Realign the income tax regime

A UAE headquartered Islamic Bank alongwith a local bank, have won the mandate to domestically float Islamic bond (Sukuk) of Rs 4.2 billion - with eight year tenor - to fund the upgradation of Karachi Shipyard and Engineering Works (KSEW).
The bond will be backed by government guarantee and can be used as an investment by Islamic banks to meet the Statutory Liquidity Ratio obligations prescribed by the State Bank of Pakistan. This will be the third local Sukuk floatation undertaken thus far. Earlier, Wapda and Sui Southern Gas had floated similar bonds. There is a scarcity of government paper for Islamic banks, which restricts their ability to grow. Unfortunately the government has failed to float its own rupee denominated Sukuk despite a successful floatation of a dollar Sukuk over a year ago.
Unlike interest based bonds, the Islamic instruments require an asset backed structuring. KSEW can pledge its land and building works towards the issue. Similarly, the government would have to back its Sukuk paper with identifiable assets. However, the Islamic Ideology Council or the Shariah advisors have been unable to overcome this conceptualisation problem inherent in the guarantee.
Pakistan has so far failed to develop its bond market. For over two years, Prime Minister Shaukat Aziz as well as the mandarins in the Finance Ministry have been going on speaking engagements and road shows to attract private equity and hedge funds into the country.
These mega funds are flowing from the Middle East. They overfly Pakistan and land into India. Why? The reason is that our tax structure is not in line with international norms.
Foreign investors are required to pay 30 percent withholding tax on interest income generated through Fixed Income Government Securities, Repo/Reverse Repo and deposit products (termed as profit on debt under Section 152 of IT ordinance) when the investments flow through "Special Convertible Rupee Account" (SCRA). A disparity comes into view when the same investment is made in equity markets where there is no withholding tax applicable on capital gains and only 7.5-10 percent is charged on dividend income.
Another anomaly in this regard is the treatment of unit price appreciation of fixed income mutual funds.
The instruments available to fixed income funds are term deposit products, corporate bonds, government bonds, etc, and hence the unit price appreciates during the holding period due to interest accrual on underlying instruments. This, in fact, is interest income but the price appreciation in case of fixed income funds is considered, by CBR, as "Capital gain" and hence exempt from any withholding tax.
However, if a non-resident directly invests in any of the above products (term deposit products, corporate bonds, government bonds, etc) through SCRA the income is treated as "profit on debt" and attracts withholding tax at the rate of 30 percent. The high withholding tax kills the entire incentive of investing in fixed income instruments.
The absence of withholding tax in the local equity market has resulted in an inflow of $600 million in the Pakistani bourses. There is also growing interest by foreign Hedge/Mutual Funds for investments in Government of Pakistan securities and Fixed Income Mutual Funds.
Resolving the tax issue would help develop the local bond market in terms of liquidity and as well as tenors, by reducing market volatility. And it would result in the resurgence of a comatose long-term debt market, making it more meaningful in pricing long-term capital requirements of a growing private sector.
The government could restrict private equity to priority sectors such as textile; leather; I.T., etc, and, exclude the much sought sectors such as banking. The tax structure must permit charging of management fee of one to two percent. Percentage of profit earned over and above a benchmark in, say, five years (known as carryover the hurdle) may be permitted to the managing agency. The existing tax regime is more attuned to government managed businesses. It needs re-alignment with international investment norms.