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Post Budget SeminarFEDERAL BUDGET 2006-2007

Presentation

on Indirect Taxes

Syed Shabbar ZaidiPartner, A F Ferguson & Co

and

President The Institute of Chartered Accountants of Pakistan

The Income Tax Bar Association Karachi

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TABLE OF CONTENTS

Revenue Collection- Direct Vs Indirect Taxes Compositional Crises and Adjustments Import Substitution Doctrine of Necessity Expansion of Tax Net- VAT on Services Sales Tax on Leasing Transactions E-Intermediaries & Documentations Disallowance of Input Tax- Tax not paid by supplier Sales Tax on Retailers Concept of Minimum Value Addition Audit by Chartered Accountants Double Entry for VAT Account Integration of Documentation For Taxes Returns Conclusion & Suggestions

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REVENUE COLLECTION- DIRECT VS INDIRECT TAXES

2005-06 2006-07 Increase

Rs Billion DIRECT TAXES 235 33% 272 32% 37

INDIRECT TAXES 481 67% 569 68% 88

TOTAL 716 841 17

There is a projected increase of 17 % which is quite reasonable. However the ratio of direct to indirect taxes needs to be improved, otherwise the principle objective of equitable distribution of wealth can not be achieved. Another important aspect is to analyze whether there has been incidence of indirect taxes on essential items.

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COMPOSITIONAL CRISES AND ADJUSTMENTS

There has been reasonable improvement in tax collection however our tax policy is going through compositional crises which are:

Direct Vs Indirect Taxes Incidence on Corporate Vs Non Corporate Sector Geographical Imbalance

Unless and until there is a serious effort to undermine these imbalances a sustained increase in taxation revenue cannot be achieved. There had been effort to improve the situation however substantial efforts are still required.

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IMPORT SUBSTITUTION- THE NATIONAL AGENDA

Pakistan Economy is facing the following problems:

Trade Imbalance Poverty Unemployment Inflationary trend in commodities

All these issues have arisen primarily on account of the fact that there has been substantial real decline in small and medium sized industries in Pakistan. There had been substantial increase in volume of trade versus industrial production.

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IMPORT SUBSTITUTION- THE NATIONAL AGENDA (Cont’d)

The argument of WTO etc are raised to project and protect the trading sector. In my view the issue is import substitution. I call it ‘Reverse Exports’. There has been complete focus on promotion of export however there had never been a serious economic study on the matter of import substitution. Unless the issue of import substitution is taken as a subject, real economic issues can not be tackled. This includes the issue of cost of doing business, availability of finances, honeymoon for certain sectors such as real estate and stock markets, etc. However the important aspect to be examined is whether or not there are certain fiscal incentives or loopholes in our taxation system which promote trade versus industries. There are many at present. Unless the government curb these measure, any future real growth in economy and consequentially in economy cannot be achieved. Agenda for future should be IMPORT SUBSTITUTION

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IMPORT SUBSTITUTION - MAJOR AMENDMENTS TOWARD IMPORT SUBSTITUTION

Our exporters are facing cut throat competition in the international market. Government has given priority to allow the industrial input at lower cost. Duty rate against 49 industrial inputs have been reduced.

The importance of IT and Telecom sector is well recognized. In order to support this sector, government has reduced duty on 54 items to 5 per cent. The existing rate of duty on these items ranges between 10-25 per cent.

Cutting tools are the requirement of artisans, skilled and semi-skilled workers. Duty rates on 12 cutting tools have been reduced from 25 per cent to 20 per cent and 10 per cent to 5 per cent.

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IMPORT SUBSTITUTION - MAJOR AMENDMENTS TOWARD IMPORT SUBSTITUTION (Cont’d)

Steel and construction sectors are the fountain heads of most of the down stream industries like cement, ceramics, wood, paints, pipes and fittings, electrical fittings, wires and cables etc. In order to reduce the input cost of construction, duty on secondary quality flat rolled steel products has been reduced from 25 per cent to 20 per cent. Duty rates on 80 items of these sectors have also been reduced.

Government as a conscious policy is constantly reducing the duty on plastic raw materials so that per capital consumption of the item is increased. Customs duty on 11 items has been reduced to enable the industry to produce more goods and services.

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IMPORT SUBSTITUTION - MAJOR AMENDMENTS TOWARD IMPORT SUBSTITUTION (Cont’d)

Duty on 95 items of machinery, equipment and parts has been reduced.

Textile is the major foreign exchange spinner of Pakistan. Bulk of the production is exported. Duty drawback is paid to the exporters to the extent of import duty incident paid at the time of import of raw material etc. In order to give a free hand to this industry 14 chemicals used in the textile processing industry have been exempted from duty.

