A Detailed Overview of Direct Tax Regime in Pakistan

Final Tax Regime

The roots of Final Tax Regime (the “FTR”) can essentially be traced to the lack of effectiveness in the collection of the net-income tax through the process of income tax filing. This friction in system was observed due to a complicated procedure of filing income tax and an absence of a tax paying culture in Pakistan. There was also an aversion in people towards entering into the tax records of the government so that there is no point of contact between the tax payer and the tax department. People avoided tax department because of the immense harassing of tax-payers for bribes. In 1980s, tax reforms were implemented which were not effective as the changes in tax policy were not accompanied with appropriate improvements in tax administration. As a result, the first indication to impose FTR was observed in 1980s with levying of FTR on the income of foreign shipping and air-transport enterprises. The rational of this imposition was to reduce the effects of depreciation allowances while computing income on a net- basis. Subsequently, the Committee on Tax Reforms in 1990 codified the rationales and effects of FTR. The Committee recommended a need to restructure the entire taxation system to generate revenue, to remove the complexity in procedures and to remove malfunction of tax administration in relation to assessment. The committee also felt the need to reduce the revenue loss by lessening tax exemptions and expanding the ambit of tax on some economic activities. In line with these recommendations, FTR was imposed on bank profits and interest, prizes, winnings from lottery, etc. FTR was also gradually extended to the technical services received by the non-residents. [1] Finance Minister of Pakistan in his budget speech of 1991-92 summarized the objects and background of FTR and called it as an “extension of the tax network to eliminate malpractices and generate more revenues by broadening the tax base.” In the 1990s, further tax reforms were initiated which imposed a final tax on residents and non-resident taxpayers on payments for supply of goods, execution of work contracts, imports and exports etc.[2]

Salient features of Final Tax Regime

In Pakistan, FTR is reflected in section 169 of the Income Tax Ordinance, 2001 (the “Ordinance”). The primary feature of FTR is that the payer of the income may deduct an amount from the income at source and submit it to the government. He shall pay the balance amount to the recipient of the income. The deduction of that amount shall function as the full and final discharge of all income tax liabilities in relation to that transaction. An example of the FTR is observed when a bank deducts tax from the proceeds of the exports before allowing the exporter to withdraw the proceeds from the bank. In this example, the bank is ‘deducting’ the tax at source. However in certain cases the tax is also ‘collected’ at source. An example of this could be a final tax on imports where the collector of customs shall load an incremental tax with custom duty. Similarly, advance tax operating as final tax shall also be collected through a withholding agent.  The most important feature of FTR is that it a transaction based taxation. It must be mentioned that the income subject to FTR is not chargeable to tax under any head of income while computing the taxable income and deduction related to any of its expenditures is also not allowed in relation to that transaction.[3] Moreover, no adjustment in the annual income tax or refund can be allowed on FTR. Thus, the FTR is essentially a system of taxation in which the inter alia value of imports, exports, execution of contracts and supply of goods could be presumed as the income of the taxpayer. This income is usually taxed at the prescribed rates. The FTR may also be in the form of a withholding tax or advance tax with no adjustment at a rate which may be lower than the progressive system of Normal Tax Regime (the “NTR”).[4] Moreover, the person paying the income tax on his own income knows his tax liability even before knowing the amount of his income in that tax year. As opposed to NTR, a person having all income subject to FTR is only required to furnish to the Commissioner a prescribed statement under section 115(4) of the Ordinance. There can be normally no audit or assessment of tax paid on such income under section 177 and section 122 of the Ordinance respectively. Various cases in the August Supreme Court of Pakistan also considered the main features of the Final Tax Regime. In Husnain Cotex Limited v Commissioner Inland Revenue (2017 P T D 1561), the court differentiated between the two types of taxpayer. One type of tax payer falls within the domain of NTR on which net profit in a tax year is determined by matching costs with the income. Many deducting factors are also considered in NTR while determining the total tax liability such as allowances, deductions, depreciations, rebates, amortization etc. The applicable rate of income tax is then applied to the net profit to determine the tax liability of the tax year. However, there are taxpayers who fell within the domain of FTR by virtue of sections 153(1) (c) and 153(3) read with section 169(b) of the Ordinance. The court noted that their income tax liability in a tax year is a certain percentage deducted from the payments subject to FTR which are made to them at a rate specified in the First Schedule to the Ordinance. Thus, the income tax deducted at source fully discharges the income tax liability irrespective of the fact that any profits or gains are made in relation to that transaction. In Elahi Cotton Mills Ltd and others v. Federation of Pakistan (PLD 1997 SC 582), the court further elaborated that FTR is basically a tax on capacity to earn. Thus, FTR could be in substitution of NTR and both cannot be applied simultaneously. Lastly, it must be noted that features of FTR are different from Minimum Tax (“MT”). In Commissioner of Income Tax Legal Division v Khurshid Ahmad (P L D 2016 Supreme Court 545), Chief Justice Nisar relied on   Elahi Cotton Mills Ltd and others v. Federation of Pakistan (PLD 1997 SC 582) to differentiate MT from FTR. The court noted that the MT “ensures that the tax-payers, who receive substantial amounts from exempt sources, pay at least some tax on their incomes of the year as many businessmen on account of showing losses, exemptions and depreciation do not give any tax.” Thus, MT ensures that at least a minimum amount of tax is submitted to exchequer. As opposed to FTR, it still allows deductions and adjustments but the liability should remain above the minimum amount whatsoever.  

