DoF LOCAL FINANCE CIRCULAR 1-93:AN ASSESSMENT OF IMPACT OF

PROPOSED AMENDMENTS

Felixberto Monasterio

August 2007

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

This paper lists and analyzes issues relating to the implementation of the proposed amendments to Local Finance Circular 1-93 from the viewpoint of existing branch banking practices of the top five commercial banks. Interviews with branch heads of these banks and other resource persons establish that major banks prefer to have branches concentrate on fund sourcing, and to decentralize lending operations via lending centers. The branch and lending center, while usually co-situated, would operate independently and report to different segments or divisions. While some banks give limited leeway for branches to engage in lending, branch heads are generally averse to it for various reasons, foremost of which is lack of competence. Further, deposit volumes are the main criteria for assessing a branch’s performance, reflecting the prevalent management trend toward specialization rather than integration of these major functions. The paper gives recommendations to help clarify certain provisions on the circular and improve tax collection from commercial banks by local governments.

Executive Summary

This paper lists and analyzes issues relating to the implementation of the proposed amendments to Local Finance Circular 1-93 from the viewpoint of existing branch banking practices of the top 5 commercial banks. The amendments seek to disperse banks’ revenue tax base outward from the National Capital Region, thereby raising local business taxes for less-urbanized local governments. The main amendment requires banks to credit a loan transaction to the branch located in the city or municipality where the borrower resides.

Branch heads of the top five commercial banks and other resource persons

were interviewed for this paper. The circular and its amendments were also explained to the respondents for the purpose of identifying potential implementation concerns.

It was established that major banks preferred to have branches concentrate

on fund sourcing, and to decentralize lending operations via lending centers. The branch and lending center, while usually co-situated, operate independently and report to different segments or divisions. While some banks give limited leeway for branches to engage in lending, branch heads were generally averse to it for various reasons, foremost of which is the lack of competence. Further, deposit volumes are the main criteria for assessing a branch’s performance, reflecting the prevalent management trend toward specialization rather than integration of these major functions.

On the circular itself, further amendments may help clarify certain

provisions, and improve tax collection from commercial banks by the LGUs in general and are summarized as follows:

1. Name the tax to avoid confusion and distinguish the Circular from other

existing taxes such as the GRT.

2. Expand definition of a branch to include extension offices that are already booking loan transactions in the provinces.

Expand definition of gross income to cover traditional major branch

income sources such as DAUD/DAIF charges. Other sources are listed below. The Joint Statement of Annual Income form will have to be amended to cover these.

Gain on sales & purchases of foreign exchange

Fees or charges on dormant deposit accounts

Fees or charges on deposit accounts which failed to meet minimum maintaining balances

Fees or charges on usage of Automated Teller Machines

Fees or charges for deposit pick-up or cash delivery services rendered

Fees or charges for cash management services to institutional and retail customers such as over-the-counter and internet-based payment and collection services

Trust fees ceded bv a bank’s trust unit to a branch 3. Clarify definition of Branch Manager. Different banks have different titles for

the officers responsible for branch operations. 4. Clarify Section 5(3). Clarifying the phrase “credit the transaction” may help in

facilitating implementation of this Circular 1-93. In banking parlance, the phrase implies the booking of the loan transaction including all of the accompanying accounting documentation.

5. Amend Section 7(a) to allow the LGU to examine the books of a branch more

than once a year. Other steps not directly related to the Circular have also been recommended for consideration.

DoF LOCAL FINANCE CIRCULAR 1-93: AN ASSESSMENT OF IMPACT OF PROPOSED

AMENDMENTS Introduction, Legal Basis and Description

To liberate provinces, cities, municipalities and barangay from over-dependence on the central government, Republic Act 7160 was passed in 1991, effectively increasing their powers and share in the taxes and wealth of the nation. Also known as the Local Government Code of 1991 (LGC), the Act declares a state policy of autonomy for its territorial and political subdivisions via decentralization of powers, authority, responsibilities and resources.

The LGC realizes this policy of decentralization by, among others, granting

local government units (LGUs) the power to create their own revenue sources, as contained in Sec. 129. This includes levying of taxes, fees and other charges.

Local Finance Circular 1-93, dated June 16, 1993, is among a series of

circulars that provides guidelines for the imposition and collection of business taxes by an LGU. This circular particularly implements Sections 143(f) and 151 of the LGC which refer to business taxes on banks and other financial institutions by municipalities and cities, respectively. It is intended to cover all banks and other financial institutions regulated by the Bangko Sentral ng Pilipinas (BSP). (Refer to Annex A for these and other relevant provisions of the LGC)

The circular imposes a percentage tax on gross receipts of branches and

other offices of banks, to be collected by and paid directly to the city or municipality where the branch or office is located. The tax rate is specified at a maximum of 0.50% of gross receipts of branches located in municipalities and 0.75% for those located in cities.

Proposed Amendments to Circular 1-93 Amendments have been proposed to Circular 1-93 aimed at strengthening

the revenue generating capability of less-urbanized LGUs. The main amendment requires banks to credit a loan transaction to the branch located in the city or municipality where the borrower resides. In this manner, it is hoped that lending revenues will be ‘dispersed’ to branches rather than centralized at banks’ head offices.

The dispersal of revenues will enable more LGUs, including less-urbanized

cities and municipalities to benefit from the business tax from banks, particularly those with a wide branch network. This will eventually lessen these LGUs’

dependence on internal revenue allotments and borrowings, thereby promoting fiscal health and speeding up countryside development. The ultimate goal therefore is to redistribute rather than impose new taxes.

The other amendments seek to firm up the veracity of financial statements

submitted by banks to LGUs by: o having the document jointly signed by head office and branch officers; o having the document notarized; and o allowing an LGU’s Treasurer to conduct a semi-annual verification of a

bank branch’s transactions, in addition to the annual examination presently provided for by the circular.

