How Can the Exploitation of 3% Withholding Tax Be Avoided?

Persons rendering services have, for the most part, remained subject to taxation as the service sector is considered to generate significant revenues. The Income Tax Ordinance 2001 taxes income at source under section 153 of the Ordinance, where the prescribed persons making payments for services are liable for tax to be deducted on each payment that is made, except when the payment is below the threshold. The existing threshold is PKR 30,000 which means that only the payments which are equal to or more than this amount shall be subject to the withholding of tax. The tax deductible at source of the recipient becomes the basis for chargeability and is then liable to be discharged as a minimum tax, i.e. if the liability computed with general rates are below the tax deductible, then the tax which is deductible becomes the tax liability.

Holistically speaking, service sector margins are very low compared to persons dealing with the supply of goods. Companies rendering services were being taxed at the rate of eight percent of the gross amount payable if they were filers. The gross amount payable can be termed as a company’s turnover if no other revenue is there of the company. Most companies are filers generally due to their compliant nature. Among them, a few sectors successfully escalated their voice to the concerned government machinery regarding these excessive tax rates which were making it difficult for them to carry on their businesses in Pakistan. The government evaluated their views and, in agreement with their stance, introduced clause 94 in Part IV of the Second Schedule of the Ordinance vide Income Tax (Second Amendment) Act, 2016.

As per clause 94, in the case of a company (that is involved in one of the services mentioned in the clause) being a filer, the eight percent withholding tax could be avoided if certain conditions outlined below were fully met. Initially, the clause applied to only a few sectors but later other sectors were made a part of it too. It remained applicable from July 1, 2015 to June 30, 2019.

Through this clause, companies avoided the eight percent withholding tax by obtaining an ‘exemption from withholding of tax’ certificate from the Commissioner under section 153 read with section 159 of the Ordinance. The exemption certificate was granted subject to the condition that tax payable or paid on the income from the company’s services should not be less than two percent of the gross amount of the turnover from all sources. Also, the company needed to furnish an irrevocable undertaking in the month of November preceding the end of the relevant tax year to present its accounts to the Commissioner within thirty days of the filing of the return for audit of its income tax affairs.

By virtue of the Finance Act 2019, clause 94 was omitted from the Ordinance. Alternatively, income from the services for all specified sectors was made subject to three percent of the withholding for all persons, not limited to companies only, keeping minimum tax the same as that prior to the amendment. Now, taxpayers do not have to request exemption certificates from Commissioners, who would take prolonged time in issuing certificates, resulting in excess withholdings from taxpayers and ultimately leaving them with cash-flow issues.

The government’s initiative is appreciable as it has saved taxpayers the time and hassle in obtaining exemption certificates. However, this has now raised further issues – concerns which were also raised by superior courts in their judgments and apprehensions shared by the Federal Board of Revenue (FBR) – that it will be difficult for withholding tax agents to deduce whether or not a recipient is subject to the exemption without having a proper certificate from the tax department.

Since no exemption certificate is now required, taxpayers are trying to stretch the meaning of sectors exempt in order to evade the eight percent withholding tax. For instance, consulting firms providing accounting services classify themselves as IT enabled services even when the usage of IT in these firms is very limited. Likewise, there are many persons who are not actually providing advertising services but are still asking the withholding tax agent to deduct tax at three percent. Similarly, people providing research on workforce are classifying themselves under the manpower sector to obtain the benefit of evading tax. Even taxpayers who had not previously been granted any exemption under clause 94 by the FBR have also been requesting the withholding tax agent to deduct tax at three percent. Resultantly, the national exchequer is losing a lot of money due to these tax evasions. Undoubtedly, this will ultimately result in too many disputes and litigation as the tax department would interpret a sector differently than a taxpayer. Not only this, but a taxpayer who genuinely falls under a specific exempt sector is also sometimes refused by the withholding tax agent who adopts a different interpretation of what the sector includes, to allow three percent of withholding.

How can this issue be resolved? First, exclusive definitions of sectors should be inserted into the Ordinance, thereby restricting their meanings within the four walls of the definition provided, which would also align the FBR’s interpretation with the taxpayer’s interpretation. Secondly, genuine taxpayers who are being denied the withholding at a reduced rate despite meeting the criterion are willing to obtain an exemption certificate as they did previously. They should be granted the certificate under section 159 of the Ordinance, which already specifies the mechanism to issue an exemption certificate. The law can be amended by inserting a provision that any taxpayer who discharges the tax deductible based on the previous tax year, with the effects of inflation if any to be included, should be granted an exemption for the current year. This will serve the purpose of withholding tax agents who find it difficult to decide whether or not a taxpayer is subject to three percent of withholding tax. This will also keep the agents from stressing about potential non-compliance when monitoring of withholding of taxes gets conducted. Ensuring compliance and saving administrative costs will contribute positively to Pakistan’s economy.

The views expressed in this article are those of the author and do not necessarily represent the views of or any organization with which he might be associated.

Mohammed Muzammil Hemani

Author: Mohammed Muzammil Hemani

The writer is currently pursuing LLB and is a researcher, practitioner and corporate trainer for matters relating to taxation. He has obtained an Advanced Diploma in International Taxation from the Chartered Institute of Taxation in the UK and is also a member of the Institute of Chartered Accountant of Pakistan (ICAP). He can be reached at [email protected]