Review of the Law on Investment— Part D

Report 

A pilot study prepared under the Integrated Framework for Technical Assistance 

Centre for International Economics
Canberra & Sydney
26 November 2001

Preface                                                                                                          
1    The need for LOI reform                                                                  
Discretionary and unpredictable investment regime
Revenue mobilisation
Objectives of LOI reform   

2    Stakeholder interpretations and views
Royal Government of Cambodia 
Private sector
International Financial Institutions

3    The way forward  
The Royal Government of Cambodia 
Exporters who are largely foreign investors
Import competing firms established through FDI
Domestic investors
Corporate tax rate  
Tax holiday provisions
Reinvestment of profits
Repatriation of earnings

4    Impact of proposed LOI reforms: conditioning factors
The duty exemption issue

5    Next steps
References 

Boxes, charts and tables
2.1     Stakeholders consulted 
3.1     Real regime tax revenue, 2000 financial year

Preface
IN AUGUST 2001, a team of consultants worked with Ministry of Commerce (MOC) officials in Cambodia conduct a diagnostic study of Cambodia’s trade policy issues and technical assistance needs. The terms of reference for this study were designed to support the Royal Government of Cambodia (RGC) in developing its Pro-Poor Trade Policy Strategy. Ministry of Commerce officials involved were H.E. Sok Siphana, Secretary of State; In Vothana, Bureau Chief; Ung Sovithiea, Deputy Bureau Chief; Keomuny Kong, Deputy Bureau Chief; Sophann Tauch, Director; and Oeur Samrith, Assistant Director. The team members were Kelly Bird, Consultant — Trade Policy; Sandy Cuthbertson, Consultant, Centre for International Economics (CIE) —Team leader; Martin Desautels, Consultant, Gide Loyrette Noel (GLN) — WTO Accession; Curtis Hundley, Consultant — sector studies on tourism and fisheries; Hiau Looi Kee, World Bank — market access survey and analysis; Ray Mallon, Consultant — sector studies on rice and labour services; Philippe Marciniak, IMF — macroeconomic assessment; Andrew McNaughton, Consultant — sector studies on diversified agriculture and handicrafts; Maika Oshikawa, WTO — trade policy, Sopanha SA, IMF — macroeconomic assessment; Isidro Soloaga, Consultant — poverty assessment; Ieng Sovanarra, Consultant — sector study on garments; and Geoff Wright, Consultant — trade facilitation. A review of investment regulation was carried out by Ross Chapman and Lee Davis of the CIE as a parallel study working directly to the Government. The World Bank Task Manager was Ataman Aksoy.

Following this fieldwork, team members prepared drafts of the following reports.

• Part A: Overview.

• Part B: Component reports — macro assessment, trade policy, trade facilitation, poverty analysis.

• Part C: Sector studies — rice, diversified agriculture, handicrafts, fisheries, garments, tourism, labour services.

• Part D: Review of the Law on Investment.

These drafts were discussed at a workshop held in Cambodia on 19 and 20 November 2001. Following that workshop the draft report was finalized particularly taking into account participants’ suggestions for technical assistance.

1. The need for LOI reform 

Cambodia’s Law on Investment (LOI) contains a range of taxation concessions for approved investment activities. These provisions include tax holidays, special corporate taxation rates, tax free reinvestment of profits and tax free repatriation of earnings.

Reviews of the LOI had concluded that it suffered in several respects (FIAS 2000, FIAS 2001). Amongst other things, the LOI was regarded as being subject to too much discretion in its application, leaving unnecessary investor uncertainty and potential for manipulation and governance concerns. Furthermore, tax-reducing provisions available under the LOI were considered to be too generous, potentially hampering revenue mobilisation by the Royal Government of Cambodia (RGC) and causing distortions to the overall tax policy framework. Both the World Bank and the International Monetary Fund shared these concerns and in early 2001 both agencies suggested a number of reforms to the LOI as part of negotiations in the context of a Structural Adjustment Credit (SAC).

From late 1999, there was a sharp deterioration in the regional investment climate, reflected in falling net flow of funds and FDI into ASEAN countries. In this environment there was concern among government ministers and within the business community that Cambodia not do anything that would reduce its prospects of either attracting investment or make it more difficult to retain what it has attracted to date. As a result emphasis was placed on the need for gradual and long term changes in any tightening of privileges under LOI reform. 

In mid 2001 the RGC identified and set in train certain procedural reforms within the Cambodian Board of Investment designed to speed up and render less bureaucratic the registrations and approval process for those investors seeking to access privileges under the LOI. Other reforms require changes to the Law itself.

