FEDERAL BUDGET 2007-2008 AN ANALYSIS BY

FEDERAL BUDGET 2007-2008AN ANALYSISBY Syed Shabbar Zaidi Partner A F Ferguson & Co KARACHI

TABLE OF CONTENTS (1) • Understanding of the Concepts • Trends over the years and future strategy • Trickle Down Effect–Misnomers • Utilisation of Public Sector Development (PSDP) • Capacity / Capability • Devolution of responsibilities • Basic Infrastructure: • Roads • Energy • Water • Irrigation System

TABLE OF CONTENTS (2) • Basic Requirements: • Food • Housing • Medical • Education • Policy framework in the Budget for Income Tax • Direct and Indirect Taxation and Composition of direct taxation • Abolition/Reduction in the Presumptive Tax Regime • Tax at Import Stage • Group Relief

TABLE OF CONTENTS (3) • Group Taxation • Computation of Income for Banks • Amalgamation • Inter-corporate Dividends • Private Equity Funds • Real Estate Investment Trust • Exports • Mergers & De-mergers • Bulk Importer Of Industrial Raw Materials

UNDERSTANDING OF THE CONCEPT (1) • Whenever we listen discussion on ‘Budget’ we hear the words: • Budget Deficit • Trade Deficit • Total Revenue • Tax to GDP Ratio • GDP Growth • Per Capital Income • Public Sector Development Programme • Inflation Rate • Foreign Exchange Reserves • Foreign and Local Debt to GDP

UNDERSTANDING OF THE CONCEPT (2) • All these terms are relevant and important economic indicators. • However, we have to admit that even a substantial number of educated people cannot exactly understand the practical applied economic effect of these terms. • Furthermore, for a common man now such discussions are becoming ‘irritating’ and ‘meaningless’. • There is a need to translate and integrate the combined effect.

UNDERSTANDING OF THE CONCEPT (3) • For economies like us these terms become partially irrelevant for the reason that: • A large part of our economy is informal and undocumented. As a conservative estimate the extent of such sectors is around 100 percent of the documented sector. • Even on the documented sector there are pampered babies outside the tax net either exempt or under presumptive regimes.

TRENDS OVER THE YEARS AND FUTURE STRATEGY • This country was made for economic independence of Muslims of certain parts of India. However, economics have been highly overshadowed by religious obstructionism and political exigencies. This could lead to disastrous consequences if immediate corrective measures are not taken. • Our future strategy for economic growth should focus on: • Growth of employment • import substitution • human development • devolution of financial resources

POLICY FRAMEWORK IN THE BUDGET FOR INCOME TAX • Following are the policy framework for income tax: • Gradual abolition of presumptive tax. • Reducing the cost of doing business and indirect taxation. • Providing space for the private limited companies to grow. • Providing space for documentation in the real estate sectors. • Consistency of policy. • No tinkering with the law. • Reducing possibility of interaction and litigation.

DIRECT AND INDIRECT TAXATION AND COMPOSITION OF DIRECT TAXATION (1) • In the financial year 2007-2008 the ratio of direct taxes to indirect taxes will be 40 percent which is substantially higher than 23 percent in 2000. • Furthermore, out of the total expected collection of around 400 billion a substantial part will be tax on income not being withholding tax. So all other past myths have been broken. This is a very positive indicator. • However, with reference to the question of distribution of wealth it is important to note that out of Rs 400 billion a substantial part is corporate tax. Real distributional equity will arise when out of the same around Rs 200 billion is personal tax. Now we have reached the stage where companies are being seen as having paid the taxes. Real distributional equality will arise when individuals start paying taxes on their income. The trends are correct.

DIRECT AND INDIRECT TAXATION AND COMPOSITION OF DIRECT TAXATION (2) • The other positive aspect is that this amount has been collected without chaos, harassment, and sensationalism. I believe system is working. If economies grow taxes grow provided policies are correct and taxation matters are dealt with economic considerations.

ABOLITION / DEDUCTION IN THE PRESUMPTIVE TAX REGIME • This budget clearly indicates a process towards the abolition of PTR. The specific steps are: • Public companies exempted from PTR even on execution of contract. • All companies out of PTR on supplies. • Bulk importers out of PTR. • This means that companies are under PTR only in the case if such companies are engaged in import for trading and such companies are not bulk importer.

TAX AT IMPORT STAGE • This budget has brought a major change in the tax rate at import stage. Under the new regime rate of tax has been reduced from 6 to 1 percent. This rate is however subject to the condition that import represents raw material for own use and the importer is registered as manufacturer under the Sales Tax Act. • As a consequence of this amendment the possibility of obtaining exemption certificate has been restricted to the case of companies having losses or which are exempt from tax. Previously there was a possibility of obtaining a certificate where there was payment of tax etc. • This is a very positive step and is a gradual return to the sensible system of income based taxation. • In the past there was an issue of abuse of certificate.

GROUP RELIEF (1) • Group relief (as introduced in 2004) that allows surrendering of loss of one group company against other has been improved. It is proposed that group relief will be available with 55 percent holding as against 75 percent in the past provided one of the companies in the group is a public company. Furthermore, in those cases where none of the company in the group is a public company 75 percent holding will be required and it would be essential for the group to list one of its components within three years. • Under this concept a subsidiary may surrender losses to its holding company or another subsidiary or vice versa.

GROUP RELIEF (2) • Concept of group relief has been extended to companies engaged in all sectors except that such relief would not be applicable for trading losses. • As in the past group relief would not be available for past losses being the losses prior to acquisition of the company by the group. • It has been further clarified that a company surrendering the losses will be paid cash equivalent to the losses being surrendered. The receipt of such amount and the deduction by the other side would not represent a taxable event.

