Certificate in Accounting and Finance Principles of Taxation a ir) (= a 4 4 oO System of taxation in Pakistan Contents Objectives of tax laws Basics of taxation laws Introduction to different taxation laws of Pakistan History of tax laws in Pakistan Chapter review ‘B Emile Woot Intemational 7 “The Insitute of Chartered Accountants of PakistanPrinciples of taxation INTRODUCTION Learning outcomes The overall objective of the syllabus is to provide basic knowledge in the understanding of objectives of taxation and core areas of Income Tax Ordinance, 2001, Income Tax Rules 2002 and Sales Tax Act 1990 and Sales Tax Rules. Concepts Lowa Candidates will be able to comprehend the main objectives of taxation Lo1t2 Candidates will be able to justify taxation as means of development Lo124 Candidates will be able to understand the implication of direct and indirect taxation Lo13.1 Candidates will be able to comprehend different kinds of taxes and their scope Lo144 Candidates will be able to state the history of taxation in the sub-continent ‘© Emile Woot Intemational 2 “The Insitute of Chariered Accountants of PakistanChapter 1: System of taxation in Pakistan 1 OBJECTIVES OF TAX LAWS Seay Definition of taxation and objectives of the taxation laws Non-revenue objectives Mustration Taxes as mean for development 1.1 Definition of taxation and objectives of the taxation laws Taxation is defined in many ways, common definition is as under: tis the process by which the sovereign, through its law making body, raises revenues in order to use it for expenses of government. tis a means for the government in increasing its revenue under the authority of the law, purposely used to promote welfare and protection of its citizenry. 2 itis the collection of the share of individual and organizational income by a government under the authority ofthe law. 1.2 Nonrevenue objectives ‘Taxes are primary revenue yielding tools of the Government of modern ages. The government levies taxes in order to achieve following objectives: Q — Forcollection of revenue to run and administer the Government; Q_—Touse as a tool for implementation of its policies; and Q For fair distribution of wealth, Aside from purely financing government operational expenditures, taxation is also utilized as a tool fo carry out the national objective of social and economic development. To strengthen anaemic enterprises by granting them tax exemptions or other conditions or incentives for growth; A To protect local industries against foreign competition by increasing local import taxes; Asa bargaining too! in trade negotiations with other countries; To counter the effects of inflation or depression; Q—Toreduce inequalities in the distribution of wealth; To promote science and invention, finance educational activities or maintain and improve the efficiency of local forces; To implement laws which eliminate discrimination among various elements in the markets/businesses. To discourage certain undesirable sectors and activities. ‘B Emile Woot Intemational 3 “The Institute of Chartered Accountants of PakistanPrinciples of taxation 13 Illustration Mlustration: Objectives of Taxation Laws Explain what are the objectives of following tax laws: aroantg eyes Tax on salary income Revenue Collection ‘Any amount transferred otherwise than Documentation of economy banking channel will be deemed as income Taxon moveable assets of the taxpayers Fair distribution of wealth Higher taxes on import of ixury goods Reduction in imports of unnecessary goods and create good balance of trade Allowabilty of expenditure of research & Prom developments ion of research & developments Zero rating on Exports, reduced rates of taxes Promotion of Exports oon imports Tax credit on Donations to approved To promote culture of payment of donation to institutions only organised and regulated institutions Tax credit on investments Promote investments in listed companies Tax exemptions to software exports Promote software Industry 4.4 Taxes as means for development ‘Taxes are one of the main sources for development. This is not because revenue collected by the state is used on developmental projects. Rather, taxes can be used in many different ways for development of the country. Some examples are as under: (1 The Government can declare some areas as free zone, industrial zone, and economic zone and provide tax incentives to such areas.Such incentives could attract businessmaniindustrialistwho may opt to establish business concems/industrial units that would bring employment, opportunities and overall prosperity in these under developed areas. o Taxing the rich at higher rates while taxing the low income groups at lower tax rates. (1 Imposition of high custom duty rates on luxury items or kind of items which are also ‘manufactured in Pakistan, This promotes local manufacturers and industry. Tax credits on charity/donations to promote welfare activities. Tax exemptions to charity organisation/educational institutions to promote these activities. Q_ Taxincentives for agro based projects to promote agriculture. ‘© Emile Woot Intemational a “The Insitute of Chariered Accountants of PakistanChapter 1: System of taxation in Pakistan 2 BASICS OF TAXATION LAWS Seay Basics of tax laws Principles for levy of tax ‘Structure of taxes Forms of escape from taxation Strategies of taxation management IMustration . . . = Characteristics of tax laws . . . 