Withholding tax system: automation

The economic topography of nations depends heavily on a robust revenue system, akin to the lifeblood sustaining its various functions. Diverse revenue streams, characterizing global economies with “tax revenue”, are emerging as the paramount source.

This crucial financial influx serves as the primary funding avenue for both current operational needs and vital developmental initiatives within a country. The effectiveness of tax revenue system significantly determines a nation’s fiscal health and its ability to address multifaceted economic demands.

In cases where dependence is mainly on tax revenue unable to meet the economic demands, governments resort to alternative, albeit costly measures such as debts, posing considerable fiscal burden.

Pakistan, facing a more than alarming predicament on this account, has been grappling with persistent imbalance between revenue generated and the escalating financial needs. Thus, the country is ensnared in a deadly debt trap.

With every passing day, monstrous size of debt burden is increasing, and net revenue left with the federal government are now entirely consumed to service the burgeoning debts demanding the need for effective fiscal strategies that are inevitable for sustainable economic stability.

The current scenario should be a serious concern for all who matter. If left unaddressed, we are on a trajectory where both the tax and non-tax revenues may solely be allocated to debt servicing.

In order to avert such a looming crisis, it is imperative to undertake a comprehensive overhaul and reevaluation of our taxation framework, aligning it strategically with the dynamic economic needs and market realities. This calls for an immediate proactive approach to reshape fiscal policies.

According to Federal Board of Revenue (FBR) Year Book 2022-23 for fiscal year (FY) 2022-23, the revenue collection reached “a historic milestone, surpassing the Rs. 7 trillion mark for the first time at Rs. 7.16 trillion”.

Despite this achievement, collection fell short by 0.5% of the revised target and approximately 4% from the original target. The major contributors to tax revenue in FY23 were direct taxes at Rs. 3.2 trillion (46%), sales tax at Rs. 2.59 trillion (36%), federal excise at Rs. 0.4 trillion (5%), and customs duty at Rs. 0.9 trillion (13%).

In FY23, revenue collection from withholding taxes amounted to Rs. 1.8 trillion, showing a substantial growth of 32.2% compared to Rs. 1.4 trillion in FY22. It confirms FBR’s main dependence on withholding taxes, primarily main spinner of its revenue stream. Withholding agents work for the State without any compensation, making it “forced labour” to collect or deduct taxes at source.

They have also to ensure timely deposit of funds in the government treasury. The withholding agents’ obligation to submit withholding statements, as prescribed in rules, imposes a cumbersome burden in terms of time and resources, resulting in elevated compliance costs.

They also face punitive actions and monetary penalties for alleged defaults. Those who squandered funds with or without the connivance of tax authorities are beneficiaries of illegal enrichment.

In FY23, approximately 57% of direct taxes were collected through withholding, signifying a substantial reliance on collection in indirect mode (compared to 66% in FY22). In pursuit of enhancing the efficiency of withholding processes, the Finance Act, 2022 introduced section 164A in the Income Tax Ordinance, 2001 that aimed to establish a fully automated system, enabling withholding agents to integrate seamlessly with the tax authorities.

The purpose of this integration was to facilitate real-time deposit of the withheld tax directly into the government treasury. This technological upgrade could have streamlined the entire withholding process marking a progressive step towards a more contemporary and efficient tax collection infrastructure. However, it has yet not been implemented for which high level probe is warranted.

In alignment with the objectives set forth, the Finance Act, 2022 also inserted sections 2(62B) and 182 in the Income Tax Ordinance, 2001. These presented the innovative concept of ‘Synchronized Withholding Administration & Payment System’ (SWAP). This groundbreaking initiative was aimed at transforming the landscape of withholding tax processes by incorporating SWAP Agents.

The core feature of SWAP is the automatic generation of withholding statements, thus heralding a paradigm shift in efficiency. Implementation of SWAP by Member (Digital Initiatives) of FBR can not only save valuable time of withholding agents, but also reduce compliance costs substantially, fostering a more business-friendly environment.

This automated system can serve as a key solution to various challenges, especially related to effectively addressing situations where agents fail to withhold or deposit taxes promptly—its quantum is in billions.

Additionally, it would ensure proper application of increased rates for inactive taxpayers, eliminating potential discrepancies while mitigating issues arising from inclusion of numerous entries categorized as “miscellaneous” taxpayers under dummy codes.

Such entries often pose difficulties for government agencies in establishing links for investigating potential tax avoidance schemes. The automated mechanism not only streamlines these processes but also enhances transparency and accountability in tax-related activities.

Since this initiative aims to automate the withholding tax system there are significant challenges that need attention to realize full potential of revenue generation. The ‘Tax Gap Report 2022’ sheds light on the disparity in sales tax collection, revealing a substantial gap.

The report indicates that the potential sales tax collection could reach Rs. 2209 billion, yet the revenue authority managed to collect only Rs. 1690 billion, a gap of Rs. 519 billion, representing approximately 24% of the tax collectable under the existing sales tax regime.

The disparity expanded when subjecting the data to a rigorous robustness check, utilizing the value-added approach, supply-use, and consumption approach-supply-use, revealing a 25% gap in the total collectible tax predominantly evident in sectors such as food and beverages, tobacco, textiles, wholesale, and retail trade.

Unfortunately, the discrepancy in income tax collection gaps surpasses that of sales tax, being 31% of the total tax collectible. The Report delineates that the potential gross income tax collection stands at Rs. 2833 billion, with estimated expenditures of Rs. 448 billion.

Consequently, net tax collectible amount was projected at Rs. 2385 billion, while the actual tax collected was Rs. 1655 billion, underlining a significant gap of Rs. 731 billion calling all the more for the need to implement comprehensive strategies to plug these gaps.

Head-wise data of income tax reveals even more alarming trends. The potential collectible income tax on ‘Salaries for Individuals’ was estimated at Rs. 153 billion, yet the tax collected amounted to Rs. 125 billion, unveiling a gap of Rs. 28 billion.

A disconcerting pattern emerges when examining Associations of Persons (AOPs) and non-salaried individuals, where the potential of total tax collection was Rs. 1300 billion, but the actual collection was only Rs. 545 billion—gap of Rs. 755 billion. Similarly, corporate tax collection was projected at Rs. 1380 billion, whereas the amount collected was 985 billion—a notable gap of 395 billion.

The disparities discussed above necessitate automation, especially implementation of SWAP. Inability to tap actual tax potential, and to crack down on informal economy directly affects compliant taxpayers and struggling classes.

It results in imposing additional taxes and duties burdening not only existing taxpayers, but also common citizens belonging to weak/marginalized segments of society. For alleviating these challenges, a comprehensive review of tax collection processes and policies is imperative, aiming for a more effective and equitable system elaborated in ‘Towards Flat, Low-rate, Broad and Predictable Taxes’ (PRIME Institute). This proactive stance is crucial to safeguarding the economic interests of both businesses and individuals, fostering a sustainable and balanced fiscal environment.

(Huzaima Bukhari & Dr. Ikramul Haq, lawyers and partners of Huzaima, Ikram & Ijaz, are Adjunct Faculty at Lahore University of Management Sciences (LUMS), members Advisory Board and Visiting Senior Fellows of Pakistan Institute of Development Economics (PIDE). Abdul Rauf Shakoori is a corporate lawyer based in the USA and an expert in ‘White Collar Crimes and Sanctions Compliance’. They have coauthored a book, Pakistan Tackling FATF: Challenges and Solutions)

Copyright Business Recorder, 2024