The Government has taken various positive steps to address the tax issues in the last four years or so. Given below is an inventory of some of the major tax issues facing the banks in Pakistan which still need to be resolved:
REFUNDS: The matter of refunds due to various banks needs to be resolved quickly. It is suggested that the Government settle this issue by issuing bonds to all the banks. Thereafter tax authorities should keep the position of assessments and the refunds current on a year to year basis and the practices to delay assessments to avoid refunds to assessee be stopped.
One related question is payment of interest on the refunds. Although provided in the law (Section 171 of the Income tax ordinance), the tax authorities have not been paying interest on assessed refunds due to the banks.
PROVISIONING FOR BAD DEBT ISSUE: Prudential regulations call for banks to set aside provisions for bad and doubtful debt.
However, such provisions are allowed as tax deductible for tax purposes only when all avenues to recover the debt have been explored.
This severely affects the financial viability and capital adequacy of banks. It may make banks pay income taxes even if they have incurred losses as per audited accounts. It also creates an incentive to postpone the recognition of loan losses.
BACKGROUND AND IMPLICATIONS: Provisioning for loan losses are necessary for prudential risk management and capital adequacy.
In Pakistan, the State Bank of Pakistan (SBP) has mandated the following provisioning for non-performing loans according to number of days that a loan is overdue:
TABLE 1
==========================================================================
Classification Time period for Provisioning required
which overdue (% of principal)
Short term loans Long term loans
--------------------------------------------------------------------------
OAEM 90 days 90 days 0
Substandard 180 days 1 year 20
Doubtful 1 year 2 years 50
Loss 2 years 3 years 100
==========================================================================
According to Section 29 0f the Income Tax Ordinance 2001 provisioning for bad debts can only be deducted if there are reasonable grounds to believe the debt to be irrecoverable.
In practice, this can only occur if all means of recovery have been exhausted and the loan written off.
One other issue is allow ability of the provisions on consumer loans, where the law restricts the allow ability to 3% of the income on consumer loans.
This should be amended to make atleast 3% of the consumer loans outstanding.
INTERNATIONAL PRACTICE AND DISCUSSION: While there is widespread acceptance of the need for banks to take provisions against bad or doubtful loans, there is controversy about whether such provisions should be deductible for income tax purposes.
The practice varies widely across countries. Many OECD countries including those in the European Union and Canada have liberal tax treatment, allowing generous tax deductions for loan loss provisions, while countries such as Japan, Korea, Mexico and Turkey have a more restrictive approach, although Japan began to adopt more liberal practices following the banking problems of the 1990s.
The United States also has a restrictive approach, allowing only write-offs to be deductible.
However, banks in the US are allowed to do partial write-offs, even as they try to pursue the delinquent party, making the tax treatment less restrictive.
In India, provisions are deductible up to 5 percent of total income and 10 percent of aggregate average advances made by rural branches.
Thus, Pakistan's tax treatment is somewhere in the middle: relatively liberal in the case of NCBs but restrictive for other banks.
From a business point of view, loan losses are an integral and inevitable part of operating expense for banks.
For this reason their deductibility should be allowed provided banks adhere to consistent and strictly enforced provisioning procedures as mandated by the SBP.
The argument that a true "loss" is one that is irreversible and that losses should be recognised only when the claim has been relinquished is not consistent with prudent business practice.
RECOMMENDATION: It is recommended that provisions made in accordance with the requirements of Prudential Regulations are allowed as a tax deductible expense.
ADVANCE TAX ISSUE: At present, banks and DFIs are required to pay advance tax based on current gross turnover; the tax is required to be calculated by applying the ratio of income to turnover of the latest assessed year.
Since profit margins of the banking industry have reduced significantly since 1998, the resultant tax payments are excessive and carry a loss of opportunity income for banks and DFIs as no compensation is payable on tax paid in advance.
BACKGROUND AND IMPLICATIONS: The current requirement for advance tax was introduced by Finance Act 1997. Prior to that year, assesses were required to calculate advance tax based on last assessed tax.
