30/05/2023
TAX ON UNDISTRIBUTED RESERVES IS ULTRA VIRES AND IT MAY BE CHALLANGED IF IMPOSED BY GOVT.
An article by Mr Shabbar Zaidi
It is being reported that the government is repeating once again the mistake of taxing undistributed reserves of a company for the third time in Pakistan. This mistake had been made twice before but was reversed in the subsequent period.
In the following paragraphs the author intends to describe the unconstitutionality of this proposal in the light of the taxing rights of the Federal Government and other valid economic reasons.
In simple words, it is being proposed that ‘future earnings’ of shareholders of a company, which are at present being held as reserves, are to be taxed upfront, even when the reserves lie with the company.
This proposal is totally absurd and has been vehemently resisted in the past and it was precisely for that very reason the legislation was withdrawn. The author is not aware of any civilised jurisdiction where future earnings are taxed.
It is the author’s view that those who introduced this provision in the past and are now proposing to do so are bereft of a proper comprehension of accounting and taxation. Tax on reserves is not a tax on income of a company.
It is a tax on the income of shareholders. It is the income of the shareholders which at the moment is lying with the company. Whenever it is distributed, it will be taxed.
If tax is levied on undistributed reserves, then whenever such reserves are distributed these will be again taxed as dividend (double taxation) unless there is a provision for tax credit when distributed.
The simple question is whether minority shareholders, whose interest is being cited to levy this tax, would agree to double taxation? In other words, this tax is tantamount to taxing income that has not been received.
Those who have proposed taxation of reserves need to revisit their concept of an ‘artificial person’ and status of a company versus an individual. There is a possibility that such reserves are never distributed. If so, can these be taxed as income of the company or the shareholders?
There is an argument that this provision is being introduced to penalise companies who do not pay taxes.
This argument is totally implausible as the majority shareholders who are alleged to withhold dividends can bear this cost of taxes, though at a different time and do not pay dividend even after this tax.
In this situation the minority shareholders will be unjustifiably penalised by a reduction in the value of their shares on account tax on reserves if there is no distribution even after such tax.
Lastly, the policymakers do not understand that all the reserves in the financial statements are not reflected by cash.
There are numerous cases where such reserves are not represented by cash; these have been invested in plants and machineries and other assets.
Distribution of reserves is a subject of corporate regulations and if there is a complaint that companies do not distribute dividends, then relevant corporate regulations can be introduced.
The constitutional provisions in this respect are very clear. The relevant entries in the Federal Legislative Lists are:
Taxes on income other than agricultural income.
Taxes on corporations.
These are two independent provisions. Taxes on income under Entry 47 covers all taxes including those on corporations. Even if it is considered that under Entry 48 there can be any kind of taxes than those levied under Entry 47, even then, in order to be taxed it has to be ‘income’.
The Division Bench of the Sindh High Court (CP D 4970 of 2017 Sapphire Textile Mills Limited Vs. Federation of Pakistan & Others) in the same case of tax on undistributed reserves has clarified this point as under:
“Entries in the Federal Legislative List.
The august Supreme Court has recognized in the Durrani Ceramics 22 that for an imposition to qualify as a tax, under the Federal Legislative List, it may be covered within entries 43 to 53 therein.
The Constitution empowers the Parliament to regulate corporations, per entry 31 of the Federal Legislative List. The power to regulate the declaration and distribution of dividends by corporations appears to fall within the domain of the said entry and no cavil in such regard has been articulated before us.
There is another entry in the Federal Legislative list, being entry 48; in respect of taxes on corporations. This entry empowers the Parliament to levy taxes on corporations. By definition, a tax is required to be a common burden for raising revenues for a general purpose.
It is our deliberated view that 5A is not covered by entry 48; as 5A does not manifest itself to be a common burden for raising revenues for a general purpose at all and instead seeks to target an additional levy on certain public companies with the objective to encourage / incentivize dividends.
