Shariah compliant finance is an important part of life for the faithful. Currently, Shariah-compliant financial products are available to both Muslims and non-Muslims around the globe. Hence, all consumers should have the opportunity to take up these products without facing undue regulatory barriers. Consequently, regulatory framework, including taxation, of Shariah compliant products should apply equally regardless of the faith of provider or consumer.
State bank of Pakistan is currently regulating the Islamic banking Mechanism through various regulatory instruments of law which includes circulars, etc, hence, alignment of other laws is required for a good framework for the correct interpretation of Shariah compliant products which ought to be based on the principle of concordare leges legibus est optims interpretandi modus – to make laws agree with laws is the best mode of interpreting them. Moreover, the law should be so amended to include the nature of contract instead of the types of contract because of the fact that contractus regit actum – contract governs the act.
This article is an endeavor to suggest a principle based framework for Shariah compliant financial products and will try to encompass various aspects of the nature of existing Shariah compliant financial products. This includes effect of laws relating to property including motor vehicle, transfer of property, registration of property, stamp duty, hence, will not only be restricted to Income Tax Ordinance, 2001 and Sales Tax Act, 1990. The suggestion in this article is based on the concept that leaving the issue unresolved would amount to maihemium est inter criminia majora minimum, et inter minora maximum – mayhem [chaos] is the least of great crimes and the greatest among small.
SHARIAH COMPLIANT FINANCIAL PRODUCTS
The most pronounced difference between Islamic financing and existing equivalent products is the prohibition of interest. This is based on the principle that it is unacceptable in and of itself for same commodity, including money, to increase in value merely by being lent to another person. However, Shariah does not prohibit the making of a return on capital if the provider is willing to share in the risks of a productive enterprise.
The principle deduced from the above discussion concludes the fact that Shariah prohibits transactions that involve interest, gambling, speculation, unethical investment, contractual terms of a transaction involving uncertainty, deception, ambiguity or lack of clarity and give rise to speculation (Gharar). Hence, Islamic financial transactions are structured using contracts or combination of contracts that satisfy the requirements of Shariah. Some of the most common Shariah compliant financial products are discussed below.
Murabaha – Basic price plus profit
A financial institution in Murabaha financing purchases the goods for the customer and re-sells them to the customer on a deferred basis, adding an agreed profit margin. The customer then pays the sale price for the goods either in installments or on lump sum basis at the end of the period. There are three sub products of this product – Basic Murabaha, Commodity Murabaha and Reverse Murabaha.
Basic Murabaha can be used to fund the purchase of a variety of assets including cars, fridges, televisions and property (both residential and commercial). Title to the asset will always pass from the Shariah Compliant financial product provider to the customer at the beginning of the arrangement.
Commodity Murabaha is used in two most common situations. Firstly, a customer requires a loan. The Shariah Compliant financial product provider purchases commodities from a supplier including the title but not the delivery and then sells immediately to the customer at cost plus profit. This allows the customer to defer payment either over a set period or until a specified future date. The customer takes title but not the delivery. The customer, using the Shariah Compliant financial product provider as its agent, then immediately sells the commodities to a purchaser at a price, equivalent to the cost to the Shariah Compliant financial product provider , to a purchaser. The Shariah Compliant financial product provider who acts as an agent but do not charge anything from the customer for acting as agent. All this is done on spot, that is, it is done almost instantaneously to avoid the risk of either a rise or fall in the commodity price. The proceeds equivalent to cost is credited in the customers account allows for subsequent use. The profit on sale of the commodity by the Shariah Compliant financial product provider to the customer is what the Shariah Compliant financial product provider makes from the deal.
In second situation, a customer requires a loan. The Shariah Compliant financial product provider , using an agent, purchases commodities from a supplier by just taking the title but not the delivery and then sells immediately to the customer at cost plus profit. This allows the customer to defer payment either over a set period or until a specified future date. The customer takes title of the goods. All this is done on spot, that is, it is done almost instantaneously to avoid the risk of either a rise or fall in the commodity price. The profit on sale of the commodity by the Shariah Compliant financial product provider to the customer is what the Shariah Compliant financial product provider makes from the deal.
Reverse Murabaha is basically the reverse to the commodity Murabaha and is normally used to affect a loan between financial institutions. Similarly, there are also two situations, however, both the Shariah Compliant financial product provider s act as agents. Firstly, Shariah Compliant financial product provider 1 requires a loan. Shariah Compliant financial product provider 2 purchases commodities from a supplier but not delivery. Shariah Compliant financial product provider 1 acting as agent, without any charge, for Shariah Compliant financial product provider 2 takes the title to the commodities and then sells the commodities immediately to Shariah Compliant financial product provider 2 at a cost plus profit, allowing Shariah Compliant financial product provider 2 to defer payment either over a set period or at a specified future date. In this process, Shariah Compliant financial product provider 1 takes title to the commodities but not delivery. Shariah Compliant financial product provider 2 then immediately sells the commodities at a cost, equivalent to the cost, to an end-purchaser. All this is done on spot, that is, it is done almost instantaneously to avoid the risk of either a rise or fall in the commodity price. The proceeds equivalent to cost is credited in the Shariah Compliant financial product provider 1’s account allows for subsequent use. The profit on sale of the commodity by the Shariah Compliant financial product provider 2 to the Shariah Compliant financial product provider 1 is what the Shariah Compliant financial product provider 2 makes from the deal.
In second situation, Shariah Compliant financial product provider 1 requires a loan. Shariah Compliant financial product provider 2 purchases commodities from a supplier but not delivery and sells immediately to Shariah Compliant financial product provider 1 at a cost plus profit, allowing Shariah Compliant financial product provider 1 to defer payment either over a set period or at a specified future date. In this process, Shariah Compliant financial product provider 1 takes title to the commodities but not delivery. Shariah Compliant financial product provider 1, with Shariah Compliant financial product provider 2 now acting as its agent, immediately sells the commodities at cost to an end-purchaser. All this is done on spot, that is, it is done almost instantaneously to avoid the risk of either a rise or fall in the commodity price. The proceeds equivalent to cost is credited in the Shariah Compliant financial product provider 1’s account allows for subsequent use. The profit on sale of the commodity by the Shariah Compliant financial product provider 2 to the Shariah Compliant financial product provider 1 is what the Shariah Compliant financial product provider 2 makes from the deal.
Ijara – Operating Lease
This product is a renting product that can be used to lease a variety of assets including cars, fridges, televisions and property (both residential and commercial). The Shariah compliant product offering institution acquires title to the asset and gives on rent to the customer. At no time does title to the asset pass to the customer nor is it expected to pass. If the customer wishes to purchase the asset at a later date a separate agreement is drawn up.
Ijara wa Iqtina – Finance Lease
This product is the same as the Ijara described above except that title to the asset is expected to pass to the customer at some time, usually at the end of the contract period. It can be used to purchase both goods and property.
Diminishing Musharaka – Shared Ownership
This product involves the use of two written contracts, being Ijara agreement and a diminishing ownership agreement (Musharaka), where two or more parties share ownership of an asset. For instance, a customer wisher to purchase a property and pays a specific percentage as a deposit to the vendor of the property and then enters into a diminishing ownership agreement with the Shariah compliant financial product provider under which the Shariah compliant financial product provider pays the outstanding amount, taking title to the property by way of a sub-lease between the vendor and the Shariah Compliant financial product provider. The Shariah compliant financial product provider’s customer now have, say 10%, beneficial interest or share in the property, with the remainder being with the Shariah compliant financial product provider. The Shariah compliant financial product provider allows the customer to defer payment of 90% over a period of, say 25 years. It does not and cannot add any interest to the 90% and so under this contract the customer pays back the exact amount paid out by the Shariah Compliant financial product provider.
At the same time, customer enters into the diminishing ownership agreement he also enters into a lease agreement, whereby the Shariah compliant financial product provider agrees to lease its share of the house to the customer for a variable amount of rent. This lease agreement runs concurrent with the diminishing ownership agreement. The customer may also be expected to pay any outgoings related to the property as well as all administrative and legal costs, arrangements fees and stamp duty.
Both the amounts repaid under the diminishing ownership agreement and the amount paid under the lease agreement are amalgamated and used to calculate how much of the Shariah compliant financial product provider’s share of the property has been purchased per month by the customer. As the Shariah compliant financial product provider’s share in the property decreases so does the amount paid under the lease agreement.
At the end of 25 years and if all the conditions contained within the two contracts have been met, the Shariah compliant financial product provider will pass title to the property to customer under the diminishing ownership agreement, normally for an additional payment. Moreover, some Shariah compliant financial product provider also require the customer to sign a third agreement under which the customer provides some form of security against payment of the amounts due under the other tow contracts, other Shariah compliant financial product providers may also require more than three agreements to be signed.
Wakala – Agency
This is an investment product, which functions in the same way as Mudaraba. The difference between the two is that with a Mudaraba all the profit is divided between the parties. Whilst with a Wakala the investor receives only the agreed ratio against investment. Anything made above that ratio is kept by the Shariah compliant financial product provider and not given to the investor.
For instance, an investor agrees to invest a sum with the Shariah compliant financial product provider for an agreed return of say 10%. The Shariah compliant financial product provider pools the investor’s funds with the funds of other investors along with its own capital and invests in Shariah compliant financial asset. At the end of a given period the Shariah compliant financial product provider return the invested sum to the investor along with the agreed 10%. Any additional revenue that the Shariah compliant financial product provider makes on the money is kept by the Shariah compliant financial product provider. If the Shariah compliant financial product provider does not make the agreed percentage return then the investor gets what has been made whilst the Shariah Compliant financial product provider gets nothing.
Islamic Current Accounts
These operate in the same way as the conventional current account except that there is no overdraft facility and no interest added by the Shariah compliant financial product provider to the account for funds in credit.
TITLE RELATED LAWS, STAMP DUTY AND CVT
Motor vehicle registration act, Transfer of Property Act, Capital Value Tax and Stamp Duty Act, needs to encompass the nature of Shariah compliant financial products for a smoother flow of transactions or contracts. The most common problem of Shariah compliant financial products is the involvement of series of transaction which is chargeable to CVT and Stamp duty and is not necessary under conventional mortgage structures. Similarly, another regulatory burden specifically related to immovable property and motor vehicle is the transfer of title in the name of Shariah Compliant financial product provider and then to the customer.
To achieve this end, Legislation needs to be amended in a manner to encompass the intrinsic features of the underlying contract based on principles deduced from Shariah. Specifically, Government must relieve the transactions entered for the purpose of Shariah Compliant property and motor vehicle related financial products from CVT and stamp duty. Similarly, Transfer of property act, 1844 and Motor Vehicle Registration Act needs to be amended in such a manner to avoid the hassle of series of transfer and the modus operandi may include stamping in the case of hire purchase and under lien or mortgage.
SALES TAX ACT, 1990 [STA, 1990]
The sales tax treatment of Shariah compliant financial products is somewhat uncertain and produces anomalous results. These anomalies can put the providers of Shariah compliant financial products at a commercial disadvantage. Consequently, the customers also suffer a disadvantage if Shariah Compliant financial product providers have to charge proportionately more for Shariah compliant financial products. One must consider the impact of sale to a general consumer and a trader as in the case of conventional banks whereby the consumer finance is for end consumer and loans for traders.
Moreover, reverse Murabaha is the only instrument available for the Islamic banks to meet the deficiency of short fall in cash reserve, hence, should not be brought into the ambit of sales tax act, 1990.
Murabaha
In Basic and Commodity Murabaha, the title to the asset passes from the Shariah Compliant financial product provider to the customer, hence, the sale should be treated as a credit sale. There are two supplies being made by the Shariah Compliant financial product provider – one of the goods and one of the facilities to defer payment. It is suggested that the consideration for supply of the goods should follow the similar treatment of hire purchase by conventional Shariah Compliant financial product provider s, hence, should neither loose its basic treatment under STA, 1990 nor suffer any further tax when the title passes from the Shariah Compliant financial product provider to the customer. On the other hand, the profit element should also be exempted from tax and treated as consideration for the defer payment by Shariah Compliant financial product provider s. This treatment would not put the Islamic Shariah Compliant financial product provider s at disadvantageous position over the conventional interest based Shariah Compliant financial product provider s.
