The Finance Act, 2022 introduced a novel tax under Section (7E) of the Income Tax Ordinance, 2001. This is deemed income in the hands of an owner, based on the fair value, even if it is a vacant plot of land, etc. The matter has been held intra vires by the Sindh High Court (The Order) on mis-application and misinterpretation of taxing rights under the Constitution.
The order is under appeal before the Supreme Court of Pakistan and the Honourable Supreme Court has decided to form a larger bench on this matter. A larger bench is also required, if another decision of the Supreme Court in the case of the Elahi Cotton Mills Limited is to be reexamined. It is possible that the said decision may be corrected, interpreted or overruled.
The author has been following this case and has read the Order of the Sindh High Court, which is under appeal. Furthermore, the arguments raised in the hearing before the Supreme Court have also been published by this esteemed newspaper.
It is the firm view of the author that certain fundamental points on this matter have not been taken up in the order or in the appellants’ arguments. It is in the interest of justice that a complete discourse is made on the matter which, in the opinion of the author, has not been correctly decided.
The Law
The provision introduced by the Finance Act, 2022 is as under:
7E. Tax on deemed income.-
(1) For tax year 2022 and onwards, a tax shall be imposed at the rates specified in Division VIIIC of Part-I of the First Schedule on the income specified in this section.
(2) A resident person shall be treated to have derived, as income chargeable to tax under this section, an amount equal to five percent of the fair market value of capital assets situated in Pakistan held on the last day of tax year……….
What does this law mean?
Under this provision a notional sum, not supported by any ‘economic transaction’ or event is ‘treated to have derived’, as ‘income’ chargeable to tax under this section, being equal to five percent of the fair market value of capital assets situated in Pakistan.
There are three relevant components in the aforesaid statement being:
a. There is no ‘Economic transaction’ or event. The only relationship of person being taxed is the ownership of that capital asset;
b. It is accepted that there is no income but ‘treated to have derived (deeming);
c. It is assumed that the tax being levied under Section 7E is covered by Entry 47, 48 or 52 of the Federal Legislative List to the Fourth Schedule to the Constitution (List).
This means that in order to levy tax under Section 7E, no ‘economic transaction’ is required to be there. The tax incidence arises without any economic event. Everything is notional and imaginary based on the ownership of an asset. In other words, to create a tax incidence a notional income has been related to ownership of a capital asset situated in Pakistan, which is owned by a resident person.
In other words, under this novel provision, a sum being a percentage of fair value of that capital asset, not being the cost, without any economic transaction, is treated to have been derived as ‘income’ chargeable under the Income Tax Ordinance, 2001.
This unprecedented extension of the meaning of ‘income’ is novel. However, detailed deliberations on this matter are available in the Order of the Sindh High Court. Nevertheless, the author considers that the High Court has not been fully assisted/apprised on the real defects in the legislation. These defects have been identified in the following paragraphs.
In order to keep the matter within the ambit of cohesive discussion the author has framed the following questions:
Questions requiring clarification
Whether or not any ‘income’ tax can be levied based on capital value of property under the Constitution?
If the answer to question (1) is in the affirmative, whether or not any tax under Entry 50 of the Federal Legislative List can be charged on a value other than cost of assets? [Section (7E) is based on fair value of assets]
What are the limits and boundaries of Entries 47, 48 and 52 of the Federal Legislative List?
Whether or not the tax under Section (7E) is a transgression of what is stated in Entries 47, 48 or 52, even if the decision of the Supreme Court of Pakistan in the case of the Elahi Cotton Mills Limited is followed?
Whether or not the concept of ‘Annual Letting Value’ (ALV) as referred to in the High Court’s order under appeal is a misleading reference and reliance as the said concept was discarded in the Income Tax Act, 2001? (This concept existed in the repealed Income Tax Ordinance, 1979 and Income Tax Act, 1922)
Question 1 & 2
Taxing Rights under the Constitution
Taxing rights and their text under the Constitution are exactly the same as those in the Government of India Act, 1935 and that contained in the Indian Constitution. The relevant provisions are produced as under:
Government of India Act, 1935
- Corporation tax.
………54. Taxes on income other than agricultural income.
