Desperate to shed its notoriety for fiscal incompetence, Benigno Aquino III’s economic team seems to have turned reckless.
On October 10, 2011, the secretary of finance wrote the Bureau of the Treasury (BTr) effectively instructing them to “withhold the final tax due on interest income derived from” zero coupon bonds (Zeros) issued in 2001. From a strictly technical perspective, that endangers prospective Philippine bond flotations and creates a de facto sovereign default.
The Department of Finance (DOF) memorandum stemmed from the Bureau of Internal Revenue (BIR) Ruling 370-2011 dated October 7, 2011. The impetus was initiated by the DOF itself when it asked for the tax treatment on the Zero’s previously tax-exempt status under previous rulings and Section 32 of the Tax Code.
The pointlessness of a default becomes evident considering the government’s arithmetic.
The government’s formula is simple. And unnecessary. On page 11 of the October 7 ruling, the BIR states that had the Zero’s bidder in 2001 “paid 20-percent final tax upon issuance, it would have paid approximately P1.4 billion [i.e., 20 percent of the present value of the discount/interest as of October 18, 2001, discounted at 12.75 percent, which is approximately P7 billion].”
The ruling further says “since no final tax was paid” upon issuance, the bidder “is held liable to pay the 20-percent final tax on the entire P24.3- billion discount, which is the present value of the original discount to date, or approximately P4.86 billion.”
The government’s formula initially subtracts from the Zero’s face value of P35 billion the P10.7 billion paid in 2001. The difference of P24.30 billion is what the government deems as subject to a 20-percent withholding tax.
Twenty percent of P24.30 billion is P4.86 billion—an amount levied on the original bidders per the BIR ruling. Curiously, it is likewise inflicted upon the final bondholders per the DOF’s October 10 memorandum.
Because the tax is levied in 2011, the government computed for the 2001 present value of P4.86 billion using a discount rate of 12.75 percent and compounding accrued interest semi-annually. The result is P1.40 billion—strangely the exact amount the government claims was unwithheld in 2001.
The ruling also states the liability at “approximately P7 billion.” Did I miss something? Flip the present value formula and compute for the rate compounded semi-annually. At P7 billion, the effective rate is 16.76 percent, ludicrously compounding every 87 days rather than 12.75 percent compounding semi-annually.
Because the government applied 12.75 percent in its computations, let us now show why no taxes are due on the Zeros after their auction.
Analyzing the highest and the lowest bid for the Zeros against historical bids for 10-year bonds, the highest differential for Zeros belies its sub-market value. Ceteris paribus, the Zeros reduced the government’s borrowing costs.
The benchmark rate when the Zeros were bid out was set two weeks before at 16.50 percent on a pre-tax basis or 13.20 percent after 20-percent taxes are withheld.
At the Zero’s 12.75-percent post-tax yield-to-maturity, the difference from 16.5-percent post-tax equivalent of 13.20 percent is 0.45 percent. In contrast, the Zero’s auction had high-low bid gaps of as much as 5.75 percent.
On October 16, 2001, the bids started coming in at 9:28 a.m. It was only at 11:09 a.m. that single bids were received for P10 billion. Earlier bids were for less with ranges between 14 percent and 18 percent. The 11:09 a.m. bids ranged from 12.24 percent to 13.00 percent. Five minutes before the bidding closed, two bids were for P10 billion but these ranged from 14 percent to 14.5 percent. Had those won, the government’s costs would have remained high.
For five bids prior to October 2001, the bid differentials ranged from approximately 0.20 percent at the lowest to 0.75 percent at the highest. Viewed from a longer perspective, the average historic bid differentials from 1998 to 2001 had winning bids at 12.25 percent and losing bids at 12.67 percent—bid levels well within the neighborhood of the Zeros.
Had the bidders not paid the tax, their bid of 12.75 percent would have grossed up by 20 percent converting bids from post-tax to a pre-tax basis. At 15.30 percent on a pre-tax basis, the difference from 16.5 percent narrows significantly. When the Zero’s modest returns as eligible Treasury reserves are factored in, the gap narrows even further.
Rather than bid at 15.3 percent on a pre-tax basis, the winning bidder had bid at 12.75 percent on a post-tax basis, thus reducing the government’s borrowing costs. But note, at 12.75 percent, the 20-percent withholding taxes had effectively been paid (as opposed to the 15.3-percent pre-tax basis). Thus extraneous taxes need not be collected in 2011 or at any time after the auction.
Do the math. Desperate to cover their embarrassing deficiencies, Aquino’s finance officials may be double-taxing. This threatens our credit ratings and recklessly exposes the government to a declaration of a sovereign default.
