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Why tax on reserves of corporates?

  1. Decline in world cotton prices
  2. WAPDA Bonds
  3. SECP launched to cleanse corporate sector
  4. Why tax on reserves of corporates?
  5. Ban on prize schemes
  6. Changes in SLR and CRR requirements

Apparently there is no logic as an exorbitant corporate tax is being charged on the earnings

July 19 - 25, 1999

While no where in the world the reserves of corporates are taxable, in Pakistan these have become taxable from the current financial year. This has been termed, on the one hand, an effort to squeeze tax from already burdened tax payers and on the other hand acceptance of failure of tax collectors to bring those under the tax net who have been rampantly evading tax. At the best this effort would defy the process of documentation of economy in the country and encourage tax evasion. The patience of tax payers has exceeded the tolerance limit.

According to new regulation, all companies having reserves 50 per cent or more than paid-up capital will be liable to pay 10 per cent tax on excess reserves. Most of the analysts term this highly ambiguous. Although the change in the income tax law, in recent budget, was aimed at penalizing companies which do not pay dividend despite huge earnings and transfer the earnings to reserves. The change will adversely affect the good performing companies which also pay dividend to their shareholders.

Some analysts say that the economic managers do not understand the philosophy behind imposing tax. At present roughly 42,000 incorporated companies, both private and public limited, are in operation in the country. This number is besides hundreds and thousand of proprietorship and partnership entities. Out of these only 769 companies are listed at the three stock exchanges operating in Pakistan. These less than eight hundred companies and their employees are also the main source of revenue collection for the government.

According to Etrat Hussain, chief executive of Paramount Leasing Company, the investors in public limited companies are already double taxes. Corporate tax is levied on the earnings and the dividend income of shareholders is also taxable. Now, the government wishes to collect yet another tax from these companies. This shows complete lack of understanding about the basic concept of transfer of earnings to reserves.

Therefore, first of all it is necessary to understand the purpose of transferring part of income to reserves. The objective is to accumulate money for future expansion of the operation of corporate and undertake BMR on regular basis. Besides, to have enough funds at the disposal of the corporate to take care of any contingency in the future. Yet another reason is to meet the statutory requirements in case of commercial banks and non banking financial institutions (NBFIs). By taxing the reserves the whole purpose is defeated. Above all there is absolutely no rationale in collecting tax on the reserves — part of earnings when income tax has been paid on the total income of the corporate.

According to many analysts, the corporate sector in Pakistan is not only over-burdened with taxes but a lot of time and energy of the management are being wasted on compliance of instructions of tax collection agencies. These agencies often raise inflated demands mainly to compensate for their inability to meet the required tax collection targets.

The employees of corporate sector also have a valid point. In the budget for the current financial year, salaries of government servants have been increased and perquisites of salaried class of private sector have become taxable. Most of the government employees are provided free accommodation, fully maintained cars, drivers and attendants. Why the cost of such facilities are not being added back to determine their tax liability? Why there is a discrimination between the government servants and the employees of private sector? If the government is serious in collecting tax from every citizen the parameters for calculating their tax liability should also be same for all.

According to the head of research of a fund manager, Theory of Finance says that if a company earns a return which is more than its weighted average cost of capital (WACC), than it should retain a higher portion of profit to reinvest into the business. This will ensure greater value-addition to shareholders. However, if the company earns a return on capital which is lower than WACC then it should distribute the profit to shareholders in the form of higher dividend. The Theory does not say that dividend should not be paid, only the payout ratio should commensurate with the firm's ability to earn a return equal or greater than WACC. Analysts have generally assessed that the WACC for a medium size Pakistani Company ranges from 22 to 28 per cent. If the return on average capital (ROAC) is lower than this range then there is a strong case for higher dividend payout. Analysts are generally of the view that fiscal policy, i.e. taxation, is not the appropriate way to tackle the non-payment of dividend by majority of the listed companies. They point out that it would be better if appropriate changes in corporate laws are made which are then strictly implemented with specific penalties on a case to case basis by the newly formed Securities and Exchange Commission of Pakistan.