To assist the RGC to assess reform options, the Government commissioned the Centre for International Economics (CIE) to conduct consultations with government and the business community and to subsequently develop and analyse some possible options regarding the specific parameter settings of four proposed reforms. This study reports on identified shortcomings of the LOI, gathers stakeholder views together, develops some reform options and spells out the likely stakeholder impacts of each alternative. Stakeholders include  

• the government as custodian of policies for economic development and employment growth,  as revenue raiser with responsibilities for fiscal integrity, and as administrator of both Customs and the investment incentives authority — the Cambodian Development Commission;

• exporters, currently dominated by the garment and footwear sector;

• import competing industries established by foreign investors; and

• other domestic market oriented investors.

In setting out possible interpretations of the proposed reforms, the paper provides discussion points for Government to lead to a determination on the reforms. The study builds on consultations already held with the government, with private sector investors and with international financial institutions.

Discretionary and unpredictable investment regime

Since the first Foreign Investment Advisory Service (FIAS) review in 1997 of investment incentives offered, the RGC has made a number of changes to the Cambodian investment environment. These changes introduced greater transparency to the granting of investment incentives, limiting the ability of ministers/ministries to exercise discretion and expanding investment monitoring capacity and customs governance.

However, despite these changes, FIAS in 2000 noted that:

‘Despite these changes, Cambodia’s investment regime remains heavily discretionary, selective, complex and open to unnecessary revenue sacrifice and abuse… (FIAS p. i, 2000)’

As discussed in chapter 2, the RGC does not appear to currently possess the governance and administrative capacity to implement the current investment incentive regime as intended. Furthermore, the complexity of the regime places an excessive administration burden on the RGC, thereby putting pressure on limited RGC resources.

From the viewpoint of private sector stakeholders, the discretionary nature of the current regime — giving rise to ‘hidden’ bureaucracy costs, uncertainty and sovereign risks — increases operating costs. Excessive layers of bureaucracy and discretion have also been cited as the reason why entitlements under the current incentive regime have not been received.

Revenue mobilisation

When the Law on Investment reform process began in 1997, revenue mobilisation was not a central consideration. However, revenue mobilisation is a priority of the RGC and reform of the LOI must be seen in that broader context. 

The International Monetary Fund (IMF) has recommended, and the RGC agreed to, increasing Cambodia’s tax revenue from 8.6 per cent of GDP in 2000 to 9.7 per cent in 2002, an increase of 1.1 per cent, equivalent to around CR 150 billion (IMF p. 7, 2001). Increasing tax revenue to 9.7 per cent will mean that current expenditure by the RGC — estimated to be 9.7 per cent of GDP in 2000 — will be financed entirely by tax revenues, thereby putting public finance on a more sustainable basis. The extent to which reform of the current investment regime will lead to net revenue mobilisation will be of obvious assistance to the RGC as it pursues fiscal self-reliance.

Objectives of LOI reform

In recognition of the problems associated with the current investment incentive regime, a number of changes to the LOI have been formulated. Broadly speaking, changes to the LOI seek to rationalise the investment regime so as to limit discretion, improve transparency and reduce the administrative burden of the current LOI. In drafting guidelines for amendments to the LOI, FIAS noted that the purpose of the guidelines is to:

…assist in creating a regime more conducive to the encouragement of private investment in Cambodia through:

• transparency, simplicity and predictability in both the approval process of private investments and the provision of fiscal incentives to such private investments; and

• the provision of investment guarantees (FIAS p. i, 2001a).

Proposed changes to the LOI as discussed by FIAS

To meet the above objectives, the proposed changes to the LOI address 4 areas — concessionary rate of profit taxation, tax holiday provisions, taxation on reinvestment of profits and taxation of distributed profits. The

changes proposed by FIAS were conditionalities of a Structural Adjustment Credit (SAC) being negotiated during 2001. The proposed changes comprised:

• elimination of the special 9 percent corporate tax rate for all new investment and phasing the 9 percent rate out to the standard 20 percent under the Law on Taxation for the next 5 years for existing and operational projects;

• repeal of the current tax holiday provisions and the introduction of a three year tax holiday, conditional on annual certification of compliance, to all qualifying new investment, without evaluation; the use of a tax holiday will deny the tax payer any benefits available under the Law on Taxation during the tax holiday including initial investment allowance as well as accelerated depreciation allowance; all current tax holidays provided under the Law on Investment will be grandfathered;

• elimination of the tax free reinvestment of profits and introduction of an appropriate investment allowance in the Law on Taxation at a rate to be determined, satisfactory to the World Bank, and applicable to all qualifying investment, new or expansion, irrespective of source of finance, without evaluation; and

• elimination of the right to the tax-free repatriation of earnings and other incomes by approved enterprises.

