Most salaried individuals in Pakistan look at business owners with some level of contempt. To them, these business owners that deal in cash and avoid taxes are why the tax burden keeps increasing on those already documented.
In some parts it makes sense. Business owners in Pakistan do often go under the radar of the tax hounds, but the reality of the problem exists with tax collection in Pakistan and the FBR continuing to deepen their tax net instead of widening it.
And they are justified in their claims. Business owners in Pakistan have since long avoided the tax net. A large number of them are either not registered with the FBR, or even if they are, they have the luxury of under-reporting their incomes, due to lack of scrutiny.
The constant criticism in this entire time has been the FBR continues to bring the hammer down on the salaried classes and fails to capture tax revenue from these businesses. Recently, in an effort to change this, the FBR tried to reinvent the wheel. They announced a scheme in six cities meant for retailers to voluntarily sign up to. Providing them with easy access through mobile apps and benefits of early registration, the FBR was aiming to bring all the businesses inside the tax net.
The first was introduced as a pilot project in a limited number of cities to test its feasibility and impact. It was aimed at understanding the challenges and opportunities associated with bringing a diverse and largely informal retail sector into the tax net. The pilot phase involved extensive consultations with stakeholders, including trade unions, business associations, and retailers, to design a tax regime that is both fair and easy to comply with.
While only a few retailers reportedly signed up for the scheme, the “success” of the pilot phase, coupled with the pressing need to increase tax revenues and formalise the economy, led to the decision to expand the scheme nationwide. In reality, the FBR has put its foot down on retailers, wholesalers and business owners, in which everyone from a kiosk owner to a tier 1 retailer is required to register themself and pay monthly advance tax on their income.
The complication comes in how this advance tax will be determined. For this determination the FBR has come up with a term called “indicative income”. To find out more about the indicative income we need to first learn about the whole system that is already in place.
A history of income tax on businesses
Before the introduction of the Tajir Dost Scheme, businesses in Pakistan, particularly small and medium enterprises (SMEs) and retailers, were subject to a more complex and traditional tax regime. This system involved various types of taxes, compliance requirements, and administrative challenges that often led to underreporting of income, tax evasion, and a large informal economy. Here’s businesses were paying their taxes before the Tajir Dost Scheme:
The primary legislative framework governing income tax in Pakistan is the Income Tax Ordinance, 2001. This ordinance outlines the tax obligations of individuals, associations of persons (AOPs), companies, and other entities.
Any businesses wishing to pay income taxes were required to register with the Federal Board of Revenue (FBR) and obtain a National Tax Number (NTN). This registration was often viewed as cumbersome, requiring extensive documentation and interactions with tax authorities.
Upon registration, these businesses were subject to multiple types of taxes, including, Sales Tax, Withholding Taxes, and Advance Income Tax.
The advance tax, more commonly known as the income tax, had to be paid by businesses in quarterly instalments based on their estimated income for the quarter, and in turn the whole year.
The tax rates varied based on the type of business entity and the income slab. For example, corporate tax rates for companies could range from 29% to 35%, while individual and AOP tax rates were progressive, depending on the income level. These taxes, while progressive in theory and higher on paper in terms of percentage when compared to salaried class, did not often yield the desired results. The problem was that any business, slightly informal, had to come up with a sales figure for themselves, proof that income level and pay the tax on that income.
Businesses would do this when filing their annual income tax returns, declaring their income, expenses, and tax payable. The process was often complex, requiring detailed financial records, something that informa businesses willingly do not possess.
While the FBR conducted audits to verify the accuracy of the tax returns filed. Audits could be random or targeted based on risk assessments. The general view was that these assessments were largely corrupt and did not capture the entire picture.
In case of discrepancies, the FBR could issue assessment orders, determining the correct amount of tax payable and businesses had the right to appeal against these assessments but the incidence of this happening was often seldom.
