicable rates/pricing policies, and types of transactions. For example, SMS transactions of telcos alone are a mix of revenue and non-revenue transactions. As discussed above, there are bonus loads granted in certain instances while there are also varying discount rates given to wholesalers and retailers. All these complicate the verification task of the BIR. 5. No standard financial reporting

Benchmarking for the industry will be more challenging because of the dissimilar presentation of financial information in the audited financial statements of the telcos—different levels of aggregation and different account titles are used, as well as different accounting policies are adopted.

A comparative presentation of the basic financial statements and account headings in the balance sheets of the telcos is presented in Annexes E and F, respectively. Annex E clearly shows that the charts of accounts of the telcos vary from each other and even deviate from the NTC-prescribed Chart of Accounts. The indicative charts of accounts of the telcos were lifted from the annual financial reports they submitted to the NTC. Annex F, on the other hand, presents the account headings in use by the telcos in their respective audited financial statements. It should be pointed out that notwithstanding the fact that the financial statements of Globe, Smart, and Digitel are all being audited by the same auditing firm, Sycip Gorres Velayo & Co., the account headings and presentation are not uniform. Part 2 of Annex F goes beyond the financial statements and attempts to compare the comparative accounting treatment/policies of each telco, as disclosed in the accompanying Notes to the financial statements. It is quite easy to spot that there are significant differences in the accounting treatment of some material financial items. In view of the differences in the account headings used and the accounting treatment of various financial transactions, the BIR will have some difficulty developing reasonable/meaningful industry benchmarks. The BIR will have to obtain more detailed information to ensure that the

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composition of each account of a telco is the same/comparable to the composition of the same account in the financial statement of the other telcos. Also, to the extent that the accounting treatment of certain items vary across telcos, the BIR may need to have the affected account balances restated to reflect uniform accounting treatment of a particular item. For example, there is notable difference in the rate of depreciation of various classes of depreciable assets across the telcos. SMART, for example, depreciates telecommunications equipment over a useful life of 8 to 10 years and cables over 20 years while Globe depreciates its investment in cables for periods ranging 5 to 15 years and telecommunications equipment from 3 to 20 years.

6. Lack of information sharing with NTC

In the course of the study, it was apparent that there has been minimal coordination and information sharing between the NTC and the BIR with respect to the telcos. It appears that NTC actually receives a considerable amount of financial information from the telcos which can be utilized by the BIR in auditing/verifying and obtaining the details of certain revenue and expense accounts of the telcos reflected in their audited financial statements and income tax returns. The annual reports submitted by the telcos to NTC, for example, actually contains a lot of details which may also be equally useful to the BIR.

7. Foreign-sourced revenue from sale of prepaid cards and e-load

The telcos generate considerable amount of revenue from the sale of prepaid cards/e-load abroad and it is not certain whether these are being fully recorded in the books of the telcos. It appears that in certain countries, such as in Hong Kong, the telcos actually maintain offices but there is no actual sale of services or prepaid cards or loads being transacted therein. It needs to be probed how revenue from prepaid services abroad are being earned and recorded by the telcos.

8. Verification of prompt revenue recognition

Considering that the cash payments received from the sale of e-load is initially recorded as unearned revenue, it is not certain whether the BIR is able to verify whether the recognition of income or the conversion of unearned income to realized income is being promptly made. However, one telco’s representation to the BIR is that it immediately recognizes proceeds of e-load sales for income tax purposes. Once verified that this is the case for all telcos, then this concern will be eliminated.

IV. RECOMMENDATIONS

While this particular study is intended to focus on the taxation of retail sales of e-load, it will be noted that a significant portion of our recommendations deals more with the telcos themselves rather than their e-load distribution network. We found this inevitable given the circumstances obtaining in the e-load distribution business. First, we have grossly inadequate information about the identity of retailers of e-load. Even assuming we limit our study to the first level distributors or the e-load wholesalers, except for the direct information from the telcos on the identity of their e-load wholesalers, we will not be able to identify these entities. Unlike telcos which are all registered with NTC or banks which are all duly licensed by and registered with the Bangko Sentral ng Pilipinas (BSP), we have no

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reasonable means of identifying and isolating major e-load sellers from among millions of persons or entities engaged in the trading business. Even a review of the primary purpose clause of some of the top SMART e-load sellers would not give us a clue that they are principally engaged in e-load trading. Second, in view of the recommendation to consider front-loading the applicable taxes on the e-load transactions from the wholesaler to the ultimate buyer at the level of the telco, it is no longer too critical to discuss in detail the taxation of the participants of the e-load distribution network. Thirdly, even assuming the foregoing recommendation is not adopted, the role of the telcos will still be the most critical in the entire effort to enforce taxation at the various levels of e-load distribution, particularly at the first level thereof. Third party information, to our mind, will be the most critical component in arriving at any assessment against e-load wholesalers. Based solely on the information obtained from the telcos, the BIR could already reasonably estimate the gross income of wholesalers. Cost of sales will be an actual figure that can be obtained from the telcos while the revenue figure can be estimated given the standard mark-up rate on the purchase price from the telcos. We foresee that in the case of e-load distributors, we can only obtain meaningful and useful third party information from the telcos. In other industries, the BIR can obtain third party information upstream and downstream of a target taxpayer, i.e., from its suppliers as well as its customers. In the case of e-load wholesalers, it would be very difficult to obtain third party information from their customers since they may already be geographically dispersed as well as too numerous as to make it cumbersome and costly for the BIR to gather sufficient relevant information from them. It is because of the critical role of information coming from the telcos that we are compelled to tackle ways and means to also ensure that data coming from the telcos are likewise reasonably accurate and reliable.

The recommendations are summarized in Table 14, with an indication of the timeframe and revenue impact. Only one recommendation has a quantifiable impact on revenue collections. At the outset, the rest of the recommendations are only meant to ascertain taxable transactions and ensure that the taxes thereon are collected. Adoption of these recommended measures, however, is key to instituting behavioral changes in tax compliance, i.e., “cultural approach to tax collection enhancement”. The latter is the more valuable contribution that these actions will make.

For comparability, the impact in ascertaining taxable transactions is expressed in varying degrees: moderate, high, and very high.

Recommendations are grouped into four categories.

The first category is statutory initiatives which include collecting business taxes upfront. This has a direct impact on revenue collection, estimated at P1.8 billion if already implemented in 2005. This can be done in the short-term.

The three other categories are regulatory enhancements; enhancement of operational methodologies and capacity-building; and technology-based solutions.

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The study also presents recommendations that are not directly related to taxing e-load, but can be used in designing the audit procedures for the telcos and related players.

All recommendations are for BIR’s action, except for the recommended technology-based solution to engage a third party to monitor control channels of cell sites, which is for the NTC to implement and share information with the BIR.


RECOMMENDATIONS

Timeframe

Revenue implication (immediate: within one year;


years) Statutory Initiatives

Impose advance percentage tax Short-term

Considering 2005 figures, about P1.8 billion, on conservative assumptions

Unify business taxes on telco Short to medium term

Not quantifiable at this time, but main impact is cost-efficiency of tax collection, which also still needs to be quantified

Regulatory Enhancements Issue revenue regulation

specifically addressing telecommunications industry tax issues: e.g. Characterization of e-load sale transaction (whether goods or service) and prescription of timing of income recognition

Immediate Not quantifiable at this time, but with high impact in ascertaining taxable transactions

Amend or expand information disclosure and reporting requirements of telcos


Enhancement of operational methodologies and capacity-building Obtain sufficient understanding

and knowledge of the telco business and full understanding of telco accounting system

Immediate Indirect

Enhance and strictly implement the prescribed procedure for the grant to telcos of authority to use computerized accounting system

Immediate Indirect


Utilize domestic sources (information on wholesalers and other parties with revenue inflow implications)


Strengthen and institutionalize linkage and data sharing between the NTC and the BIR


Utilize foreign-sourced information Immediate

Not quantifiable at this time, but with moderate to high impact in ascertaining taxable transactions

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RECOMMENDATIONS



years)

Revenue implication

Institutionalize coordination of Revenue District Office with the Large Taxpayers Service in the audit of major wholesalers


Audit wholesalers to determine reason behind the erosion of their income tax base

Immediate



Access and use information from Call Detail Records (CDR)

With political will, immediate




Areas for Further Study Examine:

Transactions involving credit card companies

Transactions involving banks Revenue sharing with content

providers Magnitude of income earned by

telcos from providing their own content

Pursuit by telcos of other business activities

A. STATUTORY INITIATIVES In view of the results of this study, we believe that there is significant basis to recommend some amendments on the taxation of telcos, which amendments should be adopted pursuant to an amendatory law to the NIRC. The mere issuance of revenue regulations approved by the Secretary of Finance, as recommended by the BIR Commissioner, would not suffice. Impose Advance Percentage Tax The fact that retailers of e-load are numerous and geographically dispersed and given that the number of sub-layers in the distribution/sale of e-load is not fixed and cannot be possibly monitored, there is tremendous pressure as well as incentive for the BIR to concentrate tax collection effort at the higher levels of the distribution chain. In fact, given the endless possibilities in the manner that e-loading may be pursued, any business tax which the BIR wishes to collect from the sale of e-load should be collected up front, ideally, at the level of the telcos. The telcos are already identified and the level of their tax compliance is comparatively high, considering that they are under the close monitoring of the Large Taxpayers Section. Being

