Tax Articles

VAT Zero-Rating:
Directly and Exclusively Used in Registered Activity

By: Atty. Fulvio D. Dawilan

Revenue Regulations No. 09-2021 (“RR 09-21”) created a confusion among the concerned regulators and businesses when it declared that the conditions provided in the TRAIN Law for the imposition of 12% VAT on certain transactions previously entitled to VAT zero-rating had been fully satisfied. Among these transactions are the sales considered export sales under Executive Order No. 226. Apparently, transactions considered export sales under EO 226 include sales to export processing zones.

The confusion was further aggravated when the Implementing Rules and Regulations (“IRR”) of the Tax Incentives under CREATE adopted RR 09-21, that is, while recognizing the VAT zero-rating on local purchases, subjects to 12% VAT those now subject to VAT under RR 09-21. This means that the supposed VAT zero-rating of local purchases by registered business enterprises (“RBEs”) shall be subject to the 12% VAT if the transaction is among those considered export sale under EO 226. In essence, this negated the incentive on VAT zero-rating of local purchases by RBEs.

The Department of Finance listened to the concerns of various sectors and agreed to issue new regulations effectively abandoning the application of RR 09-21 to RBEs. This is certainly a welcome development, with the hope that the new regulations will recognize the VAT zero-rating incentive specified under CREATE, subject only to the condition that the same shall only apply to goods and services used in the registered project or activity of the RBE.

A related issue, however, remains to be addressed. That is with respect to the coverage of purchases from local suppliers which are entitled to VAT zero-rating. CREATE merely provides that the VAT zero-rating shall apply only to goods and services directly and exclusively used in the registered project or activity by RBEs. But the IRR goes further by defining “direct and exclusive use” as referring to raw materials, inventories, supplies, equipment, goods, services and other expenditures necessary for the registered project or activity without which the registered project or activity cannot be carried out.

The definition in the IRR is limiting the application of VAT zero-rating to the expenditures that are indispensable in producing or pursuing the registered project or activity. Isn’t this too restrictive? Shouldn’t the “direct and exclusive use” pertain to all purchases that are used by a registered business enterprise in its business, regardless of whether they are needed to carry out the registered activity or not? Business enterprises, and RBEs are no exception, cannot simply rely on expenditures needed for the production of its final product to do business. For a manufacturing company, for example, while its manufacturing or operations department and the expenditures related thereto are necessary to produce the finished products that it supplies to its customers, it maintains other support offices/functions, such as finance and accounting, human resources, legal, sales and marketing, among others. All of these functions contribute in the overall success of the business. Should the expenditures related to these other functions be excluded from the coverage of zero-rated purchases?

Some have expressed the idea that the “direct and exclusive use” should be applied in relation to the possibility of having an unregistered activity, in addition to the registered activity. The interpretation should be aligned with the second paragraph of Section 295(D) of the NIRC which subjects to the appropriate taxes the sales receipts and other income derived from non-registered project or activity. This means that all income derived from the unregistered activity shall be subject to the regular taxes while all income derived from registered activity shall be entitled to the tax incentives. Applying it on the VAT zero-rating of local purchases, the said incentive shall not apply to purchases related to an unregistered activity. On the other hand, all purchases related to a registered activity should be entitled to VAT zero-rating, such that if the RBE engages only in registered activity, all purchases, regardless of which function or department of the business the purchase is used will be entitled to zero-rating. The “direct and exclusive use” will only come into play when the RBE has also unregistered activity, where a determination of which activity the transaction is related to will become a necessity.

This is also consistent with the application of the cross-border doctrine in relation to the separate customs territory concept for freeport and special economic zones, which apparently is still retained by CREATE. A registered business enterprise located in a freeport or special economic zone and pursuing purely registered activity within that zone shall be considered to be located in a separate customs territory, or a foreign soil as explained in a number of Court decision. Being in a separate customs territory, the RBE is said to be in a foreign country. As such, sales made to that enterprise by businesses from the Philippine customs territory, without regard to whether that sale is necessary for the registered activity or not, will be considered export. The basis of zero-rating is simply because the sale is considered export. This is in accordance with the cross-border doctrine which characterizes our Philippine VAT system, and which expounds the principle that exports are free of VAT.

However, an enterprise which is not registered with an investment promotion agency, even if located and doing business in an economic zone, will not be considered to be located in a separate customs territory. In such case, the cross-border doctrine with not apply and VAT zero-rating will not be available.

For a registered business enterprise doing both registered and unregistered activities within a special economic zone, it will be considered to be operating within a separate customs territory with respect to the registered activity. However, it will not be accorded similar treatment in relation to the unregistered activity. Thus, the sales to the enterprise related to the registered project should be entitled to VAT zero-rating. On the other hand, sales made to the enterprises which are related to the unregistered activity shall be subject to the 12% VAT. Similarly, sales made to the enterprises of goods and services which are used both in the registered and unregistered activities, not being exclusively used in registered business activity, shall also be subject to the 12% VAT.

An interpretation that results in the VAT zero-rating only of transactions necessary for carrying out the registered project or activity will result in two separate personalities for the registered enterprise – one which located in a separate customs territory when it purchases supplies used as material by its production department and one located in the Philippine customs territory when it purchases supplies used by its accounting department.

I hope our regulators and implementing agencies will consider these in crafting the implementing guidelines. And for the legislators, may I suggest that if an amendment is to be made, sales to registered locators of freeport and special economic zones should be specified as export sales entitled to the VAT zero-rating. In this way, even if the rule on VAT rating incentive on local purchases accorded to RBEs is disregarded or interpreted differently, the zero-rating can still apply from the point of view of the supplier making and export sale.