Changes to the LOI as discussed by FIAS will obviously contribute to revenue mobilisation. However, revenue mobilisation is not a direct objective of the proposed changes. Indeed, in putting forward a range of options with which to raise an additional CR 150 billion, the IMF does not consider any additional revenue raised by way of the proposed changes to the LOI. Broadly speaking, there is stakeholder confusion as to the relationship between proposed changes to the LOI as discussed by FIAS, and revenue raising measures put forward by the IMF. Specifically, stakeholders typically see the IMF option of a minimum import duty as being a FIAS proposal. For those export orientated firms operating under the LOI, the ability to get production inputs at world prices is a key determinant in their ability to be internationally competitive. For these firms import duties are likely to be given greater consideration than LOI reform as discussed by FIAS. Indeed, the RGC may need to resolve the issue of minimum import duties before progress can be made in advancing the LOI reforms as discussed by FIAS and key conditions of SAC release. This issue is discussed further in chapter 3.

2. Stakeholder interpretations and views

A wide range of stakeholders — encompassing representatives of the RGC, private sector and IFIs — were consulted for the purpose of seeking views and opinions as to the need, if any, to reform the current LOI and the form that any proposed changes should take. The stakeholders consulted are reported in table 2.1. Stakeholder views, opinions, attitudes and arguments are presented here.

Royal Government of Cambodia

Under current arrangements the Cambodian Development Council, the Department of Taxation and the Customs Department all have significant roles to play in delivering incentives to investors. These roles would change somewhat with the adoption of the LOI reforms as discussed by FIAS. The private sector has issues with their treatment by each of these institutions. Should government decide not to implement the reforms it would still need to decide whether the current system is capable of administering the investment law as it stands.

The advisory team met with all three organisations to form a view on this.

Cambodian Development Council

The Secretary General outlined the functions and role of the two arms of the CDC — the Cambodian Investment Board (CIB) and the Cambodian Rehabilitation and Development Board (CRDB).

After an introductory meeting with the Secretary General, and senior staff of CDC, the consultants met individually with Department Directors from the Cambodian Investment Board to gather views from within on the information and promotion, evaluation and monitoring activities of the CDC. All of these areas would experience some change under implementation of the proposed reforms.

Information and promotion activities

The consultants were provided with the standard information pack available to prospective investors. It gives an outline of the obligations of investors seeking incentives, the entitlements of those firms whose applications are approved and the commitments that the CIB must meet (for example, a 28 working day turnaround after all required documentation is submitted for evaluation.) The consultants formed the view that information, rather than investment promotion, was the function of this Department under current arrangements. Because of the maize of unofficial as well as official charges that face the incoming investor, even the task of providing a truly informative backgrounding of prospective investors would be a formidable one. Examples are provided by the ad hoc prakas powers exercised by individual ministries in levying taxes and charges which do not flow to consolidated revenue but are retained by the ministry itself and the array of charges that attach to clearing a container through customs.

Evaluation activities

The advisory team met with the Director and staff of the Evaluation Department to explore the procedures followed in awarding incentives to new developments or expansions.  An issue for government in responding to the views of the Cambodian investment community is whether the current arrangements are actually delivering incentives which are attractive by regional standards and doing so in an even handed and efficient manner, with minimal bureaucratic discretion. The recommendations of the FIAS report and the SAC conditionality on tax holidays and tax rates both point to judgements that in some respects the regime is overly generous but also failing to provide a transparent, consistent and equitable access path to those incentives. The current evaluation process has been called into question.

The use of ‘points’ awarded against an evaluation matrix to establish a prospective investor’s tax holiday entitlements is an integral part of the present evaluation system. It has so far provided relatively few holidays and none of the maximum length of 8 years provided for in the law.

The distinction in the application evaluation process between the treatment of garment manufacturers and other investors was pointed out, whereby the ‘one stop shop’ approach applying to the latter is replaced with a directing of garment manufacturers’ applications through for Prime Ministerial consideration. (The one stop shop treatment provides for the CIB to be the focal point for gathering all relevant documentation required

by other ministries to issue approvals and licences for which they are responsible. However, these clearances occur within the ministries and not at CDC.)

The obligations of the Evaluation Department at present require, inter alia, consideration of feasibility studies submitted by firms as part of the approval process and the application of ‘reasonableness tests’. The reasonableness tests consider for instance the realism of the implied ratios of stated capital equipment (numbers of machines) to stated employment, size of factory and proposed employment levels to land area and the like. These are used as rough checks against bogus applications. The Department continues to uncover applications by business brokers on behalf of their clients that are fraudulent — copies of planned operations details for factories that have already been considered by the Department.

The advisory team has yet to resolve why such evaluations, where they are warranted at all, would not be subsumed in the duties of the individual ministries in the granting of operating or business licences and the like.

The powers of the Evaluation Department in granting initial approvals appear to be limited in reality by the scope for their recommendations to be overridden.

Approved investors requiring import duty exemption submit to the CDC a list — detailing the quantity and value — of production inputs required over the next 12 months. The CDC may vary elements of the list, producing a Master List of allowable imports. As the master List is valid for 12 months, investors must provide periodic evidence to CDC for the purpose of updating import requirements.