Rationale / Background

Recent news give prominence to tax collection shortfalls of the Bureau of Internal Revenue and the Bureau of Customs, the government’s main revenue generating agencies. The estimated BIR shortfall from January to June 2007 was P40 billion; that of the BoC was P13 billion. These shortfalls significantly impact on countryside development as they seriously undermine the government’s ability to continue spending for infrastructure, social service and poverty-alleviation projects, most of which are aimed at the countryside.

Malacañang assures that the administration’s economic team remains

committed to its economic reform program that produced 5.4% growth in 2006 and 6.9% for the first quarter of 2007. To stave off a looming fiscal crisis, it has unveiled a 6-point action plan to improve revenue generation:

• review all rulings granting tax exemptions and preferential treatment; • intensify development of tax evasion cases; • verify compliance with withholding tax rules by top 1,000 corporations; • check compliance with withholding tax rules by working expatriates; • prohibit BIR officials from issuing unnumbered rulings; and • closely monitor taxpayers with declining tax payments. On the other hand, non-tax initiatives to complement the above in propping

up government finances are being actively pursued. Most notable among these are privatization of government owned companies and sale of assets or shareholdings. Recently, the government sold its 20% stake in the Phil. National Oil Co. – Energy Development Corp. for P17.1 billion. Its track record, however, is spotty, marked by famously failed biddings for the National Transmission Corp. (Transco) and the 600-megawatt Masinloc coal-fired power plant. Transco has been on the auction block since 2003, while Masinloc was re-auctioned and awarded to a Singapore-based firm this July, three years from its original timetable. In any case, these asset sales are non-recurring and therefore unsustainable over the long run.

It’s a big question mark whether these pronouncements and measures,

coming at the middle of the year, will enable the government to attain its P1.1 trillion revenue and P63 billion budget deficit targets for 2007. For its part, the Senate and Lower House have warned that it will shoot down any new tax measures, notwithstanding warnings of a Philippine credit rating downgrade due to shortfalls.

Meanwhile, local government projects and services remain heavily reliant

on internal revenue allotments which, in turn, depend on availability of funds and shifting priorities. In recent years, many local governments have resorted to issuing bonds or obtaining loans by pledging their future allotments. These borrowings, while providing much-needed liquidity, impose a debt-service burden which can potentially bear down on an LGU’s finances in the long run. Clearly, improving an LGU’s own revenue generating capability is a better alternative.

General Objective

This paper aims to identify general/broad issues relating to implementation of the amended tax circular, from the viewpoint of commercial banks. The research focused on present branch banking practices and activities of the major universal banks, and the implications of the amended circular on these.

The findings herein should serve as a starting point for discussion in a planned workshop among commercial bank and DoF representatives to refine the circular. Specific Objectives 1. To identify relevant issues and concerns raised by the respondents, whether

favorable or unfavorable, regarding implementation of the circular. 2. To consolidate these issues together with the implications on the implementation

of the circular. 3. To identify matters deemed critical for the implementation of the circular even if

not raised by the respondents. 4. To assess the points raised in this paper and provide recommendations and

further actions to address or analyze identified issues. Methodology

1. Literature survey – Among the items scanned for possible leads were the Internal Revenue Code, Local Government Code, Manual of Regulations for Banks, and recent relevant news articles.

2. Secondary data gathering – Secondary sources of information included

BusinessWorld, the Bangko Sentral ng Pilipinas, Phil. Deposit Insurance Corp., and Bankers Association of the Phils.

3. Primary sources – 7 resource persons were personally interviewed for this

paper. These include branch heads of the top 5 local commercial banks (Metrobank, BPI, BDO, PNB and Landbank), and area heads from 2 of those banks. Other resource persons were lending, branch and tax compliance officers from a mid-size universal bank, and a tax compliance officer from a multinational bank.

The interviews sought to establish existing bank practices to subsequently determine whether the circular, in particular its amendments, can be implemented and if it will be effective in attaining its goal of dispersing local taxes from Metro Manila to other LGUs. Limitations

Branches with significant loan bookings were thought to be the ideal interview subjects. However, it became clear during the course of the research that it wasn’t a practice of the respondent banks to book loans in their Metro Manila branches, preferring to centralize bookings at the head office or business/lending centers. For most of the top banks, this is also true for the operations of the branches outside Metro Manila.

The respondents were mainly composed of branch heads and area heads of

the top five universal banks. Branch heads are the most senior officer of a branch while area heads are responsible for performance and supervision of a group or cluster of branches. Both branch and area heads are marketing officers whose main function is selling a bank’s deposit products or services. While their position requires them to be familiar with branch operations, they may not be ideal resource persons for queries that will concern central liability and loans management systems or procedures which amendments to Circular 1-93 may affect.

All respondents requested not to be quoted by name for the following reasons: - they are not official bank spokespersons, - some responses are based purely on their opinion, and, - a general apprehension at being misquoted.

The Consultant felt that assurances of anonymity enabled him to extract straightforward and articulate responses from the resource persons. Initially, the Consultant thought of requesting for a formal letter of introduction from EPRA / DoF to the top management of the banks. However, this would have entailed a longer preparation period for this study considering the number of offices the letter would have to be endorsed to before a final go signal is given. Furthermore, the top officers of the banks could have warned the branch heads about the study. This would have put some degree of doubt on the accuracy and honesty of the replies generated. The Philippine Banking Industry Composition and distribution

The banking industry is composed of 7,141 financial institutions, broken

down into 861 banks, 6,273 non-bank financial institutions and 7 offshore banking units (See Table 1). These institutions operate a total of 20,888 banking offices nationwide, and as mandated by law, are regulated by the Bangko Sentral ng Pilipinas, the country’s central monetary authority.

