Separate mechanism for taxation of small companies has been recently introduced in the Income Tax Ordinance, 2001, which apparently seeks to encourage corporatization of small businesses. A major portion of business in Pakistan is conducted informally through sole or family proprietorships (which are often unregistered) without any proper organisational structure or legal form. It also means that a major portion of revenue generated through these businesses escapes the tax net.
On the other hand, it is difficult for more formal business entities such as companies or partnerships to evade taxes. Typically, company's profits are taxed twice: firstly, as income of the company when such profits are earned, and secondly, as income of its owners (shareholders) when such profits are distributed to the owners in the form of dividends or capital gains. This two level taxation on corporate form has always been a barrier to corporatization of small businesses.
All over the world, companies suffer from the menace of double taxation of its profits. The dual tax that companies have to pay on its profits is presumably derived from the notion that a company is a separate legal personality distinct from its shareholder(s).
TAX POLICY - A TOOL FOR ENCOURAGING CORPORATIZATION In order to broaden the tax base and to increase its direct tax revenues, government is rigorously working on a plan to encourage small business persons and traders to convert their informal businesses and sole or family proprietorships into more formal corporate structures. The first major step taken by the government towards encouraging corporatization of small businesses was to allow 'single member companies' under the Single Member Company Rules, 2002 whereby a single shareholder could transform his/her existing business into a single-member company as a single shareholder and at the same time be the only director and officer of that single member company.
Furthermore, ongoing compliance requirements were remarkably reduced (which may be very cumbersome for private and public companies). This allowed small business persons, proprietors and traders to incorporate their informal businesses. However, there was still a major obstacle. As a sole proprietorship, there was only one tax on the profits of the business being run as a sole proprietorship, because the law does not recognise a sole proprietorship as a legal entity (as opposed to a company).
The income of the proprietorship could be shown on the tax returns of the owner of that proprietorship, who would then be taxed according to his/her relevant tax bracket depending on the amount of income. However, if that business was transformed into a single member company, the profits of that business now had to be taxed twice: once at the hands of the company and once at the hands of its shareholder as his/her income. The rate of tax for a single member company was also fixed at much higher rate (currently at 39%).
The whole purpose of writing a new set of tax laws was to rationalise and insofar as possible, simplify the previous tax code. Simplification of the tax laws is universally considered to be the hallmark for greater tax compliance, especially in the low tax base countries such as Pakistan. Introducing different levels of taxation and separate treatment of various legal entities would ultimately lead to huge tax distortions.
Arguably, such tax distortions not only provide a tool for tax evasion to the clever and well-informed, but also discourage free competition in the business sector. With removal of various exemptions, subsidies and other tools of preference of one industry over the other, the whole jurisprudence of the tax code revolves around promoting equal treatment and free competition.
It, therefore, appears that the concept of 'taxation of small companies' is a contradiction of the overall tax policy of the government.
A CLOSER LOOK AT S. 2(59A) Under the newly inserted Section 2 (59A) of the Income Tax Ordinance, 2001, the term "Small Company" has been defined as a company that is incorporated after July 01, 2005 and i) has undistributed reserves and paid-up capital not exceeding Rs 25 Million; ii) has annual turnover not exceeding Rs 200 Million; and iii) is not formed by the splitting up or reconstitution of the business already in existence.
A preferred tax rate of 20% has been prescribed on profits made by a Small Company. Furthermore, Small Company has been exempt from the withholding requirements under S. 153 and payment of minimum tax requirements under S. 113.
A reduced rate of taxation of 20% (as opposed to 39% for private companies), exemption from requirement of deducting withholding taxes on payments for goods and services and exemption of payment of minimum tax requirements are the three incentives given to a Small Company under the recent amendments to the Income Tax Ordinance.
FLAWS IN THE REGIME OF SMALL COMPANY TAXATION
REPRESENTATIVE PROBLEM NO 1 The criterion defined by S. 2 (59A) would perhaps encompass a great number of businesses being managed in the country today, ranging from many private limited companies, family proprietorships and partnerships, sole proprietorships, shops, traders, brokers, indenters, suppliers, wholesalers, retailers etc.
Some of these businesses are no doubt being run as sole proprietorships or as informal business set-ups. However, a great majority of these businesses also comprise already existing private limited companies and association of persons (partnerships). An apparent flaw that one may notice without much deliberation is that the lower tax rate incentive (as explained above) only covers small companies that have chosen to incorporate on of after July 01, 2005.
The already existing private limited companies (which may form a significant portion of the group) are prohibited from reorganising, splitting up or reconstituting to avail the lower tax rate of 20%. This means that such already existing private companies would continue to pay to pay tax at the rate of 39%.
Suppose that a company named Acme Aircraft Parts & Co which is registered as private limited company is engaged in the business of manufacturing spare parts for aircraft in a factory located outside Lahore, and supplies hi tech aircraft parts to British Airways.
