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Pakistan’s fiscal crises are deep and cannot be easily resolved. Although the tax rates are high, these taxes are still insufficient to meet debt service and defence expenditures. Unless the tax-GDP ratio increases significantly, the economy cannot be managed effectively; the essential public services cannot be delivered.
The government promulgated on July 31, 2001 a draft of new income tax law prepared by a law professor of an Australian university who was entrusted this task by the IMF. The new Income Lax Ordinance 01 comes into force with effect from July 1, 02 for the income/tax year ending on June 30, 03.
The purpose of introducing new income tax law was to simplify the Income Tax Ordinance 1979 (Repealed Ordinance RC) in terms of language and in administration of taxation system. But in effect it is used as an instrument of maximizing revenue collection at the cost of disincentives to economic activity and investment. It withdraws exemptions granted to income of industrial units set-up in rural or backward areas,intended to promote industrialization of such areas.
Presently the discussion is confined to the issue of depreciation policy provided in the ordinance and its effect on the taxability of the assessee.
The general principle in the ordinance is that income is to be charged to tax regardless of the exhaustion or elimination of the value of the capital or capital assets generating that income. An exception has been made to this rule by allowing depreciation on, as has been termed in the Ordinance, as depreciable assets as defined u/s 22 (15). This deduction is thus, an amount representing wear and tear of depreciable assets, which is deductible from the income generated by the use of these assets in the business by the assessee.
Under the RO three types of depreciation allowances were allowed, (i) normal (ii) initial (iii) extra shift allowance for multiple shift working. But under the Ordinance only first two types of depreciation allowances are admissible. The extra shift allowance has been omitted.
It would affect the industries adversely reducing their claim for depreciation, hence it will increase their tax liability, as illustrated hereunder:
ITO-1979 ITO-2001
B/F WDV of assets 10,000,000 10,000,000
Depreciation: Normal 1,000,000 1,000,000
Double Shift 5000,000 —
Triple Shift 1,000,000 —
Total 2,500,000 1,000,000
Depreciation not
admissible — 1,500,000
Increase in tax
liability @ 35% — 525,000
The other departure from the RO is that under the RO, depreciation was allowed, full, i.e for twelve months of income year even if the asset was used for a part period during the tax year. But the ordinance u/s 22(4) restricts the depreciation allowance for the period it is actually used during the tax year.
Further the depreciation is allowed on monthly basis. It means that if the tax year of an assessee consists of a period less than twelve months, such as in case of a new business or where the business has been closed down during the tax year, the depreciation allowance will be admissible equal to the number of months the business was carried on during the tax year.
The impact of this would be that the business would loose the benefit of the depreciation allowance on its plant and machinery which remained un-operative during the tax year even due to machinery break-down, power failure due to load shedding and closure for normal overhauling, etc. It would adversely affect their tax liability which would increase as illustrated as under:
Tax year 1-7-02 Depreciation admissible:
Business started 1-1-03 10,000,000 x 10 x 3 = 500,000
Assets used from 1-4-03 6
W.D.V 10,000,000 Depreciation admissible
under RO: 1,000,000
Rate of depreciation 10% Excess tax liability due
to short allowable
depreciation under
Ordinance 175,000
The assessee will be penalized for non-operative of plants due load shedding which is beyond his control.He will also be prevented to shut down the plant for regular maintenance which is necessary for keeping it in smooth running.
Besides the high tax leviable due to the new provisions, it will also be a controversial issue between an assesses and the assessing officer who always dispute depreciation for a period of twelve months on the ground of low sales or low production volume or load shedding, etc, and thus it will become a source of harassment to assesses, who have to make choice either to go into litigation or compromise with assessing officers at the latter’s terms which fuels corruption.
Where an asset is sold during a tax year, the ordinance provides u/s 22(8) that no depreciation will be allowed for that tax year even though such asset may have been used for the purpose of business for substantial part of the tax-year. This disparity in treatment is inequitable at the disadvantage of the assessee who is allowed depreciation allowance for the number of months assets remained in operation whereas in the event of disposal of a depreciable asset he is denied of the benefit of depreciation for the period the asset was in use.
