THE small and medium enterprises (SMEs) sector is considered the backbone of an economy, as it plays a pivotal role in accelerating economic growth, creating jobs and taming inflation. The sector’s role is even more significant in lower-middle-income countries like Pakistan.

The SME sector is responsible for 60 per cent of total jobs in Pakistan, and its contribution in GDP and export revenues is 30pc and 25pc, respectively. It is an integral part of the supply chain, and plays a crucial role in achieving sustainable economic growth.

Nonetheless, the country’s SME sector has not been given due attention in the past and remains one of the neglected areas. Poor supply of credit is a serious impediment to the sector’s growth, and it can be gauged from the fact that the share of SMEs in the total private sector credit has declined from 17pc in 2006 to 7.5pc. In contrast, the share of SMEs in private sector credit in Bangladesh and Turkey is 20pc and 29pc, respectively.

Access to formal finance remains restricted to 170,000 SMEs. Therefore, a large number of SMEs are facing massive financial gap. It signifies that the triple helix model is not being best utilised in Pakistan in promoting the SME sector, as ensuring adequate supply of finances to the sector by the government is a key component of the model.

The share of small and medium enterprises in total private-sector credit declined from 17pc in 2006 to 7.5pc

Engagement of academia/educational institutions in delivering advanced vocational and technical skills to SMEs and industries in providing labour and other facilities to SMEs are other two components of the triple helix model.

Recognising the role of SMEs in the socio-economic uplift of the people, the present government has taken certain policy initiatives to resolve multiple issues facing the SME sector, especially bottlenecks in accessing formal finance.

To increase the number of SME borrowers from 170,000 to 700,000 by 2023, the government has adopted a paradigm shift in taxation policy through Finance Act 2019 concerning taxation of income of banks derived from additional advances extended to SMEs.

For tax years 2020 to 2023, a reduced rate of 20pc instead of a standard rate of 35pc is imposed on taxable income of banking companies derived from additional advances extended to SMEs.

Banking companies are required to compute taxable income arising from additional advances using the following formula: Total income subject to 20pc tax rate = (A x B) / C, where A istaxable income, B is net mark-up income earned from additional advances for tax year, and C is total of net mark-up income and non mark-up income as per accounts.

Banking companies have been allowed special deductions under the Seventh Schedule to the Income Tax Ordinance 2001 apart from business expenses directly or indirectly incurred for earning income such as depreciation, initial allowance and amortisation, which have significant reducing impact on their taxable income and tax payable.

Special deductible allowances include provisioning for advances and off-balance sheet items up to a maximum of 1pc of the total advances and allowed to carry forward provisions in excess of 1pc to the succeeding years.

However, if the provisioning is less than 1pc of the total advances, then the actual provisioning is allowed and provisioning for advances and off-balance sheet items is allowed at 5pc of the total advances for consumer and SMEs and allowed to carry forward provisions in excess of 5pc to the succeeding years and if the provisioning is less than 5pc of the total advances for consumer and SMEs, then actual provisioning for the year is allowed.

Furthermore, banking companies are allowed a deduction for any expenditure (other than on account of charge for irrecoverable debt) and the liability or a part of the liability to which the deduction relates is not paid within three years of the end of the tax year in which the deduction was allowed, the unpaid amount of the liability will be chargeable to tax under the head income from business in the first tax year following the end of three years.

However, if an unpaid liability or a part of it is chargeable to tax and is subsequently paid, a deduction will be allowed for the amount paid in the tax year in which the payment is made and adjustment of loss on sale of shares of listed companies, disposed of within one year of the date of acquisition, against business income of the tax year.

Where such loss is not fully set off against business income during the tax year, a banking company is entitled to carry forward to the following tax year and set off against capital gain only. However, no loss is allowed to be carried forward for more than six years immediately succeeding the tax year for which the loss was first computed.

This is the reason that companies operating in the non-banking sector are critical of special tax regime for banking companies that allows them a considerably higher costs ranging between Rs40 billion and Rs45bn.

Importantly, provisions of withholding tax under Income Tax Ordinance 2001 are not applicable to a banking company as a recipient of the amount on which tax is deductible.

Moreover, tax authorities instructed such withholding agents that no tax is required to be deducted at the time of making payments to banking companies and therefore no specific exemption certificate is required from the banks.

Similarly, provisions relating to group relief as contained in section 59B of Income Tax Ordinance of 2001 will also be available to banking companies, provided the holding and subsidiary companies are banking companies. Holding and subsidiary companies of 100pc-owned group of banking companies may opt to be taxed as one fiscal unit pursuant to section 59AA of Income Tax Ordinance of 2001 relating to group taxation.

Income, profits and gains of banking companies, including Shariah-compliant banking companies are computed under the provisions of the Seventh Schedule to Income Tax Ordinance of 2001.

The writer is an additional director at the Federal Board of Revenue

Published in Dawn, The Business and Finance Weekly, January 13th, 2020