DIRECT TAXATION IN PAKISTAN A course on Income Tax Law Asim Zulfiqar Ali, LL.B., FCA

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1 1. Course Description DIRECT TAXATION IN PAKISTAN A course on Income Tax Law Asim Zulfiqar Ali, LL.B., FCA (a) An Introduction to Direct Taxes Taxes are regarded as a major source of income/revenue for a state to meet its obligations towards the nation. These taxes are fundamentally utilized by the government for the purposes of public sector development programs, defense and other areas of mass importance. In Pakistan, various taxes are in force some of which are regulated by the Federal Government while some are in the domain of the Provincial Governments. The split between these is provided for in the Constitution and its rationale and the logic is not the subject matter of this course. Taxes are broadly classified into two categories viz. direct taxes and indirect taxes. Whether these are collected by the Federal Government or the Provincial Government, the division broadly remains the same. These are both income / revenue based and / or asset ownership based, depending upon the nature and type of the levy. Direct taxes are those where the incidence is borne by the person from whom the tax is collected whereas, in the case of indirect taxes, the person from whom the tax is collected acts only as an agent / intermediary and the incidence of tax is borne by another person (from whom the tax is eventually collected by the agent in the due course and deposited in the government treasury). Few examples of direct taxes, enforced by the Federal Government, are Income Tax, Wealth Tax, and Capital Value Tax and Urban Immoveable Property Tax, Professional Tax and Motor Vehicle Tax etc. are direct taxes collected by the respective Provincial Governments. Historically, direct taxes (at federal level) have remained in force in Pakistan in the form of income tax, wealth tax and capital value tax. The wealth tax was abolished by the Government in the year 2000 as part of a reform exercise whereby the Government introduced a policy of reducing the number of taxes (federal excise duty, an indirect direct, was also at one point in time propagated to be abolished gradually under this reform process but this does not seem to be happening). Another reason behind the abolition of the said tax was that it was not making significant contribution in the exchequer and in fact the cost of collection was considered to be more than the contribution. There is, however, a simultaneous criticism on the abolition. People belonging to this school of thought argued that it was a tax on rich only and its abolition had favoured a particular class and hence the same is in a direct conflict with the rationale and philosophy of imposition of direct taxes. This controversy remained unaddressed, however, there is a discussion that this should be reinstated. Through Finance Act, 2013, the Government had introduced Income Support Levy which again was in the nature of a direct tax but this was not termed as a tax by the Government and was described as a compulsory contribution by the rich for the poor. However, this again was abolished vide Finance Act, 2014 and thus remained enforced for merely one year and that too remained a subjective matter of substantial litigation. The significant amount is generated through levy of income tax and during the year ended June 30, 2016 the government collected around 40% of its aggregate revenues (both direct and indirect) as income tax. This position, without undermining the importance of other taxes, makes the income tax as the focal point of the government so far as the policy, legislation and implementation are concerned. Much of the emphasis is given in increasing the collection, removal of leakages and improvement of business processes involved in implementation of this tax.

