Tax exemptions - mixed signals

A money bill (amendments in Income Tax Ordinance) is making rounds over social media. Initially-proposed by the finance ministry, the bill now stands approved by the cabinet. However, the cabinet made some revisions to the initial proposal, which is now slated to be tabled in the parliament next week. The lower house will decide the fate of the bill within 14 days, just in time for the IMF board's meeting on 24th March.

Apart from the money bill, amendments to the SBP Act and the SOE law are also going to be tabled in the parliament. But those may take their own sweet time, as the process involves multiple stages. In addition, amendments to the Nepra Act are already in the process of parliamentary committee approval, and the executive hopes to complete the legislation before 24th March as well.

Here, the discussion is limited to proposed amendments in the Income Tax Ordinance based on the draft bill in circulation, though it is unclear whether it is the one approved by the cabinet, or the one proposed by Q-block (finance ministry). The initial impression of the business community on these amendments is that the potential increase in tax collection from withdrawal of exemptions would be insignificant, compared to the unintended "adverse consequences". On the positive side, several lacunas removed through this proposed legislation would also decrease distortions in the existing tax framework.

Pakistan's corporate sector is already taxed heavily, whereas others operating in the informal economy pay little. If the amendments are approved, the burden on existing payers would be even higher. It appears that the process of exemption removal has probably been carried out in haste, without consulting all the potentially affected stakeholders.

One proposed change is the removal of relief on inter-corporate dividend. There appears to be a conceptual confusion over the issue. On one hand, the government wants to encourage the culture of corporatization, on the other hand, however, the change may kill incentive for formation of large conglomerates.

During the Shaukat Aziz era, a concept was introduced that company should not be taxed at multiple levels. That resulted in encouragement of the holding company structure. Later, certain shareholding threshold (56%) was set. Now it is proposed that the exemption may only be retained in the case of 100 percent holding.

The tax was a pass-through item, and eventually, results in taxation of earnings of ultimate shareholders. While the government may gain some tax revenues from removing these exemptions, but the proposed change may discourage formation of corporate holding structures. Such structures are important for local business groups to receive prominence in the international arena, which is important to enter into partnerships with global players or to raise investment from global capital markets and financial institutions.

In next door India, big business groups have now become global giants. Whereas in Pakistan, nationalization in the 1970s virtually decimated the rich families, dampening the development of nascent corporate culture in the country at the time. Half a century later, this culture has reborn, but the potential change will surely hurt its future prospects. Today, very few local conglomerates exist in true corporate holding structures such as Engro Corp; yet the group based on this holding structure has already been able to attract global partners to its subsidiaries.

For example, one local group sought partnership for a renewable energy project with a global player, but the global partner demanded a guarantee from the holding company of the local group. Now, such arrangements might become harder to enter. In another example, a different local business group planned on taking advantage of the recent ease created in foreign exchange regulations and was planning to go global. Now, the group may be forced to revisit its strategy altogether.

Global companies scrutinize the balance sheet strength of local partners. That strength is easier to demonstrate through corporatization of holding company structure. With the proposed amendment, chances are that these groups will de-couple their holding structures, and once again operate on standalone basis.

Under the last political regime, Dar envisioned a similar change in law, but was unable to do so fully due to obvious disadvantages. Now the exercise is being repeated. If local business groups decide to end respective holding structures, the government will only succeed in fetching one-time tax revenue on a special dividend, but nothing later. The cost would be incurred in the long term as the end of exemption may discourage formation of holding structure by big conglomerates.

Moreover, it is also proposed that the tax exemption on sale of immovable property to REITs be removed. Today, there exists only one REIT in Pakistan, as there were several bottlenecks that hindered their growth. Now, other elements are largely sorted. One large mutual fund that was earlier thinking to attain approval from its board for establishment of a REIT may change its mind. There is no tax revenue gain for FBR from removing this exemption but will hurt the objective of promoting real estate development in the formal sector.

Similarly, exemption of tax on private equity fund was an incentive that led to promotion of the industry, although still quite nascent. But now the chances of PE funds' creation may become even dimmer. Furthermore, the IT companies are registering their protest on the changes proposed in their domain.

Of course, there were instances of abuse of the existing provisions in the law. One example is of Modarabas, which were largely established as tax evasion vehicles. The proposal to terminate the exemption is a positive step. Similarly, there was misuse of tax credit exemptions on capacity expansion that created distortions. It is better that they be removed altogether.

The bottom line is that the proposed amendments in finance bill cannot all be seen with one lens. Every amendment has its own merits and demerits. Some changes are welcomed but others may need to be revisited.

Copyright Business Recorder, 2021