Challenges and Issues with the old system
The traditional tax system was often seen as complex and burdensome, especially for small businesses with limited resources. A significant portion of the economy operated informally, with businesses avoiding registration and compliance to evade taxes.
High compliance costs and perceived corruption led many businesses to underreport income or not file returns at all and frequent interactions with tax authorities, audits, and disputes increased the administrative burden on businesses.
Retailers, in particular, faced challenges due to the informal nature of many small shops and the difficulty in tracking cash-based transactions. Many small retailers did not maintain formal books of accounts, making it hard to assess their true income. Small and medium enterprises often struggled with the lack of professional expertise to manage complex tax filings and compliance requirements. It is surprising that ever since 2001, this system has been in place. All the aforementioned discrepancies have been mentioned, more or less, by the FBR itself in its bid to install the new Tajir Dost Scheme.
For a long time the government has been scratching its head, as to how to conquer these problems. It would occasionally introduce tax amnesty schemes, allowing businesses to declare undisclosed income and assets without facing penalties.
Quite recently the FBR started integrating technology to simplify tax filing processes, such as online tax returns and e-payments. The introduction of the POS scheme is a notable one in this regard. However, none of this seems to have worked on the common retailer. Your everyday kiryana store owner. The problem becomes a huge one when large scale distributors also hide under the cloak of that “kiryana store” owner, saving themselves from a huge tax liability.
What will happen now?
The introduction of the Tajir Dost Scheme aimed to address these challenges by simplifying tax compliance, broadening the tax base, and formalising the retail and SME sectors. The scheme’s key features are fixed monthly taxes based on shop valuation and reduced administrative burden. The FBR claims that they are designed to encourage voluntary compliance and reduce the informal economy’s size.
By offering a more straightforward and predictable tax regime, the Tajir Dost Scheme seeks to create a more conducive environment for businesses to operate within the formal economy, thereby increasing government revenues and promoting economic stability.
But here is the twist. How will the FBR determine the fixed monthly taxes based on shop valuation? Which valuation will they use? The FBR valuation?
Enter the indicative income! The concept is simple. Indicative income refers to an estimated income level determined by the tax authorities based on various factors such as the rental value of the property, its location, and its fair market value. This income estimate is then used as the basis for calculating the advance tax that a retailer must pay. The article will elaborate further on what indicative income entails later.
So based on what area the business setup is in, the business owner will now pay a fixed amount of tax in advance, every month and will file an annual tax return, adjusting for other advance taxes paid during the year such as electricity and other utilities.
Let’s assume there is a shop in the MM Alam Road Area of Gulberg, Lahore. Let us also assume another shop of a similar size in the Moon Market of the Allama Iqbal town of Lahore. The indicative income determined by the FBR for the former is around Rs 28 lakh per year while that for the latter is 22 lakh. This makes the advance tax liability for an MM Alam road business owner close to Rs 45 thousand per month, while the same liability for the Moon Market business owner becomes Rs 30 thousand per month.
What the scheme does is, it offers a simplified tax regime with fixed monthly taxes based on the fair market valuation of shops, making it easier for retailers to comply without the complexities of traditional tax filing. It also reduces the burden of detailed assessments of those taxes by the regional tax collector’s office. The Special Rules 2024 provide specific criteria and exemptions for certain retailers, making that a whole different case.
Non-compliance with the regime can lead to penalties, including shop sealing and imposition of default surcharges. While this serves as a strong deterrent against remaining outside the formal tax net such penalties have always been in place. The FBR, now has the authority to seal a shop for 7 days on first incidence of non-compliance and 21 days for consequent non-compliance.
According to the recent SRO 1064(I)/2024, income tax authorities now also have the power to impose penalties and enforce compliance measures, which could include prosecution proceedings if the non-compliance breaches a certain threshold.
The mandatory elements of this scheme are that retailers are required to pay advance tax monthly. Failure to do so can result in the aforementioned penalties. The collaboration between FBR and trade unions further streamlines this registration indicating a move towards making registration almost unavoidable.
