On April 1, Puerto Rico will adopt a Value Added Tax (VAT) system and the island’s advertising industry will fall in line with other business sectors in paying a tax for services from which it was temporarily exempted.
The six-month reprieve afforded to the advertising industry, a savings estimated at $20 million, may have given the struggling sector a needed, if brief, respite but concern looms large over the impact of the new sales and use tax (SUT, or IVU in Spanish) for professional and business-to-business services (B2B).
The B2B SUT, which will be integrated into the VAT (IVA in Spanish), jumps from its current rate of 4 percent to 10.5 percent on April 1.
Estimated to bring in between $50 million and $80 million in annual collections, this tax obviously generates added revenue for Puerto Rico’s cash-strapped Treasury but the business community worries that it represents an additional financial burden in an economy now entering its 10th year of recession.
“Definitely, this is going to bring problems to companies operating with lower income and smaller profit margins,” said Marta Siverio, president of the Puerto Rico Advertising Agencies Association, standard-bearer for the island’s largest and most important agencies.
Siverio, a vice president in charge of client services at BBDO Puerto Rico, said the tax adds another wrinkle to the difficult economic environment in which her industry, which generated an estimated $500 million in billings last year (down from $649 million in 2010), is currently operating.
“This is another challenge for the industry,” she said.
Last year, as part of a plan to shift from the current SUT to a VAT system, the government hiked the SUT from 4 percent to 11.5 percent effective July 2015 and broadened the tax base to include some designated professional services and B2B services previously exempted.
These services would be taxed at 4 percent beginning in October 2015.
Come April, SUT turns to VAT but the rate remains unchanged at 11.5 percent. Out of this tax revenue, 10 percent will go to the central government, 1 percent to municipalities and 0.5 percent toward debt repayment.
The reason the B2B VAT is 10.5 percent is because municipalities will keep operating under a SUT system, which does not tax B2B services, so the extra 1 percent is dropped.
B2B to ‘thwart’ economic development
Critics of the B2B tax have argued that it will thwart economic development and job-creation efforts with smaller companies likely to feel the biggest brunt.
It is also a difficult tax to collect and “lends itself to many ways of avoiding payment,” said Economist José Joaquín Villamil.
“The tax is a huge problem,” Villamil said.
“First of all, it is not a tax on consumption but rather a tax on economic activity. Secondly, it discriminates against small and medium size firms. Large firms have services in-house, not so the smaller ones,” he wrote in reply to written questions.
Villamil said the B2B SUT, soon to be a B2B VAT, affects the cash flow of companies that are hurting from the recession and from the government’s inability to pay suppliers.
The Puerto Rico government currently owes more than $300 million in unpaid bills to its local suppliers.
“For example, a supplier to the construction industry is not paid by their clients because their clients are not being paid by the government, but they still have to pay the B2B tax at the time of invoicing,” Villamil said.
Or take a service provider whose clients pay within 60 to 90 days.
“The company providing the service must make the tax payment upfront,” he said.
In a VAT system, unlike the SUT, tax collections, remittances to the government and credits for taxes take place at each step of the supply chain. Thus, a company that contracts a service pays the tax to the provider of the service and then takes a credit for the tax payment. It is up to the service provider to remit the tax payment to the government.
Government officials have publicly heralded the “transparency” of the VAT system while insisting that it will not lead to higher prices for the consumer who, ultimately must foot the tax.
“Once we transition to a VAT next April, that B2B becomes completely transparent to merchants and won’t represent an additional cost to them. It is merely a change in the merchant’s cash flow,” said Víctor Pizarro, the Treasury Department’s deputy secretary of internal revenue, in an interview last year.
But companies are not so sure that this will indeed be the case.Kenneth Rivera, a partner in the accounting firm of FPV & Galindez.
Switching requires investment
Jorge Prats, CFO of De La Cruz & Associates Puerto Rico, said that switching to a VAT system requires an investment in new or upgraded accounting systems that many companies currently lack. He said that any accounting error could represent major losses for a company and even put some firms out of business.
Higher consumer prices are also to be expected since, all along the IVA chain, companies add “profit inflated by taxes,” Prats said.
It may still be too early to say if the tax on B2B services is driving up rates for professional services. Kenneth Rivera, a partner in the accounting firm of FPV & Galindez, said if there has been any rate increase it’s probably small and does not cover the full tax.
“There is no information yet on the impact of B2B,” said economist Heidi Calero, whose consulting firm bears her name.
“The same as with other companies, we have not increased our rates but we have indicated in our invoices that Treasury requires us to charge a 4 percent starting in October (last year). We will have to see the impact on our business when we start charging 10.5 percent in April. We don’t know yet,” she said.
According to Villamil, it is “difficult to gauge the inflationary impact because many things enter the equation.
“The tax has been in place for only a few months at a 4 percent rate. The problem will become even more serious when it is 11.5 percent beginning in April. In an environment in which the economy has been contracting for ten years it is very difficult to increase the rates for services because it very quickly makes local service providers lose competitiveness against external service providers.”
Meanwhile, outsourcing through the Internet could give companies a way to get around the tax.
“Many firms have service providers in places such as India. The B2B tax will make these arrangements much more attractive,” Villamil said.
While taxes are never favorable to business, FPV & Galindez’ Rivera doubts that the VAT on services, or products, will hurt the island’s ability to attract new businesses to the island. The VAT, he said, is a tax that international businesses are well familiar with and this factor alone is unlikely to discourage new companies from entering the Puerto Rico market.