SGV thought leadership on pressing issues faced by chief executives in today’s economic landscape. Articles are published every Monday in the Economy section of the BusinessWorld newspaper.
In last week’s article, we discussed the salient features of the CREATE bill: the immediate Corporate Income Tax (CIT) rate cut;
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(First of two parts)
To recover from economic recession and to advance towards corporate healing, the Department of Finance (DoF) fine-tuned several provisions of the Tax Reform Package 2 bill. The Corporate Recovery and Tax Incentives for Enterprises Act (CREATE) is the latest incarnation of the TRABAHO and CITIRA bills and is now part of the COVID-19 stimulus package put together by the government’s economic team.
The DoF calls CREATE the largest tax stimulus program and the first ever revenue-eroding package in the country’s history. According to the DoF, CREATE is expected to free up almost P42 billion in capital over the second half of 2020 and P625 billion in the next five years, with the government assuming that businesses reinvest their tax savings to create sustainable economic opportunities.
In a nutshell, the CREATE bill proposes to (1) accelerate Corporate Income Tax (CIT) rate reduction; (2) extend the Net Operating Loss Carry Over (NOLCO) period; and, (3) rationalize fiscal incentives to adopt to the changing business needs brought about by the pandemic.
ACCELERATED CIT RATE REDUCTION
The CREATE proposes an outright CIT rate reduction from 30% to 25%, then a gradual 1 percentage point reduction every year starting from 2023 until it hits 20% by 2027.
The acceleration of the CIT reduction timetable will help restore confidence, especially among micro, small and medium enterprises (MSMEs) that have been battered by the effects of COVID-19. The tax savings can then be used for additional working capital and sustain a massive employment drive for displaced workers.
This will also attract potential multinational investors seeking to diversify their supply chains here. By 2027, our CIT rate will be comparable to Thailand and Vietnam, which are both currently at 20%. It will then be just a matter of time before our country matches the ASEAN average of 23%.
EXTENDED NOLCO PERIOD
Non-large taxpayers will be allowed to carry over net operating losses incurred in 2020 over a period of five years from the current three years. This is a practical incentive to help MSMEs and enterprises rebuild their business operations.
However, CREATE has not yet given details on whether the extended NOLCO may be claimed by an enterprise eventually classified as a large taxpayer by the BIR within the five-year period for losses incurred back in 2020. It also appears that qualified taxpayers will have to keep operating post-pandemic to fully maximize the benefit of NOLCO.
RATIONALIZATION OF FISCAL INCENTIVES
Instead of keeping several sets of incentives currently offered by various investment promotion agencies (IPAs), CREATE proposes to rationalize and tailor-fit fiscal incentives to qualified investments.
IPAs will continue to process applications for registration but these shall be placed under the oversight of the Fiscal Incentives Review Board (FIRB). The latter will determine the target performance metrics as conditions for availing tax incentives, and unless delegated to the President or a respective IPA in certain cases, shall grant or deny the incentives recommended by the IPAs. Together with IPAs, it will formulate a Strategic Investment Priority Plan (SIPP) itemizing the priority projects and industry-location tiers, among others.
Careful reading of this proposal reveals that the FIRB will technically absorb several key functions of the IPAs. Nevertheless, streamlining the fiscal incentives can definitely change the way investors perceive our investment programs as we compete internationally for high-value projects. Investors can no longer cherry-pick from the incentives menu and go forum-shopping among the 13 current IPAs.
OTHER SALIENT FEATURES
Other proposed features in CREATE worth noting are:
1.The tax exemption on income derived from foreign currency transactions by offshore banking units and the related 10% final tax on interest income from foreign currency loans will be removed.
2.Regional Operating Headquarters (ROHQs) will be subject to CIT after two years from the effectivity of the Act.
3.Branch profit remittance tax exemption of Philippine Economic Zone Authority (PEZA)-registered entities is retained, which the CITIRA initially proposed to be eliminated.
4.The final tax rate on capital gains from the sale of shares not listed and traded on the stock exchange by foreign (resident and non-resident) corporations, as well as on interest income from FCDUs by resident foreign corporations is increased to 15%.