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fewer in number than the wholesalers, designating them as tax points allows collection to be highly centralized. With respect to the type of business tax which would be ideal to impose on the participants of the e-load distribution network, it would appear that a percentage tax would be the simplest to collect and impose. Being computed on the gross amount and there being no offsetting, as in the case of input VAT against output VAT, the likelihood of erosion of the tax base as well as the tax payable is eliminated. The recommendation contemplates not the regular percentage tax which is directly remitted by the seller subject to percentage tax but an advance percentage tax, i.e., it is collected in advance of the resale of the e-load and will be computed at 3 percent of the ultimate selling price to the end-user (street value). The percentage tax will be added to the telcos’ selling price in computing the total invoice price to the wholesaler. The telcos will continue to recognize output VAT based on their actual selling price. Hence, as shown in the following figure, for every P100 worth of e-load in the street, there is a P3 percentage tax due from the distribution chain. The said percentage tax will be withheld by the telcos and remitted to the BIR on a monthly basis, instead of waiting for the wholesalers and retailers to declare their sales and pay the business tax thereon, assuming they actually declare and pay their taxes. The tax burden will have to be shared by the players in the distribution chain. Market forces should be able to ultimately dictate how the tax will be shared among the players in the distribution chain through a corresponding adjustment in the selling price/mark-ups within the distribution chain. In any case, the street value should be unaffected. Figure 16. E-Load Value Chain with Imposition of Advance Percentage Tax

One thing that is peculiar in the e-load business and which facilitates and renders reasonable the implementation of a percentage tax collected in advance is the fact that the telcos are aware of the maximum ultimate price of the e-load to the final consumer, i.e., the street value of the load. Thus, the telcos are aware that e-load which it is selling at the discounted price of P410 actually

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has a street value of P500. Ordinarily, the wholesaler has no control or knowledge of the price at which the goods it sold will ultimately fetch when sold to the ultimate consumers. At present, it is the VAT on the mark-up or value-added after the telcos and the percentage tax on the gross sales which the BIR appears to have difficulty collecting. As discussed, a significant percentage of the resellers after the wholesalers are unsophisticated entrepreneurs who have no sufficient awareness of taxes due them, whether it be VAT or percentage tax (if their volume of business does not aggregate Php1.5 million annually), accordingly.

It is reasonable to assume that the retailers after the level of the wholesalers already earn annual gross revenue of less than Php1.5 million, in which case, they would have been subject to percentage tax anyway, at the rate of 3 percent on their gross sales.

The cumulative foregone VAT/percentage tax on the distribution levels after the wholesaler is definitely equally significant as the VAT which is collectible at the level of the wholesalers. As discussed above, the wholesalers only have a mark-up of 4% of every peso of e-load (at street value). On the other hand, the mark-up than can still be potentially added after the wholesalers is 14% of every peso of e-load (at street value). For every Php1,000,000 e-load (at street value), the VAT, percentage tax, and advance percentage tax would be as follows:

Table 16. Business Tax Due for Every P1,000,000 Worth of E-load (at Street Value), at Current

and Proposed Tax Schemes Current Tax Scheme Proposed Tax Scheme Distribution

Level Base Business Tax Due Base Business Tax Due Wholesaler to Retailer

P750,000 x 4% = P30,000

(gross profit)

P3,600 (12% VAT)

Wholesaler Retailer to End-user

P250,000 x 18% = P45,000

(gross profit)

P5,400 (12% VAT)

Retailer to End-user

P750,000 (gross sales)

P22,500 (3% percentage tax)

P1,000,000

(street value)

P30,000

(3% percentage tax)

Total P31,500 P30,000

While it appears that the prevailing tax system yields a higher combined tax, it should be noted that the percentage tax of P22,500 supposedly collectible at the level of retailers under column 3 is, to a large extent, uncollected for reasons already discussed.

Even assuming 100 percent collection of VAT and 12 percent effective VAT rate (which is unlikely), the advance sales tax will still have substantial tax gains because the percentage tax on retailers (P22,500 above) which used to be uncollected can now be collected.

Using the above analogy, Table 17 below also examines the difference in taxes due under the two different schemes, for the e-load sales is 2005 under Case 1.a in Tables 12 and 13.

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Table 17. Business Tax Due on Estimated 2005 E-Load Sales, at Current and Proposed Tax Scheme

Current Tax Scheme Proposed Tax Scheme Distribution Level Business Tax Due /1 Base Business Tax Due

Wholesaler to Retailer P286,988,311 (remaining VAT payable)

Wholesaler-Retailer to End-user

P430,482,467 (remaining VAT payable)

Retailer to End-user P2,008,918,178 (3% percentage tax)

P89,285,252,336

(gross sales of wholesaler-retailer and gross sales of

retailer)

P2,678,557,570 (3% percentage

tax)

Total P 2,726,388,955 P 2,678,557,570 /1 see Tables 12 and 13 (Case 1.a)

It can also be noted that the tax due by imposing an advance percentage tax is smaller than the tax due under the present tax system. The difference is not very significant at about P48 million or less than 2 percent of the current tax due, as the effective VAT rates for both the wholesaler and the wholesaler-retailer in Case 2.a are less than 3 percent. However, considering again that a large proportion of the taxes due are not collected under the present system, the imposition of advance percentage tax will in fact bring about a significant increase in tax collected. As shown in Table 18, since only P0.86 billion is estimated to be collected from the P2.73 billion due under the present tax system, the advance percentage tax worth P2.68 billion in fact brings about a net increase of P1.82 billion in collections (Case 1.a).

Table 18. Additional Business Taxes to be Collected from 2005 E-load Sales Using the Proposed Scheme (under different cases in Tables 13 and 14/1)

Amount (PhP) Case 1.a Case 1.b Case 2.a Case 2.b (1) Tax Due Under Current Scheme (from Table 13) 2,726,388,955

4,577,463,562

2,396,986,055

4,422,008,509

(2) Tax Due Under Proposed Scheme (from Table 17) 2,678,557,570

2,678,557,570

2,597,651,595

2,597,651,595

(3) Estimated Foregone Revenues from Business Taxes (Table 14) 1,865,424,022

2,790,961,325

1,680,496,078

2,693,007,305

(4) Estimated Business Taxes Collected [Row 1 -Row 3] 860,964,933

1,786,502,236

716,489,977

1,729,001,204

(5) Additional Business Tax to be Collected Under New Scheme [Row 2- Row 4] 1,817,592,637

892,055,334

1,881,161,618

868,650,391

/1 Case 1.a Gross Profit Rate of 4.65% for Wholesaler, Remaining VAT Payable for Wholesaler and Wholesaler-Retailer is Net of Input VAT Case 1.b Gross Profit Rate of 4.65% for Wholesaler, Input VAT only on 70% of Gross Sales (not including VAT) Case 2.a Gross Profit Rate of 0.65% for Wholesaler, Remaining VAT Payable for Wholesaler and Wholesaler-Retailer is Net of Input VAT Case 2.b Gross Profit Rate of 0.65% for Wholesaler, Input VAT only on 70% of Gross Sales (not including VAT)

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Considering all four cases in Tables 13-15, the additional taxes to be collected range from P0.86 billion to P1.88 billion.

Unify Business Taxes on Telcos As discussed in Section II.C there are two types of business taxes which the telco business attracts and the applicable tax is dependent on the service rendered, i.e., whether it constitutes outbound communication or not. For simplication of tax administration, the BIR may want to consider the unification of business tax applicable to telcos, i.e., the possibility of imposing only VAT and dispensing with overseas communications tax or vice versa. There is a need to evaluate the revenue implications of such shift as against the efficiency of collection and the facility of auditing the tax obligations of telcos.

While it is claimed that OCT is a tax on telco customers collected and remitted by the selling telco, the same is true for VAT. VAT is likewise ultimately passed on to the customer although it is collected and paid for by the selling telco. We note that although the telcos presently pay OCT rather than VAT, as discussed, there is, in fact, already an option for telcos to pay VAT in lieu of OCT. Ultimately, if the telcos determine that they have excess input VAT, they can simply shift to VAT in lieu of OCT for a period of three years at a time. As also discussed, at the moment, telcos initially record and pay VAT upon the sale of e-load but they need to have a reversing entry should some of the e-load credits sold be ultimately used for overseas calls.

B. REGULATORY ENHANCEMENTS Issue Revenue Regulations Specifically Addressing Telecommunications Industry Tax Issues We are aware that the BIR has previously considered issuing such revenue regulations but it failed to finalize its draft (refer to Annex D). The said draft was already a step towards the right direction, although, as discussed above, there are matters which it failed to address, such as e-loading (although this may be because e-loading of phone credits may not have been adopted at the time it was drafted) and the tax treatment of the sale of e-load by e-load resellers. While it is true that e-load merchants are one-step removed from the direct players in the telecommunications business, they can be covered by the same revenue regulations as they play an integral role in the pursuit by the telcos of their business. In fact, a very significant percentage of the revenue of telcos is necessarily coursed through them. The inclusion of e-load retailers within the scope of the revenue regulations contemplated may however be limited to only the wholesalers of e-load who deal directly with the telcos. Discussed below are some of the matters or issues that must be addressed by such consolidated telecommunications industry regulations.