Since, no case has been made out to qualify the enactment of 5A within the legislative remit of entries 43 to 53 of the Federal Legislative List, therefore, it is observed that such legislation could not have been endeavoured vide a money bill.”
Accordingly, the first test that would have to be passed is whether undistributed reserves in a company which arise after taxes on income of the company can be treated as ‘income’ of that ‘company’.
The answer is obviously in the negative. In that situation, unfortunately, we enter into the debate of ‘deemed income’ under the Income Tax laws. For that purpose, in the past two provisions were introduced, but not implemented effectively.
When this tax was levied earlier, the law stated as under:
Income Tax Ordinance 1979
(9A) Where an assessee, being a public company other than a scheduled bank or a modaraba, derives profits for any income year but does not distribute cash dividends within seven months of the end of the said income year or distributes dividends to such an extent that its reserves, after such distribution, are in excess of fifty percent of its paid up capital, so much of its reserves as exceed fifty per cent of its paid up capital shall be deemed to be the income having accrued to such company during that year:
Provided that in respect of assessment year commencing on the 1st day of July, 1999, the cash distribution made within the following period shall be treated as distribution for the purpose of this subsection:-
(i) where the income year ended on a date prior to the thirtieth day of June, 1999, and the distribution is made within a period of three months reckoned from the first day of July, 1999; or
(ii) where the income year ended on the thirtieth day of June, 1999, and the distribution is made within a period of eight months reckoned from the first day of July, 1999.
Explanation.- For the purpose of this subsection, the expression ‘reserves’ shall have the meaning as may be prescribed.
Income Tax Ordinance, 2001: Section 5A
“Tax on undistributed profits. (1) For tax years 2017 to 2019, a tax shall be imposed at the rate of five percent of its accounting profit before tax on every public company, other than a scheduled bank or a modaraba, that derives profit for a tax year but does not distribute at least twenty percent of its after tax profits within six months of the end of the tax year through cash:
Provided that for tax year 2017, bonus shares or cash dividends may be distributed before the due date mentioned in sub-section (2) of section 118, for filing of a return. (2) The provisions of sub-section (1) shall not apply to (a) a company qualifying for exemption under clause (132) of Part I of the Second Schedule; and (b) a company in which not less than fifty percent shares are held by the Government.”
The tax levied under Section 5A of the Income Tax Ordinance, 2001 was declared to be unconstitutional on the following grounds by the Sindh High Court:
Conclusion 21.
It has been established that section 5A of the Ordinance amounts to legislation, not contemplated in the Constitution, to be undertaken vide a money bill.
In such a scenario no rationale has been articulated before us to justify the regulation of companies’ behaviour, pertaining to dividends, to be effected vide a money bill, within the mandate of Article 73 of the Constitution, while abjuring the regular legislative process.
Therefore, it is our deliberated view that section 5A of the Income Tax Ordinance 2001 cannot be sustained on the constitutional anvil; hence, could not be construed to have legal effect.
In view of the reasoning and rationale herein deliberated, these petitions are allowed in terms delineated herein below:
i. It is hereby declared that insertion of section 5A in the Income Tax Ordinance 2001, including amendments thereto from time to time, does not fall within the parameters delineated per Article 73 of the Constitution of Pakistan, 1973, hence, the provision impugned is found to be ultra vires of the Constitution, and is hereby struck down.
ii. As a consequence, any show cause / demand notices 24 or constituents25 thereof, seeking enforcement of section 5A of the Income Tax Ordinance 2001, are hereby set aside.
The author agrees with the conclusion of the Sindh High Court on the technical grounds raised, however, the main focus that has not been deliberated in this decision is whether or not there is any limitation on the legislature to treat a sum as ‘income’’. It is the author’s view that there exist inherent limitations.
For example, can the legislature treat the ‘capital’ of a company as income as there is effectively no difference between capital and reserves for the reason that reserves become capital just by a book entry by way of issue of bonus shares? The proposition is absurd in every sense.