5.The interest arbitrage rate will be lowered until it is completely removed once the CIT rate drops to 20%.
6.The optional standard deduction for individuals and corporations, which CITIRA initially proposed to restrict, will be retained.
PENDING SENATE DELIBERATION
Unfortunately, the first regular session of the 18th Congress ran out of time to take up the bill under the Senate’s deliberations before the session adjourned on June 5. Congress, however, can convene in a special session to tackle the bill even during the break if called on by the President.
Otherwise, this will be taken up in the second regular session of the 18th Congress, with the Senate to resume on July 27. Even with the tight schedule, hopes are high that CREATE will be passed and implemented by the second half of the year. After all, CREATE was certified by the President as urgent and it is supported by various organizations and industry leaders.
CREATE BILL AS A RESPONSE TO THE COVID-19 CRISIS
Nearly all countries have moved to cushion their respective economies against the impact of COVID-19. Wage subsidies, stimulus checks, payment concessions and various financial bailouts to enterprises, among others, were implemented at varying speeds, approaches and levels of effectiveness.
No country in the world has been spared from the sharp decline and contractions of economic growth.
Two years after the TRAIN Package 1 and several bill versions since, CREATE has been repurposed as a pandemic-responsive tax reform as well as a government’s intervention to stimulate recovery and avoid long-term economic damage. The US-China Trade War has also forced ASEAN countries into a race to cut taxes and offer more incentives to investors who are either shifting their supply chains from China or are planning to diversify within Asia.
The time is now ripe for legislators to pass a responsive tax reform at this critical period. However, caution must still be in place and pace should not be equated with haste. It behooves not just the legislators but also ourselves as taxpayers to understand the important duty of dissecting the proposed measures and their finer details to arrive at a truly effective tax reform that is adaptive to the challenging needs of our time.
In the second part of this article, we will discuss in detail the rationalization of fiscal incentives through a calibrated income tax holiday, special corporate income tax, enhanced deductions and other available incentives to existing registered entities under the transitory period, as well as strategies to capitalize the fiscal incentives under the CREATE bill.
Donna Frances G. Ylade-Torres is a Senior Manager from Private Client Services, a Tax Sub-Service Line of SGV & Co.
(Second of two parts)
In the first part of this two-part series, we discussed how to assess whether changes in lease contracts are lease modifications, and covered lease concessions that are treated as variable rent, lease modifications, and accounted for as government grants.
We continue our discussion by reassessing lease terms, including the exercise of purchase, renewal or termination options, as well as the impairment of lease-related assets and a recent amendment issued on May 28 to IFRS 16 on pandemic-related rent concessions.
REASSESSMENT OF LEASE TERM INCLUDING THE EXERCISE OF PURCHASE, RENEWAL OR TERMINATION OPTIONS
In view of the adverse effects brought about by the COVID-19 outbreak, lessees and lessors should revisit the lease terms of their existing contracts. In particular, they must revisit whether or not the lessees are reasonably certain to exercise their options to extend or terminate the leases, and even their rights to purchase the leased assets at the end of the lease term. PFRS 16 requires that lease terms should be reassessed upon the occurrence of either a significant event or a change in circumstances that will affect the lessee’s assessment as to whether or not it is reasonably certain to exercise those options.
A change in the lease term brought about by a reassessment — as to whether or not a lessee is reasonably certain to exercise a renewal or purchase option, or not to exercise an option to terminate the lease — constitutes a lease modification. This will trigger lease modification accounting as discussed in the preceding part of this article.
IMPAIRMENT OF LEASE-RELATED ASSETS
The pandemic also has a possible effect on the impairment of the lessee’s right-of-use (ROU) asset and the lessor’s leased asset or lease receivable. PAS 36, Impairment of Assets, requires that both the lessee and lessor should assess if there are indicators that their respective lease-related assets may be impaired, and could therefore trigger an impairment test in accordance with PAS 36. In the case of a lessee, the adverse effect of the pandemic on their business might make it difficult to recover the value of their ROU asset, particularly if they are not able to negotiate for a lease concession from the lessor.