Advantages of the Final Tax Regime

The first advantage of FTR is the increase of the revenue collection for the government. Revenue estimates suggest that due to the position adopted in 1991 in Pakistan, an increase of over 3.5% in revenue is observed in each year.[5] Another advantage of FTR is that it is an easy way out for taxpayers as there is no requirement of book keeping. This point was also noted in Elahi Cotton Mills mentioned supra in whichthe court observed that the object of FTR seems to eliminate the hassle of filing of returns by an assessee and going through the normal procedure. Thus, it eliminates the involvement of the Income Tax Department or minimizes it to a maximum extent. The Department cannot defeat the concept of FTR even if an assessee makes a huge profit. The Revenue officer has no power to charge tax on the additional income so long as the above additional income is earned by him on account of that transaction. Moreover, this system has essentially increased the ease of doing business for the businessmen and reduced corruption. Moreover, the non-resident persons under section 152 of the Ordinance are also placed under FTR which has increased the reach of tax in relation to economic activity. An example of it could be observed in section 152-A of the Ordinance which allows the revenues deriving by the foreign ad producers to be taxed by the government.

Disadvantage of Final Tax Regime

Finance Act 2004 inserted Section 113A in the Ordinance under which a retailer having annual turnover up to Rs 5 million was allowed the option to pay income tax of 0.75% of the declared turnover. It must be noted that it is much less than the amount of tax which could have been subjected under NTR. The main disadvantage of the FTR is in its role of whitening the black money which the people whose transactions are covered under the regime could use for malicious purposes. The effect of FTR is that there is no official record of wealth. Thus, assets created out of such income are undocumented. The ‘Books of Accounts’ are not required to be maintained in such a system as there is no concept of admissibility of expenses against the income of such a transaction. Absence of any requirements to make records has further resulted in doing away with all incentive to file returns and register in the department. This shall deter government`s efforts to build a comprehensive data base to track transactions of citizens. A very bad effect of FTR is also in its inflationary nature as tax is mostly added to the cost of the product which is ultimately imposed on the consumer in the form of Advance Tax.  There is also an element to shelter the taxable income in a more lightly taxed activity through FTR. An illustration of it could be observed when FTR is imposed on construction activity which may allow many construction companies to issue false invoices to corporations which shall allow them significant reductions in their taxable income.[6] Lastly, FTR is against the principles of fair and equitable taxation. The beneficiaries of FTR pay a very small percentage of their sales as income tax. An exporter pays 1% of their exports as FTR while an average salaried person who earns much less income than the exporter may have to pay much higher amount[7]

Effects on Economic Activity

A very bad effect of FTR of economic activity is in its regressive nature.  FTR contributes around 68% in total direct tax collection of Pakistan.  It is applicable also to those transactions in which the recipient in cases of withholding or payer in case of advance tax has a taxable income below the minimum threshold for income tax and in many cases is a final tax. Thus, the tax actually translates on consumption irrespective of the income and it is passed on the end consumer. An advance tax on the purchase of mobile phone credit hits the consumer who may have income much than minimum taxable income. Thus, FTR has “camouflaged an indirect tax as a direct tax”.[8] Resultantly, the purchasing power of a common man shall be lower.