Monitoring

The Monitoring Department, which also acts as the primary database for CDC, functions in a limited way at present, handicapped by computer software problems and resulting data capture problems. For instance, whilst those investment firms which are monitored will shortly be required to complete a relatively demanding questionnaire on their activities, simple numbers of firms accessing duty exemptions are not available. Nor is any data available as a database on the firms’ actual investments as distinct from approved stated values. Monitoring activity at present is largely restricted to establishing that firms who have accessed (mainly duty exemption) privileges are indeed operational. At the instigation of the CDC Secretary General, firms are being required to produce evidence on what they exported to claim duty exemption and ‘government paid’ VAT status on imported inputs. (Customs verification of these entitlements is reportedly itself being charged for.) At present the CDC does not capture this information.

The Monitoring Department is not at present able to readily generate data on the number of firms accessing duty privileges in any one-year or a summary of the status of firms with respect to their tax holidays.

The Monitoring Department distinguishes between ‘active’, ‘non active‘ ‘deleted’ and ‘non-monitored’ firms. Active firms are monitored and established as being in business. There are some 335 non-monitored firms, a small minority of which, according to the Department are likely to be active and accessing privileges. Despite the fact that there were some 382 active firms in 2000, only 270 of these were registered with the Department of Taxation according to figures provided by the latter. The answer to the divergence between active and registered with the Taxation Department appears to lie in the fact that whilst co-operation between Taxation and CDC has improved since 2000, information flows were poorer in earlier years.

This gap raises questions for government as to why a substantial number of firms (export or domestic orientation unknown) which would seem to be accessing duty exemptions are not registered as investment firms for tax purposes. The review team were also advised that, were monitoring to reveal investor firms in breach of their obligations, it was unlikely that action would be taken to delete them in the present climate. Fear of sending signals that would be interpreted as ‘investor unfriendly’ may be contributing to this reluctance.

So whilst CDC is making steady progress in reducing the number of ‘non-monitored’ firms, the benefits of monitoring in its present form are questionable if enforcement is absent or sporadic. For CDC to fulfil its currently assigned role as monitor of firms enjoying tax and duty privileges, it appears to need clearer signs of government endorsement of that role.

Implementation of the proposed reforms would involve significant changes to both evaluation and monitoring activity, involving automatic conditional registration of applicants, entitlement to standardised tax holidays after receiving operating approval by the relevant ministries, and annual renewal of duty exemption entitlements on production of tax compliance evidence at CDC. (It is noted that the latter is an issue that importers have concerns about given the current interpretations of requirements on pre-payments of profit tax.)

Tax Department

The predominant role of border taxes (78 percent of tax revenue at present) and the medium term requirements to meet AFTA tariff rate reduction goals has caused the authorities to move towards both broadening the tax base across taxpayers and to redistribute the proportion of tax collected by the different tax instruments (principally profit tax or minimum tax on turnover, VAT, import duties and excise). In its role as assessor the Tax Department has made efforts to bring an increasing number of firms under the ‘real sector’ category where VAT payments are mandated.

In the 2000 tax year a further 500 entities were brought into the real sector category. There are now some 2700 entities in the real regime, around 300 of which would come under the proposed Large Taxpayer Unit recommended by the IMF. An additional 5 provinces were added to those already operating under the real regime.

These measures are consistent with previously published suggestions by the International Business Club (many of whom equate the LOI reform proposals with the single purpose of collecting more tax revenue from foreign investor firms) to broaden the tax base.

Calculations provided by the private sector as a response to the FIAS report purport to show how an additional US$47 million annually could readily be raised based on apparent numbers of firms registered with the Ministry of Commerce (MOC). These claims have been rebutted by the IMF and by a consultant to the World Bank, Thomas Hart, who notes ‘There is a large difference between being registered with the Ministry of Commerce and being active…there is absolutely no data to support the fact that there are 5000 registrations that do not pay tax.’

These issues have yet to be worked through with the private sector representatives. Nevertheless, a combination of the requirements of the existing Law on Investment and Law on Taxation (LOT), recent changes to replace minimum tax requirements with prepayment of profit tax, and the current practices of both CDC and the Tax Department have left elements of the international business community highly critical of current tax procedures, as discussion below reveals.

For its part, the Tax Department rejects suggestions of a parallel tax regime that allows significant numbers of domestic firms to go unchallenged on their tax status. Whilst admitting that evasion and under reporting of turnover and profit is widespread, officials deny that there are significant numbers of firms that enjoy a tax-free status to which they are not entitled.

However, the auditing strength of the Department, while growing, is limited. Very few firms maintain auditable accounts that would meet international standards and the continued lack of an accounting law allows even larger firms to present income tax statements that prove difficult to verify.