2 Few years back, (as part of reform process - facilitation), the government reclassified taxes into custom duty and inland revenues. Now, for enforcement and collection purposes, income tax, sales tax and federal excise duty are categorized as inland revenues and these are be handled by one authority. The purpose is to eliminate the hassle of dealing with multiple officials especially when in various cases similar aspects/considerations are relevant for law enforcing authorities. (b) Income Tax Law in Pakistan History, Evolution & Development In the Indo-Pak, the history of modern income taxation dates to around 1860, although prior to that license taxes based on profits, trades and professions were in vogue. This tax was introduced to meet the deficit resulted from the War of Independence and was not intended to be permanent. The levy under the Income Tax Act of 1886 was a general income tax that had been imposed on the trades by some provinces and its basic scheme, by and large, even survives today. This law underwent certain changes and finally transformed into the Income Tax Act, 1922 which was the first proper and complete legislation so far as the levy of income tax in Pakistan is concerned. Owing to amendments introduced from time to time the law was reconsolidated and substituted by the Income Tax Ordinance, 1979 which remained in force until the year An analysis of the provisions of the two legislations shows that the latter, when enacted, was in fact a redrafted and consolidated version of the former and as such there was no change in the underlying concept and philosophy. Both the legislations provided that an assessing officer would determine the income of a taxpayer on the basis of declarations/ filings of such taxpayer. In the year 1991 the income tax law was amended significantly and a new concept of presumptive / final tax regime was introduced. It was a new and unprecedented concept in the region, shift from the original philosophy and had a set objective. It prescribed a transaction based tax liability regardless of the fact that the person executing the transaction had earned any income or not in real sense. This scheme was initially conceived to be a stop gap arrangement for taxing the persons who continuously remained outside the tax net or who could claim refunds by not disclosing the real income. The idea was to increase the tax collection and eliminate the undue refunds. Though the objectives were initially achieved but the scheme changed the overall nature of the levy. This, to an extent, transformed the levy of income tax into an indirect tax as the taxpayers begun to shift the levy (incidence being known in advance) onto the customers, thus became subject of significant criticism. The scheme has its own advantages and disadvantages. No doubt it increased the revenue collection considerably but it also transformed a direct tax into an indirect tax thus causing a shift from the underlying principles/rationale. It also discouraged documentation, which is the backbone for determining the real quantum of income, to a very large extent. From the government s perspective the advantages outweighed the disadvantages hence it is still being continued even today, rather its scope has been enlarged considerably over the last two and a half decades. The concept of assessment/determination of income by a regulator was completely done away with through promulgation of the presently applicable Income Tax Ordinance, 2001 and now whatever declaration is filed by a taxpayer the same is taken to have been accepted by the tax authorities, at the first place. Nevertheless, the tax authorities are empowered to conduct an audit of a taxpayer and on discovering any underdeclaration/mis-declaration they could amend the assessments to recover the proper amount of tax. The taxpayer, however, reserves the right to challenge the said action of the tax authorities for which the provisions of law prescribe appeal forums.

3 (c) (i) Familiarity with the Legal Framework Local Income Tax Laws At present, the income tax law can broadly be classified into two categories viz. (Federal) Income Tax Ordinance, 2001 and (Provincial) Punjab Income Tax Act, 1997 (taxation of agricultural income). Similar legislations are enforced in other provinces. These statutes are a complete code and contain full procedure for computation of income, collection of taxes, regulation, monitoring, remedies etc. The provincial laws are of a very basic nature and are based on the principles earlier contained in the Income Tax Ordinance, The presently applicable system of regulating the income tax (at federal level), briefly discussed above, is fully in line with the concept provided for in OECD (Organization for Economic Co-operation and Development) guidelines, the system followed in the developed countries. It rests on the principle of convergence. Historically, there had been wide gaps between the accounting income and the taxable income. Now these gaps are being bridged and the taxable income is brought as closer as possible to the accounting income which effectively creates simplicity for taxpayers. So much so, there is provided in the 2001 Ordinance a concept of Alternative Corporate Tax whereby companies are required to pay a minimum tax as a percentage of accounting income notwithstanding the liability computed on the basis of taxable income. The conceptual shift, as discussed above, was also a part of the government s reform process. In the course of analyzing the tax administration a necessity of reposing confidence in taxpayers was felt (i) to enhance the tax collections; (ii) to reduce the deficit of trust between the taxpayer and tax collector; and (iii) to increase the level of voluntary compliance. Pakistan is the first country in the region to have successfully implemented this system of taxation. The government feels that the results achieved through implementation of this system of taxation are quite encouraging. It is evident from the fact that the tax collection has increased from Rs 330 billion in the year 2000 to over Rs 3,200 billion in the year 2016 (direct taxes - 80 billion to over 1,300 billion). The scheme canvassed in the Income Tax Ordinance, 2001 reflects broadly the consistent policies of the government. The policy is to facilitate the businesses, increase the tax collection through broadening the tax base, reduction in tax rates, reduction in exemptions, reposition of confidence in taxpayers and encouraging voluntary compliance. It is this underlying policy that the government has brought down the tax rates (which were as high as 80% in certain cases in 1960 s and 55% in 2002) to 30%, eliminated exemptions in various cases and introduced the concept of self assessment without exception. It also contains suitable provisions, compatible with the business needs, for the taxation of specialized businesses/transactions. Over the last few years the provisions of law have been amended to a reasonable extent to align the tax laws with the modern business transactions/needs. Notwithstanding the aforesaid fundamental changes in the mechanics of implementing the law, the historical/universal concept of targeting the income, to the levy of tax, broadly remains unchanged. Similarly, there is no change in the collection techniques and these remain PAYE (through withholding taxes and advance tax). The law focuses on charging the tax on income of residents of Pakistan accruing from sources existing both inside and outside Pakistan whereas in the case of non-residents the tax is payable only and only on the income accruing from the territorial jurisdiction of Pakistan. The law provides a complete mechanism for computation of income, regulation, monitoring and remedies. It also contains provisions for blocking the aspect of tax planning which is undertaken by the entities to try and reduce the (real) incidence of tax on income.