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DOCTRINE OF NECESSITY- MOTHER OF DISTORTION

In the Custom duty , Sales tax and Excise Regime there are various distortions from international best practices and VAT regimes. It is very disheartening to note that a substantial part of these distortions arise on account of the fact that business community at large has not accepted whole heartedly that ‘Payment of Tax and Documentation’ is not a desire but a necessity. When there are mass scale evasions and malpractices then governments adopts the doctrine of necessity and create distortions. Some of the example and reasons are:

Zero Rating for Export Oriented industries which arose due to mass outflow of refunds

Minimum value addition on commercial imports CVT on capital market which arose due to exemption for capital

gains Disallowance of input tax if tax not paid by supplier which arose

due to fake and flying invoices

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DOCTRINE OF NECESSITY- MOTHER OF DISTORTION (Cont’d)

The message is that all such measures in the long run would effect the system and we all would be at loss. We should not give Government a chance to apply the doctrine of necessity. As a community we should never promote any case which leads to non-documentation and short cuts.

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EXPANSION OF VAT ON SERVICES

This year there has been a substantial increase in the incidence of indirect tax on services. Major Examples are :

Tax on Non-Funded Banking services at the rate of 5 percent

Tax on Franchise Expansion of Tax on Insurance Services Expansion of Tax on Telecommunication services

This expansion of taxes on services is the part of Government policy to include services into VAT net which at present is limited to goods only. In this regard Government has taken into consideration the services provided by the organized sector only.

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EXPANSION OF VAT ON SERVICES (Cont’d)

There has been no incidence on unorganized sector services such as transport, doctors, etc. There has to be certain mechanism to cover those areas also. Furthermore at present this tax is a single stage tax. This mechanism is not correct. All such taxes be levied on pure VAT concept and adjustment be allowed.

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SALES TAX ON LEASING

In the original text of the Sales Tax laws there was a clear provision that is in line with international practice that lease would be treated as supply of goods thus subject to sales tax. However over the time such definition was changed and all kinds of leasing were taken out from the purview of sales tax. This happened notwithstanding the fact that hire-purchase continued to be subject to sales tax. Within the context of sales tax laws there is no distinction between a hire purchase transaction and a finance lease transaction. Thus, all such leases be taxed. Through this budget this anomaly has been corrected.

Consequently now all such leases would be treated as supply and subject to sales tax.

In Pakistan leasing is conducted by banks, DFI’s, modaraba and leasing companies. This would be a big change for such persons.

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SALES TAX ON LEASING (Cont’d)

In my view the issue under consideration is not of any new incidence as even at present such companies are passing the input tax borne to the customers. Any new incidence would be limited to difference between lease price and the cash price.

The real issue is the determination of mechanism through which such leasing company should discharge sales tax and the financial impact for the reason that timing of incidence of input tax does not commensurate with the output tax for the period as output tax would be in relation to rentals received. This could effect the cash flows.

CBR would have to sit down and decide the mechanism. My suggestion would be to review the VAT mechanism for Hire Purchase in UK and defer the implementation for one year.

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E- INTERMEDIARY AND DOCUMENTATION

All corporate sector’s Sales Tax and Federal Excise Returns will now be required to be filed electronically. This requires introduction of e-intermediary being a person authorized to filed return or information on behalf of the taxpayers. There are specific rules for the same. The issue to be settled by your institute and other professional bodies is the responsibility and liability of the e-intermediary. In my view the concept should not cater for anything more than an authorized representative. Nevertheless the question of sharing of responsibility of filing wrong information and custody and supply of information needs to be further clarified by the Board.

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E- INTERMEDIARY AND DOCUMENTATION (Cont’d)

The other aspect is the issue of documentation that has substantially increased including filing of quantitative data for 29 major commodities’ sales tax returns. This all leads to major role for professional accountants.

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DISALLOWANCE OF INPUT TAX IF TAX NOT PAID BY THE SUPPLIER

One of the important and strange amendment is the introduction of the concept of disallowance of input tax if the tax so claimed is not paid by the supplier. Within the overall context of collection of tax by the exchequer and the claim of input tax, the concept seems to be correct however there are practical lacuna in the implementation of this section.

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DISALLOWANCE OF INPUT TAX IF TAX NOT PAID BY THE SUPPLIER (Cont’d)

The primary issue is the manner of awareness to the buyer at the time of filing the return that such tax has not been paid. This matter needs to be resolved otherwise the law is not implementable.