Banks are further classified into universal and commercial banks, thrift

banks, and rural and cooperative banks. Commercial banks offer the following services: accepting drafts and issuing

letters of credit; discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; accepting demand deposits, other types of deposits and deposit substitutes; buying and selling foreign exchange; acquiring marketable bonds and other debt securities; and investing in allied enterprises.

Universal (aka expanded commercial) banks offer the widest variety of

banking services among financial institutions. In addition to the functions of an ordinary commercial bank, universal banks are authorized to engage in underwriting and other functions of investment houses, and to invest in non-allied undertakings.

Thrift banks are composed of savings and mortgage banks, private development banks, stock savings and loan associations and microfinance thrift banks. Thrift banks specialize in providing short-term working capital and medium- and long-term financing to small- and medium-size enterprises engaged in agriculture, services, industry and housing.

Rural and cooperative banks are the more popular type of banks in the rural communities. They promote and expand the rural economy by helping farmers through the stages of production, from buying seedlings to marketing of their produce. Rural banks and cooperative banks are differentiated from each other by

ownership. While rural banks are privately owned and managed, cooperative banks are organized and owned by cooperatives or federation of cooperatives.

Non-bank financial institutions (NBFIs) consist of institutions engaged in the borrowing of funds from lenders or investors for the borrower's own account through issuances, endorsement or assignment with recourse or acceptance of deposit substitutes for purposes of re-lending or purchasing receivables and other obligations. Included among these are investment houses, financing, leasing, lending investor, and venture capital firms, pawnshops and credit card companies.

Universal and commercial banks dominate the industry in terms of resources. As of March of this year, this segment accounted for P4.7 trillion in assets of which P1.6 trillion are loans, and P3.4 trillion in deposits (see Tables 2 and 2a). The top 5 banks accounted for 52% of assets, 59% of loans, and 55% of deposits1.

On the other hand, NBFIs have more presence, accounting for 13,177

offices or 63% of total financial institution offices nationwide. Pawnshops accounted for 12,926 or 98% of these establishments.

In terms of geographic distribution, banking offices are heavily concentrated

in Luzon, particularly the National Capital Region where 2,645 or 35% of offices are situated. Next come Region IV-A (Calabarzon) with 1,156 or 15%, Region 3 (Central Luzon) with 806 or 11%, and Region VII (Central Visayas) 504 or 7% (See Table 3). General Situation

Although the Philippines was among the first countries in Asia to recover from the regional financial crisis, its trauma continues to temper the long overdue recovery in credit activity. Banks are still too risk-averse to lend due to a legacy of bad debts from that crisis.

On the demand side, a May 2007 BusinessWorld report quotes BSP Deputy Governor Diwa Gunigundo as attributing low loan take-up partly to excess capacity and highly liquid positions of companies. Corporate borrowers, in particular, have preferred the equities market for additional financing, raising P51 billion in 2006 and P28.6 billion as of May 2007. He also attributed weak demand to the changing structure of businesses. The emerging growth industries such as trading and business process outsourcing are less capital and credit-intensive.

Sluggish lending activity, low yields of government securities, and general liquidity in the banking system have conspired to force a low-interest regime which is expected to prevail for the near to medium term. 1 Equitable PCIB and Banco de Oro were considered as one bank because of their subsequent merger.

Over the past few months, however, lending finally seems to have started

picking up. As of March this year, bank lending rose by 9.9%, with outstanding loans by commercial banks, thrift banks and rural banks reaching P1.979 trillion from P1.8 trillion a year ago. Last March’s growth was higher compared with the 7.5% expansion in the previous month and 11% in December last year. Recent Developments

The biggest development in the industry during the past year is the corporate marriage of Banco de Oro Universal Bank (BDO) and Equitable PCI Bank (EPCI). The merged entity is expected to be a formidable force in the banking sector. Both banks reported double digit net income for the first quarter of 2007, raising expectations for the combined entity to perform even better. BDO’s consolidated bottom line of P838 million grew by 19%; EPCI reported a 32% increase in unaudited net income.

The merged bank, which will reportedly retain the name of Banco de Oro, will boast of P646.36 billion in assets, dislodging Bank of the Philippine Islands (BPI) as the second largest local bank. Trends

The BDO-EPCIB merger is expected to spur another round of bank mergers and acquisitions, as other banks, particularly Metrobank and BPI, are expected to respectively preserve and reclaim their lofty status among local banks.

Mergers may also be the solution for smaller banks which are under pressure to raise capital or improve capital adequacy ratios in adherence to Basel II standards which will be implemented this year2.

Developments Favorable to Circular 1-93

The following recent developments may significantly impact on Circular 1-93’s effectiveness in generating revenues for local governments. House Bill 5811

Otherwise known as an Act Promoting Entrepreneurship and Supporting the Development of Micro, Small and Medium Enterprises, the passage of HB 5811 is

2 Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision, an institution created by the central banking authorities of Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States (aka the Group of 10).

expected to promote and accelerate lending to these businesses, many of which are based in the countryside. Its 3 major features are:

- increasing MSME loans from mandatory 8 to 10% of total portfolio; - relaxing procedural rules and requirements with respect to registration;

and - providing services and assistance to entrepreneurs, and easier access to

financing

Robust consumer lending activity

The BusinessWorld report lists encouraging signs for a sustained growth in bank lending. At the macro level, economic growth and the prevailing low interest-rate environment should eventually spur demand for credit. At the micro level, demand for credit will ride the current boom in the real estate sector, supported in large part by robust overseas Filipino workers (OFW) remittances. Inflows for the first quarter of 2007 amounted to $3.5 billion, 24% higher than that for same period in 2006. OFW remittances are seen to grow to $14 billion this year from $12.8 billion last year.

Up to a third of remittance inflows are estimated as being spent on real estate, making the housing sector a big source for consumer loans. Auto financing has also been very encouraging. As of December last year, auto loans granted by commercial banks were up by 15.5% from the previous year. Prevailing low interest rates are making housing and auto finance more accessible than before. With yields in government securities and treasury bills now much lower and corporate loan demand still sluggish, banks are turning to consumer financing more aggressively.

