Industry benchmarking of taxpayers
By Reynante M. Marcelo
First Published in Business World (9/10/ 2012)
Benchmarking has long been recognized as an effective tool for gauging whether the performance or processes of a company are aligned with those of key players within its industry.
In benchmarking, the first step is to identify the best practices among a company’s peers in their industry. Management then compares their own processes with these industry best practices to identify areas of improvement or effective models that they should consider adopting or adapting for their own organizations.
Since benchmarking carries an implicit comparison of practices in an industry, the BIR has applied the same principle in evaluating whether a particular company’s level of tax compliance is in line with the best taxpayers within a particular industry.
Benchmarking has been used by tax administrations around the world as a means to identify companies whose level of tax compliance, as shown by specific metrics such as tax payments and gross profit, is below that of the industry levels. The usual targets of industry benchmarking are small and medium-sized enterprises, since the administrative costs of ascertaining the level of tax compliance is often lower than the taxes that will eventually be collected.
Benchmarking as a means of increasing tax compliance has been in use as early as 2006, when the BIR issued Revenue Memorandum Order (RMO) No. 4-2006. Specifically, the RMO directed Revenue District Offices to conduct a taxpayer performance benchmarking by industry. In each industry or line of business, the best performing taxpayers were identified using the profit margin rate, the net VAT due, and the income tax due in relation to gross sales/receipts.
RMO 4-2006 identified several priority industries to be covered, such as manufacturing, hardwares, restaurants, shipping, IT providers, telecommunications and call center industries. It also initially covered the Top 200 taxpayers in each industry, per Revenue District, based on gross sales as reflected in the tax returns. Taxpayers who fell below the benchmark levels were subjected to enforcement activities, such as inventory stock-taking, surveillance, audit and investigation, and a tax compliance verification drive.
Recently, the BIR issued RMO No. 5-2012 to update the policies and procedures in the use of the benchmarking method. Unlike the limited taxpayers covered under RMO 4-2006, the new program under RMO 5-2012 seeks to cover as many types of taxpayers by industry as may be applicable.
The correct standard or benchmark itself is established after a series of steps or procedures are performed, comprising a benchmarking cycle. The rationale for breaking down the benchmarking process into cycles is to ensure that established benchmark levels are able to keep pace with the changing economic conditions that influence tax payments and profitability of companies in a particular industry. Under the new RMO, established benchmarks may be revised every two years from approval, or earlier, when a law is passed changing the VAT or income tax rate.
A benchmarking cycle starts with the gathering of taxpayer data, such as VAT returns, income tax returns and financial statements. Taxpayers are then classified according to their Philippine Standard Industry Code (PSIC), which is a statistical classification of economic activities prevailing in the country. PSICs are used by the Government to identify and classify specific categories of business activities.
The tax returns are then sorted according to specific categories or industries, such as manufacturing, trading, restaurants, hotels and motels. From the chosen industry, a minimum number of taxpayers are selected to represent the industry population, and their gross profit, income tax and VAT rates are computed.
Gross profit rate is derived by dividing gross profit over gross sales (regular rate). VAT rate is computed by dividing the total VAT due/payments over the VAT-taxable gross sales, while the income tax rate is computed by dividing the income tax due/payments over total sales or revenue (regular rate).
The resulting data on the gross profit ratio are then arranged from highest to lowest and are further analyzed according to three things: normal industry profit margin, VAT and income tax compliance as expressed in ratios, sales volume or revenue. A high-low point analysis is then conducted to identify the highest rate, the lowest rate, and the mean of the highest and the lowest rates of gross profit ratios.
Once the benchmark figures are established using the above analysis, taxpayers are classified into high, low or medium risk categories. High risk taxpayers, whose gap is over 30% below the benchmark, shall be the top priority target for enforcement actions, which include surveillance, inventory stocktaking and audit, CRM/POS evaluation and closure. A notice is also sent to the taxpayer requesting for an explanation as to why he or she falls below the benchmarks.
That the taxpayer is given an opportunity to explain why he or she falls below the benchmarks must perforce be a necessary implication of the benchmarking method, because even if companies belong to the same industry, there are bound to be differences in terms of gross profit for several reasons. Within the same industry, companies may be undertaking different functions, or are serving different markets or are pursuing different business strategies, which may affect their gross profit level. Industry classifications should also conform to business realities. The manufacturing industry is such a huge industry that it may be helpful to further break it down into sub-groups, with different established benchmarks within each sub-group.
Nonetheless, taxpayers will certainly appreciate being given wide latitude to explain why they may fall below established benchmarks. While the objective of benchmarking is to increase the level of tax compliance, business realities should always be taken into consideration so that a fair and effective assessment system can be created.
Reynante M. Marcelo is a Tax Partner of SGV & Co.
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.