The newly imposed of Minimum Tax of 8% on services poses a grave threat to the existence of the Services Sector in Pakistan. Previously, withholding tax (WHT) of 8% was deductible by all corporate withholding agents when making payments against the procurement of services. The amounts deducted were considered as Advanced Income Tax payments which may be all offset or claimed back against the final Corporate Income Tax liability of the service provider.
The Government has now changed the law so that the 8% deduction still applicable on payments to service providers is now to be considered as a Minimum Tax. This is a ‘revenue tax’ or ‘turnover tax’ to be imposed regardless of the whether the service provider is profitable or loss-making in the year. In fact the effective result of this new policy will be a Minimum Tax of approximately 9.5% as General Sales Tax amounts collected by service providers will be also be subject to Minimum Tax (see Note A below).
For reasons described below we believe that the imposition of such Minimum Tax will lead to the disastrous effects on the Services industry and on the economy at large.
Most Services Business Operate on Low Profit Margins:
It is near impossible to operate many services business (or arguably any kind of business) with a Minimum Tax rate of 9.5%. There are a huge number of businesses in the Services Sector which operate at very low margins (e.g. manpower outsourcing, 3PL companies, Security Services Providers, freight forwarding, cargo agents, customer handlers, BPO, ITES etc.). Before tax profit margins in such business typically range between 3 to 8 %. Minimum Tax of 9.5% effectively means payment of more than 100% of profits in taxes and thus making these businesses unviable (see Note B below for illustration). Hence, if this matter is not addressed immediately it will lead to shutdown of a number of companies causing significant unemployment in the country.
New Investments in Services Sector Are Threatened:
Minimum Tax becomes a major disincentive towards local entrepreneurship and foreign direct investment in the country. Businesses, especially in the services sector, typically operate below break-even for the first few years of establishment. Adding a tax of 9.5% of turnover makes it impossible to develop a viable business plan. Such an imposing disincentive towards investment in the Services Sector will invariably result in reduction in entrepreneurship, local investment and FDI. It is in our knowledge that many new investments have been put on hold or scrapped in the last two months (since the imposition of minimum tax) leading to irreparable loss to the economy. Without entrepreneurship and new investment, the economy will not be able to produce new jobs for the youth and thus will bring about large scale social disruption in the country.
This Minimum Tax Might be Against the Constitution:
In both cases above (i.e. low margin service providers and new investments/ enterprise) Minimum Tax is greater than profits. Therefore, businesses are required to pay this amount from existing capital or induct new capital to pay such taxes. By definition this is no longer a tax but an expropriation of capital. Expropriation of capital is strictly against the provisions of sector 4 of the Constitution of Pakistan and also illegal as provided by established precedent of law in Pakistan. Hence the imposition of Minimum Tax is both oppressive and illegal.
Services Sector is the Future of our Country:
According to the Economic Survey of Pakistan (2014-15), the Services Sector represented 59% of the GDP of the country. In addition to this, the share of the Services Sector of the economy has been growing over the past decade and it is a common view that Pakistan’s future success is most dependent on the growth of the Services Sector. Minimum Tax of 8% is now imposed on the Services Sector whereas Minimum Tax for all others is limited to 1%. Such a discriminatory measure against the sector will discourage the investment and expansion in this sector and will ultimately lead to lower growth rates of Pakistan’s economy in future years.
Discriminatory Taxes Might Lead to Growth of Black Economy:
This government is rapidly increasing its use of indirect taxes at the federal as well as provincial levels. Indirect taxes are those collected upon transactions (payment or receipt) rather than profit or real income. Indirect taxes are by definition indiscriminate and regressive. For example, in the case of this Minimum Tax, all services companies are required to pay up to 9.5% of revenue regardless of the profit margins (for loss making companies it would be unbearable).
In contrast, the norms of progressive taxation dictate that taxes should be imposed based on the capacity of the taxpayer. We are in a situation where indirect taxes are being levied on all possible transactions and aspects of life without any thought as to their collective impact on the taxpayer. They are both haphazard and onerous. This has led to an environment where the cost and complexity of compliance is now simply unbearable for companies and therefore more businesses are being pushed to the undocumented spectrum leading to the rapid expansion of the black economy (see Note C below for an analysis of impact of indirect taxation on the tax-net in Pakistan).
The Tax Was Imposed With One Day’s Notice!
Notwithstanding the destructive effect of 9.5% minimum tax, we also point to the sudden and arbitrary method of its application. In the UK when changes in the tax policy or rates are planned they are announced years in advance and then applied gradually over a period of up to 3 to 5 years (e.g. 1% per year). In this case, a new tax of 8% of revenue was imposed with just one day’s notice.
