US embassy cable - 05MANILA1839

UNCLAS SECTION 01 OF 03 MANILA 001839 
 
SIPDIS 
 
SENSITIVE 
 
STATE FOR EB/IFD/OIA, EB/ESC AND EAP/PMBS 
STATE PASS USAID FOR AA/ANE, AA/G 
STATE PASS EXIM, OPIC AND USTR 
DOE FOR TOM CUTLER 
TREASURY FOR JVELTRI 
TREASURY ALSO FOR OASIA 
USDOC FOR 4430 ITA/MAC/ASIA & PAC/KOREA & SE ASIA/ASEAN 
 
E.O. 12958: N/A 
TAGS: ECON, ENRG, PGOV, EAID, RP 
SUBJECT: VAT PROPOSALS THREATHEN POWER SECTOR REFORMS 
 
SENSITIVE BUT UNCLASSIFIED - NOT FOR INTERNET - PROTECT 
ACCORDINGLY 
 
1.  (U)  Summary:  Value Added Tax (VAT) proposals filed 
in both Houses of Congress contain provisions detrimental 
to the government's efforts to strengthen and restructure 
the power sector.  In particular, replacing the current 
"zero rating" for power generating firms with a value 
added tax (VAT) and preventing firms from passing the tax 
onto consumers would violate contracts, discourage new 
investments into the sector, and derail the National 
Power Corporation's (NPC) plans to privatize generation 
and transmission assets.  A bicameral conference 
committee is deliberating the appropriate VAT treatment 
of the power sector.  Although Congress will probably 
impose a VAT on electricity generation and fuel, the 
final bill is unlikely to require producers or fuel 
purchasers to absorb the tax.  End Summary. 
 
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VAT Bills Target Power Sector 
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2.  (U) The Congressional Bicameral Conference Committee 
is currently deliberating on bills increasing the value 
added tax (VAT) and expanding its coverage to increase 
government revenue and address the Philippines' 
burgeoning budget deficit.  Both bills remove the "zero 
rating" currently enjoyed by power producers, which 
entitles them to a refund or tax credit if their input 
taxes exceed their output taxes.  The House bill imposed 
a VAT rate of 4% for the initial year of implementation, 
rising to 6%, 8% and 12% in succeeding years, and 
prohibited power generators from passing this tax to 
consumers.  The House bill also exempts the import and 
sale of coal and natural gas, and the sale of power from 
biomass, wind and solar energy from VAT coverage. 
Meanwhile, the Senate bill proposes a 10% VAT on power 
generation, transmission and distribution, and prohibits 
passing this new tax to residential consumers and the 
National Power Corporation (NPC).  The Senate bill levies 
a zero VAT rate on the import and sale of renewable 
sources of energy. 
 
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No Pass-Through Unfairly Taxes Power Producers... 
--------------------------------------------- ---- 
 
3.  (SBU) The no pass-through provisions found in both 
the House and Senate bills effectively turns the VAT, a 
consumption tax, into a tax on producers' earnings. 
Independent power producers (IPPs) have warned that this 
provision would slash their profitability and constitute 
a breach of covenant with international and multilateral 
lenders.  This would force IPPs to nullify their 
contracts with the NPC, which guarantee complete pass- 
through of any taxes, and trigger contract buy-outs that 
several newspapers estimated would cost NPC about $27 
billion. 
 
4.  (SBU)  In discussions with us, House Committee on 
Ways and Means Chair Jesli Lapuz and House Committee on 
Trade and Industry Chair Junie Cua said that there is 
perception that IPPs make windfall profits as a result of 
their contract's "take or pay" provisions and their 
entitlement to tax credits.  Although as members of the 
bicameral committee were concerned about the provision's 
impact on power sector investment, they wanted to hear 
directly from IPPs on the damage the "no pass-through" 
provision would have on their profitability.  U.S. IPPs 
estimated that the inability to pass on the VAT would 
wipe out the bulk of their profits and set in motion the 
need for calling in their contracts. 
 
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...Further Clouds the Investment Climate 
---------------------------------------- 
 
5. (U) Requiring power generation companies to pay and 
absorb the VAT would not only make their business 
unprofitable, but would also deter any new investments in 
the power sector.  The Senate proposal to increase 
corporate income taxes from 32%, already the highest in 
ASEAN, to 35% provides another disincentive for private 
investment.  In addition, provisions exempting self- 
generation of power and the generation of electricity 
from indigenous and/or renewable energy systems from VAT 
coverage are discriminatory, giving favored sectors undue 
competitive advantage over other existing power 
producers.  The power industry considers these proposals 
contrary to standard business practice that could 
adversely affect the government's ability to attract much 
needed investments to stave off electricity shortages 
already present in the Visayas and Mindanao, and looming 
in Luzon. 
 
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...And Could Derail Power Sector Reform 
--------------------------------------- 
 
6. (U)  New uncertainties in the investment climate could 
further delay the government's target to privatize at 
least 70% of the NPC's generating capacity and 
transmission assets within the year.  The delay may mean 
additional national government borrowing just to operate 
NPC's plants. Privatization, which is central to the 
Electric Power Industry Reform Act (EPIRA), is a key 
prerequisite to achieving open access and retail 
competition in the electricity sector by June 2006 in the 
Luzon grid. 
 
7. (SBU)  Imposing a VAT on power generation, 
transmission and distribution at this time may be 
detrimental to the government's effort to increase 
electricity rates to reflect the true cost of power.  The 
Energy Regulatory Commission's rate-setting process would 
become even more politically difficult as the ERC will 
have to impute new cost items in the determination of 
electricity rates.  The ERC is expected to announce its 
decisions shortly on NPC's final generation rate and the 
Manila Electric Company's (Meralco) distribution rate 
increases.  These rate increases are crucial in steering 
the NPC and Meralco to sound financial footing.  In a 
meeting April 19, Energy Secretary Lotilla said the ERC's 
final determination of the NPC rate (provisionally 
increased by a country-wide average of 98 centavos per 
kilowatt hour in September 2004, but expected to increase 
further) will not be affected by any increases in 
electricity rates from the VAT bill. 
 
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Comment 
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8.  (SBU) The treatment of the power sector has emerged 
as among the most contentious issues in Congress' 
deliberations on the VAT bill, now under consideration in 
the bicameral conference committee (septel).  There is a 
need to balance the government's revenue generation goals 
with investor and business sentiments.  Finance Secretary 
Purisima gave assurances at a meeting with econoffs, U.S. 
IPP firms and American Chamber representatives April 19 
that while the bicameral committee will impose a VAT on 
fuel and electricity generation, it would eliminate the 
"no pass-through" provision, and commented that the 
President would veto this provision if necessary.  In 
view of his reassurances and the strong concerns 
expressed by various business groups, including the 
foreign chambers of commerce, we believe that the final 
bill will not contain the controversial "no pass-through" 
provision. 
 
RICCIARDONE