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Characterization of an E-load Sale Transaction and Prescription of Timing of Income Recognition An integral component of the issuance should be a categorical statement on the characterization that the BIR has adopted for e-load sales, i.e., whether it is to be classified as a sale of a tangible good or a sale of service—(a) at the level of the telcos and (b) at the level of the resellers. The sale of e-load by the telcos constitute a sale of the underlying service that needs to be performed by the telco (thus, for accounting purposes, telcos do not recognize the sale of e-load as a revenue-generating event and revenue is only recognized upon the subsequent use of the e-load or the expiry thereof) but at the subsequent channels of distribution, the sale of e-load partakes more of a sale of goods rather than services (thus, wholesalers should consider their sale of e-load as earned revenue, regardless when or if the buyers of the e-load actually use the load purchased). The revenue regulation should likewise specifically provide the prescribed time of recognition of income from e-load by the telcos. As discussed above, there is really no categorical rule laid down by the BIR requiring the recognition of e-load sales by the telcos as income on the date of sale. By the terms of the Income Tax Regulations, the telcos can actually adopt the accrual income recognition method that they have adopted for purposes of their audited financial statements. While it is represented that the telcos are presently recognizing taxable income from e-load sale on the date of sale, regardless of the time of the use of the e-load credits purchased, the same is voluntary and is not in compliance with a BIR regulation or NIRC requirement. If at all, such treatment is more in compliance with NTC-prescribed treatment. The explanation of the NTC-prescribed Chart of Accounts contains the following notation:

NOTE: The revenue derived from prepaid cards whether CMTS or LEC shall be recorded as revenue upon sale and allocated to the respective revenue accounts (basic local service revenue or long distance network revenue based on historical usage data).

In view of the foregoing, it is imperative for the BIR to adopt a categorical rule that sale of e-load should be recognized as income at the time of sale for tax purposes, notwithstanding the accounting treatment thereof. The difference in the timing of recognition of income for accounting and for tax purposes will only result in so-called book2-to-tax difference, and specifically, a mere timing difference,3 in contrast to a permanent difference.4 It is thus described that –

2 Pretax accounting income or pretax book income refers to the amount reported in the income statement that is prepared in accordance with Generally Accepted Accounting Principles (GAAP); taxable income is income as reported to the taxing authorities. 3 Timing differences do reverse or turn-around, in later periods. These differences occur when income tax regulations permit or require revenues or expenses to be recognized in a different period than the recognition method used in financial reporting. For example, while tax law and regulations makes a distinction between deferred payment sales (which is treated for tax purposes as a cash sale) as against installment sales, such distinction does not exist in the realm of financial accounting/reporting. Further, under accrual accounting, regardless of the terms of payment, the revenue is recognized in full at the time of sale. This then creates a timing difference. 4 Differences that will not reverse or turn around in subsequent year(s).

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“taxable income and pretax book income are affected in the same way by most revenue and expense transactions. However, most is not the same as all transactions. Those transactions that are not reported in the same way for book and tax purposes cause a difference between pretax book income and taxable income.”5

Admittedly there can be such differences because “the process of income taxation has little to do with the reporting of financial information to shareholders and other interested outside parties. Income tax laws are formulated, in part, to encourage certain kinds of behavior by taxpayers on the premise that such behavior is good for the economy as a whole. X x x.” Given the foregoing discussion, it is clear that tax treatment may deviate from accounting treatment. In this particular case, the earlier recognition of revenue from e-load sales for tax purposes is even more justified in view of the following: (a) there is no significant variable cost that is required to be incurred by the telephone companies

in the performance of the service corresponding to the value of the e-load sold; (b) there is practically no likelihood that the telephone companies will ever be required to refund

any unused portion of the e-load already sold and purchased, on the assumption that the telephone company is a going concern; and

(c) there is no uncertainty that the telephone company will be unable to collect the same,

considering that the telephone companies do not sell e-load on credit basis. Further on this issue of characterization of e-load sales transactions and the timing of their income recognition, it may be helpful to reproduce substantial portions of a report that was submitted following a thorough evaluation in the United States of the taxation its telecommunications industry, which report likewise included the study team’s recommendations. While the system of taxation in the U.S. is different, still, the BIR may get some idea of points to consider in deciding how to treat e-load sales. The relevant portions of said report read:

RECOMMENDATION 3: The Task Force recommends that prepaid calling arrangements be taxed at the point of sale rather than the point at which the service is actually used. Prepaid calling cards have been available for several years. These cards usually contain an identification code that entitles the holder of the card to telecommunications services through a telecommunications provider that is the issuer of the card. The cards may be sold through any number of retail outlets or given away as incentives for other purchases or for other reasons. Some cards are sold as collectibles. Prepaid calling arrangements are also now available where the customer receives only the access number and authorization code; no card is provided to represent the transaction. More recently prepaid arrangements cover wireless telecommunications services. Under current Maine law, the sale of a prepaid calling card or arrangement is not considered a taxable sale. Sales tax liability is determined at the time that service is provided. Sales tax must be calculated by the provider if the service provided is a taxable transaction. Sales tax is not due if the service is not taxable

5 James Reece and Robert Anthony, Accounting: Text and Cases, pp. 319.

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(interstate calling, exempt taxpayer, minutes not used and not purchased as a collectible). Determining the proper tax base, and sourcing the transactions are an onerous burden. Determining whether a customer is exempt from sales tax is impossible. According to information the Task Force received from the International Telecard Association, a small percentage of card issuers do not account for or remit usage taxes. The Association believes that switching the tax treatment to point-of-retail-sale will increase compliance. In addition, the change will improve pubic policy because these noncompliant firms, who often are the same ones who stick customers with worthless cards, may find it no longer economical to offer calling card without the ability to profit from failure to remit taxes. Twenty-one states and the District of Columbia impose sales tax at the point-of-retail-sale. Imposing the sales tax at the point of sale of a prepaid calling card increases the administrability of the sales tax for both the State and the telecommunications provider. Ultimately consumers should benefit from reduced prices fro telecommunications service.

X x x Generally, a retail sales and use tax is more difficult to administer than gross receipts taxes (although not necessarily for the telephone providers). In the event that PPCs are purchased in a state with no sales tax, such as Delaware, which has no sales tax, and the cards are used in the District, the District will have few tools available to monitor and collect use taxes. Further, since the cards are not being used in the state in which they were purchased, it is not likely that state of purchase would have the requisite nexus to the tax the PPCs. On the other hand, some telecommunications providers have argued that states are better off under a retail sales tax because taxation at the time of use raises nexus issues and because the state can collect taxes on the PPC regardless of whether the card is actually used. Option A. Tax PPCs as tangible personal property at 10% [Revenue Impact - $0 – current practice] Pro - This method is less burdensome to the telecommunications firms.

- District collects revenue on cards regardless of use. (However, the District may not be able to collect sales and use taxes if a card is used outside the District.

- Some other states are also taxing PPCs as tangible personal property Con- Creates an artificial difference in the taxation of telecommunications services, based on the nature of payment.

- OTR unlikely to collect use taxes on cards purchased elsewhere but used in the District; provides an incentive to purchase cards in a tax free jurisdiction to avoid taxation

- Creates an additional administrative burden for District retailers - Not clear if government enterprises selling PPCs charge sales tax,

meaning that a portion of the base is likely to go untaxed. X x x

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- Fails to eliminate record-keeping requirements for telecommunications providers because many other states continue to tax PPCs like other interstate telecommunications services. Option B. Revert to taxation of PPCs as telecommunications services [Revenue Impact – increase less than $1,000,000] Pro- eliminates artificial difference in the taxation of telecommunications services based on the form of payment

- Tax paid by the telecommunications providers if the card is used in the District, regardless of the taxable status of the consumer or retailer.

Con- Creates administrative burden on telecommunications providers.

- District only collects revenue when cards are used and not at all if a card goes unused. (underscoring ours)

Amend or Expand Information Disclosure and Reporting Requirements of Telcos It is given that the level of detail that is to be observed in the preparation of the audited financial statements is not something that the BIR can prescribe. The audited financial statements have to be consistent with Philippine Accounting Standards (PAS) and Philippine Financial Reporting Standards (PFRS) and are prepared for general use and not specifically for the use of the BIR. Thus, considering that BIR needs details beyond those that are contained in the audited financial statements and in the schedules ordinarily attached to the income tax returns, it may have to prescribe additional reports to be submitted to the BIR. For the purpose, BIR may invoke the authority of the Commissioner of Internal Revenue to prescribe additional procedural or documentary requirements, as expressly provided under Section 6(H) of the NIRC. Section 6(H) of the NIRC, provides:

SEC. 6. Power of the Commissioner to Make Assessments and Prescribe Additional Requirements for Tax Administration and Enforcement. — X x x. (H) Authority of the Commissioner to Prescribe Additional Procedural or Documentary Requirements. — The Commissioner may prescribe the manner of compliance with any documentary or procedural requirement in connection with the submission or preparation of financial statements accompanying the tax returns.

Among others, the additional reports or attachments to existing documentary submissions should endeavor to supply the BIR with details of the income of the telco from pre-paid subscribers. The telco should be able to detail the source of its sales of e-load (i.e., whether generated from direct sales to subscribers, sales through wholesalers, direct sales to retailers, sales through banks, or sales through credit card companies, etc.). The BIR may need to prescribe the manner that telcos have to classify their revenue account. For BIR purposes, the classification of revenue according to whether it was obtained from wireline or wireless service may not be as useful as a classification of telco revenue into revenue from

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postpaid subscribers and revenue from pre-paid revenue (in addition to revenue from interconnection charges and others—e.g. sale of phone kits). The distinction here is more significant because the audit procedure to be adopted by the BIR for each class of revenue in this case would differ.