There remains significant room for growth. The double-digit growth loans are expected to post this year remains far below the 30% growth recorded just before the Asian crisis broke out in 1997. Present Implementation of Circular 1-93

All of the respondent branches pay their local business tax once a year,

notwithstanding the quarterly mode allowed in the circular. It is not clear whether this practice is borne out of convenience but specified by each LGU’s ordinance.

Based on documents shown the Consultant by two of the respondent

branches, the cities of Mandaluyong and Makati levied a tax of 0.55% and 0.20% on their 2006 gross receipts, respectively (See Annex B). These are well below the 75% ceiling allowed for cities. Noticeably, each city has a different term for the local business tax; Makati calls it a City License, while Mandaluyong labels it as a Commercial Bank/Br tax/fee. Furthermore, each city charges other fees in addition

to the business tax. The composition and amount of these vary considerably, but generally seem to be fixed in nature. Hence, the Makati-based branch actually paid more vis-à-vis its revenues compared to the Mandaluyong branch, notwithstanding the higher business tax rate of the latter.

All of the branch heads interviewed aver that branches are responsible for

paying city/municipal taxes. The PNB Branch Head adds that the head office reviews the tax assessments and just informs and instructs the branch on the amount to pay.

Both branches paid the local business tax well ahead of the January 20

deadline.

Process Flow for Implementation of Amended Circular 1-93

Based on interviews with tax compliance officers of two banks (a mid-sized universal bank and a multinational bank), implementation of a tax circular by and within a typical commercial bank may be described as follows: Receipt - Tax memoranda or circulars and their accompanying implementing rules

and regulations (IRR) are usually received by the Compliance Dept. or its equivalent unit in a bank. This is the office which is primarily responsible for the bank’s accurate interpretation and timely implementation of tax and other regulatory matters.

Interpretation – The Compliance Dept. must examine, understand, and be able to

clearly explain the circular to the rest of the bank. It may do this on its own, or in consultation with other units of the bank such as its legal counsel or tax lawyer, accounting, and branch operations. Some banks may opt to additionally forward their interpretation and action plans to an external tax consultant for further validation.

Systems Intervention – If implementing the tax circular will involve additional

demands or revisions in manual or automated systems, the above discussion must then expand to include systems and information technology units.

Dissemination – All concerned bank departments will be notified of the circular via

electronic mail, now the fastest and cheapest method of conveying and disseminating information. Included for dissemination will be additions or changes in internal procedures affected by the circular.

Implementation & Monitoring – Branches are mainly responsible for the prompt

and accurate payment of city/ municipal taxes. Tax compliance officers are responsible for bankwide adherence to all national or local taxes.

No resource person would give a definite timetable, stating that it would depend on the complexity and coverage of the tax. In the case of an amended Circular 1-93, one month may be a reasonable time period from receipt of the circular and IRR to dissemination, if the following issues and concerns are properly addressed.

Issues, Concerns & Observations 1. Differentiation and Cost

When discussing the circular, among the first questions asked by the resource persons was how this is different from, or if this was in addition to the 5% gross receipts tax (GRT) levied by the national government. They did not recognize this as part of the local fees and taxes they annually pay to the local government.

Any tax will raise financial intermediation costs, and most of the

resource persons were anxious of a backlash when these are passed on to customers. However, this tax potentially increases lending rates by a maximum of 5 to 8 basis points, a negligible increment which banks will probably just opt to absorb3.

2. Coverage of gross receipts

It was noted that not all possible revenue sources were covered by the

circular. Among the items that were left out are the following:

Gain on sales & purchases of foreign exchange – Branches can and do record income from foreign exchange sales and purchases. However, this business can be shared or referred to a non-bank affiliate. BDO and BPI have foreign currency dealership affiliates which handle a large volume of transactions.

DAUD/DAIF4 service charges – This is a major revenue item for most

branches. DAUD service charges are tacked on withdrawals allowed for uncleared funds. DAIF charges are slapped on depositors who issue checks while having insufficient balances in their accounts.

Dormancy fees – These refer to charges on dormant deposit accounts, i.e.

those with no movements during a year.

3 Based on a universal bank’s present lending rates of 9% - 10% p.a. for consumer loans. 4 DAUD – drawing against uncleared deposits DAIF – drawing against insufficient funds

Charges on accounts with below minimum balances - Banks will penalize accounts which hold less than the minimum required balance as per bank policy. The minimum balance ranges widely from P1,000 to P50,000 depending on the class or type of deposit account.

Automated Teller Machine fees – These refer to charges for the use of

ATMs by other banks’ cardholders. These currently range from P7 to P11 per transaction.

Deposit pick-up/cash delivery – Some banks may charge for these services,

especially when the customer can’t afford to maintain a sizeable deposit balance.

Cash management service fees – In recent years, advances in information

technology and reduction in its costs have enabled banks to churn out new services to complement but not replace or duplicate traditional loan and deposit products. These include collection services wherein bank branches serve as payment centers for utilities, effectively extending these institutions’ collection counters and making it easier for customers and dealers to pay their bills. Cash management services also include disbursement services which enable conglomerate headquarters to settle their obligations with suppliers nationwide and fund provincial operations using their banks’ branch and ATM networks.

Trust fees – These are technically charged and earned by a bank’s trust unit

which is an independent institution within the bank. In some cases, trust units actually share revenues with branches that refer clients. These are actual revenue to the branch and not internal or shadow income.

3. Amendment to Section 5

An additional provision is being added to Section 5 of circular 1-93 which will require banks to credit a loan transaction to its branch located in the city or municipality where the borrower resides, regardless of where the loan application was made or approved. Subjects interviewed for this paper raised these concerns:

• It’s unfair to credit a branch just because the borrower happens to reside in

that branch’s service area, even if that branch had nothing to do with marketing or servicing the account.