Ijara, Ijara wa Iqtina and Diminishing Musharaka
Consideration for supplies made under this arrangement needs to be treated in the same way to Hire purchase or conditional sale, except property. As stated earlier, there are two supplies being made by the Shariah Compliant financial product provider – one of the goods and one of the facility to defer payment. It is again suggested that the consideration for supply of the goods should follow the similar treatment of hire purchase by conventional Shariah Compliant financial product provider s, hence, should neither loose its basic treatment under STA, 1990 nor suffer any further tax when the title passes from the Shariah Compliant financial product provider to the customer in case of Ijara wa Iqtina.
On the other hand, the profit element should also be exempted from tax and treated as consideration for the defer payment by Shariah Compliant financial product provider s. This treatment would not put the Islamic Shariah Compliant financial product provider s at disadvantageous position over the conventional interest based Shariah Compliant financial product providers.
However, where the Shariah compliant financial product provider is unlikely to be the absolute legal and beneficial owner of the asset but just takes the title by way of security, the assignment of the title should operate by way of mortgage. Any payment made by the customer will be the repayments of the price and where the amount repaid is greater than the value of the asset advanced then this should be considered as part of the facility to defer payment and be exempt from GST.
INCOME TAX ORDINANCE, 2001
It is high time that a framework needs to be incorporated in Income Tax Ordinance, 2001 whereby Shariah compliant products are taxed in a way that is neither more nor less advantageous than equivalent Shariah Compliant financial product provider ing products. The intended effect must be to allow providers to offer Shariah compliant products without facing commercial disadvantage, and to enable customers to take up these products without encountering uncertainty or disadvantage over tax treatment.
Murabaha
The most common problem of Shariah compliant financial products is the involvement of series of transaction which falls within the ambit of minimum tax, capital gain and fair market value related provision which is not the case under conventional financial products.
Section 113 needs to be amended to exclude the sale transaction of a Shariah compliant financial product from the definition of turnover. Moreover, section 153 also needs to be suitably amended to exclude deduction of tax from the installments by the customer instead of exemption certificate approach.
In furtherance, section 37, 68, 75, 77 and 78 needs to be amended in such a manner that transaction, involving capital gain, entered into by a Shariah compliant financial product provider should not be taxed under any provision of Income Tax Ordinance, 2001 in the hands of Shariah Compliant financial product provider.
Ijara, Ijara wa Iqtina and Diminishing Musharaka
Section 18 needs to be suitably amended to incorporate the concept of Ijara and Ijara wa Iqtina. In the absence of a suitable amendment, the Ijara wa Iqtina relating to a house will fall under section 15 and would put the Shariah compliant product provider at a disadvantage over the conventional Shariah Compliant financial product provider.
The core basis of such amendment is based on the fact that it involves payment of rent and principal with rent. Under the conventional banking, the amount is debited from the account and the need to deduct tax does not arise. However, the modus operandi for the Shariah Compliant financial product provider remains same but the nature of contract involves rent and principle.
Wakala – Agency
It is suggested that such an income needs to be considered in line with section 151 in the hands of the customer.
Donation out of Penalty
A heavy non-performing portfolio and default on part of clients is a serious problem confronted by the Shariah compliant financial product provider. This problem could be threat to success of Shariah compliant financial product service provider. If clients do not honor their commitment in respect of timely payment in respect of a Shariah compliant financial product, it could cause irreparable loss to the system.
In Islam, it is permissible to penalize a financially debtor but delays payment of debt without any genuine reason. Last Prophet (PBUH) said, “A rich debtor who delays payment of debt commits zulm”. Hence, the jurists allow the punishment (Taazir) to such borrower in the form of fine. In the opinion of some Maliki jurists, a delaying borrower would be obliged to pay for charitable activities.
In view of the severity of the problem, all Shariah bodies including Shariah bench of the Supreme Court of Pakistan have approved the provision of penalty clause in the contractual agreements that keeps a balance between the requirement in view of severity of the problem and that of the Shariah conditions/principles to keep the fine difference between interest and profit on Shariah compliant financial product intact.
However, the penalty proceeds would be used for charity because penalty on default in repayment cannot become an automatic source of income for the creditor. Hence, it is imperative that a new sub-section needs to be introduced in section 20, whereby all such penalties are donated and amounts are reflected in the tax returns of such not for profit making organizations having NTN.
ECONOMIC ASPECTS
Nowadays, government should seek to address an existing inequality in the tax treatment of Shariah compliant financial product and to promote fairness by contributing to the Government’s financial exclusion and asset saving objectives.
This healthy competition would seek, would commit in working together with financial services provider to achieve a reduction in the number of people who lack access to a Shariah Compliant financial product provider account of any kind. Many people, particularly those living on low incomes, cannot access mainstream financial products such as Shariah Compliant financial product provider accounts and loans.
Currently, the Government is also seeking, through measures, to provide targeted support and incentives for saving. Evidence suggests that on average people have less access to an uptake of financial services. Part of the reason for this may be the lack of provision of Shariah compliant financial product.
Applying the tax law as it currently stands would leave in place a real inequality since the tax treatment would not always reflect the economic purpose of the transaction. Customers could suffer if providers have to charge proportionately more for their products than conventional Shariah Compliant financial product provider s, although some may be better off overall if in some circumstances they would pay less tax on the equivalent products from a conventional Shariah Compliant financial product provider .
There are close links between provides of Shariah compliant financial product and the investment market, for instance, Islamic funds investment in stock market and benchmarking of profit through KIBOR etc. Benchmarking of KIBOR as minimum profit rate is criticized from Pakistan Nationals around the globe, however, some writers have advocated in favor of this at various forums, however, might is not always right.
Government, in close consultation with Securities and Exchange Commission of Pakistan, should consider allowing NBFC’s to offer Shariah compliant financial product within their sphere of activities in line with Islamic Banking offered by conventional banks. However, the modus operandi should be much more transparent by allowing them to open separate branches with fresh induction of either capital or issuance of TFC’s correlated with the weighted average rate of return on products offered by such NBFC’s on prospective products. This will improve the environment of healthier competition and serve as a deterrent of creation of cartel in Banking sector who are currently using the KIBOR as basic profit margin without keeping an eye over the fact that the consumer is ready to take any rate profit instead of a minimum guaranteed profit which is suspicious in the light of Shariah.
Moves towards removing possibly disadvantageous tax treatment for Shariah compliant financial product will extend product flexibility and consumer choice. They may also have the effect of encouraging investment in Shariah compliant financial product’s advertising themselves.
CONCLUSION
Doing nothing would not address the potential unfairness and uncertainty outlined above and would not encourage the provisions of Shariah compliant financial product by the regulated market. There is a risk that if no action is taken, such products might develop in an unregulated market.
Issuance of explanatory circular and notifications / SRO’s could address the problem in short term by alleviating the clearest anomalies whilst permanent solutions need to be developed in legislation. This allows more time to develop long-term solutions in what is still a fast developing area. However, this would provide only a temporary solution and could not address areas where current tax treatment might have conferred an advantage for one party on Shariah compliance financial product. It would not offer a structural solution capable of giving a clear framework for the future development of new products.
Ministry of Finance and Law ought to move after a detailed internal analysis and consultation, the preferred way forward is to recommend a legislative solution which may include what is suggested in this article. However, the precise form of the legislation requires careful consideration to fit with existing legal framework for tax law for Banking and NBFC’s apart from Pakistan’s responsibilities under its network of taxation treaties.
After this due consultation it will emerge that it would not be possible to address all tax issues affecting the development of Shariah Compliant financial product with a single piece of legislation. Therefore, it may be imperative to establish a forum to evaluate progress achieved by this sector and concerned ministries must work towards solutions on outstanding issues of law identified above before the issuance of finance bill, 2007.
The pace of market development suggests that a large number of financial institutions will be interested in developing a range of Shariah Compliant Financial products once greater clarity is brought to the question of tax treatment, and will benefit from enhanced flexibility in development and marketing.
Initially, most of the Shariah compliant currently in development be geared towards retail customers. However, Shariah compliant financial business products are already being developed and Banks have shown interest in expanding into this area. Over time a significant proportion of the customer base for providers of Shariah Compliant financial products is likely to be small businesses who wish to comply as far as possible with the provisions of Shariah law. At present, they may face difficulties in reconciling this obligation with securing necessary financial access.
In the light of this discussion, it can effectively be concluded that in recent years there have been a number of prominent developments in the world including Pakistan’s Islamic finance market, and there is now considerable interest in developing and marketing a wide range of products. Shariah compliant current accounts, savings accounts and house purchase facilities are now available apart from other products. The regulatory framework discussed above needs fresh blood in the light of development discussed above.
The author, Muhammad Ashraf is an International Tax Advisor, the opinion expressed in this article is personal and the firm, with whom the writer is attached, may or may not agree with it.
Wednesday, September 23, 2009
Indirect Tax Policy Considerations
When I use the word indirect taxation, I would mean to include sales tax (Federal and Provincial), excise tax and custom duty broadly speaking and in one sense can be effectively categorized as consumption taxes.
Consumption taxes have grown to be a major source of tax revenue for governments around the globe. Tax authorities worldwide are gradually migrating the overall tax burden from direct tax to the less visible indirect taxes and are the sole big reason of increasing inflation. In a recent survey, consumption taxes constituted approximately 30 percent of total taxation in OECD countries while in some countries these constituted more than 50 percent of the total tax revenue.
As the honorable chairman of proposed FBR has said that excise and customs are dying levies, hence, I will concentrate my efforts over sales tax act, 1990 which is about to be replaced with value added tax in near future and a committee is working in CBR over this law.
As now that consumption taxes are taking more prominent role, currently our government is also more focused on deriving maximum benefit from these taxes like consumption tax policies, legislation and auditing are all under increased scrutiny by government and tax officials.
Currently, we are moving ahead in the right direction recommended by the World Bank which covers four broad measures to progressively reform taxation in general.
Consolidation of the number of taxes
Cutting back on special exemptions and privileges
Simplifying filing requirement
Broadening the tax base by keeping rates moderate in the developing countries
However, I would recommend something more in the light of directions given by working party No. 9 of OECD – double taxation treaties of indirect taxes. We must prepare such treaties with an aim to avoid double taxation, promote harmonization of rules, mutual co-operation, simplification of administration and above all certainty for business.
CONSUMPTION TAX POLICIES
At the moment a consistent indirect policy keeping an eye over literacy rate and geographical segregation of urban and rural population is not reflective from any document. I think that CBR is not the only institution which is responsible for reduced tax to GDP ratio. Other institutions are also responsible for this reduced tax to GDP ration owing to the low literacy rate. There is a dire need to increase the literacy rate not only to increase the tax to GDP ratio but also the civic sense.
Efforts must not only be concentrated towards illiterates, I am not forgetting the literate portion of society – CBR must work with ministry of education to include the concept of tax, need for imposing tax, types of taxes in Pakistan, basic tax calculation of direct and indirect taxes etc in the appropriate portion of syllabus at various classes or stages at school and college level and do not limit it like a 30 marks portion in B. Com.
From the administrative front, I would recommend replacing the use of designation of collectors, assistant collectors, Inspectors, commissioner, taxation officers with assistant manager, manager, senior manager like tax facilitation manager, tax audit manager and taxpayer care manager. This will have a deep impact over the mind set of tax machinery.
The training at DOT must not concentrate only on law but the difference between wrong decisions, that is, an order of an economic manager and finance manager also need to be crystal clear in their mindset by experience sharing. Moreover, there must be a process of consultation within tax machinery for complex issues and not just throwing the ball for appeal forums.
The three dimensional strategy of Excise Tax and five dimensional strategy of Sales tax needs to be principally based instead rule based facilitation to bring certainty in Business Planning and removal of unnecessary doubts about the discrimination and transparency issues. Such conflicting rule based facilitation with dimensional tax legislation makes the excise and sales tax law the most difficult piece of legislation to comprehend.
You will appreciate the fact that strategies are hard to apply and hard to manage, however, principle based strategy is much easier to apply then a rule based strategy.
TAX ON TAX and RATES OF TAX
Tax on tax issue is not limited to section 148 of Income Tax Ordinance, 2001 but has its roots in Sales Tax and Excise tax also.
On the excise front, excise tax machinery now days taking a view that according to section 12(4), excise tax needs to be inclusive for the purpose of determination of value for the purpose of duty under section 12. Although various precedence in field at the moment, however, things need to be cleared with efficient advice mechanism for machinery by the CBR as it deteriorates the image.
Section 2 (46) – value of supply, clause (a) and (d) clearly enunciates the fact that sales tax needs to be levied on value inclusive of all taxes specially federal excise.
Such tax on tax needs to be removed and have a considerable effect over consumer price and sensitive price index issued by state bank of Pakistan. A levy needs to be independent in order to calculate its impact tax on tax is clearly an impediment for the tax administration owing to the variability in tax rates.
