May 24 - 30, 2010

Value-added tax (VAT) is based on value addition at source and exports are zero-rated on the destination principle. Hence, there is an in-built need for the documentation of transactions involved in the entire supply chain in the export business. Being an indirect tax, VAT is paid by final consumers. The VAT requires extensive documentation to process. The establishment of an institutional framework with reference to multiple options for policy, enforcement, and relationship between various stakeholders is considered as the most serious challenge at the time of introducing VAT. VAT system is marred by fake invoices creating difficulties for its smooth functioning. Textiles cater for the major exportable commodities of Pakistan. Various intermediary manufacturing and processing activities are largely carried out in the unorganized and undocumented sector.

This gap is filled by invoicing malpractices to inflate refund and suppress local supplies. Thus the refund issue in the textile sector poses enormous challenges for the VAT administration in Pakistan.

Pakistan plans to seek the assistance of experts from international lending agencies for smooth enforcement of VAT, a condition set by the International Monetary Fund (IMF) for release of $1.2 billion loan to the country, from next fiscal year 2010-11, starting from July 1. The IMF is expected to appoint a technical person to assist the World Bank and government teams till July 1 when the VAT becomes effective with the announcement of the federal budget.

The controversy over imposition of VAT between Centre and Sindh province could not be resolved despite strong efforts as the former remained firm on its resolve to collect VAT on services.

The issues relating to VAT on local supplies of zero-rated sectors are debatable. There is a suggestion of levying a nominal 2.5 minimum rate of VAT on the local supplies made by the five export oriented industries; textile, leather, sports goods, surgical instruments and carpets.

The business community fears that the VAT would create problems for the retail sector due to higher rates and documentation. Businessmen contend the delay in refund payment would be the biggest hurdle in smooth implementation. Textile sector objected that the FBR should not abolish domestic zero-rating, as it would again result in accumulation of refunds. It is argued that five major export-sectors are zero-rated due to frauds in sales tax refund payment. In case Expeditious Refund System of the VAT failed to give timely refund, this would create serious distortion in the VAT regime and refund would again be blocked.

There is however no concept of zero-rating on the local supplies in all the best VAT administrations across the world. Therefore, zero-rating facility should only be limited to the export sectors and local supplies be subjected to VAT on the pattern of best tax administrations. Presently, zero-rating facility is also available on domestic consumption.

The establishment of an institutional framework with reference to multiple options for policy, enforcement, and relationship between various stakeholders is considered as the most serious challenge at the time of introducing VAT. The operating rules need to conform to international best practices and peculiar local circumstances.

Federal Board of Revenue (FBR) has proposed a 15 percent VAT. The Senate standing committee on finance has proposed to reduce the rate of VAT from 15 percent to 12.5 percent, as the VAT is inflationary in nature. The committee proposed that 15 percent VAT will have a burden of 21 percent on the taxpayers, and hence initially, the tax rate should be fixed at 12.5 percent. FBR has shown no objection to reduce the rate of VAT to 12.5 percent in case the government is ready to sustain the revenue dip likely to accrue from rate reduction in next fiscal year 2010-11.

Some media reports suggest that Pakistani authorities are examining the Chinese model of VAT for its policy framework and implementation mechanism. China has a multiple rate tax structure, with 17 per cent basic tax rate, and lower slabs of 3, 6, and 13 per cent tax rates. While exports attract zero VAT in China, the agriculture, forestry, products of animal husbandry, aquatic products, edible vegetable and grain duplicates, tap water, heating and cooling equipments attract 13 per cent VAT.

The real issue is about the separation of VAT on goods and services, as in neighboring India VAT on goods and services is separate. Under former government of President Pervez Musharraf, the FBR was given power to collect tax on services- banking, insurance, telecom, air travel and so on. This was done in violation of the Constitution which gives the provinces the right to collect tax on services, while tax on goods is the jurisdiction of federal government under the constitution. What actually Sindh is demanding is to withdraw power to collect tax on services from the FBR. For example, the collection of services tax on telecommunication is estimated to generate around Rs50 billion. The federal government agencies are reluctant to withdraw and hence they want to implement VAT in its integrated shape.

The government made promises with IMF on the VAT issue, indicating it would take steps to iron out differences between the provinces and to ensure the new tax would be rolled out on July 1. The analysts are skeptical about the deadline of July 1 as committed by the government for implementation of VAT, as the VAT rates have not yet been set and the local business community and opposition parties have serious reservations against VAT which they think would fuel the already high inflation in the country.

Critics say that VAT would have an inflationary impact and prices of consumer items would go up due to withdrawal of exemptions under the VAT regime. Officials in Islamabad call it a propaganda being made by some unscrupulous elements to create artificial inflation after introduction of VAT from July 1, and use it for unjustified price hike. The business community contends that the problems in the exiting sales tax system could be removed instead of imposing a new VAT that would definitely have an inflationary impact, as the purpose of the government is to generate additional revenue of Rs 50 billion to Rs 60 billion.