In addition, assesses were given the option of filing their own estimates of income and pay tax accordingly, but there was a penalty of 24% per annum if the estimate was less than 80% of the actual tax liability.
This practice allowed banks and DFIs enough flexibility to pay tax commensurate with their actual income and, at the same time, had a built-in incentive for banks and DFIs to estimate their tax liability as accurately as possible. This flexibility was withdrawn by Finance Act 1997.
INTERNATIONAL PRACTICE AND DISCUSSION: A number of countries give flexibility to banks and other financial institutions to pay advance tax on the basis of the current trend of profitability.
Specifically, this practice is followed in UK, USA, Hong Kong, Thailand, Brazil, and Canada.
In addition, UK, USA, Hong Kong, and Canada allow carry forward of losses for purposes of determining the amount of advance tax. UK and Brazil allow interest on amounts to be refunded.
This approach is only rational, as the income to turnover ratio in financial business is not a static factor.
Profitability may change significantly year-to-year depending on economic and monetary variables such as inflation, the level of economic activity that affects demand for financial services, and the exchange rate.
Changes in these variables ultimately affect the ratio of lending margins. A fixed ratio of income to turnover is seldom achieved.
The current policy on advance tax payments has the effect of blocking a large sum of resources of banks in unproductive assets.
RECOMMENDATION: In order to reduce the additional cost to banks and DFIs; following changes in policy on advance tax seem reasonable:
(a) Banks and DFIs may be allowed to file their own estimates of income and tax payable as was allowed prior to 1997. To discourage underestimation of income, a penalty in force prior to 1997 should be reintroduced;
(b) Carry forward of losses for advance tax purposes may be allowed to make realistic estimation of tax liability;
(c) Certificate for nil/reduced withholding tax may be issued, in all genuine cases;
(d) The timeframe for passing of the initial assessment order may be limited to no more than one year. This will ensure timely refunds in genuine cases; and
(e) Appeal effect orders should be passed within one month of the date of the appellate order in respect of any relief allowed by appellate authorities.
WITHHOLDING TAX ISSUE: At present, financial institutions are required to pay 20% withholding tax on income from Government securities.
This practice is unnecessary given the nature of banking business and that in some cases advance withholding tax paid exceeds actual tax liability leading to blockade of funds.
BACKGROUND AND IMPLICATIONS: Irrespective of the current state of actual earnings, tax is deducted at source from interest on Government Securities at 20%.
Although this tax is adjustable against advance tax liability, in the case of major banks having surplus liquidity invested in GOP securities, the deductions often exceed the advance tax liability and as a result huge refunds accumulate which are not paid back in time.
INTERNATIONAL PRACTICE AND DISCUSSION: Major countries such as UK, USA, Brazil, Canada, and Malaysia either do not require withholding tax on Government Securities or give option for withholding. However, Thailand requires a 1-% withholding tax on all Government payments.
The rationale behind levy of withholding tax is to ensure tax collections from those who may not file a proper tax return.
However, banks in almost all countries but particularly in Pakistan are major taxpayers and are fully covered by the tax net.
They pay advance tax every quarter. Also, investing in Government securities is a major business of banks and DFIs.
Therefore, the requirement of a withholding tax for banks is unnecessary. It simply adds to the transaction cost for banks as well as tax authorities.
RECOMMENDATION: Banks and DFIs should be exempted from withholding tax requirement.
TAXATION BY AZAD KASHMIR GOVERNMENT ISSUE: The taxes paid by banks and DFIs in Azad Kashmir is not allowed to be deducted fully in Pakistan.
Moreover, head office general charges (HOGC) apportioned to Kashmir operations, though certified by the external auditors of a bank/DFI are disallowed by Tax department.
BACKGROUND AND IMPLICATIONS: Resident banks/DFIs in Pakistan are liable to be taxed on their world income including income from branches located in Azad Kashmir.