It is worthwhile here to note that rates of tax coupled with tax on tax varies the prices considerably when the items covered in sensitive price index are now manufactured and becomes the indispensable part of life of urban population. Removal of tax on tax and reduction in tax rates of indirect taxes, especially 15% rate of sales tax will greatly relieve the SPI which is continuously moving upward.
EXCISE TAX
Rule 40A (4) of Federal Excise Rules, 2005 [FER, 2005] and section 12(2) of FEA, 2005 are highly debated in the professional circles of banking industry.
Some professionals believe rule 40A (4) of FER, 2005 read with section 12(2) of the FEA, 2005 creates two fictions while others believe in three in respect of chargeability of excise duty on normal rates irrespective of following.
Provided free of charge
At discounted rate or
Normal rate.
A clarification needs to be issued to avoid plethora of cases in this regards. These will also bringing certainty. However, banks are at safer side owing to precedence available in this regard.
According to section 7 of Federal Excise Act, 2005, there are only some manufacturers which are authorized to claim input under Sales Tax Act, 1990 on payment of excise tax. This list needs to include other manufacturers also to move in the direction of burying this law and increased consolidation towards sales tax and administration.
As we know that the sales tax on services is moving in the right direction and constitutional impediment was overcome through effective arrangement, however, this may not a long term solution.
RECORD KEEPING
The strategy for prescribing the necessary records should be principle based instead of existing rule based methodology. In a principle based methodology, the taxpayers can effectively be categorized as large, medium and small.
Large taxpayers normally maintain detailed records not only for tax purposes but for effective data mining to ascertain their business share in the market and effective marketing plan for future potential. CBR should prescribe the postulates of their documents instead of the document itself.
Medium taxpayers are requested to closely align their documentation according to law while the prescription of document method needs to be left for small taxpayers.
Currently, there is no time limit needs to be prescribed in section 22 of Sales Tax Act, 1990 like section 17 of Federal Excise Act, 2005. In this regard, I would like to quote the recent judgment of Honorable Supreme Court whereby fixed asset and scrap are liable for output sales tax at the point of sales.
Unfortunately, none of the appellant tried to took the direction from Honorable Supreme Court for CBR in respect of inconsistent treatment of input and output of fixed asset. Moreover, the constraint of minimum ten years record keeping requirement under section 230(6) of Companies’ Ordinance, 1984 has not been brought to the lime light as there is not notification available under section 22 of Sales Tax Act, 1990 which clearly specifies the holding period of records.
However, from the face of the judgment, in some cases much more than ten years have elapsed and in the absence of any prescribed time limit in fiscal laws, the Companies Ordinance, 1984 becomes the base law for such companies. Let’s hope for a good review petition taking appropriate direction from the courts as it can not provide for the deficiency in law in view of Article 4 of the constitution, while exercising powers under Article 199 of the constitution.
I would strongly request CBR to resolve this matter amicably and neither revenue should discuss the fact that liability arise because of taxpayers’ incorrect interpretation nor taxpayer will argue that their understanding is based on varying notifications in the field
AUDIT
Moreover, the existing audit section needs to be rephrased under one chapter which may include audit management, taxpayers’ obligation, authorized representative obligation, modus operandi of audit, modus operandi of audit decision, postulates of an audit order and time frame to conduct & complete the audit.
From the corporatisation front, Section 96, 97 and 98 of Income Tax Ordinance, 2001 relating to promotion of corporatisation is neither harmonized with sales tax nor with excise tax. I would specifically stress over sub-section (2) of section 49 of Sales Tax Act, 1990 which needs to be suitably amended in order to avoid the timing difference and problems currently being faced by the taxpayers.
TAX REFUND INFORMATION SYSTEM
It is really applaud able that CBR is making experience adjustment starting from STARR, RCPS and now CREST, however, taxpayers are still suffering. This is just because of lack of efficient IT policy which do not use appropriate system analysis methodology.
I would suggest that CBR must consider accepting the refund related reports in MS Excel format apart from any new software; hence, the most distinguishing feature of any new software is its capability of importing such MS Excel report. By this way the taxpayers will be relieved from current practice of hectic data entry into STARR then RCPS now CREST.
Moreover, CBR may stick to its current practice of refund claim during current year but must allow adjustment of refund against various different taxes during same fiscal year – income, sale, excise and custom. A detailed modus operandi may be formulated which may include notifying different departments etc. This will have a considerable impact not only over the working capital cycle of business in avoiding liquidity crunch and taking unnecessary high cost loans but also help CBR in showing true revenue collection less tax refundable.
GROUP RELIEF
I would like to suggest that Group relief needs to be incorporated into the Sales and Excise Tax Acts whereby intermediate supply related transactions falling within the ambit of Sales Tax needs to be zero rated while intermediate goods used by another group needs to be exempted from excise tax.
SHARIAH COMPLIANT FINANCIAL PRODUCT
I am using the terminology Shariah Compliant Financial Product instead of Islamic Banks deliberately as Securities and Exchange Commission of Pakistan is currently working over a framework whereby NBFC will also be able to undertake and offer Shariah compliant financial product resembling to their current financial product.
The sales tax treatment of Shariah compliant financial products is somewhat uncertain and produces anomalous results. These anomalies can put the providers of Shariah compliant financial products at a commercial disadvantage.
Conventional financial institutions are at ease to structure the transaction, for instance, consumer finance, and hire purchase etc in such a manner that it does not fall within the ambit of Sales Tax Act, 1990. It is suggested that Shariah compliant financial products need to be brought out specifically from the preview not by implication which is the current state. This will bring the Shariah compliant financial product providers at par with conventional financial products providers and remove uncertainty. To my knowledge, there are many new investments are in the offing and waiting for clarity.
RECTIFICATION OF ERROR OR MISTAKE BROUGHT TO THE NOTICE
Currently, Sales Tax Act, 1990 do not contain any specific provision parallel to section 221 of the Income Tax Ordinance, 2001. Although the concept is present in various section but in the absence of such specific provision claim of refund under complex situations remain unresolved for instance correction of errors, revision of return, issuance of debit and credit note etc. Apart from refund claim, appeal stages also feel handicapped when any mistake was brought to their notice.
CUSTOM TARRIF
Rationalization of tariff after the WTO regime and continual Free Trade Agreements make this an unobservable secondary issue and this is also realized by CBR, hence, honorable chairman of CBR has stated that it is a dying levy.
It is suggested that tariffs needs to be suitably amended which promote investment in manufacturing and IT sector not only to become the regional hub, not only relying over textile export but a diversified product base exporter resulting in increased GDP, facilitation of transfer of modern technology including research not just technological equipment.
Moreover, CBR may not be able to reap any benefit from IT related efforts in customs unless and until there databases are attached through a key field to fetch the data and are connected through a secure intranet with the use WAN.
I personally appreciate the efforts of CBR who is trying to provide developed countries facilities in a developing country but it must adopt the practice and thoughts as tactical cum strategic economic managers not finance managers. On productivity front of masses, I would like to end up on the borrowed phrases from the preamble of History of Ibn e Khaldoon.
“if the government gives top priority or keeps an eye over facilitation and judicial system then the boldness, sense of honor and self respect remains the personality trait of the masses. However, if the government takes help from chastisement and conquest then boldness, sense of honor and self respect gradually extinct from the personality masses and the ability of guardianship and striving to repel an assailant would become almost absent. In other words, this procedure conquers their personality traits and sooner or later they become lazy and good for nothing – that is non-productive.”
The author is an International Tax Advisor.
Article courtesy of Muhammad Ashraf
Consumption taxes have grown to be a major source of tax revenue for governments around the globe. Tax authorities worldwide are gradually migrating the overall tax burden from direct tax to the less visible indirect taxes and are the sole big reason of increasing inflation. In a recent survey, consumption taxes constituted approximately 30 percent of total taxation in OECD countries while in some countries these constituted more than 50 percent of the total tax revenue.
As the honorable chairman of proposed FBR has said that excise and customs are dying levies, hence, I will concentrate my efforts over sales tax act, 1990 which is about to be replaced with value added tax in near future and a committee is working in CBR over this law.
As now that consumption taxes are taking more prominent role, currently our government is also more focused on deriving maximum benefit from these taxes like consumption tax policies, legislation and auditing are all under increased scrutiny by government and tax officials.
Currently, we are moving ahead in the right direction recommended by the World Bank which covers four broad measures to progressively reform taxation in general.
Consolidation of the number of taxes
Cutting back on special exemptions and privileges
Simplifying filing requirement
Broadening the tax base by keeping rates moderate in the developing countries
However, I would recommend something more in the light of directions given by working party No. 9 of OECD – double taxation treaties of indirect taxes. We must prepare such treaties with an aim to avoid double taxation, promote harmonization of rules, mutual co-operation, simplification of administration and above all certainty for business.
CONSUMPTION TAX POLICIES
At the moment a consistent indirect policy keeping an eye over literacy rate and geographical segregation of urban and rural population is not reflective from any document. I think that CBR is not the only institution which is responsible for reduced tax to GDP ratio. Other institutions are also responsible for this reduced tax to GDP ration owing to the low literacy rate. There is a dire need to increase the literacy rate not only to increase the tax to GDP ratio but also the civic sense.
Efforts must not only be concentrated towards illiterates, I am not forgetting the literate portion of society – CBR must work with ministry of education to include the concept of tax, need for imposing tax, types of taxes in Pakistan, basic tax calculation of direct and indirect taxes etc in the appropriate portion of syllabus at various classes or stages at school and college level and do not limit it like a 30 marks portion in B. Com.
From the administrative front, I would recommend replacing the use of designation of collectors, assistant collectors, Inspectors, commissioner, taxation officers with assistant manager, manager, senior manager like tax facilitation manager, tax audit manager and taxpayer care manager. This will have a deep impact over the mind set of tax machinery.
The training at DOT must not concentrate only on law but the difference between wrong decisions, that is, an order of an economic manager and finance manager also need to be crystal clear in their mindset by experience sharing. Moreover, there must be a process of consultation within tax machinery for complex issues and not just throwing the ball for appeal forums.
The three dimensional strategy of Excise Tax and five dimensional strategy of Sales tax needs to be principally based instead rule based facilitation to bring certainty in Business Planning and removal of unnecessary doubts about the discrimination and transparency issues. Such conflicting rule based facilitation with dimensional tax legislation makes the excise and sales tax law the most difficult piece of legislation to comprehend.
You will appreciate the fact that strategies are hard to apply and hard to manage, however, principle based strategy is much easier to apply then a rule based strategy.
TAX ON TAX and RATES OF TAX
Tax on tax issue is not limited to section 148 of Income Tax Ordinance, 2001 but has its roots in Sales Tax and Excise tax also.
On the excise front, excise tax machinery now days taking a view that according to section 12(4), excise tax needs to be inclusive for the purpose of determination of value for the purpose of duty under section 12. Although various precedence in field at the moment, however, things need to be cleared with efficient advice mechanism for machinery by the CBR as it deteriorates the image.
Section 2 (46) – value of supply, clause (a) and (d) clearly enunciates the fact that sales tax needs to be levied on value inclusive of all taxes specially federal excise.
Such tax on tax needs to be removed and have a considerable effect over consumer price and sensitive price index issued by state bank of Pakistan. A levy needs to be independent in order to calculate its impact tax on tax is clearly an impediment for the tax administration owing to the variability in tax rates.
It is worthwhile here to note that rates of tax coupled with tax on tax varies the prices considerably when the items covered in sensitive price index are now manufactured and becomes the indispensable part of life of urban population. Removal of tax on tax and reduction in tax rates of indirect taxes, especially 15% rate of sales tax will greatly relieve the SPI which is continuously moving upward.
EXCISE TAX
Rule 40A (4) of Federal Excise Rules, 2005 [FER, 2005] and section 12(2) of FEA, 2005 are highly debated in the professional circles of banking industry.
Some professionals believe rule 40A (4) of FER, 2005 read with section 12(2) of the FEA, 2005 creates two fictions while others believe in three in respect of chargeability of excise duty on normal rates irrespective of following.
Provided free of charge
At discounted rate or
Normal rate.
A clarification needs to be issued to avoid plethora of cases in this regards. These will also bringing certainty. However, banks are at safer side owing to precedence available in this regard.
According to section 7 of Federal Excise Act, 2005, there are only some manufacturers which are authorized to claim input under Sales Tax Act, 1990 on payment of excise tax. This list needs to include other manufacturers also to move in the direction of burying this law and increased consolidation towards sales tax and administration.