2.1 Basics of tax laws ‘Adam Smith's in his famous book “Wealth of Nations” has elaborated following canons of Taxation: Q Equality Tax payments should be proportional to income and applied equally to all concerned areas Q Certainty Tax liabilities should be clear and certain Convenience of payment Taxes should be collected at a time and in a manner convenient for taxpayer Economy of collection ‘Taxes should not be expensive to collect and should not discourage business. 2.2 Principles for levy of tax Following are some broad principles for levy of taxes: a The Benefit Principle This principle holds that the individuals should be taxed in proportion to the benefits they receive from the governments and that taxes should be paid by those people who receive the direct benefit of government programs and projects out of the taxes paid. The Ability-to-Pay Principle This principle holds that taxes should relate with the person’s income or the ability to pay, that is, those with greater income or wealth who can afford to pay should be taxed. Similarly, even rate of tax could increase with higher income. The Equal-Distribution Principle Income, wealth and transaction may be taxed at a fixed percentage; that is, people who earn more and spend more should pay more taxes, but not pay a higher rate of tax. 2.3. Structure of taxes a Proportional tax/Flat Tax Atax system that requires the same percentage of income from all taxpayers regardless of their eamings. A proportional tax applies the same tax rate across low, middle and high- income taxpayers. The proportional tax is in contrast to a progressive tax, where taxpayers with higher incomes pay higher tax rates than taxpayers with lower incomes. A proportional tax is also called a flat tax. ‘B Emile Woot Intemational 3 “The Institute of Chartered Accountants of PakistanPrinciples of taxation a Regressive tax. A tax that takes a larger percentage from a person's low-income than from another person's high-income. A regressive tax is generally a tax that is applied uniformly. This ‘means that it hits lower-income individuals harder. Progressive tax. A tax that takes a larger percentage from high-income eamers than it does from low- income earners. In other words, the more one earns, the more tax he would have to pay. The tax amount is proportionately equal to someone's status in the society. A rich man should pay more than a poor man. 2.4 Characteristics of tax laws Following are major characteristics of a taxation system: a Taxis an enforced contribution ‘Tax payment is not voluntary in nature and the imposition is not dependent upon the will of the person taxed, Tax is generally payable in cash (bank) This means that payment by cheques, promissory notes, or in kind is not accepted. ‘Taxis proportionate in character Payment of taxes should be based on the abilty to pay principle; higher income of the tax payer, the bigger amount of the tax paid. Tax is levied (to impose; collect) on income, transactions or property ‘There are taxes that are imposed or levied on acts, rights or privileges. Tax is levied by the state which has jurisdiction over the person or property As a general rule, only persons, properties, acts, right or transaction within the jurisdiction of the taxing state are subjects for taxation, Tax is levied by the law making body of the state This means that law must be enacted first by the Partiament in Pakistan, Taxis levied for public purposes Taxes are imposed to support the government in implementation of projects and programs. Fiscal adequacy The sources of revenue taken as a whole should be sufficient to meet the expenditures of the government, regardless of business, export taxes, trade balances and problems of economic adjustments. Revenues should be capable of expanding or contracting annually in response to variations in public expenditures. Equality or Theoretical Justice Taxes levied must be based upon the ability of the citizen to pay. Administrative Feasibility In a successful tax system, tax should be clear and plain to taxpayers, capable of enforcement by the adequate and well-trained public officials, convenient as to the time and manner of payment and not unduly burdensome to discourage business activity Consistency or Compatibilty with Economic Goals Tax laws should be consistent with economic goals or programs of the government which pertain to basic services intended for the masses. ‘© Emile Woot Intemational é “The Insitute of Chariered Accountants of PakistanChapter 1: System of taxation in Pakistan 2.5 Forms of escape from taxation Q Shitting ‘+ Itis one way of passing the burden of tax from one person to another. For example: Taxes paid by the manufacturer may be shifted to the consumer by ‘adding the amount of the tax paid to the price of the product. Kinds of Shitting + Eorward shifting occurs when the burden of the tax is transferred from a factor of the production to the factor of distribution. Backward shifting occurs when the burden of tax is transferred from the consumer to the producer or manufacturer. = Onward shifting occurs when tax is shifted two or more times either forward or backward. 