With each passing day, FTR is increasing its ambit in relation to transactions with increasing rates.[9] It is observed that an increase in even one percent of tax cause lower GDP growth. A higher tax rate induces 1 percent of firms to shift from the formal to the informal sector which lowers GDP per capita by 0.5 percent due to the lack of investment by these firms. Moreover, an easy way of levying taxes such as FTR shift focus from regulating the economy and bringing informal economy into the national fold of taxation. Therefore, increasing rate of FTR causes lower GDP growth and de-incentivize regulation of economy[10]

Self- Assessment Scheme

The basic aspect of the self- assessment scheme reflected in the Section 120 of the Income Tax Ordinance 2001 is that the taxpayers themselves assess their income and determine their tax liability. Moreover, all income tax returns are now accepted without any conditions of compulsory enhancement of tax liability over previous year. However, a certain percentage of returns filed are selected for tax audit on the basis of risk assessment to verify the accuracy of income tax returns.[11]  The aim of this scheme is also to reduce the medium of contact between the taxpayer and the tax official so that there is less collusion.

What are Deterrents in the law to ensure the effectiveness of Self-Assessment Scheme?

Commissioner`s Oversight

To ensure that there is correct disclosure of the income and assets, the Commissioner can revise the returns to rectify any omission or wrong statement under section 114(6) of the Ordinance. Moreover, the Commissioner under section 114(4) of the Ordinance may also require any person to furnish a return of income for a tax year if in Commissioner’s opinion he was required to file the return. Section 121 of the Ordinance allows the Commissioner to make a “Best Judgment Assessment” if a person fails to furnish a return of income or a wealth statement or even if the person fails to the produce the information which the Commissioner called upon from the assessee. Section 122 of the Ordinance allows the Amendment of the Assessment in both cases of deemed assessment and best judgment assessment. Under section 122(5) of the Ordinance, this amendment can be made if the Commissioner acquires definite information that any income chargeable to tax has escaped assessment or the total income has been under-assessed or any amount under a head of income has been misclassified. The term definite information is defined in section 122(8) of the Ordinance and includes inter alia the sales or purchases of goods or acquisition or disposal of assets. Commissioner also possesses considerable powers under section 122(5) (A) of the Ordinance which allows the Commissioner to initiate amendment proceedings if he considers that any type of assessment order is erroneous or harmful to the interests of revenue. However, such consideration of Commissioner should be objective so that every person who analyzes the evidence in relation to it reaches the same conclusion to amend the assessment order. Thus, this consideration of Commissioner should not be prone to the concept of “change of opinion’. In light of the above provisions, it is reasonable to construe that this whole machinery headed by Commissioner makes an impression on the filer that any misrepresentation shall not escape the departmental scrutiny.    