Specific provisions for small shops and exemptions for those with existing tax filings encourage broader participation. For example, a kiosk owner, more intuitively known as a “thela” will have to pay a fixed tax of Rs 1200 per year or Rs 100 per month.
What is the problem?
The system might definitely be able to achieve the goal of higher tax revenues however, there is obvious concerns
Let us go back to the example of MM Alam Road and Moon Market. What is it that drives profitability and income for business? Is it its presence in an expensive area or is it volume of sales? A food shop at MM Alam road that serves stale food, for example, would make much less in terms of profits and revenue as opposed to a cloth shop in Moon Market that has a good reputation.
So much so that their incomes become starkly different from each other and their respective indicative incomes. Now the TDS way might be good to take out at least a minimum share of tax from a business that was not paying any tax otherwise but is ideal when it comes to righteous estimations of income?
More importantly, if the business is in loss and does not make as much as they are expected to make according to the FBR’s estimations how will they pay the subsequently excessive advance tax? The FBR of course has a provision for appeal, in case of businesses that have a discrepancy like that but that brings us back to the initial problem of interacting with the authority and attempts of bypassing and sometimes dealing with bureaucratic red tape.
Therefore there is an obvious concern that the indicative income may not accurately reflect the actual earnings of a business and the reliance on factors like rental value and location may lead to overestimation or underestimation.
It is important to understand that each business is unique, and a standardised approach may fail to account for specific circumstances affecting a business’s profitability. Some businesses like the wholesale business, work on a small profit margin yet higher volumes, while others remain hugely profitable despite having a lower volume of sales.
Talking to profit, a senior tax professional on the subject of anonymity said that the scheme is primarily a tool for the FBR to collect data. However, in the same breath this expert suggests that the discretionary power given to tax authorities to determine indicative income could lead to corruption and favouritism. Retailers may be subject to undue influence or pressure and that becomes another cause of concern, not very different from previous concerns.
While a lot of tax burdened Pakistanis may not agree, the burden of tax on small businesses, especially those operating on thin margins can be massive. They may find it challenging to pay taxes based on an inflated indicative income and lead to potential closures.
But the biggest fear that the FBR needs to consider is a fear of being assessed at a higher income level than actually earned might discourage small retailers from registering under the scheme, undermining its goal of broadening the tax base.
The new system may also lead to an increase in disputes between retailers and tax authorities over the accuracy of indicative income assessments. This could result in a backlog of appeals and increased administrative burden. While the FBR has revised its system of appeals, to a more swift one, concerns regarding that have already been brought up by Profit magazine.
A macro impact, as pointed out by experts, is the reliance on rental value and location for tax assessments. It might distort market dynamics, as businesses in prime locations could face disproportionately high tax burdens regardless of their actual profitability. This leads to another problem of retailers seeking to underreport their rental values or shifting their business activities to avoid high indicative income assessments, leading to inefficiencies in the market.
To wrap things up
While the concept of indicative income under the Tajir Dost Scheme aims to simplify tax compliance and increase revenue collection, it raises several concerns regarding accuracy, fairness, transparency, and impact on small businesses.
The FBR seems to have made their job easier by introducing these provisions but that is about all they achieve. The potential for arbitrary assessments and lack of individual consideration could undermine trust in the tax system and hinder the scheme’s effectiveness. To address these issues, it is crucial for the Federal Board of Revenue (FBR) to ensure transparency, provide clear guidelines, and establish robust mechanisms for appeals and reviews to foster trust and compliance among retailers.
Will the FBR do that? Evidence suggests that status quo is not often changed at the board, and defaulters mostly find a way to reinvent their wheel of non-compliance. The only way forward, as suggested by experts, is formalising the informal sector of the economy.
Now one could view the current form of TDS, as a way of formalising this sector before coming down on them with more righteous measures like sales taxes, but the scepticism in the Board’s ability to do so is not unjustified.