- Taxes on the capital value of the assets, exclusive of agricultural land, of individuals and companies; taxes on the capital of companies.
Indian Union List
- Taxes on income other than agricultural income.
………..85. Corporation tax.
- Taxes on the capital value of the assets, exclusive of agricultural land, of individuals and companies; taxes on the capital of companies.
Constitution of Pakistan
Taxes on income other than agricultural income.
Taxes on corporations.
Taxes on capital value of the assets, not including taxes on immovable property.
Taxes on mineral oil, natural gas and minerals for use in generation of nuclear energy.
Taxes and duties on the production capacity of any plant, machinery, undertaking, establishment or installation in lieu of the taxes and duties specified in entries 44, 47, 48 and 49 or in lieu of any one or more of them.
This establishes that the Constitutional position with regard to ‘Tax on Capital Value of Assets’ has not changed since 1935.
The fundamental issue which is missing in the Order of the High Court and the arguments so far presented, relates to the question whether any tax, based on the Capital Value of Assets, be levied as ‘Income tax’ as a part of The Income Tax Ordinance, 2001 Or the said tax can only be levied under Entry 50 which will be separate tax; not being a part of Income Tax Ordinance, 2001, e.g., Capital Value Tax, 2022.
It is a settled position based on the precedents of legislation in Pakistan that tax under Entry 50 has always been legislated as a separate law not being a part of the Income Tax Ordinance, 2001. The Income Tax Ordinance can only tax something which is governed by Entries 47 and 48 of the List or the stretched position, as done in the case of Elahi Cotton Mills Limited under Entry 52 of the List.
This principle has been clearly demonstrated by two such taxes being Capital Value Tax levied in 1987 and Capital Value Tax imposed in 2022.
This establishes that if 7E is a tax under Entry 50 of the List then it is ab-initio ultra vires if levied under the Income Tax Ordinance, 2001. At this juncture it is unnecessary to argue the second part of the entry being that such tax be levied on immovable or movable property. In all situations no tax under Entry 50 can be levied under the Income Tax Ordinance, 2001.
It is unfortunate that this simple and straightforward point has not been raised in the Order of the High Court and the appellants argument.
Notwithstanding this primary defect, even if it can be so tax under Entry 50 of the Federal Legislative List can be based on cost of the capital assets and not the fair value of the asset.
Tax is required to be based on the cost and not fair value of assets
Whilst drafting the legislation it has been completely ignored that under the Income Tax law in Pakistan there cannot be any taxation on the fair value of assets. Income can only be taxed on the value of transaction or a deemed value of the transaction emanating from the transaction such as imported cost in case of commercial imports. An income can never be taxed on an illusionary, unsubstantiated fair value of an asset.
The concept of a fair value is only applicable in the Income tax Ordinance, 2001 on disposal of capital assets; where there is non-arm’s length transaction between the buyer and the seller. In all other situations, the basis of taxation is always the cost or any value derived from the cost.
Section (7E) is based on the fair value of the assets. There can be no tax on such a basis under Entries 47, 48 or 52. If the said tax is treated to be a tax under Entry 50 even then the said tax has been erroneously levied on the fair value of the assets instead of cost. There is no such right under that Entry also.
This argument has also not been raised anywhere in the order of the High Court and appellate arguments.
Question 3
Meaning and extent of Deemed Income and the Elahi Cotton Case
Income tax on ‘Presumptive’ and/or ‘Turnover’ were levied by the Finance Act, 1991 in the repealed Income Tax Ordinance, 1979. Presumptive tax means that a part of the value of a transaction or taxes collected etc, not being a sum determined after deducting expenses from the sale proceeds of an item, is treated as ‘deemed income’. Furthermore a part of turnover (sale value) is treated/or deemed as income taxable under the Income Tax Ordinance, 2001.
The meaning and extent of deemed income were contested before the Supreme Court of Pakistan and the decision has been referred to as the Elahi Cotton Mills Limited case reported as l1997 SLD 340,1997 PLD 582, (1996) 76 TAX 5, 1997 PTD 1555,1997 PTCL 260. In this case, the Supreme Court of Pakistan discussed the matter of the sum which can be taxed as income under the income tax law.
(To be continued tomorrow)
Copyright Business Recorder, 2024
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