On the contrary the underlying concept for the

introduction of this law seems to take into account the situations where the input tax has arisen on account of fake or flying invoice or the supplier has genuinely made a default in the payment of tax. As identified earlier this is a case of Doctrine of Necessity.

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DISALLOWANCE OF INPUT TAX IF TAX NOT PAID BY THE SUPPLIER (Cont’d)

There is a need to reexamine the current provisions and necessary amendments are required to be made to clarify the manner of application of law if made applicable. It would be my suggestion to withdraw this provision unless a proper system is not introduced.

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SALES TAX ON RETAILERS

There has been a major departure on basis of taxation for retailers. Now every retailer exceeding turnover of Rs 5 million will be paying taxes equal to 3 per cent of the value of turnover or at the option of the taxpayer on input / out put taxes at the rate of 15 per cent.

Previously such retailers other than, those engaged in one retail business of Export Oriented products were subject to tax at 10 per cent minimum value addition on purchases.

It is strongly recommended that this frequent swing for basis of taxation be stopped and one system be consistently applied.

Furthermore, it is reiterated that the term ‘Retail’ business be defined in practical sense.

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CONCEPT OF MINIMUM VALUE ADDITION

It is reiterated that concept of minimum value addition on import business is distortive in nature, however, such measures are introduced on account of ‘Doctrine of Necessity’.

This year, it has been further provided that in case of a commercial importer, there would be a minimum value addition of 5 per cent on local sale by such persons of locally manufactured goods.

This action is in principle a step to discourage under declaration of value addition. This step though regressive in nature, should on economic front assist in the ultimate goal for import substitution.

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CONCEPT OF MINIMUM VALUE ADDITION (Cont’d)

It is recommended that in order to promote the documented sector, such law should be made applicable for those corporate entities which provide proper information and discharge reasonable level of taxes (Income plus Sales tax)

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AUDIT BY CHARTERED ACCOUNTANTS

A new provision has been introduced whereunder all refund claims for export oriented would be ‘audited’ by a Chartered Accountant.

We are thankful to the Government for reposing confidence on this matter.

There has been certain discourse on the terms of reference and the charges.

It is my personal view (not as the President of the Institute) that role of an audit viz-a-viz certification and the relevance of an ‘Agreed upon procedures’ be discussed and finalized before entering into any such process.

Furthermore, the fee based on the amount of refund needs to be changed.

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DOUBLE ENTRY FOR VAT

This is a very important change that has not been fully appreciated by the accountants.

This means that all ‘Dr’ or ‘Cr’ entries related to Sales Tax would be kept in a separate account in the books of the Taxpayer. This would in effect mean the other side of a sales tax return.

I consider this step as an in built check. An auditor, now by implication would be required to give opinion on the validity of ‘Dr’ or ‘Cr’ is much clearer terms than earlier.

This mechanism is in place in UK and other VAT model countries and provide a reasonable check on the accuracy of return.

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INTEGRATION OF DOCUMENTATION FOR TAXES

As a process of second generation reform now there has been process of integration of return:

Sales Tax with Federal Excise Duty (One Return) Annual Sales Tax Return reconciled with Annual

Turnover as per accounts. Qualitative information in the return.

The message in quite clear. Now there has to be relationship of information being furnished to various organs of CBR.

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RETURNS

Previous Proposed

1) Retailers - Export Oriented Items Monthly Monthly

- Others Monthly Monthly

2) Commercial Importer Monthly Quarterly

3) Manufacturer - Quantitative Importer

(29 items) - Yes

- Others (20th following

month) Monthly Monthly + Yearly

4) Third Schedule Items Same Same

5) Others Monthly Monthly

6) Service Providers - Monthly

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CONCLUSION AND SUGGESTION

In 1996, when I stood at this forum and talked about ‘Tax Reforms’ and ‘Sales Tax’ there was a aura of ‘hopelessness’. I was hopeful then and today after a decade I am even more hopeful. We cannot show gloom to our future generations.

Now Defence expenditure is Rs 250 billion whereas Development Budget is 415 Billion. This is the result of positive thinking, framing fiscal laws with economic rationale and adoption of international best practices. However, we should not be complacent. We have yet to bridge a wide gap.

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CONCLUSION AND SUGGESTION (Cont’d)

Now the role has changed. It is now the matter of capability and capacity of spending by the Government.

My sincere request to the nation is to agree on a ‘Mesaaq Economics’.

There is no difference in the economic policies of almost all the parties and groups. If it is so, then why do we not agree that such policies will continue to be consistently applied. This would bring ‘Trust’ and improve investment climate.

Our future is bright.

Thank you