Revenue from postpaid subscriptions can more readily be audited through the billings to subscribers. On the other hand, a totally different verification procedure may be necessary to confirm the correctness of the declared revenue from pre-paid services. Itemization of all prepaid revenue sources should be required. The BIR should already identify the major categories of sources, such as: (a) Banks and credit card companies; (b) direct sales to retailers; (c) direct sales to subscribers; (d) sales through wholesalers/distributors, among others. C. ENHANCEMENT OF OPERATIONAL METHODOLOGIES AND CAPACITY-

BUILDING Obtain Sufficient Understanding and Knowledge of the Telco Business and Full Understanding of Telco Accounting System The foregoing discussions sufficiently emphasize the increasing complexity of the way the telcos do business, the increasing variety of services that they are able to render, the myriad of transactions, arrangements, and agreements that telcos enter into, the increasing number of parties that constitute the network of business partners of telcos in the conduct of their business, and the constantly evolving technology that drives significant changes in the manner that telco services are rendered/performed/delivered, marketed, and settled. In view of the foregoing, it is indispensable for an effective enforcement of tax laws in the telecommunications industry for the tax authority and its agents to acquire a good understanding of the telco business and the significant factors affecting it. To be able to conduct an effective audit of the books of the telcos, simply having access to the accounting books of the telcos would not suffice. The examiners/auditors should have a more in-depth knowledge of the business of telcos. For example, at this time, telcos do not simply earn from their traditional sources of revenue, such as from voice calls (directly billed by them to subscribers or earned through other telcos by way of interconnection charges) and installation fees. Telcos now have a far wider variety of revenue sources and the auditors must have an understanding of the nature of these new revenue sources such as: (a) SMS and MMS fees, (b) share in the revenue of content providers, (c) sale of telephone units and related accessories, (d) transaction fee in the case of sale of e-money or sale of value for e-wallet purposes, (e) revenue from the use by subscribers of their e-wallet credits, (f) revenue from e-remittance, among others. Knowledge of only the traditional telco business would be grossly inadequate to enable an examiner or auditor to thoroughly plan the audit of the telcos’ books and assess their level of tax compliance. A better understanding of the business of telcos and its nuances will enable the auditor to ask intelligent questions, know what they should watch out for, and understand and put into proper context the figures and other information being given them. In order to obtain sufficient current information about the telco business, the BIR should endeavor to provide its examiners tasked to audit the telcos training seminars/briefings regarding the telecommunications industry facilitated by industry experts. At least an annual briefing can

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be scheduled so that BIR examiners are regularly kept abreast with relevant industry information that can help them anticipate and prepare for the future challenges that they will have to address. We understand that the telcos have been requested to make a presentation to BIR examiners of their accounting practices such as how they record certain revenues and recognize various taxes such as VAT on their transactions. This is a development in the right direction. However, such presentations from the telcos may somehow be self-serving and may not be comprehensive enough to provide BIR examiners the relevant information they need to plan a good tax audit. Enhance and Strictly Implement the Prescribed Procedure for the Grant to Telcos of Authority to Use Computerized Accounting System Given that there is compelling practical reason to concentrate tax collection effort at the level of the telcos and their wholesalers/distributors, there is a need to confirm that all e-load sales are actually being reported. To be able to establish an effective way to audit this item, it is imperative for the BIR to obtain a good understanding of the accounting system of the telcos.

To justify BIR’s inquiry into the accounting system and not just the accounting books of the telcos, the BIR may look into the possibility of invoking its authority to audit the accounting system in view of the requisites for approval of the use of automated/computerized accounting system. Under existing BIR rules, specifically Revenue Memorandum Order No. 29-02 dated September 16, 2002 (Revised Procedures in the Processing and Approval of Applications for Permit to Adopt Computerized Accounting System), it is categorically required that all taxpayers who have computerized accounting systems or components thereof shall apply for permit prior to its use of the same.

Procedure issuance of authority For the purpose of evaluating an application, the BIR has prescribed documentary requirements as well as procedures which will enable it to assess the computerized system and satisfy itself that the integrity of the accounting information is preserved by the computerized system.

Detailed flowchart of the flow of information through the system should be required to be submitted by the telcos. However, more importantly, the BIR should require that a walk through of the system should be made. This particular procedure is not presently prescribed. In fact, even actual systems demonstration may be dispensed with in specified instances.

A walk through is a standard audit procedure for computerized systems. A “walk through,” or more technically described as a transaction flow audit of the system, tests several transactions of each type. The transaction flow audit should be organized by transaction type (e.g., sales orders, credit notes, customer master file changes) and should cover the:

• Transaction (e.g., customer order to shipping notice to invoice to customer statement, etc.); • Related control information and balancing procedures (e.g., batch total of shipping notices to

batch control log to reconciliation of control totals to monthly sales summary); • Error correction procedures (e.g., error list to original source document to subsequent

correcting entry).6

6 From www.accounting.uwaterloo.ca/ccag2001/8CHAP97.htm - 320k viewed on 21 March 2006.

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In this case, the walk through contemplated would require the BIR to identify critical transactions and have representative test data for each critical transaction type. Given the information obtained from this Project, the BIR should be able to identify the specific critical areas, such as—

a. how sales of e-load from abroad is accounted for and ultimately recorded; b. how the system tracks transactions made using pre-paid credits to enable the timely

recognition of income upon realization thereof; and

c. how expiry of e-load credits is tracked by the system such that the transfer of values from unearned revenue to earned or realized income is triggered.

Testing of the worthiness of the system should focus on the following major aspects of the telcos’ operation—

a. Revenue path – the BIR should obtain sufficient information and should be satisfied that all

revenues of the telco is being captured by the system and are ultimately reflected in the declared revenue of the telco. Not only income from local postpaid subscriptions and prepaid services but also foreign-sourced income such as those generated from interconnection fees should all be fully accounted for. A walk through of the revenue path must include for example, tracing how the computerized system records and subsequently processes the following test transactions: i. the receipt of a SMS or call from a pre-paid subscriber of the telco to another subscriber

of the telco (to test the recording of the recognition of income in view of the use of e-load credit originally recorded as unearned revenue);

ii. the receipt of a SMS or call by the telco’s subscriber from a subscriber of another telco

(to test recording of revenue from interconnection or termination chargers);

iii. the receipt of a SMS by the telco’s subscriber from a sender using web-based SMS service provider (e.g. Chikka) and the subsequent reply of the telco’s subscriber to said Chikka-sent message (to test that the record used for purposes of revenue sharing with Chikka is complete);

iv. the download of a ring tone by the telco’s pre-paid subscriber (to test the recording of

earned income from revenue sharing arrangements with content providers); and

v. the use e-load by a subscriber to make a call, etc. where the e-load was purchased using bank debit, credit card, and e-wallet (to test that revenue earned is being recorded promptly and that recording of earned revenue is consistent with representations on how such transactions are treated.

b. Cash receipts path – given that not all cash receipts of the telcos are automatically recorded as revenues but a significant amount thereof is first recorded as unearned revenues, the cash receipts path is also critical. Thus, it needs to be verified that all cash receipts from various sellers of e-load, whether third parties or the telco itself, are being recorded. Moreover, given that the telcos issue electronic money as well as enter into a wide variety of other transactions, it needs to be determined how the receipts of money from typical transactions of the telco are actually being recorded.

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Thus, the walk through may include the tracking of the recording and further processing of the following transactions: i. the receipt of cash from the purchase of e-load by a subscriber from the telco; ii. the receipt of cash from the purchase of e-load by other resellers of e-load; iii. the receipt of cash from the purchase of value from the telco for loading into the

subscriber’s e-wallet; iv. the receipt of cash from other local and foreign telcos representing payment of

interconnection or termination fees; and v. the receipt of payment from postpaid subscriber which has various types of transactions,

i.e., international roaming, calls to subscribers of other telcos, outbound calls, among others.

c. Cash disbursements path – this will serve to verify that the amounts which were not reported as

part of the telcos’ revenue, since they are owing to third parties such as interconnection charge due to other telcos or content fee due to providers, are factual and are actually subsequently paid out. Thus, the walk-through of transactions involving cash disbursement would give an indication of how the revenue generated is ultimately distributed or applied to operations, such as for--

i. the payment of interconnection fees;

ii. payments to content providers; and iii. payments for regular business expenses (operating or otherwise).

Composition of the Computer System Evaluation Team We understand that the evaluation process prior to the approval of an application to use a computerized accounting system is conducted by the Computer System Evaluation Team (CSET), the composition of which is as provided under RMO 29-02. We observed, however, that the prescribed composition of the CSET does not require the inclusion of a member who is well-versed about the industry and who may be aware of the nuances of said industry.

It would be ideal to have a resource person who is familiar with the industry to which the applicant taxpayer belongs, whose function is to assist the CSET design the specific evaluation/audit procedures to be carried out, including outline the pertinent questions that need to be answered by the applicant. Alternatively, instead of having a CSET member who is an industry specialist, the BIR may simply engage on a one-time basis, consultants who will just design the audit program and procedures for the telecommunications industry. Somebody familiar with the industry would know what to look for and would already help the CSET identify critical areas and identify the important test transactions. Conduct periodic audit of the computerized accounting system

We note that Revenue Memorandum Circular No. 71-03 prescribed the conduct of a post system evaluation of computerized accounting systems. However, there is no express provision therein that this will be done periodically. We suggest that the post-audit should not be done only once after the approval of the computerized accounting system; ideally, it should be performed once during each fiscal year, to ensure that the approved computerized accounting system that was approved by the BIR continues to be unaltered in all respects. The audit should be unannounced.

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An abbreviated audit procedure may be alternated with a more comprehensive systems audit from year to year. We note that while it is expressly provided that a new application needs to be made if any enhancement to the accounting system is introduced, this assumes that the taxpayer is responsible and honest enough to promptly declare such enhancements or changes made on the duly approved computerized accounting system. Prescribing periodic audits of the computerized system serves to compel taxpayers to promptly report enhancements to their systems. In addition, a penalty for tampering with/altering the computerized system that was approved by the BIR without corresponding notice to and approval of the BIR should be prescribed. Maximize the Use of Third Party Information Utilize domestic sources Information about wholesalers. At the moment, there is no way that the BIR can identify the wholesalers/distributors of e-load other than by specifically requesting this information from the telcos. Notwithstanding the submission of the alphalist of revenue transactions subject to VAT there is nothing in said list that would enable the BIR to flag the e-load wholesalers from the other revenue sources of the telcos.