• Will the credited branch also be charged for attendant expenses and be liable

for any audit issues on the account? • If a borrower is from a city where a bank has more than one branch, what

branch should be credited?

• What happens if the borrower changes residence while the loan is

outstanding?

• The Metrobank area head points out that branch location is only one criteria customers use in choosing their bank. A significant and perhaps more important factor is relationship, whether past, direct or indirect. Customers may want to continue dealing with a branch head even if he/she is transferred to another branch because of familiarity, trust or satisfaction with the service. A customer may refer colleagues, relatives or businessmen friends to a favored branch even if the referrals do not necessarily live or hold office in the vicinity of the branch.

• On the other hand, BPI Sales Officers (as branch heads are now referred to)

merely refer commercial loan and consumer loan requests to head office and affiliate BPI-Family Bank, respectively. They assist in obtaining information and documents from loan applicants, but otherwise have no participation in the evaluation, recommendation, approval and post-administrative functions such as review, billing & collection.

It’s clear that the phrase ‘credit the transaction’ in the added provision is

interpreted by the respondents as synonymous to booking the loan.

4. Concentration of Lending Activity

Commercial bank lending activity remains highly concentrated in Metro Manila, which may put into doubt the effectiveness of the amended circular in improving finances of suburban and rural municipalities. Latest statistics from the BSP show that over 90% of loans are booked in the National Capital Region. Central Visayas, where 2nd major city Cebu is located, accounted for only 2% (see Table 4). In terms of operating income, the situation is even more skewed with NCR accounting for 96% (see Table 5).

It’s easy to understand the concentration of lending activity in Metro

Manila. This is where multinationals and national conglomerates, the so-called prime credits, have their headquarters. Commercial banks naturally have larger loan exposures to these types of clients which are perceived to be better credit risks, and have bigger financing requirements.. While these customers borrow to support nationwide operations, a central authority based in head office negotiates and sources financing. For example, a food conglomerate’s chief finance officer will negotiate and obtain a long-term loan from a bank or syndicate of banks in Makati to finance construction of a manufacturing plant in General Santos City. Thus, the loan will be booked in the lending banks’ Makati branch or head office but the utilization would be in the countryside. The income would therefore go to the Makati instead of the GenSan LGU where the revenue would probably be more needed. On the other hand, booking the

loans in Makati would be the logical thing to do for banks and the borrower for the following reasons:

loan repayment will come from the borrower’s headquarters where its

finance office and functions are usually centralized; and billings, payments and other loan administration functions will therefore be

coordinated with client’s headquarters.

To a limited extent, the major banks have decentralized their loan bookings. The interviews confirm that, instead of booking loans at branches, these banks maintain regional lending or business centers to facilitate the delivery and administration of loans to provincial areas. These are established in strategically important urban centers, and while usually co-situated with a branch, have separate and distinct functions, and are much fewer compared to branches. Branch systems and backroom operations are designed to specialize in deposit services. Lending centers specialize in of course, lending activities and its backroom will therefore specialize in loan transactions. It will be very hard to argue against the efficiency and effectiveness of this system that has become the standard for these top-tier banks.

It’s safe to say commercial banks will continue to put up and maintain

more brick-and-mortar offices dedicated to sourcing and servicing deposits than to loans. With few exceptions, these will be sited in urban and developed communities which promise more business compared to rural and underdeveloped areas.

5. Competence and Confidence

There was a general aversion among the respondent branch heads to lending. When asked if they would want to book loans in their branches, only the PNB Branch Head answered in the affirmative, with a condition that he be given the necessary manpower. The rest of the respondents preferred not to book loans for various reasons:

• Branches are generally viewed as cost centers, with a primary function of

deposit-taking. Hence, deposit volume is the major criterion in appraising its performance.

• Deposit generation and credit/lending are two different disciplines, and branch officers and staff are traditionally adept at the former. The function and responsibility of lending is better left to account officers or relationship managers who specialize and are better trained and experienced in credit.

• They are generally wary of the financial and audit risks attendant to loan accounts. Given that loans are not a key performance factor, engaging in this activity does not offer a good risk-to-benefit ratio for branches.

• At least 3 of the respondents admit and recognize that their staff is not competent in loan administration (i.e. pricing, accounting, documentation, monitoring, billing and collection).

The reactions come from a common and logical mindset that a branch

becomes responsible for any and all transactions booked in it. This may also a hangover from recent failed attempts by at least four

commercial banks to convert their branches into both deposit and loan generation units.

6. Voluntary rather than mandatory

For the gross receipts tax to be enforced, the city or municipality must pass an appropriate ordinance after conducting public hearings. Even if an ordinance is in place, LGUs may opt to waive these for preferred businesses or investors.

Giving the LGU the power to implement or waive is prudent as it

becomes an incentive for banks to set up branches in the locality especially if adjoining towns are likewise being considered as potential sites. A bank branch in a town (countryside) may serve as a magnet for more businesses because of the financial services it may offer to local business. Indirectly, the branch may also induce more downstream or upstream investments with the entry of new investments. The “ripple” effect comes into play as the increase in purchasing power induces greater spending thus initiating an increase in economic activity. This means more income for the LGU in the long run. The preference for long term gains versus short term income or vice versa is matter for the local leaders to ponder and decide on.

7. Existing BSP Policy on Loans vs. Deposits

Part Three, Chapter K, Section X393 of the BSP’s Manual of

Regulations for Banks prescribes a loans-to-deposits ratio for all banking offices located outside the National Capital Region. Its main provision reads as follows:

Statement of Policy. At least 75% of total deposits, net of required reserves against deposit liabilities and total amount of cash in vault, accumulated by branches and other banking offices of banks in a particular geographical grouping shall be invested therein as a means to develop the area.