The banks/DFIs are being regularly assessed in Azad Kashmir and the credit for tax assessed in Azad Kashmir is being allowed under the provisions of section 164 of the Income Tax Ordinance, 1979 in the relevant income year provided the bank/DFI is not assessed at a loss in Pakistan.
In other words if there is a loss in Pakistan (on a world-wide basis) the credit for tax paid in Azad Kashmir will not be allowed.
Azad Kashmir operations of Pakistani Banks/ DFIs are net provider of funds that are utilised in the rest of Pakistan through creation of assets.
Tax authorities in Azad Kashmir normally add between 1% to 4% to the internal pool rate of the banks/DFIs operating in Azad Kashmir and levy additional tax on the incremental amount.
Ostensibly, this is on the assumption by the Azad Kashmir Government that the bank is generating a higher return (than the pool rate) by investing such funds outside AK.
The tax paid on the income arising from the additional pool rate is disallowed by tax department in Pakistan resulting in double taxation.
Moreover, enhanced income of Azad Kashmir in Pakistan resulting from enhanced pool rate has corresponding effect of enhancing allocation of HOGC.
Azad Kashmir tax authorities disallow this additional apportionment of head office expenses.
Non-resident banks suffer even more because any taxes paid in Azad Kashmir are not deductible from income in Pakistan.
While Pakistani resident banks are, in principle, assured that they would not be subject to double taxation, there is no similar arrangement between Azad Kashmir and the country in which foreign banks are resident.
RECOMMENDATION: The current tax treatment is a major disincentive for banks to do business in Azad Kashmir depriving businesses in Azad Kashmir of competitive banking services.
TO RECTIFY THIS ANOMALOUS SITUATION THE FOLLOWING ACTIONS ARE RECOMMENDED: Full tax credit for tax paid in AK be legitimately allowed in Pakistan. Also, in case there is no tax liability in Pakistan, tax paid in Azad Kashmir should be allowed to be carried forward for adjustment against future tax liabilities in Pakistan.
DOUBLE TAXATION OF PERQUISITES: The issue of double taxation on perquisites, first in the hands of the employer in the form of excess perquisites and secondly in the hands of employees has not been addressed by the CBR as yet.
Consequently the perquisites are taxed twice first in the hands of employers if these exceed 50% of the basic pay for employees and is again taxed in the hands of the receiving employees.
RECOMMENDATION: Provisions relating to taxation of perquisites should be amended appropriately so that an item of perquisite to an employee is not taxed twice.
INTEREST IN SUSPENSE ISSUE: In 1998, the CBR began to tax interest income that accrued on a loan but was not paid, reopening assessments going back to 1991 for this purpose.
Thus, interest accrued on loans that had not been serviced for years-and on which the State Bank of Pakistan required the bank to take provisions-were taxed as if the interest payments had been received on time.
In the 2000 Finance Ordinance, the Government announced that interest credited to the suspense account after July 1, 2001 would not be treated as income.
However, it did not specify how to treat the large amounts of tax liabilities being disputed by banks for the period 1991-2000.
BACKGROUND AND IMPLICATIONS: For performing loans, accrual-based international accounting rules require that banks recognise income from assets at specified intervals regardless of the payments made.
However, for non-performing loans, SBP's prudential regulations following the international practice prohibit banks from creating any income from such loans; the rationale being that if the principal is considered to be non-recoverable, it would be illogical and imprudent to book income on such principal.
Therefore, SBP mandates the banks to keep in suspense; the interest income accrued on such a loan.
After classifying the debts as non-performing, banks continue to accrue the interest on such debt to the suspense account, even as they may continue litigation against the delinquent party to recover as much as they can.
Such regulatory treatment is also consistent with international accounting standards (IAS 18 and 30).
While the Government has resolved the situation going forward, the huge disputed taxes paid on interest in suspense in past years are seriously affecting banks finances.