As we know that the sales tax on services is moving in the right direction and constitutional impediment was overcome through effective arrangement, however, this may not a long term solution.
RECORD KEEPING
The strategy for prescribing the necessary records should be principle based instead of existing rule based methodology. In a principle based methodology, the taxpayers can effectively be categorized as large, medium and small.
Large taxpayers normally maintain detailed records not only for tax purposes but for effective data mining to ascertain their business share in the market and effective marketing plan for future potential. CBR should prescribe the postulates of their documents instead of the document itself.
Medium taxpayers are requested to closely align their documentation according to law while the prescription of document method needs to be left for small taxpayers.
Currently, there is no time limit needs to be prescribed in section 22 of Sales Tax Act, 1990 like section 17 of Federal Excise Act, 2005. In this regard, I would like to quote the recent judgment of Honorable Supreme Court whereby fixed asset and scrap are liable for output sales tax at the point of sales.
Unfortunately, none of the appellant tried to took the direction from Honorable Supreme Court for CBR in respect of inconsistent treatment of input and output of fixed asset. Moreover, the constraint of minimum ten years record keeping requirement under section 230(6) of Companies’ Ordinance, 1984 has not been brought to the lime light as there is not notification available under section 22 of Sales Tax Act, 1990 which clearly specifies the holding period of records.
However, from the face of the judgment, in some cases much more than ten years have elapsed and in the absence of any prescribed time limit in fiscal laws, the Companies Ordinance, 1984 becomes the base law for such companies. Let’s hope for a good review petition taking appropriate direction from the courts as it can not provide for the deficiency in law in view of Article 4 of the constitution, while exercising powers under Article 199 of the constitution.
I would strongly request CBR to resolve this matter amicably and neither revenue should discuss the fact that liability arise because of taxpayers’ incorrect interpretation nor taxpayer will argue that their understanding is based on varying notifications in the field
AUDIT
Moreover, the existing audit section needs to be rephrased under one chapter which may include audit management, taxpayers’ obligation, authorized representative obligation, modus operandi of audit, modus operandi of audit decision, postulates of an audit order and time frame to conduct & complete the audit.
From the corporatisation front, Section 96, 97 and 98 of Income Tax Ordinance, 2001 relating to promotion of corporatisation is neither harmonized with sales tax nor with excise tax. I would specifically stress over sub-section (2) of section 49 of Sales Tax Act, 1990 which needs to be suitably amended in order to avoid the timing difference and problems currently being faced by the taxpayers.
TAX REFUND INFORMATION SYSTEM
It is really applaud able that CBR is making experience adjustment starting from STARR, RCPS and now CREST, however, taxpayers are still suffering. This is just because of lack of efficient IT policy which do not use appropriate system analysis methodology.
I would suggest that CBR must consider accepting the refund related reports in MS Excel format apart from any new software; hence, the most distinguishing feature of any new software is its capability of importing such MS Excel report. By this way the taxpayers will be relieved from current practice of hectic data entry into STARR then RCPS now CREST.
Moreover, CBR may stick to its current practice of refund claim during current year but must allow adjustment of refund against various different taxes during same fiscal year – income, sale, excise and custom. A detailed modus operandi may be formulated which may include notifying different departments etc. This will have a considerable impact not only over the working capital cycle of business in avoiding liquidity crunch and taking unnecessary high cost loans but also help CBR in showing true revenue collection less tax refundable.
GROUP RELIEF
I would like to suggest that Group relief needs to be incorporated into the Sales and Excise Tax Acts whereby intermediate supply related transactions falling within the ambit of Sales Tax needs to be zero rated while intermediate goods used by another group needs to be exempted from excise tax.
SHARIAH COMPLIANT FINANCIAL PRODUCT
I am using the terminology Shariah Compliant Financial Product instead of Islamic Banks deliberately as Securities and Exchange Commission of Pakistan is currently working over a framework whereby NBFC will also be able to undertake and offer Shariah compliant financial product resembling to their current financial product.
The sales tax treatment of Shariah compliant financial products is somewhat uncertain and produces anomalous results. These anomalies can put the providers of Shariah compliant financial products at a commercial disadvantage.
Conventional financial institutions are at ease to structure the transaction, for instance, consumer finance, and hire purchase etc in such a manner that it does not fall within the ambit of Sales Tax Act, 1990. It is suggested that Shariah compliant financial products need to be brought out specifically from the preview not by implication which is the current state. This will bring the Shariah compliant financial product providers at par with conventional financial products providers and remove uncertainty. To my knowledge, there are many new investments are in the offing and waiting for clarity.
RECTIFICATION OF ERROR OR MISTAKE BROUGHT TO THE NOTICE
Currently, Sales Tax Act, 1990 do not contain any specific provision parallel to section 221 of the Income Tax Ordinance, 2001. Although the concept is present in various section but in the absence of such specific provision claim of refund under complex situations remain unresolved for instance correction of errors, revision of return, issuance of debit and credit note etc. Apart from refund claim, appeal stages also feel handicapped when any mistake was brought to their notice.
CUSTOM TARRIF
Rationalization of tariff after the WTO regime and continual Free Trade Agreements make this an unobservable secondary issue and this is also realized by CBR, hence, honorable chairman of CBR has stated that it is a dying levy.
It is suggested that tariffs needs to be suitably amended which promote investment in manufacturing and IT sector not only to become the regional hub, not only relying over textile export but a diversified product base exporter resulting in increased GDP, facilitation of transfer of modern technology including research not just technological equipment.
Moreover, CBR may not be able to reap any benefit from IT related efforts in customs unless and until there databases are attached through a key field to fetch the data and are connected through a secure intranet with the use WAN.
I personally appreciate the efforts of CBR who is trying to provide developed countries facilities in a developing country but it must adopt the practice and thoughts as tactical cum strategic economic managers not finance managers. On productivity front of masses, I would like to end up on the borrowed phrases from the preamble of History of Ibn e Khaldoon.
“if the government gives top priority or keeps an eye over facilitation and judicial system then the boldness, sense of honor and self respect remains the personality trait of the masses. However, if the government takes help from chastisement and conquest then boldness, sense of honor and self respect gradually extinct from the personality masses and the ability of guardianship and striving to repel an assailant would become almost absent. In other words, this procedure conquers their personality traits and sooner or later they become lazy and good for nothing – that is non-productive.”
The author is an International Tax Advisor.
Article courtesy of Muhammad Ashraf
Direct Tax Policy Principles
First of all, I would like to applaud the efforts of UN awarded and world’s leading accounting body ACCA for utilizing its notable expertise owing to its presence in 160 countries by providing us an opportunity to share our expectations and thoughts on prospective budget for the fiscal year 2007-2008.
Minimization of compliance costs not only for businesses but also for the collectors and maximization of revenue for Pakistan seems to be the core issue of this seminar. When I use the word direct taxation, I would mean to include income tax (Federal and Provincial) and Capital Value Tax broadly speaking and in one sense can be effectively categorized as direct taxes.
TAXES – a source of Public Finance
Taxes are essential to finance public services but there are good and bad ways to collect them. The design of the tax system can have significant economic impacts and can influence residents of a country and multinationals in deciding where to invest.
Tax collection has long been a despised activity. But taxes are essential. Without them there would be no money to build schools, hospitals, courts, roads, airports or other public infrastructure that helps business and society to be more productive and better off.
TAX REGIMES
There are two types of tax regimes – complex and simple as there is no third type.
Complex tax regimes
Tax regimes with relatively high marginal rates and which include a number of exemptions and allowances tend to be less economically efficient in relation to encouraging employment, saving and investment. Such regimes generally also impose higher tax compliance and administration cost which is evident from Income Tax Ordinance, 2001.
We have experienced Acts of 1918 and 1922 which have lead the basis of creation of Income Tax Ordinance, 1979, however, Income Tax Ordinance, 2001 was created to make the things simple. We know from our experiences about acts and ordinances, burdensome tax systems served as a deterrent and normally lead to tax evasion. According to a World Bank survey, Companies in 90% of surveyed countries [175 Countries including Pakistan] rank tax administration among the top five obstacles to doing business. The main factors contributing to this are
The large number of business taxes to pay
Lengthy and complex tax administration
Complex tax legislation
High tax rates
Simple tax regimes
Evidence suggest that simpler tax systems promote economic growth and can help achieve a win:win for government and industry. To help with paying taxes and implementing reforms, government and CBR need to consider all aspects of tax system. All taxes borne and collected by businesses should be recognized along with the related tax compliance costs not just federal taxes.
IMPACT OF TAX RATE OVER COMPLIANCE
In the ongoing reforms, tax administration and compliance, being significant obstacle to businesses, needs to be considered as part of the decision on reform. One should not loose its sight over the fact that government imposes taxes to finance public services but taxes must first be collected and high tax rates do not always lead to high tax revenues. However, the larger the share of informal business activity before reform, the higher the revenue growth after and is evident in Pakistan.
On average, Middle Eastern and East Asian countries make paying taxes the easiest. OECD countries impose the smallest administrative burdens and charge moderate tax bills. According to a World Bank study, between 1982 and 1999, the average corporate income tax rate worldwide fell from 46% to 33% while corporate income tax collection rose from 2.1% to 2.4% of national income [Hines (2005)].
This outcome was achieved because more businesses entered the formal economy and because tax exemptions and other tax incentives were reduced or eliminated.
Developed countries tend to have lower business taxes and less complex tax administration processes. Simple moderate taxes and fast, cheap administration mean less hassle for businesses – as well as higher revenues.
In contrast, Developing countries tend to use business as a collection point, charging higher business taxes. Latin American and South Asian countries impose the heaviest burdens, mainly because of high compliance costs. Africa follows, largely because of high taxes.
As stated earlier, Developing countries try to levy the highest amount of tax on businesses on the premise that these high taxes are needed to fund public services and correct fiscal deficits. However, the evidence suggest otherwise. Higher rates typically do not lead to higher revenues in developing countries. Instead they push businesses into the informal economy. As a result the tax base shrinks and less revenue is collected.
Lower rates work best when their administration is simple. Growing evidence shows that tax reforms creates more vibrant businesses and is evident in Pakistan. A smaller tax burden encourages firms to invest. However, they are undermined by exemptions that shrink tax base. I would like to share an adverse experience, tax revenues has fallen in Uzbekistan, where the enthusiasm for income tax cuts was not matched by efforts to improve tax administration and expand the tax base and that where CBR is trying to move through recent conference which requires more than a simple applaud.
Recent Reformers – Tax Rate Cut and Higher Revenue Target
Ghana Exceeded its mid-year revenue targets despite significant cuts in corporate tax rates in the last two years
Albania Corporate tax revenue rose 21% after the rate was cut
Moldova Corporate tax revenue rose 28% after the rate was cut
Latvia Corporate tax revenue rose 37% after the rate was cut
Romania Corporate tax revenue rose 8% in real terms after cut in tax rate in 2004
Economic growth in these countries is a factor in the increased revenue but compliance is also up [Source: World Bank (2006)]. Overall growth is also higher with lower taxes and better collection [Lee and Gordon (2004)].
Overall growth is also higher with lower taxes and better collection. And with tax incentives aligned to encourage work, more firms and more jobs are created. One study shows a cut of one percentage point in corporate tax rate is associated with up to a 3.7% increase in the number of firms and up to 1.1% higher employment [Goolsbee (2002)]. Tax reforms inspire political debate and can be hotly contested. But both businesses and government benefit when taxes are simple and fair and set incentives for growth.
TRANSPARENCY and CORRUPTION
Transparency is the key – Governments need to be accountable for how taxes are spent. Businesses will potentially be more willing to pay taxes if they can see the benefits of improved public services and infrastructure.
Businesses are more willing to pay taxes if they see that the money is used to improve public services. Yet many developing countries with high tax rates fail to improved business infrastructure or education and training – two things that employers care about.
Across countries, higher taxes payable are not associated with better social outcomes, even allowing for country income levels. They do not increase government spending on health and education, raise literacy or life expectancy or lower child mortality, nor are they associated with better infrastructure and other public services.
Burdensome taxes do however generate other undesirable outcomes. They are associated with more informality, as entrepreneurs often choose to avoid the formal system altogether and operate underground. They also breed corruption as every point of contact between a bureaucrat and an entrepreneur could present a dander of bribery and confusion on voluminous, often contradictory rules which may create room for discretion.