None of the respondents claimed any knowledge of this apparently

obscure provision, much less if it is being enforced. While the provision has no direct relationship on circular 1-93, it certainly falls within the ambit of policies

aimed at developing the countryside. Among the recommendations in the last section of this paper is to harmonize the circular and this BSP regulation.

8. Beyond Revenues

A case can be made for making deposits rather than revenue the basis for taxing branches at the LGU level. Consider the following:

The main function of bank branches remains that of providing funds for

lending and investing activities, which have traditionally been centralized at head office or regional offices. Branches are therefore natural marketing and booking offices for deposits.

Using the deposit level as basis for taxation by the LGU seems fair given

that the Bank is tapping the resources of the town that will eventually earn profits for the Bank. This is very similar to the concept applied in the mining or power generation industries where host localities are provided with benefits or even outright subsidies. Since the company is extracting these resources that are within the area, it is only proper that residents benefit from the activity.

The geographical distribution of deposits is not as skewed towards

Metro Manila. The NCR accounts for 71% of total commercial bank deposits, in contrast to 96% for operating income (see Table 6).

Implications of Issues & Observations on Implementation of Amendments

None of the respondents stated any technical hindrance to the implementation of the amendments to Circular 1-93. However, it must be reiterated that while they were conversant in branch operations, their knowledge or familiarity of loans systems was not established, nor can it be assumed.

In addition to the questions already raised in the previous section, the

following need to be addressed as they will affect monitoring, billing, accounting, internal audit and performance appraisal processes:

What does the phrase ‘credit the transaction’ in Sec. 5(3) mean? Does this

entail booking the loans in the branch, or simply assigning the revenues?

If the intent is to simply assign or credit the revenues while retaining the booking at head office, this would be analogous to booking a deposit in a branch and charging the interest to head office. Is this allowed by the BSP?

In either case, the branch has to at least carry the revenue in its

books. Otherwise, the branch won’t be able to include it in its Schedule of Annual Income, from which the LGU computes the local business tax.

Branch heads will have to get used to understanding and analyzing these financial statements which may contain transactions the branch was not actually responsible for.

Will the amendment affect outstanding loans i.e. must banks go through all their borrowers addresses and ‘credit the transactions’ to the appropriate branches?

How can compliance with Section 5(3) be ensured? The LGU has little

option but to accept the figures presented by the branch. It’s probably not possible or practical for an LGU auditor to go through a bankwide list of borrowers, nor will banks allow it.

Implementation of Section 5(3) will also affect external and regulatory audit

procedures. For example, auditors may be faced with more dispersed bookings of loan transactions, or situations where the asset is booked at head office and corresponding revenues in a branch.

The joint signatories and notarization of the Schedule of Annual Income

may potentially cause bottlenecks. Designated head office signatories will be under pressure to sign documents from tens to hundreds of branches all seeking to beat the January 20 deadline for payment of local taxes. Adding to the wait is the notarization which, under current rules, will need to be done twice – one each for the branch and head office signatory.

Recommendations Statistics and current best practices may not support immediate attainment

of Circular 1-93’s main purpose. However, further amendments to the circular may help clarify certain provisions of the circular, and maximize tax collection from commercial banks by LGUs in general. Insights gleaned from the interviews may also provide clues to guide policy-makers in coming up with complementary tax measures.

Two sets of recommendations have therefore been drawn up. The first

contains suggestions to improve effectiveness and avoid possible ambiguities in interpretation of Circular 1-93. The second lists down those which are outside the scope of the circular but which may contribute to the same goal of enhancing revenue generation of LGUs. Recommendations on Circular 1-93 6. Name the tax. It was noted that LGUs use different terms for the local business

tax, and respondents mistook this for the national GRT.

To distinguish between these similarly based taxes, it is suggested that this tax be specifically named and that this name be uniformly used by all LGUs. ‘Local Business Tax’ should be a usable term, and should likewise be adopted in related tax circulars on other businesses.

7. Expand definition of a branch. The circular presently excludes regional or

extension offices in the definition of a branch. However, the research reveals that at least 4 of the major banks have lending centers outside of their head offices. These were established to bring loan marketing and operations activities closer to markets outside of Metro Manila. It is apparent that transactions of these lending centers are not booked in regular branches. To capture transactions which are neither booked in head offices or branches, it is suggested that the definition of ‘branch’ be made to include any bank office which maintains records of financial transactions separate from head office.

8. Expand definition of gross income. The circular seems to have missed out on

traditional major branch income sources such as DAUD/DAIF charges. It is recommended that Section 2(b) of the circular be expanded to include the following items:

Fees or charges on deposit accounts due to DAUD/DAIF

Gain on sales & purchases of foreign exchange

Fees or charges on dormant deposit accounts

Fees or charges on deposit accounts which failed to meet minimum maintaining balances

Fees or charges on usage of Automated Teller Machines

Fees or charges for deposit pick-up or cash delivery services rendered

Fees or charges for cash management services to institutional and retail customers such as over-the-counter and internet-based payment and collection services

Trust fees ceded bv a bank’s trust unit to a branch

Amending the Joint Statement of Annual Income form to include these incomes (Annex C) is recommended.

9. Clarify definition of Branch Manager. The last paragraph of Sec. 2(b) of the

circular requires submission of a “Joint Statement of Annual Income . . . which shall be signed by a designated Officer of the Head Office and by the Branch Manager.” However, it was noted in the course of the interviews that banks have different titles for branch managers. BPI, for example, now calls them Sales Officers, in keeping with their restated functions and responsibilities. For clarity and avoidance of doubt, it is suggested that a separate paragraph be added in the circular to define ‘Branch Manager’ as the highest official of a

branch. This will include heads of bank offices included in the expanded definition of the term ‘branch’ in recommendation no. 1.