Suppose that the total paid-up capital of Acme is Rs 24 million and its total annual turnover is Rs 199 million with a net profit (before taxation) of Rs 20 million for the year 2005. Assume that the rate of tax for private companies for the year 2005 was 39%.
Therefore, the total tax payable by Acme would be Rs 7,800,000/- as tax on its income and a net profit of Rs 12,200,000/-.
Now let's suppose another firm ABC Partners was engaged in the same business and has now incorporated its business as a Small Company pursuant to the new incentives given to Small Companies and is now called ABC & Co Suppose that the annual revenues of ABC are also Rs 199 million and a net profit before taxation of Rs 20 million for the year 2005. Now the rate of tax for ABC would be 20% because it is a small company.
Therefore, total tax payable by ABC on the same amount of profits as that of Acme would be Rs 4,000,000/-. Please note that there is a Rs 3,200,000/- difference between the tax payable by Acme from that of ABC solely because ABC is a newly registered company whereas Acme was already conducting business in the corporate form.
Because both companies in our above example belong to the same industry and most likely compete for the same supply contracts and orders, this new regime potentially favours one business over the other.
Suppose that due to low rate of taxation and a Rs 3,200,000/- savings, ABC can lower its costs and perhaps drive Acme out of the market. In a way, in our preposition, the government has directly subsidised one business to drive another business out of the market.
REPRESENTATIVE PROBLEM NO 2 Suppose there is a trader Ali who runs a small grocery store in Faisalabad. The total income generated by Ali (exclusive of taxes) from the grocery store for the year 2004 was Rs 290,000/-. Since Ali operated the grocery store as a sole proprietorship, the income of grocery store was considered to be Ali's personal income under the tax law.
Therefore, the total tax payable by Ali for the year 2004 was Rs 28,750 based on a tax rate of 12.5% for Ali's tax bracket. Ali's net income after deducting taxes amounts to Rs 261,250/-.
Now suppose that inspired by government's policy of encouraging corporatization of small businesses, Ali decides to convert his grocery business from proprietorship to a 'single member company' who he names as Best Grocery Ltd. Now suppose that Best Grocery Ltd earns Rs 290,000/- for the year 2004. Based on the then prevailing rate of 41% for private companies, the total tax payable by Best Grocery Ltd would be Rs 118,900/-. After paying the tax, Best Grocery Ltd is left with Rs 171,100/- as its net income.
This amount of Rs 171,100/- is distributed by Best Grocery Ltd to Ali as his profit in the form of dividend. Upon such distribution a further tax on dividends amounting to Rs 17,100/- at the rate of 10% is levied. Ali receives the remaining amount of Rs 154,000/- as his total income for the year 2004 for being the sole owner of Best Grocery Ltd.
As we have seen above, for Ali, running the business as sole proprietorship has earned him Rs 261,250/-. On the other hand, corporatization of his business would only leave him with Rs 154,000/-. The difference of Rs 107,250/- has been lost in tax distortions. Only a mere change in form of the business has cost Ali 107,250/-.
No doubt that the introduction of this new regime of taxation of small companies has been introduced as an attempt to increase tax compliance and corporatization. However, the effectiveness of this regime is doubtful and its distortions more than clear.
Under this new regime, a small company would be taxed at the rate of 20% as opposed to 39% for a private company. Many private companies and most of the single member companies would fall under the 'small company' regime but we also need to figure out whether reduction in the tax rate would do anything to reduce the tax incidence on Ali. As a sole proprietor, based on his income, Ali falls under the category which is taxed at the rate of 12.5%.
Tax incidence for Ali for running his business and earning the amount of money he normally earns is typically 12.5%. Does the introduction of this new 'small company' tax regime ensures that Ali's tax incidence remains the same even after he decides to corporatize his business? Very clearly, the answer is in the negative. Ali's tax incidence would remarkably increase in case he decides to shift from informal setup and incorporate his business.
These are the kind of tax distortions which festers the growth of a business economy, restrain expansion, and create hurdles in free competition, and would ultimately cost the economy and the tax bill.
It is true that certain steps need to be taken to provide incentive to small traders and business persons to corporatize their businesses and move to formal economy. One such step would be to provide such new entrants a relief from the menace of double taxation (as described above). It is not clear whether the mechanism adopted by the policy makers is the most efficient.
Similarly, the new addition in the tax code regarding separate and to some extent preferred rate of taxation for small companies is not adequate enough to lure small informal businesses to incorporate. Any trader conducting business through informal business entities is very likely to think about the issues described in the above prepositions.
In view of the aforesaid, it is highly unlikely that this cosmetic change would bear any fruitful result and it seems that the attempts made by the policy -makers to encourage corporatization of small and informal businesses and consequently hoping to increase the corporate tax base is more likely to fail due to the creeping disincentives created by the changes which were ironically introduced to provide incentives.
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