Audit

Audit of tax payers is the most important deterrent in relation to the correct disclosure of assets and income. The rationale for audit is that some tax payers and big companies rarely make obvious mistakes. Moreover, the number of assesses and the magnitude of data make it simply impossible to check every return. Thus, the number of returns selected for audit is usually on the basis of some specific information and are aimed when there is enough monetary incentive for the department.[12] There is an elaborate mechanism present in the Ordinance to effectively peruse the income and assets of the tax-payer. Effective deterrence of audit requires certain powers which are reflected in the Ordinance. Section 174 of the Ordinance mandates every tax payer to maintain records, documents and accounts for six years after the tax year to which they relate. However, the record or documents or books of account can only be called after recording reasons in writing and communicating such reasons to the taxpayer. Section 175 of the Ordinance allows the department officers with authorization of the Commissioner to enter premises of the business and to access or search records. Under section 176 of the Ordinance, the Commissioner is also allowed to require any person to furnish the required information or present himself for examination. Moreover, these powers can also be accorded to the Chartered Accounted Firm conducting audit under section 177. Section 177 of the Ordinance allows the Commissioner to select a person for audit in accordance with the criteria laid down by the Board (“FBR”) itself. The Commissioner can select a person for an audit of the person’s income tax with regard to his history of compliance, the amount of tax payable by the person and any other matter which is material for determination of correct income. Section 177 of Ordinance further empowers the FBR to delegate audit to a firm expert in these matters with all powers. After obtaining records, the Commissioner shall audit income tax affairs including examining accounts, records, enquiry into expenditure, assets & liabilities of that or any other person and may call further information deemed appropriate. If there is any irregularity or evasion, the Commissioner can under section 122(5) of the Ordinance amend the assessment order to levy true tax liability. It is important to note that the Commissioner is obliged to obtain taxpayers explanation on all issues which are raised in the audit and amend the assessment accordingly. It is an important requirement under section 177 as absence of it shall be the denial of fundamental right of the due process.[13]    Under section 214(c) of Ordinance, the FBR also possesses the power to select audit through exercising computer balloting. Audit selection is done by the FBR but audit is conducted by Commissioner.  In the case of computer balloting, the procedure of audit except for ‘recording reasons’ and ‘communicating to taxpayer’ shall apply. Moreover, there is no legal prohibition against selection of a person for each year. It can be construed that the random selection which creates an element of “apprehension to be caught” among concealers and extensive powers of audit complemented with advance data mechanism shall considerably deter the tax-payer not to misrepresent income or assets. In Defence Housing Authority v. Commissioner Inland Revenue etc. (2015 PTD 2538), the court elucidated the powers of the Board under section 214(c) and stated that there is less controversy in relation to random selection but the Board must evolve an ‘undisputed and transparent’ policy for the selection of cases for audit on parametric basis. However, the court also noted that it is the right of the State to audit income tax affairs of a person, at least once in six year. Selection for audit cannot be termed as detrimental to rights as government has the power to collect tax under Article 77 of Constitution of Pakistan 1973. Similarly, in Nestle Pakistan Limited etc. v The Federal Board of Revenue, the court defined the parameters for the selection and conduct of audit. The court ruled that should not be ex facie detrimental to the interest of taxpayer. The court subsequently issued certain guidelines for audit which includes: 1) A taxpayer selected and audited in preceding tax year shall not be selected and audited without giving reasons for such selection 2) FBR shall enhance its capacity to audit a selected taxpayer for last five years to give a break from consecutive selections. 3) If audit is not completed within the given time frame, the selection shall be deemed to have been dropped. 4) After selection for audit, any demand for increase in payable tax to drop audit proceedings is against the scope and spirit of audit. [14]  The presence of the sections enabling both the Commissioner to conduct through inquiry and the Board through balloting caused confusion that whether they should exist simultaneously. This matter was clarified with the insertion of ‘Explanation’ in section 177 of Ordinance which clarified that the Commissioner has independent powers to select a case of a taxpayer for audit. Thus, the scheme of law is to retain deterrence so that the commissioner if provided with a definite evidence of concealment just does not sit on it but act to stop the concealment. In Kohinoor Sugar Mills v Federation of Pakistan, (2018 PTD 821) this explanation was held to be declaratory and the court clarified that Commissioner has independent powers to select for audit, under Section 177 of Ordinance, in presence of FBR’s power under Section 214C of Ordinance. It was observed that provisions of Section 177 are machinery in nature, therefore, are effective retrospectively. It was opined that language of Section 177 clearly confers a power on Commissioner to call for any record or documents including books of accounts, maintained under the Ordinance, for conducting audit of income tax affairs. The court further noted that powers available to the Commissioner under Section 177 are independent and exercisable subject to a different set of conditions while powers under Section 214C, which are not record based, consist of power to select by random or parametric ballot. They are not subject to the same conditions, checks, balances and an obligation to disclose reasons and provide an opportunity to the taxpayer to defend himself. Thus, both powers are fundamentally different in nature, genesis and conditions.  Thus, they are not mutually exclusive. In summation, various powers are present within the audit system under the Ordinance which equips the officers to deter the tax payer from any violation of the Ordinance. However, this is not to be at the expense of injustice to the taxpayer.