10. Clarify Section 5(3). Clarifying the phrase “credit the transaction” may help in

facilitating implementation of this Circular 1-93. Does it entail booking the loan transaction, or does it entail simply assigning the revenue? Choosing any of these alternatives gives rise to further questions that are detailed in the previous section. In banking parlance, the phrase implies the booking of the loan transaction including all of the accompanying accounting documentation.

11. Amend Section 7(a). If the intent of this provision is to empower an LGU to

examine a branch’s books more than once a year, it is recommended that this provision be amended to read as follows:

“The Treasurer of the LGU . . . may conduct a semi-annual verification of the transactions of the bank branch and an annual examination of the books . . .”

Changing the conjunctive from ‘or’ to ‘and’ empowers the LGU to

examine a branch’s books up to thrice a year (i.e. two semi-annual and one annual audit/inspection).

Other Recommendations 1. Determine geographical concentration of borrowers. The rationale for this

exercise is to gauge how the amendments to Circular 1-93 will effectively disperse booking of revenues from banks’ head offices to the countryside, i.e. less-urbanized LGUs.

This can be done by analyzing a sample size of say, 500 borrowers from

the top 5 banks. It is quite safe to say that big businesses or so-called corporate borrowers maintain their headquarters in Metro Manila or the other major urban centers. However, it is less clear how individual borrowers (micro-business or consumer loans) are concentrated or dispersed.

The data provided from this exercise can then be correlated with average

loan sizes, thereby giving policymakers a better picture of the potential effect of the amendments.

2. Expand coverage to foreign exchange dealerships. The LGC includes foreign

exchange dealers in its definition of ‘banks and other financial institutions’. However, these operations do not seem covered by 1-93 or its other related circulars on local business taxes.

The major banks operate dedicated subsidiaries which handle bulk of

both foreign currency purchase and sale transactions. The bank branch and

forex company have a working relationship wherein the former refers clients to the latter subject to certain criteria. One of the branches interviewed shared space with this subsidiary.

3. Split the withholding tax on deposits. Further study on this option is highly recommended. Arguments have been put forth in the previous section. A local tax on deposits can be implemented without imposing a new tax. The DoF may want to look at merely shaving off 1% from the existing 20% final withholding tax on interest and have this automatically withheld in favor of LGUs. It should be fairly simple for banks to implement this at the branch level because branch accounting systems are naturally set up to handle and book deposits.

4. Harmonize Circular 1-93 with Loans-to-Deposits Ratio. To facilitate

compliance to the Loans-to-Deposit Ratio, the BSP allows for loans in a geographical grouping to be assigned and considered part of the loans of offices in another geographical grouping, subject to presentation of acceptable proof that the end users of the loan proceeds are located in the latter grouping. Acceptable proof may include, but not be limited to: a) ticket showing that the loan proceeds were released by an officer in that

geographical grouping, and b) cable advice from the lending office to the office in the geographical

grouping where end-users are located relative to approval of loan and release thereof.

The DoF, BAP and BSP may consider agreeing to include Circular 1-

93’s Section 5(3) as another method of complying with the ratio. In doing so, LGUs can benefit from the BSP’s audit process and ensure they get their fair share of taxes.

These agencies also need to come out with more mutually acceptable

geographical groupings in the interest of countryside development. At present, these groupings are too broad – Luzon (Regions 1 – V), Visayas (Regions VI – VIII), and Mindanao (Regions IX – XII) – to be truly effective in spreading out investments. The groupings may also need to be updated in order to account for the newly carved out regions of Cordillera Administrative Region (CAR), Autonomous Region in Muslim Mindanao (ARMM), and Caraga. (See Annex D).

5. Use fund utilization as tax basis. The indicator for this tax may be an option to study further. The concept of benefiting from the use or extraction of local natural resources may be the basis for such. To illustrate, Dole or del Monte borrows money through their Makati offices and uses the funds for plantation development in a remote town in Mindanao. Makati does not tax them based on the loan level (booked in the Makati office) but the remote town will. It serves

as the local community’s benefits from the Company’s business activities which exploits the land within the locality. On the other hand, it may be argued that borrowing funds elsewhere and spending it for the plantation is a direct investment in that Mindanao town, benefiting it in a more effective and faster manner than thru taxes. This idea, however, may be too complex to implement but may be worth a second look.

ANNEX “A”

THE LOCAL GOVERNMENT CODE OF THE PHILIPPINES

PROVISIONS RELEVANT TO LOCAL FINANCE CIRCULAR 1-93

BOOK I. - GENERAL PROVISIONS TITLE ONE. - BASIC PRINCIPLES

Chapter 1 – THE CODE, POLICY AND APPLICATION

SECTION 2. Declaration of Policy. - (a) It is hereby declared the policy of the State that the territorial and political subdivisions of the State shall enjoy genuine and meaningful local autonomy to enable them to attain their fullest development as self-reliant communities and make them more effective partners in the attainment of national goals. Toward this end, the State shall provide for a more responsive and accountable local government structure instituted through a system of decentralization whereby local government units shall be given more powers, authority, responsibilities, and resources. The process of decentralization shall proceed from the national government to the local government units.

SECTION 3. Operative Principles of Decentralization

(d) The vesting of duty, responsibility, and accountability in local government units shall be accompanied with provision for reasonably adequate resources to discharge their powers and effectively carry out their functions; hence, they shall have the power to create and broaden their own sources of revenue and the right to a just share in national taxes and an equitable share in the proceeds of the utilization and development of the national wealth within their respective areas;

Chapter 2 – GENERAL POWERS AND ATTRIBUTES OF LOCAL GOVERNMENT UNITS

SECTION 18. Power to Generate and Apply Resources. - Local government units

shall have the power and authority to establish an organization that shall be responsible for the efficient and effective implementation of their development plans, program objectives and priorities; to create their own sources of revenue and to levy taxes, fees, and charges which shall accrue exclusively for their use and disposition and which shall be retained by them; to have a just share in national taxes which shall be automatically and directly released to them without need of any further action; to have an equitable share in the proceeds from the utilization and development of the national wealth and resources within their respective territorial jurisdictions including sharing the same with the inhabitants by way of direct benefits; to acquire, develop, lease, encumber, alienate, or otherwise dispose of real or personal property held by them in their proprietary capacity and to apply their resources and assets for productive, developmental, or welfare purposes, in the exercise or furtherance of their governmental or proprietary powers and functions and thereby ensure their development into self-reliant communities and active participants in the attainment of national goals.