2 Capitalization ‘* This refers to the reduction in the price of the tax object to the capitalized value of future taxes which the purchaser expects to be called upon to pay. For example: A reduction made by the seller on the price of the real estate, in anticipation of the future tax to be shouldered by the future buyer. Transformation occurs when the manufacturer or producer upon whom the tax has been imposed pays the tax and endeavours to “recoup” (make up for) himself by improving his process of production. Tax Exemption is the granting of immunity or freedom from a financial charge or obligation cr burden to which others are subjected. Grounds for tax exemption ‘© Contract, wherein the government is the contracting party. + Public policy + Reciprocity 2.6 Strategies of taxation management Tax practitioners and taxpayer normally adopts any of the following technique to lessen tax burden: Tax avoidance is generally the legal exploitation of the tax regime to one's own advantage, io attempt to reduce the amount of tax that is payable by means that are within the law ‘whilst making a full disclosure of the material information to the tax authorities. Examples of tax avoidance involve using tax deductions, changing one's business structure through incorporation or establishing an offshore company in a tax haven 1 By contrast tax evasion is the general term for efforts by individuals, firms, trusts and other entities to evade the payment of taxes by illegal means. Tax evasion usually entails taxpayers deliberately misrepresenting or concealing the true state of their affairs to the tax authorities to reduce their tax liability, and includes, in particular, dishonest tax reporting (such as under declaring income, profits or gains; or overstating deductions). ‘B Emile Woo Intemational 7 “The Institute of Chartered Accountants of PakistanPrinciples of taxation 27 Mlustration Ilustration: Basics of Taxation Laws Explain which type of Tax strategy is being employed by following persons and what are its legal ‘consequences: brvang Mr. A earned Turnover of Rs. 10 M. However, he kept it as cash in his bank locker and hid it from tax authorities. He paid all related expenses from this cash Cen) Tax evasion , Criminal Act, he cannot buy any asset or settle liabilities unless he declares this income and also pays tax due on it Mr. B earned income of Rs, 10 M. However, he declared only so much of income which is verifiable from the banks i.e. 6M, remaining ‘amount he has hidden in a separate bank account This too is tax evasion, a understatement is also an offence Mr. C earned Rs. 10 M. However, he recorded ‘7M expenses employing legal tactics to reduce his net income and offering the ing income of Rs. 3 Million for Taxes. Tax avoidance, which is legally permissible. ‘© Emile Woot Intemational 3 “The Insitute of Chariered Accountants of PakistanChapter 1: System of taxation in Pakistan 3 INTRODUCTION TO DIFFERENT TAXATION LAWS OF PAKISTAN Seay = Brief overview of different direct and indirect taxes = Tax reliefs in cross border transactions 3.4. Brief overview of different direct and indirect taxes Federal taxes in Pakistan like most of the taxation systems in the world are classified into two broad categories, viz., direct and indirect taxes. A broad description regarding the nature of administration of these taxes is explained below: DIRECT TAXES Income Tax Direct taxes primarily comprise of Income Tax. In the Income Tax Ordinance, 2001, tax is levied generally on the net income of a taxpayer eared during a tax year computed by applying the specified tax rates as applicable to respective taxpayer. For the purpose of the charge of tax and the computation of total income, all income is classified under the following heads: a Salary Income from property 2 Income from business Capital gains; and 2 income from other sources Capital Value Tax Capital value tax on different transaction such as transfer of immoveable property, transfer of rights etc. INDIRECT TAXES Following are the indirect taxes under the Pakistani Taxation System Custom Duty Goods imported and exported from Pakistan are liable to rates of customs duties as prescribed in Pakistan Customs Tariff. Customs duties in the form of import duties and export duties constitute ‘a major part of the total tax receipts. The rate structure of customs duty is determined by a large number of socio-economic