4 (ii) Agreements for Avoidance of Double Taxation The aforesaid universally applicable principle of taxing the resident (on world income) and non-residents (for income accruing in the territory of a state) by any state gives rise to a possibility of double taxation in the case of residents i.e. once in the other state where the income is earned (under the principle of territorial jurisdiction) and once in Pakistan (under the principle of residency). In order to eliminate the incidence of possible double taxation, the law allows a credit for taxes paid abroad. Besides, there are Agreements for Avoidance of Double Taxation, which the states sign to limit their rights to tax the income. These Agreements, generally known as double tax treaties, are a complete code in itself and have an overriding status vis-à-vis the local laws. Pakistan has signed double tax treaties with around 70 countries /states. From a practical perspective, an understanding of the philosophy and rationale of these treaties is essential. (d) Understanding the Tax Planning Entities invariably undertake tax planning for the purposes of reducing the incidence of overall taxation. For entities operating in only one country tax planning is usually carried out through structuring of a business/transaction whereas for entities operating in more than one country, double tax treaties are also used for this purpose. In the past, the local entities also used the presumptive /final tax regime as a tool for tax planning. That was so because under this regime the tax liability was predetermined and thus businesses/transactions could be restructured to reduce the incidence of tax. The groups, undertaking business in multiple countries understandably endeavour to accrue profits in states with less incidence of tax through adoption of transfer pricing techniques. The law, therefore, includes anti-avoidance provisions to address this aspect. It enables the tax administration, of course on the basis of conclusive evidence, to disregard the avoidance techniques undertaken by the entities to reduce the incidence of tax and to determine the proper tax liability attributable to the activities carried out in the state under the principles of arms length transactions. The provisions of law include the most modern concepts, fully compatible with developed countries, in this respect and thus reduce the avenues of tax planning to some extent. Notwithstanding the aforesaid development in the law, it is considered that the tax administration has not been properly trained to tackle these techniques undertaken by the entities and hence there still is a reasonable potential for tax planning. The provisions of certain treaties also leave a lot of room for tax planning because at the time of signing these treaties the Pakistan perspective was not thoroughly watched. (e) Role of the Regulator The provisions of law clearly define the role and the responsibilities of the regulator/ Federal Board of Revenue [FBR]. The regulator ensures the collection of tax and the compliance/implementation of law. The regulator is also authorized to conduct audits in suspected/identified/selected cases. It also facilitates taxpayers education through issuance of circulars, clarifications and advance rulings. Outside the book, it also facilitates in fixation of annual budgetary targets, laying down the policy and proposes amendments in law to implement these policies. On a practical side, the responsibility of negotiating treaties with other counties also rests with the regulator.

