To arrive at correct tax liability of business income, the income tax law contemplates a dynamic two stages scheme of computation of business income i.e. accounting computation of business income and (ii) tax computation of business income. Errors in the accounting stage of computation are rectifiable. But amateurish, non-professional approach towards the second stage of tax computing is often fraught with grave risks. The most explosive risk of business taxation is claiming legally inadmissible expenditures; and ending up (i) paying extra taxes penalties and (ii) falling in the Commissioner’s potential list for audit. A businessman in his true essence is always averse to face a taxman in his audit venture. This article aims to inform the taxpayers about their rights and obligations, the risk areas and an insight of the basic principles of business taxation to help them take tax savy business decisions, have a better use of their tax advisers and save every rupee of the avoidable taxes at the time of signing their own annual return of income as owner/ manager or the return of their company as a CEO/CFO/MD.
Fundamentally, a person’s income from business in a tax year shall be the excess or deficit of the total amounts (business revenues) over total admissible and business related expenditures i.e. whether revenue or capital in nature. Any expenditure revenue or capital that is an integral component of a business, professional or vocational cycle can be claimed as an expense. The excess of business revenue over admissible business expenses is recognized as profit and taxed progressively i.e. higher the income higher the tax incidence. The deficient of business revenue over the business related expenditures is recognized as loss and is adjustable against future income, if any, for six years.
Admissibility Regime – The Ladders
Admissibility of business expenditures is not item specific but principle specific i.e. any expenditure that satisfies the given three (03) core principles is an admissible expense. These three principles are (i) the indispensability (wholly and exclusively expended for the purpose of business) principle, (ii) the durability (has a normal useful life exceeding one year) principle and (iii) the necessity principle.
A business income enjoys an unrestricted range of revenue expenditures and a restricted range of capital expenditures so far as these are incurred wholly and exclusively for the purposes of business, profession or vocation i.e. the principle of indispensability. A retail shop keeper can claim expenses in the nature of rent, salesman’s salary, transportation charges etc. an advocate can claim expenditure for buying a new black coat or for dry cleaning charges of his necktie or shirts. Likewise; a doctor can claim expenses for buying a stethoscope and for medicine inventory at his clinic. A plumber is allowed to claim expenses for the tools and ancillary material to perform his job. You will find that the above mix of expenses are incurred wholly and exclusively for the purposes of operating a retail shop, running a doctor’s private clinic, or a lawyer’s practice or for undertaking maintenance tasks of a plumber.
The Tax Law provides a restricted range of ten types of admissible capital expenditures that satisfy the principle of durability. Of these four types of expenditure contemplate of deduction of varying percentage of the cost of acquisition of all types of tangible and intangible assets that are employed in a business. These varying sums of admissible sums are technically known as;
- initial allowance (additional depreciation)
- intangible (depreciation on intangible assets)
- pre-commencement expenditure.
The rest of six types of expenditures contemplate admissibility of the whole cost that have durable impact to stimulate the socio-economic objects of public policy. These capital expenditures are technically known as;
- Scientific research expenditure
- Employee training and facilities
- Profit on debt, financial costs and lease payments
- Bad debts
- Profit on non-performing debts of a banking company or development finance institution
- Transfer to participatory reserve.
The above said admissible capital expenditures must also fulfill the principles of;
- prescribed criteria of eligibility.
Two key components of the eligibility criteria to claim any capital expenditure including tangible or intangible assets are;
- ownership by the taxpayer
- its usage for the purposes of the business, vocation or profession.
Thus; an expenditure of capital nature i.e. deep freezer purchased by a retail shop keeper, a set of books purchased by a lawyer, an X-ray machine purchased by a doctor running a private clinic would be an eligible expenditure having the effect of a reducer of taxable income.
Revenue expenditures incurred for restructuring of a corporate entity (merge, acquisition, amalgamation) as warranted by business prudence and involving legal, financial, advisory and administrative costs are also admissible on the principle of necessity.
Inadmissibility Regime – The Snakes
For safeguarding the integrity of the tax system the Income Tax Law also contemplates a formidable range of thirteen mandatory provisions violation of which may have explosive consequences for the business as well as the taxpayers. When we appreciate the intent apparent and cumulative tone and tenor of these provisions we find that all of them serve a common goal of punishing defiance to the desired behavior of a taxpayer in term of repugnance to the express public policy objectives i.e. documentation of economy, non-compliance to withholding taxes obligations and violation of any law, rule or regulations in force in Pakistan etc.
This formidable inadmissible regime of thirteen provisions in fact torpedoes six types of derelict behavior of taxpayers:
- Abusive claim of tax payments/deductions as business expense.
- Failure of tax deduction/deposit at the time of payment against specific economic transactions.
- Employer’s contributions toward unapproved welfare funds.
- Expenses incurred in a style as are violative of social propriety or incurred on account of violation of any law.
- Claiming Expenses that are maternally irrelevant to deriving income form business profession or vocation.