factors. However, the general scheme envisages higher rates on luxury items as well as on less essential goods. The import tariff has been given an industrial bias by keeping the duties on industrial plants and machinery and raw material lower than those on consumer goods, Federal Excise Duty Federal Excise duties are levied on a limited number of goods produced or manufactured, and services provided or rendered in Pakistan. On most of the items Federal Excise duty is charged on the basis of value or retail price. Some items are, however, chargeable to duty on the basis of weight or quantity. Classification of goods is done in accordance with the Harmonized Commodity Description and Coding system which is being used all over the world. All exports are liable to Zero per cent Federal Excise Duty. ‘Sales Tax Sales tax is levied at various stages of economic activity @17 per cent on: 2 Allgoods imported into Pakistan, payable by the importers ‘B Emile Woot Intemational a “The Institute of Chartered Accountants of PakistanPrinciples of taxation (All supplies made in Pakistan by a registered person in the course of furtherance of any business carried on by him ‘There is an in-built system of input tax adjustment and a registered person can make adjustment of tax paid at earlier stages against the tax payable by him on his supplies. Thus, the tax paid at any stage does not exceed 17% of the total sales price of the supplies. 3.2 Tax reliefs In cross border transactions In cross border transactions, Pakistan taxation system provides the following types of reliefs: Unilateral Relief ‘A person resident in Pakistan is entitled to a relief in tax on any income eared abroad, if such income has already been subjected to tax outside Pakistan. Proportionate relief is allowed on such income at an average rate of tax in Pakistan or abroad, whichever is lower. Agreement for avoldance of double taxation and fiscal evasion with respect to Taxes The Government of Pakistan has so far signed agreements to avoid double taxation with more than 50 countries including almost all the developed countries of the world. These agreements lay down the ceilings on tax rates applicable to different types of income arising in Pakistan. They also lay down some basic principles of taxation which cannot be modified unilaterally ‘© Emile Woot Intemational 70 “The Insitute of Chariered Accountants of PakistanChapter 1: System of taxation in Pakistan 4 HISTORY OF TAX LAWS IN PAKISTAN Seay History of tax laws in Pakistan 4.1. History of tax laws In Pakistan In Pakistan, Federal Government is empowered to levy and collect tax on the income of a person. The history of modem income taxation dates back to the year 1860. The British Empire introduced first formal Income Tax Act of 1860 in an effort to end the budgetary deficit faced due to the war of independence of 1857. The tax was not intended to be permanent and was repealed in 1865. The Income Tax Act of 1886 was a general income tax that had been imposed on traders by some of the provinces. This Act of 1886 was a great improvement on earlier enactments. Its basic scheme, by and large, survives till today. It introduced the definition of “agricultural income” which is almost the same as in the Income Tax Ordinance 2001. This Act continued in force for 32 years, The 1918 Act consolidated a number of wartime amendments. A graduated super tax on income over Rs.50,000 and on the undistributed profits of the corporation and other entities was introduced by the Super Tax Act of 1917 and continued in force through modifications by the ‘Super Tax Act of 1920. The Income Tax Act and the Super Tax Act were later on consolidated in another act i.e. the Income Tax Act of 1922, which remained in force in Pakistan till 30th June 1979; when the new law was promulgated i.e. the Income Tax Ordinance, 1979 with effect from ‘1st July 1979. Income Tax Ordinance 1979 was amended through innumerable presidential ordinances, annual finance acts/ordinances and statutory regulatory orders (SROs) and most of its lacunas were removed over a long period of time, However, after approximately 23 years of its existence when substantive amendments and judicial pronouncements made it a universally understandable and acceptable piece of legislation for everybody, a new ordinance i.) Income Tax Ordinance, 2001 was promulgated on 13th September 2001 ‘B Emile Woot International 1 “The Insitute of Chartered Accountants of PakistanPrinciples of taxation 5 CHAPTER REVIEW Pay Before moving on to the next chapter check that you now know: ‘What are the objectives of taxation Laws? ‘What are basics of taxation laws? ‘What are different types of direct and indirect taxes in Pakistan? ‘What are different types of tax reliefs in cross border transactions? ‘What are different federal taxation laws of Pakistan? ‘What is history of legislation of taxation laws in Pakistan? ‘© Emile Woot Intemational 7 “The Insitute of Chariered Accountants of Pakistan