Thus, to identify the wholesalers, the BIR must require the telcos to submit the list of their wholesalers of e-load and to provide information regarding the magnitude of their transactions with these e-load wholesalers. This can be requested in the exercise of its authority to obtain third party information or even in the course of its audit of the “Unearned Revenue” account appearing in the audited balance sheets of the telcos. In the course of our review of BIR issuances relating to collection of third party information, we noted that under Revenue Memorandum Order No. 52-937, it is provided that access letters to be sent to the identified third party informants will have to specify the following:

• Name and address of purchaser/lessor/lessees, number of the club, user of facility, etc. and

the TIN; • Date of transaction; and • Total amount of the transaction or installment payments, membership fees, etc. in the year of

the transaction. We are not certain whether in the implementation process, the inclusion of foregoing specified information is deemed mandatory. Our concern is, if access letters are required to indicate the foregoing information, then the BIR is limiting itself to obtaining third party information only when it has the above information to start with. The law itself, i.e., Section 7 of the NIRC does not limit the authority of the BIR to obtain third party to instances when it has identified a specific person whose information it wants to obtain. Thus, in this case, given that the BIR does not actually have information on the identity of all the major e-load distributors, it can simply request the list of e-load wholesalers, with a further request for the telcos to disclose the value of their transactions with these wholesalers, and all other information which the telcos are assumed to have on their e-load wholesalers.

7 Subject: Collection of Third Party Information by Authority of Section 7 of the National Internal Revenue Code.

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Information on other contracting parties of telcos. Either in the course of audit of the telcos or on the basis of the BIR’s exercise of its authority to obtain third party information, the BIR should be able to gain access to or obtain copies of contracts with significant revenue inflow or cost implications on the telcos. To prevent the BIR from being swamped with too many documents from the telcos, only copies of contracts that meet the prescribed threshold annual transaction value should be obtained. Often times, even a cursory reading of a contract would give one a good idea of all the types of costs and expenses that will be incurred or income that can be earned by the parties to the contract. It can serve to verify whether all the income under a particular arrangement are being reported and the timing that they are reported is in accordance with the terms of the contract. This recommendation is an offshoot of our study group’s difficulty in identifying all the possible sources of the telcos’ revenues beyond the traditional sources of telco revenue. For example, we are not convinced that in issuing electronic money their only incentive is to enhance the array of services they offer to subscribers. The study group is inclined to believe that aside from the processing fee that telcos charge to issue e-money, which is quite minimal, they are earning a discount on the amounts they pay to the merchants accepting electronic money, similar to the discount that credit card companies charge merchants who accept their credit cards. It should be noted that electronic money loaded in the e-wallet of a subscriber is similar to a debit card which is often extended by credit card companies. A debit card allows the holder thereof to pay using the said card to the extent of his existing deposit balance in a related account.

Admittedly, at this point, even in other countries, the use of electronic money has been observed to be predominantly used in the settlement of micro-payments. In the future, however, there is every possibility that the use of e-money will become more widely acceptable. The mechanics of fee sharing between content providers such as Chikka.com and the telcos is also not known. The contract itself between the content providers and the telcos would be the best source of information about their fee arrangement. In general, the contracts are the best possible source of information on the actual mechanics of a particular transaction being executed through or in tandem with other parties such as merchants, distributors, etc. Strengthen and institutionalize linkage and data sharing between the NTC and the BIR BIR needs to be aware of the available financial and other relevant information that is lodged with the NTC by the telcos. Legally, BIR could have access to this information, whether or not the same is in connection with on-going audit of a particular taxpayer. Section 5 of the NIRC provides:

SEC. 5. Power of the Commissioner to Obtain Information, and to Summon, Examine, and Take Testimony of Persons. — In ascertaining the correctness of any return, or in making a return when none has been made, or in determining the liability of any person for any internal revenue tax, or in collecting any such liability, or in evaluating tax compliance, the Commissioner is authorized: (A) To examine any book, paper, record, or other data which may be relevant or material to such inquiry;

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(B) To obtain on a regular basis from any person other than the person whose internal revenue tax liability is subject to audit or investigation, or from any office or officer of the national and local governments, government agencies and instrumentalities, including the Bangko Sentral ng Pilipinas and government-owned or -controlled corporations, any information such as, but not limited to, costs and volume of production, receipts or sales and gross incomes of taxpayers, and the names, addresses, and financial statements of corporations, mutual fund companies, insurance companies, regional operating headquarters of multinational companies, joint accounts, associations, joint ventures or consortia and registered partnerships, and their members; X x x. (underscoring ours)

For benchmarking purposes for the telco industry, the financial information with the NTC may in fact be more useful to the BIR than the information from the audited financial statements, particularly upon the full/strict implementation by the NTC of the use of uniform system of accounts. With a uniform system of accounts in place, comparability of financial information is enhanced and can more readily be used for benchmarking by the BIR.

Under Republic Act No. 7925 (An Act to Promote and Govern the Development of Philippine Telecommunications and the Delivery of Public Communications Services), the NTC is mandated to require telcos to set up a uniform system of accounts. The NTC has issued a uniform system of accounts with corresponding guidelines or explanations thereto,8 but a perusal of the reports submitted to NTC by the telcos as of 2004 indicate that there is still no consistent use and compliance of the uniform system of accounts. There is also a reason to strengthen the linkage between the BIR and the NTC in anticipation of the broadening of the authority of the NTC under a presently pending bill concerning the NTC. In House Bill No. 49429 which is now pending and introduced by former NTC head, Rep. Simeon L. Kintanar, the NTC is proposed to have the following authorities, among others—

• Prescribe rules and regulations, guidelines, measures and specifications for the following:

a. The setting and imposition of appropriate fees and charges over persons and entities within its jurisdiction, such as:

i. radio spectrum fees for all assignees except those assigned to military and public safety services;

ii. permits, certificates, registrations and license fees; iii. supervision and regulations fees; and iv. other administrative fees and charges, fines and sanctions;

b. The determination and prescription of rates and tariffs for facilities and services except when these rates and tariffs are deregulated or established by international bodies or association of which the Philippines is a participating member or by bodies recognized by the Philippine Government as the proper arbiter of such rates and tariffs. Rules shall be established for payment schemes whether for regulated or deregulated rates;

• Mandate a fair and reasonable interconnection of systems, stations, networks, facilities and/or services of authorized network operators and other providers through appropriate modalities

8 Attached as Annex G is the NTC Chart of Accounts for Telecommunications with the corresponding description of accounts. 9 An Act Reorganizing The National Telecommunications Commission Into The National Information And Communications Commission, Defining Its Powers And Functions, And Appropriating Funds Therefor.

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of interconnection, that provides a reasonable and fair level of charges, so as to provide the most extensive access, availability and affordability to the public, and ensures that no single player or interest controls access to facilities and services;

• Directly intervene, enjoin speedy settlement through modes of alternative dispute resolution, and impose judgment on on-going and protracted disputes involving interconnection among service providers, including the final approval of any interconnection agreements;

• The Commission shall have the power to make rules and procedures for the conduct of its proceedings and in arriving at its decisions or orders, and impose fines and penalties to enforce compliance with any rule, regulation, order or other requirements;

• The Commission may summarily punish for contempt by a fine not exceeding five thousand pesos or by imprisonment not exceeding thirty (30) days or both, any person guilty of such misconduct in the presence of the Commission or so near thereto as to seriously interrupt any hearing or session or any proceedings before it, including cases in which a person willfully fails or refuses, without just cause, to comply with summons, subpoena ad testificandum, subpoena duces tecum, injunctions, decisions or orders, rules and regulations legally issued or promulgated by the Commission; or being present at a hearing, session or investigation, refuses to be sworn as a witness or to answer questions when lawfully required to do so, or to furnish information required by the Commission. The police agencies of the place where the hearing or investigation is conducted shall, upon the request of the Commission, assist in enforcing the provisions of this section;

• Require any public service or utility to produce before the Commission any and all records, data, statistics and documents deemed proper or necessary in the exercise of its powers and functions, and cite for contempt, direct or indirect, any person who fails or refuses to comply with any lawful order of the Commission;

• Inspect, on its own or through duly authorized representatives, the operations, premises, books of accounts and records of any person or entity at any reasonable time, in the exercise of its quasi-judicial power for purposes of determining the existence of any anti-competitive behavior and/or market power abuse and any violation of rules and regulations issued by the Commission;

• Enlist the aid and support of any and all enforcement agencies of the Government, civil or military as well as any private institution, corporation, firm, association or person in the implementation of its powers and functions under this Act;

• Approve the submission by all operators of information and communication, radio, broadcast, CATV and other multi-media facilities, stations, systems or networks and services including radio training schools, the following:

a. The amount, terms, and conditions of each proposed issue, sale or other disposition of its capital stocks ;

b. The terms and conditions of each proposed contract or agreement for the interconnection of systems, facilities, networks and services;

c. Any contract or arrangement entered into between operators and program/content providers which tends or aims to exclude, inhibit and frustrate the ability to offer diverse programs for a wider variety of choices and diversity of programming to the subscribing public; and

d. Any contract, agreement, reports as may be prescribed by the Commission from time to time.

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The exercise of the foregoing authorities of the NTC presupposes that it has and it can obtain substantial financial information from the telcos. In line with the general intention of HB 4942 to further empower the NTC, it may be helpful to point out the Federal Communications Commission (FCC) of the United States is specifically granted the following authorities:10

• Prescribe the forms of any and all accounts, records, and memoranda to be kept by carriers

subject to this Act, including the accounts, records, and memoranda of the movement of traffic as well as of the receipts and expenditures of moneys.

