CREATE (Corporate Recovery and Tax Incentives for Enterprises Act) has been certified for immediate passage by March 9. It is up to Congress to meet this deadline.
Why the rush? The deadline is set in March when most companies finalize their financial statements and tax returns for the previous year. If the deadline is met, companies will be able to revise their corporate tax payable downwards before they are required to pay them in April.
CREATE seeks to lower corporate tax rates by lowering the uniform rate from 30% to 25%. In the case of small companies, the rate is further lowered to 20%. For corporations adversely affected by the pandemic, the minimum tax rate is lowered from 2% to 1%. These reductions will be effective on July 1, 2020.
Beyond being an additional pandemic relief measure, CREATE’s long-term goal is to improve “the equity and efficiency of the corporate tax system.” It provides an additional incentive for small businessmen to form a corporation instead of remaining as sole proprietors.
Under the TRAIN Law passed in 2018, sole proprietors whose sales or receipts fall below the VAT threshold are permitted to use a simplified taxation system and pay only 8% tax on their sales or receipts. Employees with businesses and those whose sales or receipts exceed the VAT threshold are not qualified to avail of such a system. Small businessmen are, however, subject to a relatively low tax. For example, when their taxable income is around P5 million, they will be subject to an effective tax rate of 29%. Starting 2023, this will further be lowered to 26.05%.
Because of CREATE, small corporations with the same taxable income of P5 million will enjoy an even lower tax rate of 20%. In view of the dividend tax rate of 10%, individual shareholders of small businesses will effectively be subject to a 28% tax rate. The roughly 2% tax savings starting in 2023, if they remain single proprietors, is negligible. It may be offset by unfavorable rules against them when computing taxable income.
To illustrate, the optional standard deduction (OSD) benefit of an individual under the current regulations is computed based on his gross sales or receipts. In contrast, the OSD benefit of a corporation is computed based on its gross income. This means that in computing the OSD, a corporation may claim its direct costs as deduction while a sole proprietor may not. This rule is ripe for correction. After all, the TRAIN Law declares the maximum base of the OSD as “not exceeding forty percent (40%) of his gross sales or gross receipts.” The OSD of an individual, if he is permitted to use his gross income as the base, will definitely not breach such maximum amount.
Since 2019, Congress has permitted the use of One Person Corporations (OPCs). They are the incorporated sole proprietorships whose respective owners are shielded from personal liability from business losses. CREATE incorporates this concept into the Tax Code. Moreover, it removes the penalty on improper accumulation of corporate earnings, which is typically slapped on earnings in excess of the company’s capital. The removal of this penalty is certainly a welcome development for those with low capital who would marshal such earnings for operations rather than pay tax on dividends.
The grant of all these reforms is consistent with the Government’s goal of increasing its tax collection. It will be easier for government to regulate companies as against individuals. With the introduction of these reforms, the BIR will have an easier time determining non-paying individual taxpayers. They typically deal with big businesses, which are generally required to report to BIR the amounts paid to their suppliers, including individual taxpayers. The BIR can easily use such a report in counterchecking if such individuals declare their income and pay the corresponding tax.
Full time employees who also conduct business may find it convenient to use corporations for their business. This will permit them to avail of the so-called substituted filing system. Their employer’s report and payment of tax on their compensation income shall excuse them from filing a separate tax return. This benefit is not available when they have mixed income. They will be better off to isolate and report their business income through their corporation.
CREATE promotes equity in our tax system. The government collects reduced tax on small businesses, even when conducted through corporations. It also facilitates efficiency in tax administration. It is indeed imperative for Congress to rush the passage of CREATE, if it wants small businesses to pay correct taxes.
This article first appeared on Rappler on 25 January 2021.