4 things you need to know about PEACe bonds tax issue

MANILA, Philippines – Neither the PEACe bonds investors nor the national treasury was favored by the Supreme Court decision on October 18.

The high court issued the 11th hour decision on a tax issue that was hanging over the state-issued financial instrument that the government was supposed to settle in full also on the same day.

In question was a P4.9 billion sum that represents withholding tax equivalent to 20% of the P24.3 billion interest earnings due to investors of Poverty Eradication and Alleviation Certificates or PEACe Bonds.  

While there was no final decision yet on whether the 10-year bonds were subject to tax, the Supreme Court said that P4.9 billion should be set aside in an escrow fund in the meantime.

The Supreme Court acted on a petition for a temporary restraining order (TRO) filed by banks who were wholesalers or retailers in selling the bonds to individual or corporate investors since 2001.

Why is the PEACe bonds controversial and why is the tax issue an issue now?

Below are four key things to know about this controversial investment product. 

1. Promises, promises

The tax issue on the PEACe bonds focused on these questions:

  • Will the Philippine government honor a promise?
  • Was that promise wrong?

In an October 17 ruling, the tax agency basically decided not to honor the promise: The interest earnings aggregating to P24.3 billion would be paid at the end of 10 years and it would be tax free.

The P24.3 bilion gross interest would be part of the P35 billion that the national treasury was supposed to pay investors in full.

Consider this: If investors put their money on a regular bond, a withholding tax would be slashed from their interest earnings. It was precisely because the PEACe bonds were sold tax-free in 2001 that investors found these bonds attractive. They were going to be P4.9 billion richer on October 18 if this was kept.

But the Bureau of Internal Revenue (BIR) said that promise of a tax-free investment was wrong from the start.

The tax agency, now under the Aquino administration, said this rule applies to all: Financial products issued by the Philippine government earn interest that must be slapped with a 20% withholding tax.  

The PEACe bonds issued by the Bureau of Treasury (BTr), another revenue-generating agency, should be considered a “deposit substitute” and, therefore, is taxable.

Eight banks that sold PEACe bonds sought relief from the Supreme Court on October 17. The Supreme Court acted on their petition for a TRO the crucial day after.

Banks are the frontliners in this whole scheme. They interact directly or indirectly with clients when they were dangling the sweetened product in 2001. They needed to deal with clients again come October 18.  

2. Timing issue

The PEACe bonds matured on October 18, the day of reckoning. The Philippine government was meant to fulfill its original promise: Pay investors the P35 billion it owes them.  

Bankers literally “banked on” the government’s ability to pay all P35 billion–the P10 billion principal plus interest–due to PEACe bond investors.

Normally, investing in government-issued debt notes are risk-free, and the zero-coupon PEACe bonds should have been no exception.

In “zeroes”, an industry lingo for bonds that pay clients on a one-time-big-time basis, investors let their money “sleep” with the debt issuer, in this case the Philippine government, without receiving interest earnings over the entire life of the bond. They receive the principal and the accumulated interest on maturity day itself.     

Of the P35 billion, bulk or P24.3 billion represents the interest earnings for the investors. However, the Supreme Court issued a TRO that mandated the government to pay the entire P35 billion to the banks who acted as the retailers. In turn, the banks were required to set aside 20% of the remaining bonds in escrow as the high court deliberates on whether to allow the bonds to remain tax-free or not.

No one wins but no one loses either. The banks and insurance companies who bought the PEACe bonds in the secondary market don’t get their promised return but they also don’t have to pay P4.96 billion in taxes.

Meanwhile the government is in wait-and-see mode but the escrow ensures BIR will collect revenue if the bonds are taxable.

3. Illegal or immoral?

Critics of the PEACe bonds have yet to prove that the deal was illegal. The tax issue is an easier route for the government to pin down the message that there was wrongdoing at all.

Another nagging criticism is that the deal was immoral. They said the transaction carries features of rent-seeking and influence-peddling in the name of the poor.

They said rules were relaxed for the PEACe bond since it had an unpleasant mix of money, family and politics.

The deal was set up months after former President Gloria Macapagal Arroyo rose to power in 2001. The key player, Code-NGO, a consortium, had helped put her there by mobilizing street protests against then sitting president Joseph Estrada.

In a 2002 interview with Newsbreak, the then Code-NGO national coordinator Danilo Songco said the only capital the NGO had was its “credible track record” in socio-civic work and the “goodwill of Edsa 2.”

The head of Code-NGO, Marissa Camacho, and the Finance Secretary at the time the deal was transacted, Jose Isidro Camacho, are siblings. They inhibited from the transaction and had claimed the process was transparent.

The process went like this: Code-NGO’s banker, Yuchengco-led Rizal Commercial Banking Corporation (RCBC) bought the bonds from the Bureau of Treasury for P10 billion with a coupon rate of 12%. Code-NGO had a share of P1.4 billion, of which only P1.3 billion went to an endowment fund for pro-poor projects.

Critics said RCBC cornered the deal through Code-NGO’s clout. Its unit, RCBC Capital, then re-sold the 10-year bonds to other other banks and insurance firms that either kept them for themselves or sold them to retail investors. 

The tax exemption, a sweetener, was added to the bond issue to make it attractive to investors. At the time in 2001, investors had other choices, including financial products bearing more competitive rates of up to 16%. The PEACe bonds had a coupon rate of only 12%.

Tax chief Kim Henares said they raised the tax issue on the PEACe bonds in keeping with the agency’s efforts to run after tax evaders’ wayward cash.  

 

4. Investments and debts

The tax issue on the PEACe bonds has little direct economic impact on ordinary citizens who are largely not part of the bond market. Not known to be sophisticated savers, most Filipinos who don’t have millions in spare funds consider bonds unaffordable.  

But it touched on three economic aspects: revenues, debts, and investor confidence. Anything that impacts these would eventually be felt down the economic food chain in terms of social services, jobs, prices, among others.

Involved in the revenue and debt angles of the PEACe bonds controversy were two of the government’s biggest money-makers: the BIR and the Bureau of Treasury.

Treasury-issued PEACe bonds are debts that the government owe investors. This is a relationship that has been interpreted many ways. One is that the PEACe bonds contributed to a growing national debt. Another is that the money from PEACe bond investors partly funded important social services that the government have to spend for.  

Financially speaking, the Arroyo government has already spent the borrowed funds and the Aquino government now has to pay for it.

At the core of both interpretations is the fact that the government does not raise enough revenues to fund its growing expenses. The Philippines has been nursing a budget deficit for decades, perennially plugged by borrowings.

If the Supreme Court finally decides to consider that the PEACe bonds are taxable, the P4.9 billion now in escrow could be considered an unexpected windfall. It could help plug this year’s deficit expected to reach about P300 billion.

The fate of the holders of PEACe bonds has been a must-watch among investors who are usually averse about uncertainties or unfulfilled promises. After all, government-issued bonds are supposed to be risk-free. – Move.PH

You can follow the authors @lalarimando and @k_visconti on Twitter.)

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