• At all times have access to and the right of inspection and examination of all accounts,

records, and memoranda, including all documents, papers, and correspondence now or hereafter existing, and kept or required to be kept by such carriers, and the provisions of this section respecting the preservation and destruction of books, papers, and documents shall apply thereto. The burden of proof to justify every accounting entry questioned by the Commission shall be on the person making, authorizing, or requiring such entry and the Commission may suspend a charge or credit pending submission of proof of such person.

• In case of failure or refusal on the part of any such carrier to keep such accounts, records, and

memoranda on the books and in the manner prescribed by the Commission, or to submit such accounts, records, memoranda, documents, papers, and correspondence as are kept to the inspection of the Commission or any of its authorized agents, such carrier shall be subject to the imposition of corresponding penalty.

• Any person who shall willfully make any false entry in the accounts of any book of accounts

or in any record or memoranda kept by any such carrier, or who shall willfully destroy, mutilate, alter, or by any other means or device falsify any such account, record, or memoranda, or who shall willfully neglect or fail to make full, true, and correct entries in such accounts, records, or memoranda of all facts and transactions appertaining to the business of the carrier, shall be deemed guilty of misdemeanor.

• Issue orders specifying such operating, accounting, or financial papers, records, books,

blanks, or documents which may, after reasonable time, be destroyed, and prescribing the length of time such books, papers, or documents shall be preserved.

• After the Commission has prescribed the forms and manner of keeping of accounts, records,

or memoranda to be kept by any person as herein provided, it shall be unlawful for such person to keep any other accounts, records, or memoranda than those so prescribed or such as may be approved by the Commission or to keep the accounts in any other manner than that prescribed or approved by the Commission.

It would be to the advantage, not only of the NTC but also the BIR if the foregoing or comparable authority or powers are vested by law on NTC under an amendatory law.

Not only the problem of availability of data will be resolved but likewise the uniformity and comparability of telco data will be achieved if the NTC is vested authority comparable to the foregoing and the NTC exercises such authority that it is granted. With standardized reporting,

10 Communications Act of 1934 [47 U.S.C. 220].

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the BIR should be able to arrive at its industry benchmarks more easily. With NTC authority to closely monitor financial information of telcos and the accuracy thereof, then greater reliability of telco data will likewise be achieved.

Lastly, in connection with any future amendment of the law governing NTC, while it may be best to have an express provision authorizing the NTC to provide relevant financial information to the BIR, this may be strongly opposed by the telcos. Thus, the absence of an express prohibition on NTC from sharing information to other government agencies such as the BIR would suffice. We note that, to a certain extent, in the course of data gathering for this Project, the opportunity for future cooperation between the BIR and the NTC was opened. So far, the BIR has been furnished copies of certain reports which were submitted by telcos to NTC. This cooperation between the two agencies can be strengthened, broadened, and institutionalized. In fact, some of the data requirements of the BIR can be requested to be made an integral part of the annual reports submitted to the NTC, to the extent that NTC would also find such information/data relevant for their purposes. Foreign-sourced information

Aside from obtaining relevant financial information or access to information relating to the telcos from local sources, it may also prove fruitful for the BIR to obtain the level of traffic and corresponding income actually earned by telcos from abroad. The BIR can specifically target the countries where there is considerable concentration of Filipino nationals and which have existing tax treaties with the Philippines.11

Existing tax treaties of the Philippines with other countries generally include provisions on exchange of information, which can be exploited by the BIR in order to obtain cross-border information, pertaining to the foreign related companies of a Philippine entity. The RP-US Tax Treaty provision on exchange of information, for example, reads:

A. EXCHANGE OF INFORMATION

(1) The competent authorities shall exchange such information as is

necessary for carrying out the provisions of this Convention or for the prevention of fraud or for the administration of statutory provisions concerning taxes to which this Convention applies provided the information is of a class that can be obtained under the laws and administrative practices of each Contracting State with respect to its own taxes.

(2) Any information so exchanged shall be treated as secret, except that such

information may be —

(a) Disclosed to any person concerned with, or

11 The Philippines has a tax treaty with the following countries: Australia; Austria; Bahrain; Bangladesh; Belgium; Brazil; Canada; Czech Republic; Denmark; China; Finland; France; Germany; Hungary; India; Indonesia; Israel; Italy; Japan; Korea; Malaysia; The Netherlands; New Zealand; Norway; Pakistan; Romania; Russia; Singapore; Spain; Sweden; Switzerland; Thailand; United Kingdom of Great Britain and Northern Ireland; United States; and Vietnam.

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(b) Made part of a public record with respect to the assessment, collection, or enforcement of, or litigation with respect to the taxes to which this Convention applies.

(3) No information shall be exchanged which would be contrary to public

policy. (4) If information is requested by a Contracting State in accordance with

this article, the other Contracting State shall obtain the information to which the request relates from or with respect to its residents or corporations in the same manner and to the same extent as if the tax of the requesting State were the tax of the other State and were being imposed by that other State. A Contracting State may obtain information from or with respect to its residents or corporations in accordance with this paragraph for the sole purpose of assisting the other Contracting State in the determination of the taxes of that other State.

(5) If specifically requested by the competent authority of a Contracting

State, the competent authority of the other Contracting State shall provide information under this Article in the form of depositions of witnesses and copies of unedited original documents (including books, papers, statements, records, accounts, or writings) to the same extent such depositions and documents can be obtained under the laws and administrative practices of each Contracting State with respect to its own taxes.

(6) The exchange of information shall be either on a routine basis or on request with reference to particular cases. The competent authorities of the Contracting States may agree on the list of information which shall be furnished on a routine basis.

In July 1997, the BIR issued Revenue Memorandum Order No. 42-97 which prescribes the revised procedures in requesting information from tax treaty partners to the Philippine tax treaties. Moreover, telecommunications authorities of other countries likewise gather significant volume of detailed information that is made available to the public. In any case, it is important to first know what information can be readily obtained from foreign telecommunications authorities without going through their bureaucratic process. The FCC of the United States, for example, has information which can readily be accessed by the public under the Freedom of Information Act. The information from other countries, particularly the telecommunications authorities of these countries, is beyond the control and influence of any local company and thus, can be relied upon to provide highly reliable information. Data from them can be used to verify the accuracy/correctness of the declarations of the telcos with respect to their income from termination fees from abroad.

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Institutionalize Coordination of Revenue District Office with the Large Taxpayers Service in the Audit of Major Wholesalers It is best that information relating to the telcos’ sales to their e-load wholesalers be centrally obtained by the Large Taxpayers Service as it is the BIR office that already deals closely with the telcos. It would be ideal if BIR could be furnished the following information by the telcos: o The name, address, and tax identification number of their e-load dealers; o The monthly value of sales to these dealers; and o The applicable discount rate given to the dealer concerned.

It would suffice for the Large Taxpayers’ Service to require the telcos to disclose their top 100 dealers. Based on the data furnished us by Smart covering a period of only 11 months, more than fifty percent (50%) of their over 150 listed wholesalers purchased Smart e-load amounting to over Php100 million and at least four (4) purchased e-load amounting to more than Php1 billion. Relevant information obtained by the Large Taxpayers Service about the wholesalers such as the value of their e-load purchases from the various telcos can be summarized and furnished to the Revenue District Officer (RDO) where these wholesalers are registered (assuming they are not themselves large taxpayers). Such important information could be the trigger for the RDO concerned to initiate the tax audit of the said wholesaler. A procedure could be put into place to require the RDO to report to the Large Taxpayers Service or the appropriate office of the BIR, the specific action that was taken by the RDO in view of the third party information it was furnished. Subsequently, within a given period, a report should likewise be made on the final findings of the audit or the amount of assessment issued, if any. Focus of Audit of Wholesalers: Reason Behind the Erosion of their Income Tax Base In the audit of the wholesalers, detailed scrutiny is in order, to account for the noted erosion of their taxable base. Based on the limited financial information that we were able to obtain on some of the major wholesalers of Smart, it appears that their net income before tax is a very low percentage of 0.05% to 0.19% (refer to excerpts of Annex G in Table 9) of their gross revenue. In our view, the business of selling e-load should not require a significant amount of overhead cost. If at all, the most significant predictable cost item for them would be commission expense paid to their sales agents, unless the sales and marketing function is actually done by their own employees. It appears that materials to advertise the sale of e-load in retail outlets is also borne by the telcos rather than the wholesalers. The income statements of wholesalers that we have reviewed do not even indicate specific claim for advertising expense. In sum, we fail to understand why a gross profit rate equivalent to 3%-4% of the street value or 4.88% of the telco’s selling price is reduced to a measly 0.3%-0.5% and ultimately further eroded to reflect a net income before tax rate of only 0.05% to 0.19%. In the case of Wholesaler C, for example, one of the four (4) billion Peso level wholesalers of Smart, its audited sales is a humongous amount of P1,575,153,031.43 but after deducting its direct cost (which is indicated to be solely accounted for by the purchase price of the goods sold) what remains is a measly amount of P4,866,206.75. As discussed above, based on the results of

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our study, the average mark-up rate of wholesalers is 3%-4% of the street value (or a higher rate of 3.6% - 4.8% of the telcos’ selling price of the load). It remains to be explained how such indicative gross profit rate could be reduced to a low “actual” gross profit rate of 0.3%.

We only had the opportunity to compare the audited financial statements of a few Smart e-load/prepaid card retailers. We have no basis to conclude that they exclusively deal with Smart e-load, i.e., they do not at the same time sell e-load for the other telcos. Assuming that they exclusive sell for Smart, then it would seem that they are substantially reporting their e-load purchases from Smart. In the case of Wholesaler C, for example, it is indicated that for 2003, it purchased P1,688,055,100.25 worth of goods (which, it would appear, is mostly prepaid cards). In Smart’s summary of sales to its wholesalers in 2005,it is indicated that it sold P1,311,322,237.71 for the period February to December 2005 or an estimated P1,430,533,349 for the entire year.