This is contributing to an outcome where, for the CDC approved investor non-tax or ‘outside’ sources of information (for example, from Customs, outcomes of garment quota auctions etc) are required to establish under reporting of tax. Reassessment of 71 firms in 1999 resulted in additional tax payable of CR 18.1 billion. But the advisory team understands that these were export firms and the capacity to deal with offending domestic oriented firms remains questionable.

That revenue from investor firms which is collected as profit tax or its equivalent is collected in the form of monthly prepayments from 175 firms which are loss making and a further 36 whose profits are less than the 1 percent threshold. The remainder, 20 firms in 2000, prepaid profit tax monthly in to be credited against their 9 percent profit tax liability. The first type of firm includes firms that have qualified for tax holidays. However the Tax Department takes the view that the LOI currently offers tax holidays from the first year of profit making, not the first year of operations so prepayments are required. These two categories together yielded CR 42.3 billion, while profit taxes from the remainder paying 9 per cent yielded CR 21.7 billion.

The apparently conflicting provisions of the Law on Investment, which allows for tax holidays to commence when profit is first earned and the Tax Department’s interpretation that prepayments are due from all other taxpayers is an issue that will have to be resolved in the course of reaching a decision on the proposed reforms. It is highly contentious with the private sector.

Customs

Meetings with senior customs officials and the IMF consultant managing the Customs Reform Workplan touched on procedures within Customs, progress with reform and the interface between Customs responsibilities and practices and the delivery of investment incentives through duty exemption arrangements.

Smuggling

There is recognition within Customs that irregular practices and under the counter charges are raising the cost of trade transactions and contributing to competition problems for local industry. Low pay for officials was cited as a fundamental cause and a contributory factor in official smuggling — where dutiable imports come through customs points duty free in return for payments to customs officers. Steps to address this through officer rotation and the formation of a smuggling task force and audit teams were outlined.

Some Customs officials believe quantities of goods are smuggled in containers that bypass the pre-shipment inspection (PSI) system (garment inputs). Customs are developing a record set on volumes and weights of imports and re-exports of individual producers as a means of identifying offenders.

There are also reported concerns with the PSI system itself, with one estimate suggesting more than 50 per cent of containers entering under that system are entering unsealed or with broken seals, suggesting a further contributory factor in the smuggling problem.

Customs interface with CDC

Customs officials have a role to play at CDC in the establishment of Master Lists for importers but suggest that negotiated outcomes are reached between manufacturers and CDC before Customs is involved. They question why a set of norms is not established and adhered to, avoiding repeated negotiation.

However, no clear position emerged on questions concerning Customs own valuation procedures. Arbitrary undervaluation of some imports is admitted to as a disincentive to smuggling. Adherence to valuation codes would have some costs in this respect and these would need to be recognised in advance.

Customs clearance charges

Discussions with the private sector revealed widespread dissatisfaction with elements in the total bill for clearance of a container that cannot be traced to any service, tax or duty. This arbitrary cost-raising element is one of the main complaints brought against Customs and it is not clear what definitive steps are planned to tackle the problem. These charges typify one of the areas where change is needed if investors’ competitiveness is to rely on other than compensating taxation privileges.

Views of government ministries and government members of the Working Groups

The advisory team sought views on the proposed reforms, and impediments to their implementation, from the Ministries of Agriculture, Forestry and Fisheries; Commerce; Economy and Finance; Industry, Mines and Energy; Public Works and Transport; and from the National Bank of Cambodia.

In principle support for LOI reform but questioning of priorities

The consensus that could be found among this group was confined to in principle support for implementation of the proposed reforms under a generous timetable and with reservations about some of the FIAS recommendations. The lack of specific detailed criticism of these, not all of which are part of the reforms, suggested to the advisory team that not all ministries have had the incentive or opportunity to study either the FIAS report or the proposed reforms in fine detail.

Some ministries were of the view that reform of the LOI along the lines indicated was a second order issue. There was concern on the part of some that whilst current incentives were adequate or even generous by regional comparison, they did little to offset the primary cost, risk and competitiveness problems generated by:

• insecure land tenure (with illegal invasions in rural districts);

• poor infrastructure, high transport costs and high utilities charges;

• lack of laws on commercial agency, contracts, property leasing, secured transactions and accounting, an inadequate penal code for enforcing those laws that are operative;

• high and hidden (corruption) costs of bureaucracy;

• smuggling;

• relatively small scale production compared to regional neighbours such as Vietnam and Thailand, especially in agriculture;

• low workforce productivity; and

• mistrust of the banking sector following bank closures and re-licensing.

LOI privileges however only compensate a select few firms for the costs imposed by such impediments. An alternative policy may be to compensate all firms through a generous tax code that would assist all 2700 firms within the real regime to overcome cost impediments.