In the case of a lessor in an operating lease, the lessor might have to deal with the same impairment issue as they might encounter difficulties in recovering the value of their leased asset. Similarly, in the case of a lessor in a finance lease, the lessor should factor the impact of the outbreak on the collectability of their lease receivable in estimating credit losses in accordance with PFRS 9. Lease renegotiations are thus expected to result in balancing the interests of both parties to ensure the least amount of impairment if it cannot be avoided.
AMENDMENT TO IFRS 16 ON PANDEMIC-RELATED RENT CONCESSIONS
As discussed previously, the guidance under PFRS 16 in accounting for pandemic-related lease concessions can be difficult, especially if there are many contracts to deal with and the rent concessions qualify as lease modifications. In order to help ease the accounting burden, the International Accounting Standards Board issued on May 28 an amendment to IFRS 16 that provides an option to lessees not to account for qualified pandemic-related lease concessions as lease modifications. A lessee shall apply the amendment for annual reporting periods beginning on or after June 1. Earlier application is permitted, including financial statements not authorized for issue by 28 May 2020.
In order to apply this option, the following criteria must be satisfied:
1.The concession must be a direct consequence of the pandemic;
2.The concession results in a revised consideration that is substantially the same or lower than that immediately preceding the grant of the concession;
3.The reduction in lease payments affects only payments originally due on or before 30 June 2021; and
4.There is no substantive change in other terms and conditions of the lease.
While the amendment aims to provide relief, it also poses some challenges even to lessees. First, the amendment does not prescribe an accounting treatment for lease concessions if the expedient is invoked. However, the basis for conclusion to the amendment provides that if a qualified lease concession is not accounted for as a lease modification, then a lessee will generally account for it as a variable lease payment with a charge to profit and loss for the period. Absent one accounting treatment for the same type of concession, it can result in diversity in practice among lessees.
It is also noteworthy that while lessees that elect to apply the expedient do not need to assess whether a concession constitutes a modification, lessees still need to evaluate the appropriate accounting for each concession as the terms of the concession granted may vary.
Second, since the amendment provides an option, a lessee that avails of it may produce financial results that may be incomparable to those produced by one that does not. Treating lease concessions as variable lease payments, for example, will likely result in a higher net income for a period; however, this will also result in an unadjusted or higher ROU asset which can trigger impairment concerns.
Third, in order to qualify for the expedient, the concession should only affect lease payments originally due on or before June 30. While there are currently only a few lease concessions in the Philippines that extend beyond this date, the uncertainties surrounding the pandemic pose possible issues in respect of future concessions that may not qualify for the expedient.
Finally, while the amendment provides relief to lessees, lessors do not enjoy the same. They may therefore need to account for lease concessions in accordance with PFRS 16 as discussed above.
CONSENSUS IN CONCESSIONS
The pandemic significantly impacted our economy, with many businesses left with no choice but to rationalize operations for fear of not being able to pay their rents on time. For both lessors and lessees, there is the question of the continuing impact on their existing lease agreements if the pandemic continues.
Perhaps the best and most sustainable approach is for both parties to develop a joint strategy to compensate any rental loss suffered during the outbreak. Parties can seek help from their legal counsels to better understand their contracts in the hope that both will be able to arrive at a mutually beneficial solution. In most cases, agreements based on mutual trust and consent produce the best economic results, especially during these challenging times. After all, consensus is the foundation of contracts and the economic successes of both lessor and lessee are not separate but rather shared.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed above are those of the author and do not necessarily represent the views of SGV & Co.
Jerome B. Ching is a Senior Manager from the Assurance Service Line of SGV & Co.
(First of two parts)
Almost every part of the country has been, and remains, under community quarantine to help curb the COVID-19 pandemic. Business owners were forced to announce the temporary closure of non-essential establishments such as shopping centers, schools and office buildings, supermarkets, drugstores and other essential businesses which saw changes in operating hours and on-site operations, while food providers such as restaurants were only allowed to provide take away and food delivery services. As a result, commercial tenants found themselves in a dramatic situation where they lost all their revenue overnight while their obligations under their lease agreements continue to apply.