The RO had allowed normal depreciation on the cost of the asset. But the Ordinance allows normal depreciation in the year of acquisition of the asset on the written down value as defined in the section 22(5). The amount of initial depreciation permissible u/s 23 shall be deducted from the cost of the depreciated asset for computing normal depreciation for the tax year in which it was acquired. This provision will be to the disadvantage to the assessee as he would be entitled to a lower amount of depreciation in the first year compared to the current practice.
The section 23 of the ordinance entitles an assessee to an amount of the initial allowance at the rate of 50 per cent of the cost of the asset which is placed into service for the first time in a tax year provided the asset is wholly and exclusively used by the assessee in deriving income from business chargeable to tax.
The initial allowance is admissible on the eligible depreciable assets which u/s 23(5) of the ordinance excludes (i) any road transport vehicle unless the vehicle plying for hire, (ii) any furniture including fittings,and (iii) any plant or machinery that is acquired second hand. The RO had allowed initial depreciation on second hand plant and machinery provided such assets were not previously used in Pakistan.
But the ordinance does not allow the initial allowance to the investors on the acquisition of second hand plant and machinery. Although different kind of machineries specifically that of textile are scrapped on its becoming unproductive due to high maintenance and labour cost in the USA,Japan,etc. The second hand machinery can be quite economical for Pakistani industrialists, who are discouraged to invest in such machinery.
The ordinance does not provide for any other incentive except initial allowance contrary to the RO under which more classes of allowances were allowed at varying rates ranging from 20 per cent to 80 per cent as first year allowance, reinvestment allowance, and industrial building allowance were introduced through the Finance Act 1998.
The first year allowance under the Rule 5A was allowed depending upon the category of industry at the rate of 40 per cent to 8 per cent of the cost of machinery and equipment. The un-absorbed FYA was allowed to carry forward for adjustment in accordance with section 38 of RO.
Re-investment allowance was allowed at 40 per cent of the cost of plant where a company invested its profits in balancing, modernization and replacement and expansion of its plant and machinery. Industrial building allowance equal to 20 per cent of the cost of industrial shed or structures which are erected by an industrial undertaking.
Moreover the RO had allowed extra shift allowance for multiple shift working equal to 50 per cent and 100 per cent of normal depreciation for double and triple shift working respectively. All these depreciation allowances have now been withdrawn under the new ordinance. Consequently these withdrawals will adversary affect the tax liability of a business as illustrated hereunder:
ITO-1979 ITO-2001
i) Plant & Machinerybe
B/F WDV 01-07-02 10,000,000 10,000,000
Addition during tax year 10,000,000 10,000,000
Less: initial allowance — (5,000,000)
WDV: 30-06-03 20,000,000 15,00,000
Depreciation - Normal
@ 10% 2,000,000 1,250,000
(5,000,000 x 3 x 10 = 250,000)
Double Shift 1,000,000 —
Triple Shift 2,000,000 —
FYA @ 40% initial 4,000,000 5,000,000
Allowance —— ——
9,000,000 6,250,000
ii) Building
B/F WDV 01-07-02 18,000,000 18,000,000
Addition 2,000,000 2,000,000
WDV 30-06-03 20,000,000 20,000,000
Depreciation normal 2,000,000
(2,000,000 x 3 x 4 10%) 1,900,000
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Industrial Building
Allow. 400,000 —
2,400,000 1,900,000
Total depreciation 11,400,000 8,150,000
Low depreciation
allowed 3,250,000
Excess tax liability
@ 35% 1,137,500
During the subsequent years the deprecation admissible under the Ordinance will be lower than it is admissible under the RO, hence high tax will be payable by the business.
The Rule 12 of the Income Tax Rules 2002 prescribes the particulars required to be furnished by the tax payer for claiming depreciation or initial allowance or amortization deductions, along with the return of income for the tax year.
If the government is eager to see businessmen to play their part in the uplift of the country, it should consider the irritants that were discouraging investment in the country, one of them is indicated in this paper. The Ordinance instead of giving more incentives for industrialization and investment, it has withdrawn those already available and has twisted the provisions in a manner that will prove discouragement.