Simplifying the tax regime by reducing tax rates and eliminating exemptions is the main way to reduce corruption in tax administration. According to a World Bank survey, Georgia introduced major reductions in tax rates and simplifications to the tax system in 2004 – has seen a drastic fall in perceived corruption of tax officials. Georgia showed the sharpest drop in perceived corruption among 27 transition economies.
Recent Reformers – Tax Rate Cut and Corruption
Georgia Previous level 44% Current level 11%
Romania Previous level 14% Current level 8%
Slovakia Previous level 11% Current level 5%
[Source: World Bank (2006)]
All the above referred factors, tax rate cut and corruption, tax rate cut and transparency, tax rate cut and increased compliance etc present a good case for reduction in corporate tax rate while applicability of individual’s tax rate over small companies.
TAX COMPLIANCE COST
Businesses need to understand and communicate their total tax contribution, so that they are more able to manage and control it and demonstrate the full extent of the contribution made to public finances. I would suggest using indirect tax expense and taxing compliance cost as a separate head of expense in profit and loss account instead of rent, rate and taxes.
A better way to meet revenue targets is to encourage tax compliance by keeping rates moderate. Russia’s large tax cuts in 2001 did exactly that. Corporate tax rates fell from 35% to 24% and a simplified tax scheme lowered rates for small business. Yet tax revenue increases – by an annual average of 14% over the next three years. One study showed that the new revenue was due to increased compliance [Ivanova, Keen and Klemm (2005)].
It is not just businesses that gain from reforms. Streamlining taxes also brings savings for government. A Complicated tax system costs a lot of money to run – funds that could be better spent on education, health care and infrastructure. In Denmark, one Kroner spent on tax administration generates 113 Kroner of tax revenue. In Hungary, one forint produces only 77 and in Mexico one peso produces only 33. Such data is missing from performance measurement and must include the loans and grants received.
COMPLEXITY AND ITO, 2001
A particularly worrying consequent is that with sheer volume of tax legislation no one individual can possibly read all of it. So the days of a tax director being confident of spanning all the relevant parts of the tax code seem to have all but disappeared. Embodying all previous SRO’s of section 50 of Income Tax Ordinance, 1979 by virtue of section 239 (10) did the rest.
Similarly, at least as regards advising large to medium size corporate, the ability of a single tax advisor to span all the relevant tax legislation is circumscribed, hence, increased the relevance of specialists and sub-specialists.
This leads to an at least two tier market – those who can afford the necessary advice, and those for whom such advice may be of only marginal benefit on a cost/benefit analysis. It is also leading to a situation where the primary tax legislation is being read by fewer and fewer people.
The boldest reform is to simplify tax law so that every business faces the same tax burden – with no exemptions, tax holidays or special treatment for large or foreign businesses. Income Tax Ordinance, 2001 has also started in that way! But when hard times come and government needs revenue, tax rates are if not rates are freeze at current level.
This is unpopular, and large or well connected businesses usually obtain special treatment. Soon the tax law becomes riddled with exceptions, generally at the expense of small businesses, which have the least ability to lobby. Often they are pushed into the informal sector. Few reformers dare eliminate exemptions like Egypt – 3000 Exemptions.
To conclude, Central Board of Revenue needs to reflect on the likely deterrent effect of the ever increasing complexity of Income Tax Ordinance, 2001 and the resulting probable reduction their international competitiveness. Ultimately, when tax legislation becomes too voluminous, compliance drops more through ignorance then deliberate evasion.
SIMPLER TAX REGIME with CONSOLIDATED TAXES
Number
Corporate Income Tax Payments 5
Labor Tax Payments 25
Other Tax Payments 17
---------------
Total Tax Payments 47
---------------
Hours
Compliance Time – Corporate Income Tax 40
Compliance Time – Labor Tax 40
Compliance Time – Consumption Tax 480
---------------
Total Compliance Time 560
---------------
Corporate Income Tax – Average 27.00%
Statutory Corporate Income Tax 37.00%
Labor Taxes - Average 14.6%
Other Taxes 1.80%
---------------
Total Tax Rate 43.40%
---------------
Consolidating taxes is also a worthwhile reform
For instance, Pakistan have more than one labor tax, yet such taxes are typically based on gross salaries, why not unify them? Tax offices can then distribute the revenues among government agencies – Slovakia just did that.
A practical problem arose in many countries where social security agencies would be reluctant to part with their powers – especially if there is a chance that tax offices won’t give them their share of revenue. To gain their trust, an automatic separation of revenue can be introduced so that there is no room for discretion through codes on tax payment receipt. Moreover, stamp duty needs to be collected by Central Board of Revenue along with CVT on tax payment receipt.
Recent Reformers – Cut in number of Taxes
Georgia [2004] Number of taxes from 21 to 9
Russia [2001] Number of taxes from 20 to 15
Iran [Recently] Number of taxes from 3 to 1
[Source: Georgia Business Council Interview and FIAS (2004)]
Reforms should also target minor taxes like stamp duties – which cost money to administer but do not raise much revenue – or particularly distorting taxes. Small businesses have a particularly hard time dealing with multiple tax payments. Why not help them by making their interactions with the tax agency simpler? Central Board of Revenue Chief should work with federal and provincial ministries in this regard.
WHT AGENT RISK
Withholding Tax agents’ costs have three folds – taxes borne, taxes collected/deducted and tax administration. The question arises whether Withholding Tax agents are properly focused on managing these significant tax costs. Bear in mind that risks in the tax arena generally come in many guises and Withholding Tax risks are no different.
Operational Risk The possibility of processing errors, which because of volume involved could lead to significant additional costs in the shape of additional tax.
Compliance Risk The possibility of late submission with consequent penalties
Reputation Risk Making errors in the employment tax arena is unlikely to lead to adverse external publicity but it could impact on staff relations
Some might argue that these risks have always been present. However, it is apparent that tax authorities see the Withholding Tax compliance arena as a fruitful area for their efforts. It is suggested that companies and governments alike need to consider them and make sure that they factor them properly into planning. The important issue is transparency through WHT Audit and that they are properly reported.
Honorable Chairman with due respect, I totally disagree regarding recent mechanism of filing of Withholding Tax forms. Being an accountant you will agree over the fact that accountants are normally busy in management reporting during the first 10 days of the month and this include monthly closing apart from preparation of monthly profit and loss account.
It is suggested that the filing date of 15th of every month needs to be extended to 25th of every month, quarterly statements needs to be submitted after one month and annual statement after three months instead of current two months. However, these statements need to be submitted branch wise without any need of consolidation along with Cash/bank ledger of every branch and summary of adjustments of payments involving deduction of tax. This will also put the tax department on their toes and also give an ease.
Concept of adjustment needs to be specifically incorporated into Withholding Tax sections of Income Tax Ordinance, 2001 however; this needs to be reflected in Foreign Exchange Manual of Pakistan. Any amendment in this regard needs to be made after close consultation with State Bank of Pakistan. This will also provide an ease to the local and multinational businesses; however, transaction involving foreign exchange needs to be reported to Central Board of Revenue and SBP.
RECONCILING PRINCIPLES - FINANCIAL ACCOUNTING AND TAX ACCOUNTING
The IASB is developing a financial reporting matrix whereby the various components of a company’s result are split broadly into two categories – Operating income which comprises cash or near-cash items and valuation adjustments, leading to a total performance column described as comprehensive income. This future format of profit and loss account needs to be incorporated into section 34 of the Income Tax Ordinance, 2001.
I believe that items falling into operating income should form a reasonable basis for tax reporting and assessment. Items included as valuation adjustments need to be considered in more detail. They may include items such as provisions for doubtful debts and obsolete stock etc, they may form a normal part of taxable income according to the provisions of Income Tax Ordinance, 2001 and various precedence.
However, valuation adjustments are of more subjective and volatile nature and do not therefore posses the features which have traditionally been seen necessary of costs having been incurred or income having been realized, or certainty as to amount to be appropriate to utilized for tax purposes.
There needs to be a detailed review of the items falling into the valuation adjustment category and principles must be developed in the common rules chapter of Income Tax Ordinance, 2001 in dealing with these items and any other items that may arise in future.
The main principles should revolve around the distinction between assets readily convertible into cash where adjustments would be taxed or allowed and other assets which would be dealt with on a realization basis for tax purposes. Moreover, plethora of precedence relating of principles of capital and revenue expenditure/income and realized and unrealized income needs to be immediately considered in the common rules chapter of Income Tax Ordinance, 2001.
It is a detailed topic and I was working for almost three months on this. This cannot be covered in this small passage of time and you may see my detailed article on this in near future.
COHERENT STRATEGY OF ACCOUNTING AND RECORD KEEPING
Section 32 to 36 of Income Tax Ordinance, 2001 and Chapter VII – Records and Book-keeping must be aligned with organizational hierarchy of tax department and needs to be aligned with indirect tax laws. A suggestive structure is as follows.
SUGGESTED STRUCTURE
Category Tax Policy Record Type Legal Organizational Structure
Large Tax according to normal accounting practice IAS/IFRS
Fourth Schedule of Companies' Ordinance, 1984 Incorporated/ Unincorporated
SME Medium Tax according to normal accounting practice Fourth Schedule of Companies' Ordinance, 1984 Incorporated/ Unincorporated
SME Micro Tax according to normal accounting practice
OR
Final Tax Regime Fourth Schedule of Companies' Ordinance, 1984
Record Keeping
Postulates prescribed in Income Tax Rules, 2002 - Chapter VII Incorporated/ Unincorporated
SME Small Final Tax Regime Suggestive record format to be prescribed in schedule of Income Tax Rules, 2002 Unincorporated
Following is a suggestive structure which may be used in conjunction with existing threshold for LTU, MTU and RTO.
Category Sub-category Quantitative Criterion Monetary limit of Quantitative Criterion
Large 1. listed companies Nil Nil
2. Susidiary of a listed company
3. PE or Non-Resident Company
4. Monetary criterion of LTU Turnover
Staff
Capital
SME Medium 1. Non-Listed Nil Nil
2. Private Limted Company Nil Nil
3. Manufacturing Turnover
Staff
Capital 2 Billion
500
500 million
4. Trading Turnover
Staff
Capital 900 Million
200
200 million
5. Service Turnover
Staff
Capital 500 Million
200
200 million
SME Micro 1. Single Member Private Limited Company Nil Nil
2. Manufacturing Turnover
Staff
Capital 500 Million
250
50 Million
3. Trading Turnover
Staff
Capital 90 Million
100
10 million
4. Services Turnover
Staff
Capital 50 Million
50
10 million
SME Small 1. Manufacturing Turnover
Staff
Capital 50 Million
50
5 million
2. Trading Turnover
Staff
Capital 10 Million
10
1 million
3. Services Turnover
Staff
Capital 50 Million
50
0.5 million
ACCOUNTING QUALIFICATIONS
Honorable chairman, ACCA syllabus is the benchmark for the whole world according to the United Nations and Pakistan’s student have the option to choose Pakistan’s tax and corporate as part of their studies for appearance in exam. A level playing field with a conducive environment needs to be provided.
This will also help Central Board of Revenue in interacting with various accounting bodies like ACCA, ICAP and ICMAP which will enable to them to draw the conclusion on the basis of pool of opinions bodies of public accountants. Moreover, this will also bring healthier competition which will end up on Quality improvement.
AUDIT
A section is not enough and a chapter needs to be devoted for Audit. Moreover, the existing audit section needs to be rephrased under one chapter which may include audit management, taxpayers’ obligation, authorized representative obligation, modus operandi of audit, modus operandi of audit decision, postulates of an audit order and time frame to conduct & complete the audit.
STANDARDIZATION OF ORDERS
Current practice is that good orders are awarded; however, this exercise is not cashed yet by finalizing a standard format of order. There seems to be a dire need to finalize a standard format of orders for assessment, amendment in orders, revision, appeal effect and audit.
Moreover, a standard format of order is also required for CIT Appeals and ITAT, however, when I use the word standard this means that basic principle based postulates needs to be prescribed, for instance for appellate forums transaction nature, sections applied, sections not considered, beneficial circulars, accounting and tax principles applicable, department’s argument, taxpayer’s argument, precedence available, reasons of not considering any of the afore mentioned point, argument or precedence and finally the decision itself. A good speaking order normally reflects this but we must strive to make all order speaking!
Moreover, I would request honorable Chairman to please specify a time limit for appeal effect orders.