Although some lease contracts have provisions relating to force majeure events, most, if not all of these contracts do not include clauses on rent concessions specific to pandemics. In view of the situation, some lessors have announced that they are giving concessions to their lessees in the form of rent holidays or rent reductions during the lockdown, interest-free delays in rental payments, and even the restructuring of the amount and timing of rental payments until the end of the lease term. In lease contracts without force majeure clauses, lessors technically retain the discretion on whether to grant these reliefs, the extent of the relief to be provided, and over who they consider is entitled. Meanwhile, some lessees also proactively seek rent concessions (e.g., deferral of lease payments) or even amendments to the lease contracts to cushion their economic burden until the end of lease term, given that the full adverse effect of the pandemic remains unknown to this day.
Considering the voluntary nature of these concessions in this instance, many are curious as to how the lessors and lessees should account for these under PFRS 16, Leases.
ASSESSING WHETHER CHANGES IN CONTRACT ARE LEASE MODIFICATIONS
When changes are made to the terms of lease contracts (e.g., in lease payments or lease terms), the accounting for those changes will depend on whether they meet the definition of a lease modification under PFRS 16, which is defined as “a change in the scope of or consideration for a lease that was not part of the original terms and conditions of the lease.”
In assessing whether there has been a change in the scope of a lease, an entity considers whether there has been a change in the right of use granted to the lessee, which can be manifested in adding or terminating the right to use one or more underlying assets or extending or shortening the lease term. For example, a lessee may decide to rationalize operations and agree with the lessor to decrease the leased area from 1,000 square meters to 500 square meters. Another example would be a lessee negotiating with the lessor to extend or reduce the lease term.
On the other hand, when assessing whether there was a change in the consideration for a lease, the lessee and lessor should consider the overall effect of the change in the lease payments due under the contract. For example, there is a change in consideration when the lessor decides to provide a rental waiver during periods of the pandemic or when the lessor and lessee agree to change the lease payments from fixed to variable.
If there is no change in either the scope of or the consideration for the lease, then there is no lease modification. Even if there are such changes, but those would have resulted from clauses in the original lease contract or in the law or regulation covering the said contract, those changes are considered part of the original terms and conditions of the lease, hence there would still be no lease modification even if the effect of those clauses was not previously contemplated.
In considering whether changes in the scope or consideration are part of the original terms and conditions of a lease contract, an entity should consider all relevant facts and circumstances which may include the lease contract itself, or the law or regulation applicable to the lease contract. A paper by the International Accounting Standards Board (IASB) mentioned that for a change to be part of the original terms and conditions of the contract, there should be a clause present in either the contract itself or in the law or regulation governing the lease contract that provides an automatic adjustment of lease payments if a particular event occurs or circumstance arises. In some instances, it can be demonstrated by the presence of a force majeure clause in the contract, which allows for possible renegotiations or revisions when a specific situation occurs, such as when lease payments are suspended in cases of a prolonged market instability.
The presence of force majeure clauses in contracts would not automatically make the changes part of the original terms and conditions of those contracts. Oftentimes, these clauses are broadly written and do not specify what contractual rights and obligations are consequential to the occurrence of a force majeure event, much less what events would constitute force majeure. Therefore, the lessor and lessee may need to revisit the lease contract and agree on the coverage of the force majeure clause. In many cases, the parties may need to involve expert legal interpretation.
LEASE CONCESSIONS TREATED AS VARIABLE RENT
When it is established that a change in scope or lease consideration is not a lease modification, said change will generally be accounted for as a variable lease payment. Accordingly, each party should continue to account for the lease under the original lease contract, with the rent concession accounted for as an adjustment to lease income or expense in the period in which the concession arises.
LEASE CONCESSIONS TREATED AS LEASE MODIFICATIONS
When the change in lease payments is considered a lease modification, both the lessee and lessor should apply the guidelines for lease modifications under PFRS 16. The lessee in this case will remeasure the lease liability by discounting the revised lease payments using a revised discount rate, with a corresponding adjustment to the right-of-use (ROU) asset. This accounting treatment has an effect of recognizing the impact of the concession over the remaining lease term.