Equating of reforms with reduced profit margins and reduced investment flows

Several ministers had formed the impression that the primary (and perhaps sole) aim of the reforms was revenue raising and were of the view that this would inevitably mean further loss of competitiveness of existing investors, an extinguishment of attraction to new investors and the risk of departure of garment and footwear firms. There was some support for the view that these measures should wait until a number of the ‘primary’ problems listed above could be addressed even though these were conceded to be long term problems.

There was a frequently encountered view that the SAC reforms to the investment incentives available to firms through CDC would inevitably cut after tax profit margins across the board. This would endanger the growth sector — garments and footwear — which operates on very fine margins. There was little focus on the cost cutting potential of the bureaucratic streamlining of incentive administration and delivery contained in the SAC reforms. But there was recognition of an ‘in parallel’ need to address bureaucratic slowness and illicit charges that were burdening exporters and firms competing with smuggled goods alike.

It was apparent to the advisory team that, despite the creation of the Working Groups that had improved government–industry contacts, ministry to ministry communications were not optimal for reducing bureaucratic costs. One instance was given of a 3-month delay in gaining export approval for export of a manufactured food product, with subsequent loss of market in Malaysia.

Tightening existing tax collection as alternative to SAC reform

There was also a questioning of the adequacy of existing tax collection procedures with the implication that there might be significant scope for revenue raising without going from ‘lax’ to ‘strict’ investment incentives. (Some ministries had interpreted the abolition of discretionary 8 year holidays — which no one has to date been awarded — with ‘automatic’ 3 year holidays for all qualified firms as an indicator of this.) One Minister suggested that the consultants do a survey of stall holders in Phnom Penh to establish what tax they pay.

In focussing on the revenue raising or saving capacities of the reforms there was some discussion about the fact that these were, as one Minister pointed out, long-term reforms. The implication was that there would be short-term pain for investors and the economy would only benefit, if at all, in the longer term. The fact that ‘grandfathering’ of existing privileges for investors already here is a significant part of the proposals has possibly been overlooked by some, as has the fact that efficiency gains to incoming investors would be almost immediate

There was widespread reference to the vulnerability of the economy to the garment sector with its 170 000 employees and the fact that 30 factories had reportedly closed this year. An issue for discussion was the extent to which changes to incentives would adversely impact on this sector and what role incentives would play in the run up to the uncertain world trade regime following the expiry of the Multi Fibre Agreement (MFA) in 2005. It was suggested that there was a need to work through the likely impact of the reforms for these firms but recognition that actual cost data would be difficult to obtain.

The need for diversifying the economy to reduce its vulnerability to the garment sector was raised. With this in mind, and the possibilities for manufacturing enclaves on the Thai–Cambodian border, it was suggested that the consultants revisit the incentives available there and compare them with those that would be available under the SAC reforms.

The minimum duty issue

It was evident that some ministries were not clear on the point that, though related through revenue strengthening and ESAF requirements and the government’s commitment to raising a further 1.1 percentage points of GDP through taxation, a measure to introduce a minimum tariff was not one of the four SAC conditionalities.

One Minister suggested that it was important to uncover what other countries did by way of imposing a minimum duty. There were also calls for further analysis to demonstrate the possible impact on firms’ financial position. This suggests that not all ministries have had the opportunity to study the impact analysis provided by FIAS in June 2001 in response to requests for such an exercise.

Private sector

Two meetings were held with the private sector. The first meeting was held with members of the International Business Club (IBC), who represented the interests of the garment, manufacturing and professional services sectors. The second meeting was with the Garment Manufacturers Association in Cambodia (GMAC) who put forward the views and opinions of Cambodia’s textiles, clothing and footwear sectors.

International Business Club

The private foreign investment sector, as represented by the IBC, considers (unanimously) that the business environment in Cambodia is not conducive to making an acceptable return to invested capital. Depending on type of economic activity and focus (export or domestic market), businesses place different weighting on the range of problems reported to exist in Cambodia. However, typically cited problems include:

• high operating costs, in part brought about by poor infrastructure and overpriced utility services;

• excessive layers of bureaucracy that add to production costs and introduce uncertainty and sovereign risk;

• ‘hidden’ transaction costs and smuggling; and

• a lack of good governance (transparency, accountability and respon­sibility).

Given these ‘real world’ considerations, investment incentives as granted under the LOI are claimed to be an important consideration when deciding whether to invest in, or to continue to operate in, Cambodia. The point was stressed that if the business environment in Cambodia was perfect and the above listed problems did not exist, then investment incentives would only be of marginal importance. However, as this is not the situation, invest­ment incentives are important, in contrast to the FIAS assertion that they are not a primary consideration.