This means that the operating model of services companies was fundamentally altered overnight leaving no time whatsoever for adjustment to the new regime. Such sudden shifts in tax policy send a very negative signal to investors, both local and international. They raise grave concerns over the stability and continuity of our policy. This matter needs immediate rectification but even if and after this is done so, it has already put forward a new type of risk of doing business in Pakistan (i.e. instability of tax policy).
Lack of Transparency and Consensus in Policy Development:
There are also grave procedural concerns in the method in which Minimum Tax was imposed. In the Budget speech of 5 June 2015, no proposal to introduce minimum tax was mentioned. If this was done so, the industry would have been provided a narrow window of 3 to 4 weeks to reach out to the Government and jointly revisit the implications – this is a normal practice in the annual budgetary cycle. Instead, the introduction of Minimum Tax was informed to the industry on the same day as the approval of the Finance Act 2015 by the President of Pakistan. This points towards a complete breakdown of transparency and consensus in policy development of the Government.
Massive Strikes Are Looming in the Near Future:
As a result of this existential threat to the services sector, many companies and sub-sectors will be moving towards severe industrial action in the coming days and weeks. It is pertinent to note that Freight Forwarders, Cargo Agents and Custom Agents have already sounded their intention to completely shut down their businesses until such time that relief is granted. Notices have been sent to the highest quarters in the Government machinery.
Such Industrial Action in these sub-sectors will most definitely lead to severe blockages in the supply chains including the ports of the country. These Services Sector businesses no other choice as the Minimum Tax imposition has completely invalidated their business model and it is no longer possible for them to continue operations. We fear that if actions are not taken swiftly, the damage caused by these strikes will have deep and lasting adverse effect on the national economy.
Minimum Tax Threatens IT Sector:
Information Technology Services (ITS) and Information Technology Enable Services (ITES) represents one of the fast growing sectors in the country. According to the leading players in these sectors, ITS services supplied to local clients attract a margin around 8-10% of revenue where as ITES services attract 4-6%. In this light, the ITS/ITES sectors will simply not be able to survive leading to significant unemployment. ITS and ITES are sectors which can open new vistas of growth for the country through innovation. Minimum Tax will permanently shut down such avenues of future potential for the country.
The FBR and Ministry of Finance Are Unwilling to Listen or Act:
Several meetings and conversations have taken place with the Ministries of Finance/ FBR and the Services Sector since 1st July. In the first few meetings, high-ranking officials at the FBR empathized and agreed with the point of view of the industry and even promised relief for the same in August. However, no such relief has been provided as yet and it is clear that the government has no intent in addressing the issue. The Services Sector is moving towards legal action in large numbers. Two petitions have already been filed in the Lahore High Court by two companies. We are expecting at least 25 more petitions over the next two weeks in both the LHC and the SHC. Furthermore, this number will rapidly rise until such time that relief is granted.
This Debacle is Wasting Precious Time:
In addition to all of the above, the leadership of companies in the Services Sector has spent highly inordinate amounts of time in addressing this matter and this will likely continue until such time that relief is granted. Such pervasive focus on this has had and will continue to have adverse impact on the results of the companies. Instead of putting forth policy which supports innovation and growth in the services sector, the government is introducing obstacles and oppressive/ extortionist measures. It would appear that the message to investors is clear – that they should pack-up and go to other places to do business.
The Minimum Tax is unjust, counter-intuitive, against the principle of free market and contrary to practices of the better marketplaces in the world. Furthermore, it will have disastrous effects on the development of services, technology and innovation in the country rendering many business models unviable and thereby causing huge contraction in unemployment in these sectors. With this in mind, we plead that it be reversed from the Finance Act 2015 at the earliest possible opportunity.
A Minimum Tax is to be applied to 8% of gross consideration paid to the service provider. Gross consideration is defined to be inclusive of General Sales Tax (GST). The prevailing GST rate for some services (e.g. Call Center Outsourcing) is 19.5% and 8% Min Tax would be charged to 19.5% GST (equaling 1.56%). Hence the effective Min Tax rate would be 9.56%.
Services Value Rs 100
GST (19.5%) Rs 19.50
Total Invoice Rs 119.50
Min Tax (8%) Rs 9.56
Effective Min Tax Rate 9.56%
B The disastrous effects of the Minimum Tax of 8% can be seen especially on low margin or even loss making companies as below.
|Examples to Illustrate Tax Impact|
|Company||Fee||Reimbursable Expenses||Total Invoice Value||Net Profit Margin||Net Profit Earned||Minimum Tax Rate||Minimum Tax Paid||Effective Rate of Tax|
C A recent study by the Policy Research Institute of Market Economy shows an inverse relationship between indirect taxation and the so called ‘tax-net’. According to the research, the number of tax return filers went down considerably from 1.8 million in 2006 to 0.85 million in 2014-15. This is during a period that the use of withholding taxes as a revenue generation instrument has increased exponentially (see this Tribune story).