Since the modification requires the remeasurement of lease liability using a revised discount rate, it is necessary for the lessee to determine an incremental borrowing rate at the date of modification. The problem, however, is that the outbreak has driven market volatility, which could pose difficulties in estimating the revised incremental borrowing rate.
On the other hand, lessors will need to check whether the modification triggers a change in lease classification. For finance leases, if the modification changes the lease classification to an operating lease, then the lessor at the time of modification will derecognize the finance lease receivable and recognize the underlying assets according to their nature (i.e., property and equipment or investment property) at an amount equal to the investment in the lease immediately before the effective date of the modification. If the modification does not change the lease classification, the lessor shall recalculate on the modification date the present value of the renegotiated cash flows discounted at the lease receivable’s original effective interest rate, and recognize a gain or loss applying the concepts in PFRS 9, Financial Instruments.
For operating leases, the lessor treats the modification prospectively by recalculating the straight-line lease income, considering the effects of the concession and any prepaid or accrued rent at the time of modification over the remainder of the lease term.
LEASE CONCESSIONS ACCOUNTED FOR AS GOVERNMENT GRANTS
We observed that in some countries, governments roll out financial relief measures to support local businesses impacted by the pandemic. For example, in countries where most land properties are government-owned, the government provides relief to the lessees of these properties such as a waiver of rent, one-time property tax rebates and cash assistance during the outbreak. These government measures are not yet observed here at this point, although we may expect the same from the Philippine government to help drive the economy should the pandemic continue for a longer period. These actions by the government are outside the scope of PFRS 16 and may qualify as government grants to be accounted for in accordance with PAS 20, Accounting for Government Grants and Disclosure of Government Assistance.
LEASE TERM REASSESSMENT AND THE IMPAIRMENT OF LEASE-RELATED ASSETS
In the second part of this article, we will discuss the reassessment of lease terms, including the exercise of purchase, renewal or termination options, as well as the impairment of lease-related assets and a recent amendment issued on 28 May 2020 to IFRS 16 on pandemic-related rent concessions.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.
Jerome B. Ching is a Senior Manager from the Assurance Service Line of SGV & Co.
The COVID-19 pandemic caught the world off guard, adversely affecting peoples’ lives and businesses on an unprecedented scale. According to the EY Global Risk Survey in 2020, four out of five of companies’ board members and CEOs across the globe said their businesses were not well-prepared to face the pandemic crisis head on.
Companies have been employing various, often reactive actions, and even alternative methods to address the growing concerns impacting their businesses. These add pressure as they try to keep their business operations afloat. Furthermore, it has dramatically changed the risk landscape and given rise to new risk hot zones:
Health, safety and mobility: The community transmission of the virus poses a huge health risk. This immensely affected the life and ways of working for customers, business owners and employees as their mobility becomes limited.
Macroeconomics: The health crisis crippled the global economy. Supply chains across countries remain stressed, disrupting both demand and supply.
Cybersecurity: The lockdown has forced people to work remotely and connect virtually. The spike in use of technology and cyberspace opens cracks for cybercriminals to hack, phish and even infect vulnerable IT networks and infrastructure.
Compliance and stakeholder perception: The pandemic has caused governments to implement urgent measures and programs to fight the novel coronavirus, disrupting various industries. This event has further challenged companies to fulfill their obligation to issue fair disclosures to their stakeholders and maintain their societal brand and reputation.
These disruptions open opportunities for the company’s Internal Audit (IA) function to play a pivotal role as companies are challenged to successfully steer a course towards survival and growth amidst the pandemic.
IA can build trust by exhibiting reliability and continuing to be engaged as co-stewards of the company. It presents a real opportunity to collaborate with other business functions and enable company continuity. This can be achieved by being at the forefront of this pandemic through rapid assessments to identify focus risk areas; being agile in engaging and responding to stakeholder needs; and the continuous monitoring of the pandemic risks and impact on the company.
ACTIVATING IA AS A TRUSTED BUSINESS ADVISOR
IA is in a unique position as its experience allows it to assist in evaluating and managing internal and external business risks in the changing risk landscape. It can provide strategic business continuity advice, acting as consultants and crisis managers. It can start assessing business readiness on the new risk hot zones and potentially identify other risk areas.