TRANSFER PRICING
Internationally, the horizon is much bigger than pharmaceuticals and time has come to bring certainty in businesses. I would suggest that Chapter VI – Transfer Pricing needs to include what State Administration of Taxation of China has done in line with OECD guidelines. They have included a principle set of documentation and includes
Business and Industry Analysis, that is, description of the industry in which the company operates
Functional Analysis, that is, description of the functions carried out, the assets used and the risks borne by the company in question
Identification and quantification of the related party transactions
Selection of the most appropriate transfer pricing methodology to analyze arm’s length nature of the related party transactions and
Application of the most appropriate methodology, with conclusions on arm’s length nature of the pricing of the related party transaction
This documentation should be prepared before the tax return for the year in question is submitted but there will no requirement to submit the report to the Income Tax at the time of return just a box ticking, however, no time will be given when the report is required to be submitted through a special notice.
However, I would like to go beyond this and would like to suggest about the Advance Pricing Arrangements [APA], although my detailed article was published on this three years back, suggested in OECD Transfer Pricing Guidelines.
APA is an arrangement that determines, in advance of controlled transactions, an appropriate set of criteria for the determination of the transfer pricing for those transactions over a fixed period of time.
An APA is formally initiated by a taxpayer and requires negotiations between taxpayer, one or more associated enterprises and one or more tax administrations, hence, can be unilateral, bilateral and multilateral.
TAKAFUL INSURANCE AND REINSURANCE
My detailed articles has been published in local and international press on this topic, however, I would like the honorable Chairman to consider introduction of a new schedule for re-insurance and provide special exemption or deductions to the payers. This will not only help in development of a new industry but will also save outflow of foreign exchange.
SHARIAH COMPLIANT FINANCIAL PRODUCTS
It is high time that a framework needs to be incorporated in Income Tax Ordinance, 2001 whereby Shariah compliant products are taxed in a way that is neither more nor less advantageous than equivalent banking products. The intended effect must be to allow providers to offer Shariah compliant products without facing commercial disadvantage, and to enable customers to take up these products without encountering uncertainty or disadvantage over tax treatment.
Murabaha
The most common problem of Shariah compliant financial products is the involvement of series of transaction which falls within the ambit of minimum tax, capital gain and fair market value related provision which is not the case under conventional financial products.
Section 113 needs to be amended to exclude the sale transaction of a Shariah compliant financial product from the definition of turnover. Moreover, section 153 also needs to be suitably amended to exclude deduction of tax from the installments by the customer instead of exemption certificate approach.
In furtherance, section 37, 68, 75, 77 and 78 needs to be amended in such a manner that transaction, involving capital gain, entered into by a Shariah compliant financial product provider should not be taxed under any provision of Income Tax Ordinance, 2001 in the hands of Shariah Compliant financial product provider.
Ijara, Ijara wa Iqtina and Diminishing Musharaka
Section 18 needs to be suitably amended to incorporate the concept of Ijara and Ijara wa Iqtina. In the absence of a suitable amendment, the Ijara wa Iqtina relating to a house will fall under section 15 and would put the Shariah compliant product provider at a disadvantage over the conventional bank. The core basis of such amendment is based on the fact that it involves payment of rent and principal with rent.
Wakala – Agency
It is suggested that such an income needs to be considered in line with section 151 in the hands of the customer.
Donation out of Penalty
A heavy non-performing portfolio and default on part of clients is a serious problem confronted by the Shariah compliant financial product provider. This problem could be threat to success of Shariah compliant financial product service provider. If clients do not honor their commitment in respect of timely payment in respect of a Shariah compliant financial product, it could cause irreparable loss to the system.
In Islam, it is permissible to penalize a financially debtor but delays payment of debt without any genuine reason. Last Prophet (PBUH) said, “A rich debtor who delays payment of debt commits zulm”. Hence, the jurists allow the punishment (Taazir) to such borrower in the form of fine. In the opinion of some Maliki jurists, a delaying borrower would be obliged to pay for charitable activities.
In view of the severity of the problem, all Shariah bodies including Shariah bench of the Supreme Court of Pakistan have approved the provision of penalty clause in the contractual agreements that keeps a balance between the requirement in view of severity of the problem and that of the Shariah conditions/principles to keep the fine difference between interest and profit on Shariah compliant financial product intact.
However, the penalty proceeds would be used for charity because penalty on default in repayment cannot become an automatic source of income for the creditor. Hence, it is imperative that a new sub-section needs to be introduced in section 20, whereby all such penalties are donated and amounts are reflected in the tax returns of such not for profit making organizations having NTN.
GROUP RELIEF
I would like the honorable chairman to also consider following question.
LOCAL CONSOLIDATION
How will the territorial boundary of a multinational group be defined
Will the controlled foreign companies be included in a group
The term group is not defined in Companies' Ordinance, 1984, hence, will any new framework will have its own definition
Should groups be given the option to be taxed on the basis of group consolidated account or should the consolidated basis be mandatory – and what about groups which are not required to produce consolidated accounts under Companies' Ordinance, 1984
How will associated companies and minority interests be dealt with
How will losses be dealt with
Will the elimination, on consolidation, of profits on intra group sales of trading stocks and other intra group trading transactions be followed for tax purposes
How will consolidation adjustments be dealt with
To the extent that group member companies outside the national territory are included, how will the limitation on national taxing right afforded under bilateral tax treaties be identified
INTERNATIONAL CONSOLIDATION
It will be necessary to harmonize the basis of computation of similar profit and gains, especially trading profit
It will be necessary to harmonize the basis of taxation of intra-group dividends
It will be necessary to determine some method of apportioning consolidated profits and losses between countries having DTT and dealing with effects of cross-border set-off of losses against profits
TAX RETURNS
It is requested that the tax return dates should be extended from September 30 to October 31 and from December 31 to January 31 as this will provide an ease to the taxpayers. However, this needs to be coupled with obligation over Withholding Tax agents to send Withholding Tax deduction certificate and tax payment receipts to the person from whom tax was collected or deducted till September 30 or December 31. This may also be coupled with rigorous penalties.
It is also suggested that persons, from whom Withholding Tax was deducted or collected, needs to file tax returns, however, the literacy rate may become an impediment in this.
TAX REFUND, ADJUSTMENT AND VERIFICATION
Central Board of Revenue’s recent refund adjustment circular is highly applauded, however, the point is to verify the refund. Refund was verified at the time of assessment and then again at the time of refund. The problem is coupled when the tax payment receipt are from all over Pakistan. This needs to be resolved.
ROOT CAUSES OF TAX EVASION - PERCEPTION
Firstly, this Income Tax was introduced in 1860 after the Ghadar or Battle of Freedom for five years and then there was a three years gap in order to subsidize the loss of this battle. It was again imposed in 1868 till 1873 and then again imposed in 1886 for around 30 years. Then in 1918 a new enactment was enacted which was renamed as 1922 after some amendments which was then changed into Income Tax Ordinance, 1979 and currently available in the shape Income Tax Ordinance, 2001.
However, in Pakistan there were and are many perceptions regarding the applicability of Income Tax being Un-Islamic as people believe that zakat, khiraj, fai and Jazia are the only prescribed taxes. However, taxes are not limited to that but one may wonder import tax – chungi was first imposed during the period of first four Caliphs as this is a need of the society.
However, still the wrong perception about tax has not been corrected, although corrective measure has been taken by reducing tax rate, etc, still owing to the following reasons they remain intact.
Name based exemptions instead of industry or principle based exemptions
Social welfare schemes are not normally undertaken owing to non-availability of principle based exemptions for donations and deduction for the taxpayer
In Islam there is a concept of donation, left hand should not know when the right hand donates and one must help their poor relative, however, no such concept is recognized in Income Tax Ordinance, 2001
Zakat is a deductible allowance but it is not allowed to be deducted from tax payable – this strengthens the concept that Income Tax is Un-Islamic.
A person earning 200K required to feed a family of three member while another person earning the same income are required to feed not only his family but parents and small sister and brother – Both are taxed in the same way!
Concept of one’s deduction and other’s income is absent - as this may bring new taxpayers on verification.
POINT FOR CONSIDERATION
Central Board of Revenue
Consider tax reform which takes into account all taxes borne and collected by businesses as well as the cost of tax compliance – Total Tax Contribution
Increase governments accountability and communicate with taxpayers as to how taxes are spent
Consider clear tax education campaigns to explain the taxes, how to pay them and the benefits to all stakeholders
Consider how simplification of tax legislation, the ease of compliance burden, and the consolidation of taxes might generate benefits for both governments and taxpayers.
Consider consultation with taxpayers when developing ideas for tax changes
Taxpayers
Gather information on the total tax contribution including all taxes borne and collected, as well as the cost of tax compliance.
Ensure that information around the total tax contribution is made accessible to governments and tax authorities to help inform their decisions over reform.
Communicate the total tax contribution to the wider stakeholder groups to demonstrate the extent to which they are supporting public finances through taxes.
Engage in regular dialogue with Central Board of Revenue over the need for reform and specific areas of concern.
I personally appreciate the efforts of CBR who is trying to provide developed countries facilities in a developing country, however, they are in a room full of age old garbage with a vision of clean room. Central Board of Revenue is moving right direction but when things move in right direction than expectation grows! As stated earlier, taxpayer’s need to know how their taxes are spent and I would like to end up on small part of history.
“At times, Syria (Sham) was attacked by Tatars, the King decided to take judicial decree from the Islamic Scholars for imposing a tax to meet the expenses. When the issue came before Imam Noovi [Rahmat ullah Alah], he opined
The King lives a lavish life and has a lot of wealth, he also spends a lot of money but his wealth, income and perquisites are not taxable, let him start first by donating his wealth and then the treasury has the right to tax over the common people.”
[The writer is an International Tax Advisor and this paper was read at ACCA’s pre-budget seminar held in Islamabad]
Article courtesy of Muhammad Ashraf
Minimization of compliance costs not only for businesses but also for the collectors and maximization of revenue for Pakistan seems to be the core issue of this seminar. When I use the word direct taxation, I would mean to include income tax (Federal and Provincial) and Capital Value Tax broadly speaking and in one sense can be effectively categorized as direct taxes.
TAXES – a source of Public Finance
Taxes are essential to finance public services but there are good and bad ways to collect them. The design of the tax system can have significant economic impacts and can influence residents of a country and multinationals in deciding where to invest.
Tax collection has long been a despised activity. But taxes are essential. Without them there would be no money to build schools, hospitals, courts, roads, airports or other public infrastructure that helps business and society to be more productive and better off.
TAX REGIMES
There are two types of tax regimes – complex and simple as there is no third type.
Complex tax regimes
Tax regimes with relatively high marginal rates and which include a number of exemptions and allowances tend to be less economically efficient in relation to encouraging employment, saving and investment. Such regimes generally also impose higher tax compliance and administration cost which is evident from Income Tax Ordinance, 2001.
We have experienced Acts of 1918 and 1922 which have lead the basis of creation of Income Tax Ordinance, 1979, however, Income Tax Ordinance, 2001 was created to make the things simple. We know from our experiences about acts and ordinances, burdensome tax systems served as a deterrent and normally lead to tax evasion. According to a World Bank survey, Companies in 90% of surveyed countries [175 Countries including Pakistan] rank tax administration among the top five obstacles to doing business. The main factors contributing to this are
The large number of business taxes to pay
Lengthy and complex tax administration
Complex tax legislation
High tax rates
Simple tax regimes
Evidence suggest that simpler tax systems promote economic growth and can help achieve a win:win for government and industry. To help with paying taxes and implementing reforms, government and CBR need to consider all aspects of tax system. All taxes borne and collected by businesses should be recognized along with the related tax compliance costs not just federal taxes.
IMPACT OF TAX RATE OVER COMPLIANCE
In the ongoing reforms, tax administration and compliance, being significant obstacle to businesses, needs to be considered as part of the decision on reform. One should not loose its sight over the fact that government imposes taxes to finance public services but taxes must first be collected and high tax rates do not always lead to high tax revenues. However, the larger the share of informal business activity before reform, the higher the revenue growth after and is evident in Pakistan.
On average, Middle Eastern and East Asian countries make paying taxes the easiest. OECD countries impose the smallest administrative burdens and charge moderate tax bills. According to a World Bank study, between 1982 and 1999, the average corporate income tax rate worldwide fell from 46% to 33% while corporate income tax collection rose from 2.1% to 2.4% of national income [Hines (2005)].
This outcome was achieved because more businesses entered the formal economy and because tax exemptions and other tax incentives were reduced or eliminated.
Developed countries tend to have lower business taxes and less complex tax administration processes. Simple moderate taxes and fast, cheap administration mean less hassle for businesses – as well as higher revenues.