The BIR therefore, may need to more importantly audit the sales declared by the wholesalers. If the official receipts issued by wholesalers tally with the reported audited sales, it remains to be further investigated if the amounts indicated on the official receipts are actual and the indicated buyers are not fictitious. It is possible that official receipts are not in fact being issued and do not correspond to actual sales transactions.

D. TECHNOLOGY-BASED SOLUTIONS

Given the nuances of the telecom industry (not only the e-load segment of the telecommunications business), we find that it is imperative for the BIR to adopt a revenue (to include revenue from pre-paid services) verification/audit method that is fairly stable and will not require it to continually adopt/adjust to emerging technology. The state of available technology impact on the way the telcos do business, but it need not necessarily impact on the manner that the BIR will verify and confirm correctness of tax payments. The audit methodology or verification system should, as much as possible, be technology insensitive. To a significant extent, continuous technology enhancements are focused on (a) the manner of delivery/performance of the service and (b) manner of selling the service, including the manner of payment for the service sold. The first item affects more the cost efficiency and the quality of service of telcos but may not have any significant impact on tax administration and compliance. As telcos increasingly sell their services electronically and engage in e-commerce themselves, the tax administration and compliance issues of the telecommunications industry will become more and more similar to the unresolved issues posed by electronic commerce. A specific example is the increasing transaction of telcos involving electronic money. As electronic money is analogous to cash, it increasingly enables them to undertake anonymous and untraceable transactions. As it is, identification of parties to communications and transactions utilizing these new technologies and verifying records when transactions are conducted electronically raises serious issues. However, it is yet uncertain whether developments in the science of encryption and related technologies may lead to systems that verify the identity of persons online and ensure the veracity of electronic documents.12

12 Ibid.

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It is common knowledge that prepaid phone cards are the predecessors of the present e-loading system. Prepaid phone cards previously circulated and sold can be described as single purpose cards as they are specifically intended to be used in availing of telecommunications services and their full value is deemed as a prepayment to the telephone company concerned. With the emergence of the appropriate technology, not only are the prepayments being received by the telephone companies limited to prepayments for their services, they now also accept prepayments for a wide array of goods and services of an increasing number of merchants. Thus, as discussed above, telcos are also now in the business of issuing e-money. The BIR cannot improve its effectiveness in enforcing tax laws if it is pressed to continually evolve and adopt new regulations and audit procedures as the technology evolves. We do not find it realistic to expect the BIR to be able to keep pace with the relentless evolution of relevant technologies in the telecom industry. A case in point is the BIR’s limited capacity to quickly release pertinent regulations to specifically address telecom issues. To date, there is no revenue regulation directly concerning telecommunications industry, notwithstanding the fact that it is admittedly one of the leading industries and some of the leading taxpayers of the country are actually in the telecoms business. It appears that as early as July 2004, the BIR had sensed the need to issue regulations governing the telecom industry as there is a draft revenue regulation that has long been posted on its website. Noticeably, the said draft nowhere mentions e-loading and only refers to prepaid cards. At this time, prepaid cards are becoming obsolete and are now being eclipsed by e-load. Thus, even before the BIR could release the regulation, the underlying technology behind pre-paid telecom service has evolved in a major way.

Access Use Information from Call Detail Records

A specific revenue auditing/verification tool which should be effective regardless of the changes in the technology used is verification with the use of and through access to Call Detail Records (“CDR”) of the telcos. The CDR constitutes the master data and transaction record, uniformly used by telcos. Among others, the CDR contains the following basic information, in coded form:

Date and Time of Activity Type of Activity: Voice (IDD, NDD), SMS (revenue or non-revenue), MMS Source of Activity Destination of Activity

For example, the CDR contains all the following activities that transpired for telephone with SIM number 0999-1234567: DATE TIME FROM TO DURATION TYPE 1106 0723 09991234567 09171002000 0:00 TEXT 1110 1000 09991234567 0012131234567 10:00 IDD CALL 1114 0921 09991234567 09182003000 0:00 ELOAD 1130 2310 09991234567 04512340000 2:21 NDD CALL

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Information in the CDRs can be sorted in many different ways. All information necessary for the preparation of billing statements as well as information necessary to adjust the remaining load balance of a prepaid subscriber originate from and is contained in the CDR. Moreover, considering that it is the initial data record after systems log are filtered, the likelihood that there will be diversion or leakage of information or data is diminished, if not eliminated. A wide variety of specific test transactions reflected in the CDR may be traced through the entire accounting system of the telco to confirm that all these types of transactions get properly processed by the telco’s accounting system such that, ultimately, the transactions are converted into a unit of realized income ultimately reflected in the declared income of the telco. The required access to the CDR may not be continuous nor is it necessary to cover long periods of time. In fact, a copy of only the CDRs around the time that the test transactions were executed may be required for use by the BIR. Requesting the CDR covering several days or long periods may prove to be unnecessary and not manageable for the BIR. On the other hand, it may also increase the resistance of telcos to be subject to such a requirement.

To summarize, the BIR can do at least two things if it is given access to the CDR:

1. Random check of the recording system

The BIR can make a test transaction and check this in the CDR, i.e., buy e-load and generate a call using these e-load credits (Figure 16). This particular transaction can then be located in the CDR and then traced where it ends up in the financial records of the telco. Specifically, the following may be verified/determined: a. How the transaction was recorded, if it was, in fact recorded, and whether what was

recorded in the accounting books ultimately became an integral part of the declared taxable sales of the telco for the quarter when the sale was consummated; and

b. Whether the use of the e-load credits triggered a change of unearned income to realized

income.

Figure 17. Suggested Random Check of the Financial Recording System Using the CDR

2. Sampling of Periodic Sales and Usage

For a particular month, the records can be sifted for the following:

1. Sales of pre-paid credits: sales to wholesalers, sales to retailers, sales to end-users; and

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2. Usage of services: voice, SMS, MMS

The trends for longer periods can be made by generating empirical formulas from the sample data, and these can be compared to the financial statements provided by the telcos.

Figure 18. Suggested Random Sampling of Period Sales and Usage Using the CDR

Given access to a CDR and subsequent walk through on how each type of transaction in the CDR is ultimately recorded and processed will give the BIR a way to confirm the representations of the telcos on the manner that they record transactions in their accounting records. The BIR is also able to test, on a sample basis, whether there are transactions which are not fully accounted for, i.e., not processed until they are ultimately reflected in the various financial statement accounts reported in the audited financial statements. Given CDR access, the BIR is not only able to gather information which can be used in estimating the number of calls, SMS, or MMS transactions paid for electronically, but also the volume of transactions that is subject to interconnection charge to or from other telcos, the volume of transactions requiring payments to content providers, etc., as there is always a possibility of offsetting of interconnection charges.

Admittedly, the information appearing in the CDR does not yet include the monetary value of the transactions recorded therein. The CDR will be most valuable in confirming the volume of telco transactions but not necessarily the gross revenue earned therefrom. Further coordination with the telcos need to be made in order to determine the actual value of the recorded transactions.

As can be readily observed, telcos are always offering different price-based promotions. There are different payment plans including promotions offering unlimited SMS use, with or without free calls. Promotions such as the unlimited SMS drastically increase the volume of SMS traffic but may not necessarily proportionately increase the revenue of the telco concerned.

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Engage Third Party Services in Monitoring Call Traffic

The data and transaction records can also be obtained using monitoring mechanisms that can capture the information in the control channel of cell sites. The information can be of use similar to a CDR, with even less chance for alteration of information as monitoring is conducted by a third party. However, data to be obtained is limited to specific cell sites monitored.

E. AREAS FOR FURTHER STUDY

Study findings make it imperative to also recommend that the following matters be examined by BIR even if not related directly to taxing e-load. These can be used in designing the audit procedures for the telcos, as well as for other players involved.

1. Transactions involving credit card companies

As discussed above, credit card issuers are now getting into the value chain of the e-load business. Credit card issuers can now authorize the e-load of specified sums into the account of prepaid subscribers. It is not clear at this point whether the credit card issuers are themselves the merchants of e-load or it is still the telcos who are selling and the credit card issuers are sticking to their business of only facilitating payment.

There may be a need for the BIR to look further into the arrangement between the telcos and the credit card companies in this case. The contract between the telcos and these credit card companies, if any, may need to be obtained. If the credit card companies in this case are themselves the merchants, then there is a withholding tax that they have to withhold and remit to the BIR to the extent that they have been identified as one of the top 10,000 private corporations. This is pursuant to Section 2.57.2 (M) of Revenue Regulation 2-98, as amended, which reads:

SECTION 2.57.2. Income Payment Subject to Creditable Withholding Tax and Rates Prescribed Thereon. — Except as herein otherwise provided, there shall be withheld a creditable income tax at the rates herein specified for each class of payee from the following items of income payments to persons residing in the Philippines: X x x.

(M)Income payments made by the top ten thousand (10,000) private corporations

to their local/resident supplier of goods and local/resident supplier of services other than those covered by other rates of withholding tax. — Income payments made by any of the top ten thousand (10,000) private corporations, as determined by the Commissioner, to their local/resident supplier of goods and local/resident supplier of services, including non-resident alien engaged in trade or business in the Philippines.

Supplier of goods – One percent (1%) Supplier of services – Two percent (2%)

X x x.