ANNEX “A” (continuation)

BOOK II. - LOCAL TAXATION AND FISCAL MATTERS TITLE ONE. - LOCAL GOVERNMENT TAXATION

CHAPTER 1. - GENERAL PROVISIONS

SECTION 129. Power to Create Source of Revenue - Each local government unit shall exercise its power to create its own sources of revenue and to levy taxes, fees, and charges subject to the provisions herein, consistent with the basic policy of local autonomy. Such taxes, fees, and charges shall accrue exclusively to the local government units.

CHAPTER 2. - Specific Provisions on the Taxing and Other Revenue Raising Powers of Local Government Units

Article Two. - Municipalities

SECTION 143. Tax and Business - The municipality may impose taxes on the following business:

(f) On banks and other financial institutions, at a rate not exceeding fifty percent (50% of one percent (1) on the gross receipts of the preceding calendar year derived from interest, commissions and discounts from lending activities, income from financial leasing, dividends, rentals on property and profit from ex change or sale of property, insurance premium.

Article Three. - Cities

SECTION 151. Scope of Taxing Powers. - Except as otherwise provided in this Code, the city, may levy the taxes, fees, and charges which the province or municipality may impose:

Provided, however, That the taxes, fees and charges levied and collected by highly urbanized and independent component cities shall accrue to them and distributed in accordance with the provisions of this code.

The rates of taxes that the city may levy may exceed the maximum rates allowed

for the province or municipality by not more than fifty percent (50%) except the rates of professional and amusement taxes.

ANNEX "B"

ACTUAL LOCAL TAXES PAID IN 2007 BY TWO COMMERCIAL BANKS

CITY: MANDALUYONG CITY: MAKATI FEE / TAX AMOUNT FEE / TAX AMOUNT

Commercial Bank/Br ¹ 46,425.60 Bank

3,000.00

Mayor's Permit Fee 2,250.00 Forex

3,000.00

Garbage Charges 1,500.00 City License ²

339.93

Sanitary Fee 200.00 Sanitary Fee

1,750.00

Building Ins. Fee 200.00 Garbage Fee

6,250.00

Electrical Ins. Fee 150.00 Signboard Fee

200.00

Mechanical Ins. Fee 600.00 Individual MP Fee

600.00

Plumbing Ins. Fee 60.00 Individual HC Fee

600.00

Sign/Billboard Ins. Fee 111.00 Total

15,739.93

Fire Fee 507.10

Sticker Fee 60.00

Total 52,063.70

Notes: ¹ Comm Bank/Br Tax is based on gross receipts of P8,441,020.21 ² City License is based on gross receipts of P169,966.77

ANNEX "C"

A C C O U N T S REC. NO. AMOUNTA. INTEREST INCOME

1) Interbank Loans Receivables2) Loans and Discounts3) Agrarian Reforms / Other Agricultural Credit Loans4) Bills Purchased5) Import and Domestic bills Under LC &/or TR

B. BANK COMMISSION - LENDING ACTIVITIES

C. BANK COMMISSION - DEPOSIT & FOREIGN EXCHANGE ACTIVITIES1) DAUD/DAIF Fees/charges/penalties2) Fees/charges/penalties on deposit accounts with below minimum balance3) Fees/charges/penalties on dormant accounts4) Fees/charges on usage of automated teller machines (ATMs)5) Fees/charges for deposit pick-up or cash delivery services6) Fees/charges for payment & collection services7) Income on sales and purchases of foreign exchange

C. EXTRAORDINARY CREDITS/CHARGES1) Income From Assets Acquired2) Profits/(Losses) from Assets Sold/Exchanged3) Dividends - Equity Investment4) Trust fees/income ceded by trust unit to the branch

D. RENT INCOME1) Safe Deposit Boxes2) Bank Premises and Equipment

E. INTEREST INCOME IN FINANCIAL LEASING

F. TOTAL INCOME SUBJECT TO GRT(A+B+C+D+E)

G. TAX DUE (______% OF F)

H. QUARTERLY AMOUNT DUE(G divided by 4)

Notes:

Doc. No. __________Page No. __________Book No. __________Series of 200_

P.T.R. No. _______________

JURAT

SUBSCRIBED AND SWORN to before me at ____________________, this _______ day of _______________ 200_, the affiant _______________________________ exhibiting to me his Community Tax Certificate No. ________________ issued at ______________ on _______________, 200_ and affiant _______________________________ exhibiting to me his Community Tax Certificate No. _______________ issued at ______________ on _______________, 200_

NOTARY PUBLICMy commission expires Dec. 31, 200_

We hereby certify that this Joint Statement of Annual Income is true and correct.

Signed at ______________________, this _____ day of _______________, 2007

(Designated Officer of the Head Office) (Branch Manager) ___________________________________ _____________________________

For the Year Ended ______Date: _______________________

(in Thousand Pesos)

INTEREST INCOME includes interest on demand loans, time loans, discounts earned and mortgage contract receivables as defined in the Bangko Sentral ng Pilipinas Manual of Accounts for Commercial Banks.

JOINT STATEMENT OF ANNUAL INCOME (amended)SUBJECT TO GROSS RECEIPTS TAX

PURSUANT TO SECTION 143 OFTHE LOCAL GOVERNMENT CODE

ANNEX “D”