Areas of confusion

Broadly speaking, private sector foreign investors (as represented by the IBC) consider the primary, and indeed only, objective of the LOI reform package, as discussed by FIAS, to be revenue raising. This is, according to the private sector, exemplified by raising profit tax to 20 per cent and the minimum import duty of 5 per cent. (We note that there is apparent confusion here as the issue of a minimum tariff was not a FIAS recommendation. Indeed the FIAS report circulated prior to the March workshop contained no recommendations as such.) The private sector does not distinguish between the proposed reforms (which largely address rationalisation of the investment regime) and the minimum import duty (which is a revenue raising measure).

Furthermore, while the proposed reforms seek to rationalise the investment regime so as to limit discretion, improve transparency and reduce the current administrative burden of the current LOI, the private sector is not aware of, or giving any weight to, these objectives. It did not feel that these objectives were adequately addressed in the FIAS report. Quite simply, the private sector did not, for example, equate a guaranteed 3-year tax holiday with improved predicability and heightened transparency.

It was quite evident that the private sector had either chosen to over look the elements of the FIAS package targeting good governance or had not realised/been made aware as to how achieving these objectives could improve the business environment in Cambodia and promote competition and further investment. It was noted that limiting discretion and providing certainty were good objectives, but it was felt that the FIAS report did not highlight this or indicate how the proposed reforms mapped to these objectives.

Further discussions with a subset of the private sector made it clear that people were not aware that some elements of the proposed reforms were open for potential further discussion, such as the parameters of the investment allowance; the manner in which the profit tax is to be increased from 9 to 20 per cent; and the trigger point /starting date of the 3-year tax holiday.

Problems associated with the current LOI regime

Many examples were provided of problems/difficulties associated with the current LOI privilege regime. However, there was broadly unanimous support for the current regime (that is, it should not change). This led the consultants to doubt whether the ‘benefits’ of current LOI regime had been accurately evaluated and compared against the proposed reforms. Some cited examples of difficulties with the current regime follow.

• Failure to get CDC approval for import duty exemption in the first year of operation for domestically orientated LOI approved firms.

• Failure of the vast majority of LOI approved firms to be granted tax holidays.

• Discretionary nature of decision-making and its contribution to ‘hidden’ transaction costs.

• Ability of government to alter the ‘rules of the game’ and impose additional costs on businesses through issuing a prakas.

• Excessive layers of bureaucracy, hampering expediency in problem resolution and leading to additional transaction costs.

From these examples it is apparent that the current LOI regime is significantly flawed — there are costs associated with bureaucracy, lack of transparency, uncertainty, unpredictability and sovereign risk. However, these are exactly (with the exception of sovereign risk) the types of problems that the reforms are trying to address. Given this, the consultants question whether the private sector has critically evaluated what advantages they currently receive, and what adopting the proposed LOI reforms would mean in terms of costs and benefits.

The primary concern with reforming the current LOI

Putting aside for the moment the issue of when LOI reforms would take effect and what the reforms actually embody, the private sector feels that implementation of the LOI reforms contained in the FIAS report would impose immediate costs on firms currently operating under LOI privileges. However, any benefits arriving from the reforms — should they ever eventuate — such as improved governance and infrastructure, and a broadening of the tax base, will not be felt for many years to come. In the intervening period between immediate costs and future benefits, firms enjoying the current LOI privileges will go out of business.

This raises the issue of whether LOI reforms are a matter of timing — does an opportunity exist to link reforms to cost reducing improvements elsewhere in the economy?

An issue of timing?

While differing in focus, a continual theme of discussions with the private sector was that due to inherent problems facing businesses in Cambodia, assistance via way of LOI privileges was critical to current investors and central to attracting new investors. However, should the above mentioned problems be addressed, then this questions the need for the level of privileges currently offered under the LOI.

However, when questioned about appropriate triggers, it appeared that the private sector had not given much thought to what triggers would be required for them to support the LOI reform requirements as currently specified in the proposed reforms. It was stated that it was not up to the private sector to detail a credible timetable of triggers — it is a RGC responsibility. For some (particularly import competing producers) this reflects an apparently entrenched position that existing privileges are inadequate and there is an unwillingness to consider any of the reform elements. For others there is an interest in finding out what is negotiable.

Developing a set of time bound actions with which to gain support for and advance LOI reform will require the RGC to develop and set out a credible portfolio of achievable triggers. However, the private sector noted potential difficulties with such an approach — in their eyes the RGC is not seen as credible, it has not established a good track record and does not have the political will for reform. This culminates in the private sector placing little, if any, confidence in a government promise of ‘it will be good for you in the long run’.

What the IBC would like to see

Assuming the IBC ‘line’ accurately represents the wishes of all members of the group, then the IBC would like greater assistance rather than less. This is obviously a wish of all businesses around the world, irrespective of the country in which they operate. The IBC wish is premised on the view that the reforms do not offer any additional benefits relative to the current regime.