Results of the assessment can be used to further understand the current impact of the disruption, foresee upcoming impacts that the disruptions may bring about, and plan how to appropriately respond to ensure public safety, business continuity and social responsibility.
LEVERAGING COLLABORATION TO DRIVE CHANGE
IA is a key contributor in defining the necessary actions that key stakeholders should consider in addressing new threats as a result of the “new normal.” Constant communication is critical to keep key stakeholders aware of and aligned with plans despite the continuing uncertainty.
IA can have more frequent, real-time discussions with the Audit Committee and Management to provide real-time advice on escalating risk focus areas, including critical action plans that they can consider taking.
As governments apply strict social distancing guidelines and curtail travel, IA can assist businesses and provide advice on adjusting to a remote work environment, such as how usual controls can be executed or mitigating possible changes in roles.
It is also a good opportunity to proactively engage and collaborate with external auditors to discuss the impact of the situation, especially for some procedures that may need to be performed differently due to limited face-to-face interaction.
ADVANCING TECHNOLOGY TO ANTICIPATE EMERGING RISKS
IA can implement a process supported by data analytics and technology to continuously monitor emerging risks. This will open avenues for key stakeholders to collaborate within various business functions. It will also be able to determine areas in their critical processes to stress-test and proactively identify resiliency plans and crisis protocols that can support sustainability of business functions.
STEP CHANGE: NOW, NEXT AND BEYOND
As companies slowly regain momentum to address the impact of the pandemic and prepare for their new normal, there is increasing pressure to reprioritize company resources and drive spending where it matters most.
NOW
IA as a function is called on to adapt to disruption by being more innovative and dynamic in its approach. There is a need to reassess audit priorities and expand the IA lens to clearly evaluate the impact of the pandemic on the organization’s financial, IT and operations risks.
IA can invigorate decision-making as IA resources can be repurposed to directly support the business by providing real-time advice on crisis management, business continuity, cybersecurity issues, employee well-being, brand protection and working capital management.
It is also a good opportunity for IA to proactively revisit control design changes and discuss internal control focus areas. In particular, key controls on processes such as inventory count or financial close may need to be performed remotely because of social distancing requirements, or in the event that the individual executing the control is ill for an extended period.
NEXT
Audit scope may shift focus to escalating risks such as data privacy and information security, liquidity and working capital, employee health and well-being, business resiliency and regulatory changes. As IA reprioritizes the audit plan, it needs to assess whether IA resources have the right skills, methodology and technology to enable them to execute its work.
IA work can be continued, but with considerations on cost and the least disruption to the business. With the possibility of an extended economic downturn, more IA departments may face budget cuts. Hence, IA will need to find innovative solutions to enable them to do more with less. It may also consider performing analytics-based procedures which can be performed remotely, or leverage on third party IA service providers as subject matter experts for audits where IA either does not have expertise yet or are in locations currently restricted in lieu of on-site audit procedures.
BEYOND
Chief Audit Executives (CAEs) should continue to innovate their ways of working and interaction with key stakeholders. Short sprints and focused, real-time reports may replace traditional detailed reporting. Internal auditor requirements may also need revisiting as the need for data analysis and automation skills increases while on-site procedures decrease due to social distancing protocols. A flexible workforce structure can also be considered, such as the use of third-party resources, developing an offshore workforce and enabling business rotations to give access to the right subject matter skills at the right place and time.
CAEs must examine their efforts to transform their organization through a new lens with renewed motivation and optimism. IA should continue to act in an advisory capacity to the business to address escalating and emerging risks upfront. As companies face difficult budget decisions, having an IA function that is viewed as a trusted business advisor is key in withstanding tightening budgets and workforce reductions.
While there is no one-size-fits-all solution, CAEs as leaders can be catalysts for change in defining the new normal. The question is, in a world of uncertainty, will they just watch the events unfold or will they have the resilience to reimagine and reinvent the future?
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.
Partner Christiane Joymiel Say-Mendoza, Manager Pia Isabella Pagdanganan, and Manager Meleusipo C. Fonollera are from the Advisory Service Line of SGV & Co.