5 2. Goals of the course The goal is not to make the students familiar with the prevailing tax laws only. The students are meant to be equally familiar with the philosophy and the rationale of taxation as well as the aspect of tax planning. The strengths and weaknesses of the applicable system would also be debated. Comparative analysis with the laws in the other states would be carried out to determine as to where the local law has an edge or where it is deficient. In short, the course would encompass practical knowledge vis-à-vis all perspectives whether the student pursues the career as a tax practitioner, or tax regulator/policy maker or a businessman. 3. Required Texts i) Law & Practice of Income Tax by Dr. Ikram-ul-Haq; ii) The Law & Practice of Income Tax by Kanga, Palkhivala and Vyas; iii) Principles of Income Tax Law with International Tax Glossary by Dr. Ikram-ul- Haq; iv) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations by OECD; v) Cross Border Transactions and tax Treaties Theory and Practice by Ahmad Khan; vi) Commentary of OECD on Articles of model double tax treaty; vii) Guidelines/Brochures issued by Federal Board of Revenue on various topics and available (in publication section) on the website: viii) Important case laws settling basic principles of taxation; 4. Course outline The course is proposed to be covered during the sessions as under: Session 1 Understanding the concept and principles of taxation ; types of taxes, legislative developments and outline of present legislation ; - Understanding the rationale of taxation and its role in the economy; - Types of taxes viz. direct taxes and indirect taxes and their concept; - Direct taxes applicable in the country both at federal and provincial level; - Transformation (in practical sense) of direct taxes into indirect taxes over the last two decades to a very large extent; - The development and evolution of law relating to direct taxes in Pakistan (income tax perspective), including the measures for broadening the tax base and gradual reduction in tax rates; - An overview of existing legislative framework (income tax perspective), including its focus, scheme and processes; - Rules of interpretation of fiscal statutes;

6 Session 2,3,4 The scheme of taxation contained in the Income Tax Ordinance, 2001; rationale and philosophy; - Understanding the present form of taxation, its origin and necessity; - Understanding the concept of income ; - Distinction between real income and deemed income; - Bifurcation of income into heads and computation of income under these heads ; - Concept of computation of total income ; - Distinction between resident and non-resident and the need for such distinction; - Scope of taxation for residents and non-residents ; - Assessment of income, the role of the regulator; - Minimum taxation for companies; Session 5&6 Withholding taxes & Presumptive / Final tax regime - Concept of withholding taxes; - Effect of withholding taxes (transformation into indirect taxes); - Role of government machinery in collection of taxes; - Monitoring of voluntary compliance to withholding provisions; - Concept of presumptive tax regimes, its rationale and effect on economy; - Reality vis-à-vis the concept/thought behind introduction of presumptive tax regime - Legality of presumptive tax regime ; Session 7 Session 8 Mid-term Exam Taxation of Specialized Businesses/Transactions - Need for introduction of provisions for governing the taxation of specialized businesses; - The extension in these provisions over the last few years owing to the need and complexities involved in such businesses; - Taxation of oil exploration companies, insurance companies and banks; - Taxation of leasing transactions; Session 9 Remedies available under the statute - Need for incorporating remedies in the law; - Conventional (historical) appellate forums; - Federal Tax Ombudsman; - Out of court settlement, its necessity, importance, advantages and disadvantages; - Alternative Dispute Resolution Committee (ADRC) mechanism; - ADRC whether failure or a success; - Comparison of ADRC mechanism with other states; - Judicial response to TAX in recent days;

7 Session 10 Tax Planning - Need and concept of tax planning; - Structuring the transaction/business; - Concept of tax avoidance and tax evasion; - Transfer Pricing tool for tax planning; - Continuous expansion (accelerated depreciation) tool for tax planning; - Cross border transactions; - Anti tax planning provisions, their need and rationale; Session 11 Tax incentives and exemptions - Necessity for introduction of exemptions and incentives; - Historical perspective of exemptions/incentives; - Present policy regarding exemptions/incentives; - International agreements/commitments vis-à-vis foreign governments / agencies; Session 12 Double taxation vis-à-vis cross border transactions - The concept/possibility of double taxation on any one component of income; - Allowability of credit for tax paid in one state against tax liability on the same component of income in another state; - Agreements for Avoidance of Double Taxation; - The source of Agreements historical perspective; - Tax sparing cross border transactions only; - Overriding status of these Agreements; Session 13 Role of the regulator - Structure; - Fixation of Revenue Targets/Budgets; - Collection of taxes; - Implementation of law; - Monitoring; - Administration; - Policy making; - Clarifications/Circulars; - Addressing the anomalies; Session 14 Class discussion Important case law