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On the other hand, if the credit card companies are still just a payment channel rather than merchants of e-load, their payments to the telcos will still be subject to withholding tax but the basis will be Section 2.57.2 (L) of Revenue Regulation 2-98, as amended, which reads:

SECTION 2.57.2. Income Payment Subject to Creditable Withholding Tax and Rates Prescribed Thereon. — Except as herein otherwise provided, there shall be withheld a creditable income tax at the rates herein specified for each class of payee from the following items of income payments to persons residing in the Philippines: X x x. (L) Certain income payments made by credit card companies. — On ½ of the gross amounts paid by any credit card company in the Philippines to any business entity, whether a natural or juridical person, representing the sales of goods/services made by the aforesaid business entity to cardholders — 1%; (RR 6-01)

2. Transactions involving banks

As discussed above, e-load may already be paid through automatic charge to their bank account balance. Bank of the Philippine Islands (BPI), for example, in its webpage, indicates that a BPI bank depositor can load value to his own or another prepaid telephone account. It is not also clear at this point how the banks account for this transaction, i.e., whether they serve as merchants or they are mere payment conduits with the telcos remaining as the direct sellers of the e-load to the bank depositors.

If the latter is true, then it needs to be determined if they earn in the same way as that they earn when they serve as bills payment centers. However, if they are themselves the merchants of e-load, the BSP may also have regulatory concerns in this regard.

It should be noted that these transactions are electronically executed and there is no deposit or withdrawal slips that need to be filled or receipts that need to be issued by BPI for the purpose.

3. Revenue Sharing Arrangement with Content Providers

It is not clear at this point how much is the actual amount of revenue earned by telcos from transactions involving content providers since the revenue balance presented in the audited financial statements is not itemized. In this regard, it may be good to have access to the underlying agreements. Based on limited disclosure in the notes to financial statements, it is indicated that revenue from said transaction is presented in the financial statements net of the portion of the fees that goes to the content providers. As such, a further issue that the BIR may need to look into is whether the netting out of the amount due or paid to the content providers is appropriate, particularly with respect to VAT. It is not clear at this point if the telcos also pay VAT on such transactions based on the net amount. If so, the BIR may need to make a categorical determination on whether such net amount is what should appropriately be considered as “Gross Receipts” for purposes of computing VAT. Under Revenue Regulations No. 16-2005, “Gross receipts” for VAT purposes is defined as follows:

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SEC. 4.108-4. Definition of Gross Receipts. -“Gross receipts” refers to the total amount of money or its equivalent representing the contract price, compensation, service fee, rental or royalty, including the amount charged for materials supplied with the services and deposits applied as payments for services rendered and advance payments actually or constructively received during the taxable period for the services performed or to be performed for another person, excluding VAT.

Almost similar to special arrangements with content providers, it would appear that there would also be a revenue sharing arrangement between Chikka.com and the telcos. We understand that a subscriber who responds to a SMS sent via Chikka (using sender’s PC) will be paying a higher amount/rate than when the subscriber does not respond to the SMS sent via Chikka but sends a reply via the message sender’s regular phone account.

4. Determining the magnitude of income earned from providing their own content

At this point, it is not certain to what extent the telcos earn from being content providers themselves. In Chapter K-Taxation of Telecommunications in the District of Columbia of the report of the District of Columbia Tax Revision Committee titled “Taxing Simply Taxing Fairly” prepared by David Meyer, it was mentioned that one of the challenges of taxation of telecommunications is the bundling of services. In this regard, the report discussed:

Bundling of services poses another dilemma for tax authorities. Telecommunications firms are in the process of consolidating services. Whereas in the past, a consumer had separate providers for Internet access, wireless services, local telephone service, and long distance telephone services; increasingly, individual companies are offering these services bundled together at a discount. X x x. However, for tax administrators, bundling can be a challenge to current tax policies—particularly when tax laws treat individual services differently and apply inconsistent rates. When service providers are taxed differently based on historic designations, tax administrators will have difficulty because new providers do not fit easily into the old categories. X x x.

The foregoing situation would be further complicated should telcos begin to become content providers as well—offering products or services that extend beyond voice, data, and video transmission services to include the actual sale of goods via electronic means. Such companies could offer discounts through cash, credit, or other goods, in order to entice consumers to make purchases through the provider.

Taxing authorities may be forced to rely increasingly on use taxes, which the seller may or may not be required to collect. Use taxes are notoriously difficult to enforce, and compliance is relatively low for these taxes. Further, if electronic money or credit is used to lure customers, there is the added complexity of valuing the credits and establishing rules about when taxes would become due—when the credits are earned or when they are used.

X x x.

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5. Pursuit by telcos other business activities Together with relevant government agencies, there is a need to determine whether prudence requires that telcos be prohibited from engaging in the business of issuing electronic money other than what can subsequently be exclusively used for the purchase of e-load. In the absence of any prohibition on telcos from acting as issuers of e-money (or pursuing money remittance operations) using the same entity as the telecom service provider, appropriate regulations must be issued to establish required procedures and reports which will serve to distinguish, classify, and segregate the revenue and expenses related to this sub-business of e-money issuance. It may in fact be prudent to require them to maintain separate set of books for such distinct business activities that clearly do not qualify as core telco business. In this regard, the NTC should likewise be concerned such that, in evaluating the rates applied for by the telcos, the costs and expenses and revenues relating to the other business activities of the telcos are not consolidated with the telco service revenues, costs, and expenses.

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References

• David Meyer, Tax & Economic Policy Administration, Office of Tax and Revenue, Washington D.C. and presented to the Committed on State Taxation

• Doug Mohney, IMS – Flavor of the Month, Von Magazine, June 2005 • H. Gilbert Miller, Henry D. Levine and Sandra N. Bates, Welcome to Convergence, Surviving the

Next Platform Change, IT Pro Magazine, June 2005 • International Telecommunication Union, Pinoy Internet: Philippines Case Study, March 2002 • Intel White Paper, An Introduction to Multimedia Services, 2005 • James Reece and Robert Anthony, Accounting: Text and Cases, 1989 • Mobile Data Network Solutions: A Tellabs Business Solutions Briefing, September 2005 • P.R. Chevillat, W. Schott, Broadband radio LANs and the Evolution of Wireless Beyond 3G,

IBM Journal of Research and Development, March/May 2003 • Republic of the Philippines, Bureau of Internal Revenue, National Internal Revenue Code, 1997 • Republic of the Philippines, National Telecommunications Commission, Chart of Accounts for

Telecommunications, 2000 • The Economist Economic Intelligence Unit, Executive Briefing: Philippines, 2004 • United States Department of the Treasury, Office of Tax Policy, Selected Tax Policy Implications

of Global Electronic Commerce, November 1996 • United States Federal Communications Commission, Communications Act of 1934 • Website of Commil Corp., viewed on 2006 <www.commil.com> • Website of National Telecommunications Commission, Philippines. <www.ntc.gov.ph> Viewed

2006 • Website of Techdirt, viewed on December 2004 <www.techdirt.com> • Website of University of Waterloo, School of Accountancy, Ontario Canada, viewed on 21

March 2006 <www.accounting.uwaterloo.ca/ccag2001/8CHAP97.htm> • Website of whatis?com, viewed on 2006 <www.whatis.com>

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ANNEXES

ANNEX A Pro-forma Agreement of a SMART Wholesaler with Retailers and Information Sheet for SMART Retailers

ANNEX B Sample Flyers for SMART Retailers

ANNEX C Summary of Findings in Financial Statements of

Selected E-Load Wholesalers of SMART Communications

Summary of Findings in Financial Statements of E-Load Wholesalers of SMART Communications Name and Address

Sales Per Smart Record (Feb-

Dec 2005)

Annualized (Derived)

Sales Per Audited F/S

Year

Remarks

Wholesaler A 767,320.455 837,076,859 833,456,184

2002 Latest available audited F/S with SEC is 2002, thus it may not include any e-load sales but its sales includes prepaid card sales of P608,935,415. It is engaged in other businesses such as sale of units and services but has itemized Sales figure in its F/S. It is possible that it is also selling prepaid or e-load for Globe, in which case, its audited F/S Sale from Cards/E-load should be significantly higher than PhP 837 million. However, the Cost of Sales figure is already a lump sum amount rather than itemized per type of business activity. Gross profit (P4,373,443) rate is 0.52% and net income (before tax – P576,223) rate is 0.069%.

Wholesaler B 1,619,891,636 1,767, 154,512 1,190,010,235 2004 Minimal capitalization. There is no indication whether its sales consists solely of sale of prepaid card/e-load sales. Gross profit (P14,261,758) rate is 1.2% and net income (before tax P2,312,330)rate is 0.19%

Wholesaler C 1,311,322,238 1,430,533,349 1,575,153,031 2003 The purpose clause of its Articles of Incorporation indicates authority to engage not only in trading but also performance of services. Thus, it is not clear how much of its sales is attributable to sale of prepaid card/e-load. It also needs to be determined if it is also selling Globe prepaid cards/e-load. Gross profit (P4,866,206) rate is 0.3% and net profit (before tax- P892,424) rate is 0.056%.

Wholesaler D 656,574,684 716,263,291.60 SEC registration revoked. Latest available audited F/S is for 2000, in which case, it could not yet

Wholesaler E 2,086,304,068 2,275,968,074 No SEC Registration; No DTI Registration Wholesaler F 795,684,189 868,019,116 DTI Registered. No available audited FS

with DTI (not required) Wholesaler G 1,960,995,454 2,139,267,768 No record found in SEC and DTI Wholesaler H 639,167,613 697,273,760 Different registered name; registered with the

DTI. No FS available with the DTI (not required)

ANNEX D Draft Revenue Regulations on Taxation of

Telecommunications Transactions

ANNEX E Comparison of Basic Financial Statements of the Telcos

ANNEX F Comparative Account Headings in Consolidated

Balance Sheets

ANNEX G NTC Chart of Accounts for Telecommunications

a study on retailing mobile phone credits by electronic loading and its implications

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