For example, the IBC would like to see not only export-orientated firms exempt from import duties on production inputs, but domestically oriented firms as well. The IBC has given no explicit consideration to what this would mean for government revenues. Duty exemption was seen as necessary so that domestically oriented firms could compete with (cheaper) smuggled goods. On the issue of smuggling, IBC members suggested that for some commodities they could provide details on ‘who’, ‘how much’, and ‘when’ — but no such data was made available during the meeting. This remains a matter for further exploration with the private sector.

Garment Manufacturers Association in Cambodia

GMAC welcomed the consultation process as a major step forward in improved mutual understanding between the private sector and government. They were grateful for the opportunity to discuss their concerns frankly with an independent group in a non-adversarial atmosphere.

However, as with the IBC, GMAC members were not aware that the minimum import duty — the source of their greatest concern — was not part of the proposed reforms. Furthermore, on clarification of what the reforms actually embody, and the scope for potential negotiation on some of the details and transitional arrangements, GMAC members appeared willing to engage in further the dialogue and consider the reforms put forward.

To facilitate further dialogue, GMAC suggested the following steps be taken.

• Clarification on what the proposed reforms actually mean in practice. For example, clarification of the reasons why elimination of tax-free repatriation of profits does not equate to double taxation.

• Quantitative (that is, spreadsheet) examples of the effects of differing investment allowances and dividend taxation.

• To view any impact analysis/marginal effective rate of taxation studies that might be available (FIAS has undertaken such analysis and provided it as part of its impact analysis).

Problems associated with the current LOI regime

Problems arising from the current LOI arrangement stem form an apparent conflict between the Law of Investment and the Law of Taxation. Under the current LOI, the tax holiday of CDC approved firms commences once the firm makes a profit. However, prior to profit, LOI firms are required, under the Tax Department’s interpretation of the LOT, to make profit tax prepayment (equivalent to 1 per cent of turnover). GMAC make two comments about this current arrangement.

• It is unclear to GMAC members whether the profit tax prepayment is to be seen as a tax credit, or is it revenue forgone? From conversations with the Tax Department, it is seems that profit prepayment is to act as a tax credit. However, GMAC report that continued inquiries about the status of their tax prepayment have gone unanswered.

• Conflict between the LOI and LOT arises as once a tax holiday is enacted (that is, the firm makes a profit), under the LOI the firm is not required to make profit tax prepayments. Rather, the firm submits a monthly tax declaration to the Tax Department. However, under the LOT, monthly prepayments are required. Hence due to the absence of tax prepayments, CDC approved firms are not tax compliant and hence cannot get import duty exemptions from CDC as tax compliance is a requirement for exemption. This raises the prospect that CDC approved firms need to pay the tax prepayment — even though they are exempt from it under the LOI — in order to get import duty exemptions.

Other problems raised by GMAC are consistent with those raised by the IBC — hidden bureaucracy costs, slow turnaround time of CDC to amend the Master List, excessive bureaucratic burden associated with undertaking business, and ability of Ministries to exercise discretion and issue prakas that impose additional costs on firms. Examples of these types of problems follow.

• GMAC estimates that between 40–50 per cent of the cost of clearing a 40-foot container through customs can be attributed to unofficial payments.

• It takes around 2 weeks for CDC to amend the Master List for imports. Depending on the price discrepancy, it may not be worth amending the list due to the time taken.

• Ministry of Commerce and Ministry of Labour respectively issuing decrees requiring quality inspection charges for imports and apprenticeship programs for enterprises with more than 60 personnel.

It is the consultants’ opinion that GMAC’s concerns with minimum tariff are of higher order than reforms to the LOI as embodied in the proposed reforms.

International Financial Institutions

World Bank

The consultants had an opening briefing from the Country Chief of Office. The history of the debate on LOI reforms was reviewed and the Chief of Office gave an account of the government’s concerns as understood by the Bank. The timing constraints facing the Bank and the RGC were outlined.

International Monetary Fund

The IMF Resident Representative pointed out that when the LOI reform process began in 1997, revenue raising was not a central consideration. The current LOI is seen as costly, unpredictable, slow and not implemented.

Given the lack of international accounting standards and the apparent continued inability of LOI approved firms to make a profit, the IMF

consider a minimum import duty of 1–3 per cent and prepayment of profit tax as possibly the only means by which tax can be raised from them.

The Draft Accounting Law is about to go before the National Assembly, the Secure Contracts Law will be drafted by October 2001, and the Bankruptcy Law is scheduled to be completed by early 2002. Before such laws are enacted — especially Accounting Law — there is an issue of whether revenue mobilisation can be achieved without placing greater emphasis on border taxes.

Consultation with an IMF Customs Adviser was also undertaken. Consistent with private sector wishes, the Customs reform package is focusing on reducing opportunities for discretion. This is to be achieved through automation and simplification of the customs process. However, the reform Customs package is a long-term process — significant changes in capacity and governance are not expected for at least 12 months.

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