- Cash expensing beyond the prescribed monetary threshold.
Now we discuss in specific term the scope and reach of various expenditures that militate against the specific undesirable behavior of taxpayers:
Abusive Claim of Tax Payments/Deductions as Business Expense
A set of provisions in this regard repulses expenditure claims in the nature of.
- any cess, rate or tax paid or payable by the person in Pakistan or a foreign country.
- any amount of tax deducted at source on behalf of a person.
Failure of Tax Deduction/Deposit at the Time of Payment Against Specific Financial Transactions
This provision is the gravest landmine in tax laws as it ordains that where a taxpayer fails to deduct and deposit tax at the time of making payment on accounts of;
- brokerage or commission
- payment to non-resident
The whole of such amounts shall be disallowed and taxed. Fatal consequences of violation of the above provisions for all types of enterprises small, medium or a big one is self evident
Employer’s Contributions Towards Unapproved Welfare Funds
The law ordains that while setting up any welfare fund in the nature of (A) provident fund (b) pension fund and (c) superannuation fund, its prior approval from the Commissioner of Income Tax is imperative. Otherwise any contribution made by an employer towards such welfare funds would be dismissed and taxed/ in the same wheightage the law requires that while maintaining any approved welfare funds including the above three funds; an organization/firm/company must `install strict internal controls to ensure that any excessive payment to an employee and falling in the nature of deemed salary income (perquisite) is duly subjected to instant tax deduction at source.
Expenses in Violation of Social Propriety Norms or Incurred on Account of Violation of Any Law
The tax ventures to regulate the behavior of a taxpayer in ethical and social terms in the area of entertainment expenditure claim. It ordains that while incurring expenditure for;
- entertaining foreign customers, suppliers/local customers or suppliers, share holders, agents, directors or employees or at the time of opening of branches
- serving refreshment to employees
Only such expenditure shall be admissible as is consistent with the “norms and customs of business in Pakistan.” The tax law also punishes any behavior that is repugnant to the rule of law. It ordains that any five or penalty paid for violation of any law, rule or regulation for the time being enforce in Pakistan can’t be claimed as a business expenses. It gives no premium to law breakers. Any taxpayer fined for theft of electricity can’t claim such fine as an expenditure against his business income.
Claiming Expenses that are Materially Irrelevant to Deriving Income from Business, Profession or Vocation
The letter of law repudiates the attempt to artificially inflate the business expenditures (evade taxes) as enumerated below:
- any personal expenditure incurred by the taxpayer;
- any amount carried to a reserve fund or capitalized in any way;
- any expenditure paid or payable of a capital nature.
- any profit on debt, brokerage, commission, salary or other remuneration paid by an association.
The expenses shown in item (d) are declared inadmissible because according to the basic scheme of tax laws, legal identity of an Association of persons (AOP) and its member is indivisible.
Cash Expensing in Specified Transactions Beyond Prescribed Monetary Threshold
Tax law of Pakistan is also used as a deterring instrument to strongly discourage the practice of cash payments in settlement of some critical transactions. Any expenditure for a transactions, paid or payable under a single account head (of account) which, in aggregate, exceeds fifty thousand rupees,(Rs.50,000/-) made other than by a crossed cheque drawn on a bank or by crossed bank draft or crossed pay order or any other crossed banking instrument showing transfer of amount from the business bank account of the taxpayer shall be disallowed and taxed.
Any of the above transactions carried out on line or though credit card shall also be treated as documented transactions. Similarly another provision discourages the payment of salaries in cash in excess of Rupees Ten thousand (Rs. 10,000/-) per employee per month. Micro, small and medium enterprises may have gravest tax consequences when failing to pay salaries exceeding Rs.10,000/- otherwise than by crossed cheque.
Tax laws are equally pragmatic in respect of expenses which are documented by default and do not suffer from any monetary threshold for the purposes of their admissibility. These expenses are;
- Utility bills
- Freight charges
- Travel fare
- Payment of taxes, Duties, Fee, Fines or any other Statutory Obligation.
Successful enterprises are those who measure the quality of their business decisions in terms of their tax consequences. The new tax law is littered with virtual landmines. Any taxpayer showing reckless behavior towards or an outright ignorance of such provisions may fall in the worst risk and might end up facing crippling effects on his hard earned fortune.
It means that an average investor, owner/manager and an entrepreneur or a company must be fully conscious of the above discussed opportunities and threats while conducing routine business transactions and taking critical business decision in the areas of investment, development or employees welfare. All this is going to have profound impact on the ultimate crucial decision of filing annual return in a tax year.
It is a rule of thumb that intelligence and sniffing instincts of the taxman are never underestimated. An entrepreneur’s best time is better spent in creating wealth by observing the rules (tax) of the game as according to the new scheme of law ultimate responsibility about veracity of the tax returns rests upon a taxpayer even when it is filed through the assistance of a tax adviser.