GROUP RELIEF (3) • A special concession has been introduced whereby transfers of shares for the formation of the group are not to be treated as a taxable event. However, an approval to that effect would have to be obtained from the Securities & Exchange Commission of Pakistan that such transfers are for the formation of the group.

GROUP TAXATION • A concept of group taxation is being introduced in Pakistan for a 100 percent holding company. In this situation, both the companies or the group as the case may be are treated as a single fiscal unit meaning thereby that for tax purposes provisions of tax law will apply as if both the companies are one entity. This provision would be applicable for domestic companies only. Option to be taxed on group basis shall be applicable for five years.

COMPUTATION OF INCOME FOR BANKS (1) • A separate schedule has been introduced for the computation of income and tax payable by a scheduled bank. This is termed as Seventh Schedule. • Under this new system for taxation purposes the income of a bank shall be taken to be the income as disclosed in the accounts to be furnished to the State Bank of Pakistan. However, for taxation purposes only the following adjustments shall be made: • Charge for irrecoverable advances as per Prudential Accounts as included in the accounts shall be accepted except that the portion relating to ‘Sub-Standard’ shall be added back. An external auditors’ certificate to that effect shall be required to be furnished.

COMPUTATION OF INCOME FOR BANKS (2) • Depreciation on asset and amortization shall be allowed under the income tax laws and accounting. • Charge for depreciation and amortization shall be added back. There shall be no adjustment for asset under finance lease and for that purpose accounting treatment would also represent the tax treatment. • An adjustment on account of application of IAS 39 shall be deemed to be a non-taxable event. • Head office expenses shall be allowed only if such expenses are recorded in the books of the Permanent Establishment and a certificate to the effect of nature of expenses and reasonableness shall be furnished by the auditors.

COMPUTATION OF INCOME FOR BANKS (3) • In case of Shariah Compliant banking a statement shall be furnished providing adjustment between the two systems in the accounts and the reported profit shall be adjusted for tax purposes accordingly resulting in effect to a system that income shall be computed as if would have been a conventional banking system. This adjustment shall be certified by the auditors. • Whole income of the bank shall be treated as income from business and taxed accordingly. However, gross dividend and capital gains arising on sale of shares where the holding period exceeds twelve months shall be taxed at the rate of 10 percent.

COMPUTATION OF INCOME FOR BANKS (4) • Banks have been exempted from all provisions relating to withholding or collection of taxes as recipient. • Banks shall be required to pay advance tax in 12 equal installments.

AMALGAMATION • Brought forward and capital losses will not be available in case of Amalgamation. Unabsorbed depreciation continue to be available through section 97A.

INTER-CORPORATE DIVIDENDS • As an important measure to promote corporatisation of businesses and development of holding companies inter-corporate dividends between resident companies have been treated as adjustable. Through this measure a major bottleneck in the promotion of holding companies and consolidation of shareholding has been removed. As a result of the same companies shall not be subject to presumptive tax regime on their dividend income.

PRIVATE EQUITY FUNDS • Private Equity Funds as registered by the Securities and Exchange Commission of Pakistan (SECP) shall enjoy all the exemptions as are available to mutual funds. • Under the rules being issued by the SECP, in the Budget Package both local and foreign funds shall be eligible for such registration. • Such private equity would accordingly be exempt from tax if such funds distribute 90 percent of their income. • In order to provide incentive for economic growth of companies the owners of the shares of companies selling shares to a Private Equity fund shall be taxable at the rate of 10 percent as against normal rate under the law.

REAL ESTATE INVESTMENT TRUST • Real Estate Investment Trust is treated as pass through entities and is not subject to tax. • In order to promote the development of REIT and correction in the valuation of recorded price of the properties it has been proposed that any seller of property to a REIT shall not be taxable on the income arising from the sale of property even if such transaction represents the normal business activity of the seller. For that purpose an amendment has been proposed that the concept of ‘Adventure in the nature of trade’ shall not be applicable on transaction of sale of properties to REIT.

EXPORTS • Rate of withholding uniform at 1 per cent; • Services for export to be treated as Services rather than export; not for companies.

MERGERS & DE-MERGERS (1) • Tax law has appropriately been amended to clarify that transactions on account of reconstruction of companies resulting in merger and demerger would not result in taxable event both for the company and the shareholders. A separate section has been introduced for this purpose. Under the proposed status all reconstruction of companies under Section 284 to 287 and 282L of the Companies Ordinance, 1984 or section 48 of the Banking Companies Ordinance shall be treated as a non-taxable event both for the companies involved and the shareholders. Mergers and demerger of all companies, non-banking financial institutions, and banks shall qualify for this provisions.

MERGERS & DE-MERGERS (2) • These provisions are in line with international practices. • Unabsorbed depreciation prior to merger or demerger shall be available to the company to which the assets are being transferred. • Any receipt, allotment or cancellation of shares under the Scheme of Arrangement shall not be treated as disposal. For the purposes of any subsequent sale of such shares the original cost of the share prior to merger or demerger shall be taken into account to determine the amount of capital gains.

BULK IMPORTER OF INDUSTRIAL RAW MATERIALS • Companies engaged in bulk import of industrial raw materials shall not be subject to presumptive tax regime. Income of such companies shall be taxed at the normal rate. This exemption shall however be available if the following conditions are fulfilled: • Paid up capital of companies exceeds Rs. 100 million • Fixed assets of the companies exceed Rs. 100 million • Those companies are subject to audit under the Companies Ordinance, 1984.

FEDERAL BUDGET 2007-2008 AN ANALYSIS BY