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DIRECT TAXATION IN PAKISTAN

A course on Income Tax Law


Asim Zulfiqar Ali, LL.B., FCA
Spring 2014

1. Course Description

(a) An Introduction to Direct Tax es

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 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. Urban Immoveable Property Tax, Professional
Tax and Motor Vehicle Tax etc. are types of 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 has introduced Income Support
Levy which again is the nature of a direct tax but this is not termed as a tax by the
Government. The Government has described the same as a compulsory contribution by the
rich for the poor.

The significant amount is generated through levy of income tax and during the year ended
June 30, 2013 the government collected around 38% 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.
Few years back, (as part of reform process - facilitation), the government has 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
revenue 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) Incom e Tax Law in Pakistan History, Evolution & Developm ent

In the Indo-Pak, the history of modern income taxation dates to 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 consolidated and
substituted by the Income Tax Ordinance, 1979 which remained in force until the year 2002.
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 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. 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 refunds. Though the objectives were initially achieved but the
scheme changed the overall nature of the levy. This 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. 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 governments perspective the advantages outweighed the
disadvantages hence it is still being continued even toady. In fact its scope has been
enlarged considerably over the last decade.

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 under-
declaration/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.
(c) Fam iliarity w ith the Legal Fram ew ork

(i) Local Incom e Tax Law s

At present, the income tax law can broadly be classified into two categories viz. (Federal)
Income Tax Ordinance, 2001 and (Provincial) Income Tax Act, 1997 (taxation of agricultural
income). 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, 1979.

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.

The shift was also a part of the governments 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 encouraging. It is
evident from the fact that the tax collection has increased from Rs 330 billion in the year
2000 to Rs 1,930 billion in the year 2013 (direct taxes - 82 billion to over 740 billion).

The scheme canvassed in the Income Tax Ordinance, 2001 reflects the 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 1960s and 55% in 2002) to 35%, 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, 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 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.
(ii) Agreem ents for Avoidance of Double Tax ation

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--vis the local laws. Pakistan has signed double tax treaties with
over 60 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 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 entities 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) R ole of the R egulator

The provisions of law clearly define the role and the responsibilities of the regulator. 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.
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--vis all perspectives whether the student
pursues the career as a tax practitioner, or tax regulator/policy maker or a businessman.

3. R equired Tex ts

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: www.fbr.gov.pk;
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;
Session 2,3,4 The scheme of taxation contained in the Income Tax Act, 1997
(Provincial) and the Income Tax Ordinance, 2001 (Federal); 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 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--vis the concept/thought behind introduction of
presumptive tax regime
- Legality of presumptive tax regime;

Session 7 Mid-term Exam

Session 8 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;
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--vis foreign
governments / agencies;

Session 12 Double taxation vis--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

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