In contrast, Developing countries tend to use business as a collection point, charging higher business taxes. Latin American and South Asian countries impose the heaviest burdens, mainly because of high compliance costs. Africa follows, largely because of high taxes.
As stated earlier, Developing countries try to levy the highest amount of tax on businesses on the premise that these high taxes are needed to fund public services and correct fiscal deficits. However, the evidence suggest otherwise. Higher rates typically do not lead to higher revenues in developing countries. Instead they push businesses into the informal economy. As a result the tax base shrinks and less revenue is collected.
Lower rates work best when their administration is simple. Growing evidence shows that tax reforms creates more vibrant businesses and is evident in Pakistan. A smaller tax burden encourages firms to invest. However, they are undermined by exemptions that shrink tax base. I would like to share an adverse experience, tax revenues has fallen in Uzbekistan, where the enthusiasm for income tax cuts was not matched by efforts to improve tax administration and expand the tax base and that where CBR is trying to move through recent conference which requires more than a simple applaud.
Recent Reformers – Tax Rate Cut and Higher Revenue Target
Ghana Exceeded its mid-year revenue targets despite significant cuts in corporate tax rates in the last two years
Albania Corporate tax revenue rose 21% after the rate was cut
Moldova Corporate tax revenue rose 28% after the rate was cut
Latvia Corporate tax revenue rose 37% after the rate was cut
Romania Corporate tax revenue rose 8% in real terms after cut in tax rate in 2004
Economic growth in these countries is a factor in the increased revenue but compliance is also up [Source: World Bank (2006)]. Overall growth is also higher with lower taxes and better collection [Lee and Gordon (2004)].
Overall growth is also higher with lower taxes and better collection. And with tax incentives aligned to encourage work, more firms and more jobs are created. One study shows a cut of one percentage point in corporate tax rate is associated with up to a 3.7% increase in the number of firms and up to 1.1% higher employment [Goolsbee (2002)]. Tax reforms inspire political debate and can be hotly contested. But both businesses and government benefit when taxes are simple and fair and set incentives for growth.
TRANSPARENCY and CORRUPTION
Transparency is the key – Governments need to be accountable for how taxes are spent. Businesses will potentially be more willing to pay taxes if they can see the benefits of improved public services and infrastructure.
Businesses are more willing to pay taxes if they see that the money is used to improve public services. Yet many developing countries with high tax rates fail to improved business infrastructure or education and training – two things that employers care about.
Across countries, higher taxes payable are not associated with better social outcomes, even allowing for country income levels. They do not increase government spending on health and education, raise literacy or life expectancy or lower child mortality, nor are they associated with better infrastructure and other public services.
Burdensome taxes do however generate other undesirable outcomes. They are associated with more informality, as entrepreneurs often choose to avoid the formal system altogether and operate underground. They also breed corruption as every point of contact between a bureaucrat and an entrepreneur could present a dander of bribery and confusion on voluminous, often contradictory rules which may create room for discretion.
Simplifying the tax regime by reducing tax rates and eliminating exemptions is the main way to reduce corruption in tax administration. According to a World Bank survey, Georgia introduced major reductions in tax rates and simplifications to the tax system in 2004 – has seen a drastic fall in perceived corruption of tax officials. Georgia showed the sharpest drop in perceived corruption among 27 transition economies.
Recent Reformers – Tax Rate Cut and Corruption
Georgia Previous level 44% Current level 11%
Romania Previous level 14% Current level 8%
Slovakia Previous level 11% Current level 5%
[Source: World Bank (2006)]
All the above referred factors, tax rate cut and corruption, tax rate cut and transparency, tax rate cut and increased compliance etc present a good case for reduction in corporate tax rate while applicability of individual’s tax rate over small companies.
TAX COMPLIANCE COST
Businesses need to understand and communicate their total tax contribution, so that they are more able to manage and control it and demonstrate the full extent of the contribution made to public finances. I would suggest using indirect tax expense and taxing compliance cost as a separate head of expense in profit and loss account instead of rent, rate and taxes.
A better way to meet revenue targets is to encourage tax compliance by keeping rates moderate. Russia’s large tax cuts in 2001 did exactly that. Corporate tax rates fell from 35% to 24% and a simplified tax scheme lowered rates for small business. Yet tax revenue increases – by an annual average of 14% over the next three years. One study showed that the new revenue was due to increased compliance [Ivanova, Keen and Klemm (2005)].
It is not just businesses that gain from reforms. Streamlining taxes also brings savings for government. A Complicated tax system costs a lot of money to run – funds that could be better spent on education, health care and infrastructure. In Denmark, one Kroner spent on tax administration generates 113 Kroner of tax revenue. In Hungary, one forint produces only 77 and in Mexico one peso produces only 33. Such data is missing from performance measurement and must include the loans and grants received.
COMPLEXITY AND ITO, 2001
A particularly worrying consequent is that with sheer volume of tax legislation no one individual can possibly read all of it. So the days of a tax director being confident of spanning all the relevant parts of the tax code seem to have all but disappeared. Embodying all previous SRO’s of section 50 of Income Tax Ordinance, 1979 by virtue of section 239 (10) did the rest.
Similarly, at least as regards advising large to medium size corporate, the ability of a single tax advisor to span all the relevant tax legislation is circumscribed, hence, increased the relevance of specialists and sub-specialists.
This leads to an at least two tier market – those who can afford the necessary advice, and those for whom such advice may be of only marginal benefit on a cost/benefit analysis. It is also leading to a situation where the primary tax legislation is being read by fewer and fewer people.
The boldest reform is to simplify tax law so that every business faces the same tax burden – with no exemptions, tax holidays or special treatment for large or foreign businesses. Income Tax Ordinance, 2001 has also started in that way! But when hard times come and government needs revenue, tax rates are if not rates are freeze at current level.
This is unpopular, and large or well connected businesses usually obtain special treatment. Soon the tax law becomes riddled with exceptions, generally at the expense of small businesses, which have the least ability to lobby. Often they are pushed into the informal sector. Few reformers dare eliminate exemptions like Egypt – 3000 Exemptions.
To conclude, Central Board of Revenue needs to reflect on the likely deterrent effect of the ever increasing complexity of Income Tax Ordinance, 2001 and the resulting probable reduction their international competitiveness. Ultimately, when tax legislation becomes too voluminous, compliance drops more through ignorance then deliberate evasion.
SIMPLER TAX REGIME with CONSOLIDATED TAXES
Number
Corporate Income Tax Payments 5
Labor Tax Payments 25
Other Tax Payments 17
---------------
Total Tax Payments 47
---------------
Hours
Compliance Time – Corporate Income Tax 40
Compliance Time – Labor Tax 40
Compliance Time – Consumption Tax 480
---------------
Total Compliance Time 560
---------------
Corporate Income Tax – Average 27.00%
Statutory Corporate Income Tax 37.00%
Labor Taxes - Average 14.6%
Other Taxes 1.80%
---------------
Total Tax Rate 43.40%
---------------
Consolidating taxes is also a worthwhile reform
For instance, Pakistan have more than one labor tax, yet such taxes are typically based on gross salaries, why not unify them? Tax offices can then distribute the revenues among government agencies – Slovakia just did that.
A practical problem arose in many countries where social security agencies would be reluctant to part with their powers – especially if there is a chance that tax offices won’t give them their share of revenue. To gain their trust, an automatic separation of revenue can be introduced so that there is no room for discretion through codes on tax payment receipt. Moreover, stamp duty needs to be collected by Central Board of Revenue along with CVT on tax payment receipt.
Recent Reformers – Cut in number of Taxes
Georgia [2004] Number of taxes from 21 to 9
Russia [2001] Number of taxes from 20 to 15
Iran [Recently] Number of taxes from 3 to 1
[Source: Georgia Business Council Interview and FIAS (2004)]
Reforms should also target minor taxes like stamp duties – which cost money to administer but do not raise much revenue – or particularly distorting taxes. Small businesses have a particularly hard time dealing with multiple tax payments. Why not help them by making their interactions with the tax agency simpler? Central Board of Revenue Chief should work with federal and provincial ministries in this regard.
WHT AGENT RISK
Withholding Tax agents’ costs have three folds – taxes borne, taxes collected/deducted and tax administration. The question arises whether Withholding Tax agents are properly focused on managing these significant tax costs. Bear in mind that risks in the tax arena generally come in many guises and Withholding Tax risks are no different.
Operational Risk The possibility of processing errors, which because of volume involved could lead to significant additional costs in the shape of additional tax.
Compliance Risk The possibility of late submission with consequent penalties
Reputation Risk Making errors in the employment tax arena is unlikely to lead to adverse external publicity but it could impact on staff relations
Some might argue that these risks have always been present. However, it is apparent that tax authorities see the Withholding Tax compliance arena as a fruitful area for their efforts. It is suggested that companies and governments alike need to consider them and make sure that they factor them properly into planning. The important issue is transparency through WHT Audit and that they are properly reported.
Honorable Chairman with due respect, I totally disagree regarding recent mechanism of filing of Withholding Tax forms. Being an accountant you will agree over the fact that accountants are normally busy in management reporting during the first 10 days of the month and this include monthly closing apart from preparation of monthly profit and loss account.
It is suggested that the filing date of 15th of every month needs to be extended to 25th of every month, quarterly statements needs to be submitted after one month and annual statement after three months instead of current two months. However, these statements need to be submitted branch wise without any need of consolidation along with Cash/bank ledger of every branch and summary of adjustments of payments involving deduction of tax. This will also put the tax department on their toes and also give an ease.
Concept of adjustment needs to be specifically incorporated into Withholding Tax sections of Income Tax Ordinance, 2001 however; this needs to be reflected in Foreign Exchange Manual of Pakistan. Any amendment in this regard needs to be made after close consultation with State Bank of Pakistan. This will also provide an ease to the local and multinational businesses; however, transaction involving foreign exchange needs to be reported to Central Board of Revenue and SBP.
RECONCILING PRINCIPLES - FINANCIAL ACCOUNTING AND TAX ACCOUNTING
The IASB is developing a financial reporting matrix whereby the various components of a company’s result are split broadly into two categories – Operating income which comprises cash or near-cash items and valuation adjustments, leading to a total performance column described as comprehensive income. This future format of profit and loss account needs to be incorporated into section 34 of the Income Tax Ordinance, 2001.
I believe that items falling into operating income should form a reasonable basis for tax reporting and assessment. Items included as valuation adjustments need to be considered in more detail. They may include items such as provisions for doubtful debts and obsolete stock etc, they may form a normal part of taxable income according to the provisions of Income Tax Ordinance, 2001 and various precedence.
However, valuation adjustments are of more subjective and volatile nature and do not therefore posses the features which have traditionally been seen necessary of costs having been incurred or income having been realized, or certainty as to amount to be appropriate to utilized for tax purposes.
There needs to be a detailed review of the items falling into the valuation adjustment category and principles must be developed in the common rules chapter of Income Tax Ordinance, 2001 in dealing with these items and any other items that may arise in future.
The main principles should revolve around the distinction between assets readily convertible into cash where adjustments would be taxed or allowed and other assets which would be dealt with on a realization basis for tax purposes. Moreover, plethora of precedence relating of principles of capital and revenue expenditure/income and realized and unrealized income needs to be immediately considered in the common rules chapter of Income Tax Ordinance, 2001.
It is a detailed topic and I was working for almost three months on this. This cannot be covered in this small passage of time and you may see my detailed article on this in near future.
COHERENT STRATEGY OF ACCOUNTING AND RECORD KEEPING
Section 32 to 36 of Income Tax Ordinance, 2001 and Chapter VII – Records and Book-keeping must be aligned with organizational hierarchy of tax department and needs to be aligned with indirect tax laws. A suggestive structure is as follows.
SUGGESTED STRUCTURE
Category Tax Policy Record Type Legal Organizational Structure
Large Tax according to normal accounting practice IAS/IFRS
Fourth Schedule of Companies' Ordinance, 1984 Incorporated/ Unincorporated
SME Medium Tax according to normal accounting practice Fourth Schedule of Companies' Ordinance, 1984 Incorporated/ Unincorporated
SME Micro Tax according to normal accounting practice
OR
Final Tax Regime Fourth Schedule of Companies' Ordinance, 1984
Record Keeping
Postulates prescribed in Income Tax Rules, 2002 - Chapter VII Incorporated/ Unincorporated
SME Small Final Tax Regime Suggestive record format to be prescribed in schedule of Income Tax Rules, 2002 Unincorporated
Following is a suggestive structure which may be used in conjunction with existing threshold for LTU, MTU and RTO.
