The Income Tax Ordinance, 2001 (hereinafter "the Ordinance") contained progressive rates for taxing both individuals and association of persons (AOPs) until the Finance Act 2010 that imposed a flat rate of 25% tax on AOPs with retrospective effect.
The Finance Act 2010, except for this amendment, became effective from July 1, 2010, meaning by that all the amendments were applicable from the tax year 2011. AOPs, filing returns for the tax year 2010, caught unawares, were made to suffer because of this retrospective amendment, levying heavy rate of tax even for those small establishments having meagre income or income below taxable limits.
Of course, this was a move that was much resented and met with futile opposition but all AOPs were left with no option except to pay 25% as required under the law, as it was too late to dissolve the existing firms to take advantage of the rates meant for individuals.
When two or more persons join hands for the common purpose of earning income, they are assessed to tax as a single entity known as the AOP. But members or partners of AOPs are not considered a separate entity as is the case between a company and its shareholders. An AOP can comprise merely individuals, a group of non-individuals (firm, company etc) or a conglomeration of both individuals and non-individuals but the motive behind such an arrangement is just making profits through joint business operations. Under the tax law, constituents of AOP could be either members or partners depending on partnership agreements. In order to prevent corporate bodies taking advantage of lower rates of tax enjoyed by AOPs, the law clearly provides section 88A according to which, if any company is a member it would still be taxed at 35% (corporate rate of tax) on its share in profits from the AOP.
In our society, self-employed people are involved in a variety of ways to earn their living. Most of the times, they resort to simple methods requiring low capital, less complication, fewer employees and straightforward financial records. In this process, sometimes one individual finds himself handicapped on account of expertise or even finances and looks towards another for support. Under such circumstances, resources and know-how are pooled in to form a long lasting business relationship capable of yielding profits. Thus, small and medium-sized enterprises (SMEs) prefer to carry on as AOPs rather than corporate bodies. Even though there is no minimum limit of paid-up capital in order to get incorporated, there are many legal encumbrances and formalities that have to be fulfilled both at the time of registration and during the life-term of a company.
Besides, another very important factor that cannot be ignored is the high-level of illiteracy prevalent amongst the masses that renders them ignorant about the law. Since understanding and following corporate law necessitates sound education, very few persons would consider this as a practicable option. Not that all illiterate people are imprudent enough to realise the benefits of incorporation as they could be involved in multi-million rupee companies running their business successfully. Such cases are, however, very few and too insubstantial to be considered as exemplary.
The general commercial atmosphere which exists in this country is that of small and medium-sized businesses requiring fewer legal obligations. Considering this nature of our public, it comes as a surprise that the economic wizards of Pakistan have suddenly resorted to taxing AOPs at the rate of 25% of taxable income snatching from them the earlier facility available under paragraph 1 of Division 1 of the First Schedule to the Ordinance, wherein no tax was payable on taxable income of Rs 100,000 up to tax year 2009. Now after the amendment, tax of Rs 25,000 has been levied on this income which is an exorbitant amount on very small incomes.
Remarkably, it has escaped the attention of wizards sitting in FBR that any salary, brokerage, commission, profit on debt or any other remuneration etc paid to partners/members of AOP is an inadmissible expense under section 21(j) of the Ordinance, which is not the case for companies subjected to tax at the flat rate of 35% or 25% in the case of small companies. If the purpose was to force corporatization then the restriction of inadmissibility of such remunerations should also have been removed. On the one hand an exorbitant rate of 25% is imposed on all levels of incomes of AOPs and on the other they cannot claim as deductible expenses any amount paid to their members/partners. Parity demands that pre-2010 position should be restored in the case of non-corporate SMEs, or alternately clause (j) of section 21 should be deleted.
The different questions that come to one's mind include, (i) what could be the rationale behind this move and that too with retrospective effect? (ii) What was the need to send such a shock wave to AOPs in particular? (iii) Was the revenue increase considerable as a result of this measure? (iv) Who are the real beneficiaries of this amendment?
The obvious answer to the first three questions would be that there must have been some good increase in revenue collection as the AOPs were caught unawares and were understandably forced to pay 25% tax, even if their earnings were a paltry Rs 300,000 as per the new rates for tax year 2010. Such AOPs that would not have otherwise been liable to pay a single rupee had to pay Rs 75,000 tax on this income. There cannot be any doubt about enhanced revenues but what about those AOPs which were not even provided any option to exercise their choice of either continuing their partnerships and be willing to pay a high rate of tax or dissolving them to avail the benefits of being assessed as individuals.
Even from the perspective of revenue, the future does not seem so bright as the unsuspecting AOPs having once been bitten must have become twice shy and resorted to either going for dissolution or incorporation. It seems that the business of auditors must have got the biggest boost from this amendment as helpless members of AOPs rushed to them for advice. One wonders if this amendment was provoked by a certain segment of service providers to sustain their faltering businesses. Perhaps it brought in the much-needed respite from dwindling commercial activities hitting at the interests of some audit companies.
On the one hand, the FBR facilitated through this amendment expansion of business of auditors and on the other did not take into account the best practices in the world that do not allow external auditors to act as tax advisors for the same clients. India has already passed a law to this effect [section 44AB of the Income Tax Act, 1961] which was accepted by the Indian Council of Chartered Accountants barring external auditors to act as tax advisors in those cases in which they have signed audit reports. In the US, after the Enron case, the Congress passed the Sarbanes Oxlay Act, 2002, which imposed a bar on auditors to act as tax advisors for the same person.
Whatever may have been the rationale or logic for abruptly depriving AOPs from beneficial tax rates, the fact remains that this has been quite a detrimental amendment for small and medium trading bodies. Remarkably no such change has been contemplated by our neighbouring country India, which continues to maintain the same rates for AOPs as for individuals. The reason could be that their revenue authorities are not influenced by auditors - many of whom in Pakistan sit in reform committees of the FBR ignoring the well-established principle of conflict of interests.
(The writers, tax lawyers, are Adjunct Professors at Lahore University of Management Sciences)