Penalty

An important deterrent provided in law in relation to the self-assessment schemes is the threat of penalty. Section 182 of the Ordinance embodies the offenses which shall be liable to a specific penalty. These penalties are of pecuniary nature. An example of such a penalty is a pecuniary punishment reflected in entry 12 of the table of section 182 of Ordinance. It states that where a person has concealed income or furnished inaccurate particulars of such income and suppressed any income or amount chargeable to tax, he shall pay a penalty of 100,000 rupees or amount equal to tax which he sought to evade. A table under section 182 notes more than 28 offences including concealment of income or assets and prescribes specific penalties for them. It must be noted that under section 182(2) of the Ordinance, the penalties shall be applied in a consistent manner. Moreover, the penalties shall not be payable unless an order in writing by Commissioner, Commissioner Appeals or the Appellate tribunals is given after hearing the concerned person.   

Prosecution

The greatest deterrent present in Ordinance is the threat to the tax payer that tax department can bring a criminal charge against a person who shall not fully disclose income and assets. An example of such punishment is reflected in section 192A which states that a person who conceals incomes which can in the form of claiming a deduction for any expenditure not actually incurred or suppression of income or who furnish inaccurate particulars of his income and this cause a revenue loss of Rs. 500,000 shall be convicted for two years in prison or with fine or both punishments.  Under section192B, a person who fails to declare an offshore asset to the Commissioner or furnish inaccurate particulars of an offshore asset which causes revenue loss of ten million rupees or more shall be liable with three years in prison or with a fine of up to five hundred thousand Rupees or both punishments. Under section 138 of the Ordinance, the Commissioner can also attach the property or even arrest a person for a period of 6 months to compel the person to pay taxes.

[1] Khan A, “Presumptive Tax as an Alternate Income Tax Base: A Case Study of Pakistan” (1993) 32 The Pakistan Development Review 991, 996

[2] Khan A, “Presumptive Tax as an Alternate Income Tax Base: A Case Study of Pakistan” (1993) 32 The Pakistan Development Review 991, 996

[3] . “Aim of Introducing Presumptive Tax” Business Recorder (April 26, 2006) <https://fp.brecorder.com/2006/04/20060426415184/> accessed May 20, 2020

[5] Khan A, “Presumptive Tax as an Alternate Income Tax Base: A Case Study of Pakistan” (1993) 32 The Pakistan Development Review 991, 997

[6] Khan A, “Presumptive Tax as an Alternate Income Tax Base: A Case Study of Pakistan” (1993) 32 The Pakistan Development Review 991, 1001

[7]Rana S, “FBR Calls for Ending Final Income Tax Regime” Express Tribune (May 28, 2019) <https://tribune.com.pk/story/1981597/2-fbr-calls-ending-final-income-tax-regime/> accessed May 20, 2020

[8]Kazi MM, “Tax Challenges Faced by Pakistani Governments” (RIAA Barker Gillette February 13, 2017) <https://www.riaabarkergillette.com/pk/tax-challenges-faced-by-pakistani-governments/> accessed May 20, 2020

[9] “Amendments in Federal Taxation Laws through Finance Act, 2019” (KPMG 2019) <https://assets.kpmg/content/dam/kpmg/pk/pdf/2019/07/KPMG Finance Act 2019.pdf> accessed May 20, 2020

[10] Lagakos D and llzetzki E, “International Growth Centre” <https://www.theigc.org/blog/macroeconomic-benefits-increasing-tax-enforcement-pakistan/> accessed May 20, 2020

[11]  “INCOME TAX SELF ASSESSMENT SCHEME” The News (September 24, 2020) <https://www.thenews.com.pk/archive/print/72709-income-tax-self-assessment-scheme> accessed May 20, 2020

[12] Azhar BA, “Tax Pilferage—Causes and Cures” (1996) 35 The Pakistan Development Review 657

[13]“Self-Assessment and Audit” Business Recorder (June 13, 2004) <https://fp.brecorder.com/2004/06/20040613116171/> accessed May 20, 2020

[14] Nestle Pakistan Limited etc. v Federal Board of Revenue [2017] 115 TAX 84