Category Sub-category Quantitative Criterion Monetary limit of Quantitative Criterion
Large 1. listed companies Nil Nil
2. Susidiary of a listed company
3. PE or Non-Resident Company
4. Monetary criterion of LTU Turnover
Staff
Capital
SME Medium 1. Non-Listed Nil Nil
2. Private Limted Company Nil Nil
3. Manufacturing Turnover
Staff
Capital 2 Billion
500
500 million
4. Trading Turnover
Staff
Capital 900 Million
200
200 million
5. Service Turnover
Staff
Capital 500 Million
200
200 million
SME Micro 1. Single Member Private Limited Company Nil Nil
2. Manufacturing Turnover
Staff
Capital 500 Million
250
50 Million
3. Trading Turnover
Staff
Capital 90 Million
100
10 million
4. Services Turnover
Staff
Capital 50 Million
50
10 million
SME Small 1. Manufacturing Turnover
Staff
Capital 50 Million
50
5 million
2. Trading Turnover
Staff
Capital 10 Million
10
1 million
3. Services Turnover
Staff
Capital 50 Million
50
0.5 million
ACCOUNTING QUALIFICATIONS
Honorable chairman, ACCA syllabus is the benchmark for the whole world according to the United Nations and Pakistan’s student have the option to choose Pakistan’s tax and corporate as part of their studies for appearance in exam. A level playing field with a conducive environment needs to be provided.
This will also help Central Board of Revenue in interacting with various accounting bodies like ACCA, ICAP and ICMAP which will enable to them to draw the conclusion on the basis of pool of opinions bodies of public accountants. Moreover, this will also bring healthier competition which will end up on Quality improvement.
AUDIT
A section is not enough and a chapter needs to be devoted for Audit. Moreover, the existing audit section needs to be rephrased under one chapter which may include audit management, taxpayers’ obligation, authorized representative obligation, modus operandi of audit, modus operandi of audit decision, postulates of an audit order and time frame to conduct & complete the audit.
STANDARDIZATION OF ORDERS
Current practice is that good orders are awarded; however, this exercise is not cashed yet by finalizing a standard format of order. There seems to be a dire need to finalize a standard format of orders for assessment, amendment in orders, revision, appeal effect and audit.
Moreover, a standard format of order is also required for CIT Appeals and ITAT, however, when I use the word standard this means that basic principle based postulates needs to be prescribed, for instance for appellate forums transaction nature, sections applied, sections not considered, beneficial circulars, accounting and tax principles applicable, department’s argument, taxpayer’s argument, precedence available, reasons of not considering any of the afore mentioned point, argument or precedence and finally the decision itself. A good speaking order normally reflects this but we must strive to make all order speaking!
Moreover, I would request honorable Chairman to please specify a time limit for appeal effect orders.
TRANSFER PRICING
Internationally, the horizon is much bigger than pharmaceuticals and time has come to bring certainty in businesses. I would suggest that Chapter VI – Transfer Pricing needs to include what State Administration of Taxation of China has done in line with OECD guidelines. They have included a principle set of documentation and includes
Business and Industry Analysis, that is, description of the industry in which the company operates
Functional Analysis, that is, description of the functions carried out, the assets used and the risks borne by the company in question
Identification and quantification of the related party transactions
Selection of the most appropriate transfer pricing methodology to analyze arm’s length nature of the related party transactions and
Application of the most appropriate methodology, with conclusions on arm’s length nature of the pricing of the related party transaction
This documentation should be prepared before the tax return for the year in question is submitted but there will no requirement to submit the report to the Income Tax at the time of return just a box ticking, however, no time will be given when the report is required to be submitted through a special notice.
However, I would like to go beyond this and would like to suggest about the Advance Pricing Arrangements [APA], although my detailed article was published on this three years back, suggested in OECD Transfer Pricing Guidelines.
APA is an arrangement that determines, in advance of controlled transactions, an appropriate set of criteria for the determination of the transfer pricing for those transactions over a fixed period of time.
An APA is formally initiated by a taxpayer and requires negotiations between taxpayer, one or more associated enterprises and one or more tax administrations, hence, can be unilateral, bilateral and multilateral.
TAKAFUL INSURANCE AND REINSURANCE
My detailed articles has been published in local and international press on this topic, however, I would like the honorable Chairman to consider introduction of a new schedule for re-insurance and provide special exemption or deductions to the payers. This will not only help in development of a new industry but will also save outflow of foreign exchange.
SHARIAH COMPLIANT FINANCIAL PRODUCTS
It is high time that a framework needs to be incorporated in Income Tax Ordinance, 2001 whereby Shariah compliant products are taxed in a way that is neither more nor less advantageous than equivalent banking products. The intended effect must be to allow providers to offer Shariah compliant products without facing commercial disadvantage, and to enable customers to take up these products without encountering uncertainty or disadvantage over tax treatment.
Murabaha
The most common problem of Shariah compliant financial products is the involvement of series of transaction which falls within the ambit of minimum tax, capital gain and fair market value related provision which is not the case under conventional financial products.
Section 113 needs to be amended to exclude the sale transaction of a Shariah compliant financial product from the definition of turnover. Moreover, section 153 also needs to be suitably amended to exclude deduction of tax from the installments by the customer instead of exemption certificate approach.
In furtherance, section 37, 68, 75, 77 and 78 needs to be amended in such a manner that transaction, involving capital gain, entered into by a Shariah compliant financial product provider should not be taxed under any provision of Income Tax Ordinance, 2001 in the hands of Shariah Compliant financial product provider.
Ijara, Ijara wa Iqtina and Diminishing Musharaka
Section 18 needs to be suitably amended to incorporate the concept of Ijara and Ijara wa Iqtina. In the absence of a suitable amendment, the Ijara wa Iqtina relating to a house will fall under section 15 and would put the Shariah compliant product provider at a disadvantage over the conventional bank. The core basis of such amendment is based on the fact that it involves payment of rent and principal with rent.
Wakala – Agency
It is suggested that such an income needs to be considered in line with section 151 in the hands of the customer.
Donation out of Penalty
A heavy non-performing portfolio and default on part of clients is a serious problem confronted by the Shariah compliant financial product provider. This problem could be threat to success of Shariah compliant financial product service provider. If clients do not honor their commitment in respect of timely payment in respect of a Shariah compliant financial product, it could cause irreparable loss to the system.
In Islam, it is permissible to penalize a financially debtor but delays payment of debt without any genuine reason. Last Prophet (PBUH) said, “A rich debtor who delays payment of debt commits zulm”. Hence, the jurists allow the punishment (Taazir) to such borrower in the form of fine. In the opinion of some Maliki jurists, a delaying borrower would be obliged to pay for charitable activities.
In view of the severity of the problem, all Shariah bodies including Shariah bench of the Supreme Court of Pakistan have approved the provision of penalty clause in the contractual agreements that keeps a balance between the requirement in view of severity of the problem and that of the Shariah conditions/principles to keep the fine difference between interest and profit on Shariah compliant financial product intact.
However, the penalty proceeds would be used for charity because penalty on default in repayment cannot become an automatic source of income for the creditor. Hence, it is imperative that a new sub-section needs to be introduced in section 20, whereby all such penalties are donated and amounts are reflected in the tax returns of such not for profit making organizations having NTN.
GROUP RELIEF
I would like the honorable chairman to also consider following question.
LOCAL CONSOLIDATION
How will the territorial boundary of a multinational group be defined
Will the controlled foreign companies be included in a group
The term group is not defined in Companies' Ordinance, 1984, hence, will any new framework will have its own definition
Should groups be given the option to be taxed on the basis of group consolidated account or should the consolidated basis be mandatory – and what about groups which are not required to produce consolidated accounts under Companies' Ordinance, 1984
How will associated companies and minority interests be dealt with
How will losses be dealt with
Will the elimination, on consolidation, of profits on intra group sales of trading stocks and other intra group trading transactions be followed for tax purposes
How will consolidation adjustments be dealt with
To the extent that group member companies outside the national territory are included, how will the limitation on national taxing right afforded under bilateral tax treaties be identified
INTERNATIONAL CONSOLIDATION
It will be necessary to harmonize the basis of computation of similar profit and gains, especially trading profit
It will be necessary to harmonize the basis of taxation of intra-group dividends
It will be necessary to determine some method of apportioning consolidated profits and losses between countries having DTT and dealing with effects of cross-border set-off of losses against profits
TAX RETURNS
It is requested that the tax return dates should be extended from September 30 to October 31 and from December 31 to January 31 as this will provide an ease to the taxpayers. However, this needs to be coupled with obligation over Withholding Tax agents to send Withholding Tax deduction certificate and tax payment receipts to the person from whom tax was collected or deducted till September 30 or December 31. This may also be coupled with rigorous penalties.
It is also suggested that persons, from whom Withholding Tax was deducted or collected, needs to file tax returns, however, the literacy rate may become an impediment in this.
TAX REFUND, ADJUSTMENT AND VERIFICATION
Central Board of Revenue’s recent refund adjustment circular is highly applauded, however, the point is to verify the refund. Refund was verified at the time of assessment and then again at the time of refund. The problem is coupled when the tax payment receipt are from all over Pakistan. This needs to be resolved.
ROOT CAUSES OF TAX EVASION - PERCEPTION
Firstly, this Income Tax was introduced in 1860 after the Ghadar or Battle of Freedom for five years and then there was a three years gap in order to subsidize the loss of this battle. It was again imposed in 1868 till 1873 and then again imposed in 1886 for around 30 years. Then in 1918 a new enactment was enacted which was renamed as 1922 after some amendments which was then changed into Income Tax Ordinance, 1979 and currently available in the shape Income Tax Ordinance, 2001.
However, in Pakistan there were and are many perceptions regarding the applicability of Income Tax being Un-Islamic as people believe that zakat, khiraj, fai and Jazia are the only prescribed taxes. However, taxes are not limited to that but one may wonder import tax – chungi was first imposed during the period of first four Caliphs as this is a need of the society.
However, still the wrong perception about tax has not been corrected, although corrective measure has been taken by reducing tax rate, etc, still owing to the following reasons they remain intact.
Name based exemptions instead of industry or principle based exemptions
Social welfare schemes are not normally undertaken owing to non-availability of principle based exemptions for donations and deduction for the taxpayer
In Islam there is a concept of donation, left hand should not know when the right hand donates and one must help their poor relative, however, no such concept is recognized in Income Tax Ordinance, 2001
Zakat is a deductible allowance but it is not allowed to be deducted from tax payable – this strengthens the concept that Income Tax is Un-Islamic.
A person earning 200K required to feed a family of three member while another person earning the same income are required to feed not only his family but parents and small sister and brother – Both are taxed in the same way!
Concept of one’s deduction and other’s income is absent - as this may bring new taxpayers on verification.
POINT FOR CONSIDERATION
Central Board of Revenue
Consider tax reform which takes into account all taxes borne and collected by businesses as well as the cost of tax compliance – Total Tax Contribution
Increase governments accountability and communicate with taxpayers as to how taxes are spent
Consider clear tax education campaigns to explain the taxes, how to pay them and the benefits to all stakeholders
Consider how simplification of tax legislation, the ease of compliance burden, and the consolidation of taxes might generate benefits for both governments and taxpayers.
Consider consultation with taxpayers when developing ideas for tax changes
Taxpayers
Gather information on the total tax contribution including all taxes borne and collected, as well as the cost of tax compliance.
Ensure that information around the total tax contribution is made accessible to governments and tax authorities to help inform their decisions over reform.
Communicate the total tax contribution to the wider stakeholder groups to demonstrate the extent to which they are supporting public finances through taxes.
Engage in regular dialogue with Central Board of Revenue over the need for reform and specific areas of concern.
I personally appreciate the efforts of CBR who is trying to provide developed countries facilities in a developing country, however, they are in a room full of age old garbage with a vision of clean room. Central Board of Revenue is moving right direction but when things move in right direction than expectation grows! As stated earlier, taxpayer’s need to know how their taxes are spent and I would like to end up on small part of history.
“At times, Syria (Sham) was attacked by Tatars, the King decided to take judicial decree from the Islamic Scholars for imposing a tax to meet the expenses. When the issue came before Imam Noovi [Rahmat ullah Alah], he opined
The King lives a lavish life and has a lot of wealth, he also spends a lot of money but his wealth, income and perquisites are not taxable, let him start first by donating his wealth and then the treasury has the right to tax over the common people.”
[The writer is an International Tax Advisor and this paper was read at ACCA’s pre-budget seminar held in Islamabad]
Article courtesy of Muhammad Ashraf
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