INTERNATIONAL PRACTICE AND DISCUSSION: When interest payments are unlikely to be paid, accrual methods would overstate bank income and the bank would end up paying taxes on income that has not been received and is not likely to be received.
This is why for non-performing loans, best practice calls for banks to switch from accrual accounting to cash based accounting, recording income only when it is actually paid.
Therefore, the policy from FY2000 onwards for banks is rational and sensible. It is also consistent with international accounting standards (IAS 18 and 30).
PROPOSED SOLUTION: As the Government has essentially acknowledged the inappropriateness of past practice, it should go further in moving towards a fair settlement of taxes already paid since 1990/91 on this account.
WITHHOLDING TAX ON INSTRUMENTS: Withholding tax is applicable to payments by way of profit or interest on bonds, certificates, debentures, securities or instruments of any kind issued by any banking company or any company or local authority or finance society.
The words "securities or instruments of any kind" have always been interpreted to relate to instruments such as TFCs, Certificates of Investment, WAPDA Bonds and similar instruments issued by the entities and not to loan and financing agreements which are bilateral agreements executed between a banking company and its borrowers.
However, the tax authorities had held the view that a loan agreement falls within the term "instruments of any kind" referred to in section 50(7D) of the Income Tax Ordinance, 1979.
They issued show cause notices to banks' customers requiring them to give reasons as to why tax was not deducted whilst making interest payments.
RECOMMENDATIONS: While the anomaly has been addressed in the income tax ordinance 2001, the issue has remained un-resolved in the past assessments as the matter is pending before Sindh High Court.
It is recommended that CBR take steps to address the past issues.
INTERNATIONAL ACCOUNTING STANDARD 39 There is a proposal currently under consideration to implement IAS 39. Large banks in particular and banking industry in general would be required to make additional substantial provisions in respect of their non-performing loans.
Currency SBP Prudential Regulations require to determine Provision against NPLs after taking forced sale value of mortgages.
IAS 39 requires determination of provision based on present value of expected cash flows from the financial assets.
The difference between the two methods would result in large substantial provisions.
These large provisions would again be disputed by tax department in the tax assessment of banks.
Furthermore IAS 39 would require recognition of income on non-performing loans. This would mean that income that is carried to a "Suspense" account currently will be carried to profit and loss account under IAS 39.
This again will create tax complications. ICAP and SBP should convince CBR now, not to tax these items on implementation of IAS 39, otherwise the banks would end up with huge taxes stuck up again, on account of disallowance of provisions for bad debts and tax on interest income against NPLs taken to profit and loss account in compliance of the IAS 39.
DERIVATIVES: With the help of SBP derivative products like FRAs will be introduced in Pakistan soon.
It is important that CBR now decide about taxability of income on such products rather than taking adverse decision on recognition of income later which might kill such products.
UNDERSTANDING THE BANKING: There is a need that CBR understand that banking is a specialised field and for that purpose is has to train the tax officers. It is proposed that CBR and Pakistan Banks Association join hands together and provide training on job to tax officers.
This will greatly help developing understanding of the banking business in the tax department.
SEPARATE SCHEDULE FOR BANKS: "Financial services" is a specialised field. In order to resolve its tax issue CBR may consider a separate schedule in the income tax ordinance for computation of tax of companies engaged in "financial services" covering banks, leasing companies mutual funds, investment companies etc.
It is recommended that if such a schedule is acceptable, income of 'financial sector' should be accepted under the proposed schedule based on the financial statements prepared in accordance with the international accounting standards and SBP/SECP requirements adjusted for normal timing and permanent differences.
SALES TAX IN CASE OF BANKS: Banks operate as unregistered persons under the sales tax regime and consequently pay 3% higher charge.
It is recommended that the banks be allowed to register to be able to reduce the sales tax charge in their case by 3%.
COLLECTION CHARGES: Banks and companies are providing services to CBR by collecting funds and depositing it on its behalf.
In addition they maintain records for CBR for this purpose. All such services are being provided without any compensation by CBR.
Comments
Comments are closed.