Tax on undistributed profit of companies: Need for review and change – I

The new law 

Pakistan is one of the unique jurisdictions that charge tax on already taxed undistributed profits/reserves. There had been experiences in our fiscal policy on this subject which are discussed in the following paragraphs. In my view, there is a need to review the aforesaid tax and change the present fiscal policy on this matter.

Through the Finance Act 2017 a substantial change has been made in the provisions relating to tax on undistributed income/reserves. The summary of the provisions of the law relating to tax on undistributed reserves/income prior to amendment are as under:

— There was a tax at the rate of 10 percent on undistributed reserves after including profit for the year if they exceed 100 percent of paid up capital of the company;

— This tax was not payable if there is ‘cash distribution’ not being issue of bonus shares of an amount equal to 40 percent of profit for the year or 50 percent of the paid up capital whichever is lower.

This law effectively taxed ‘undistributed reserves’ as long as reserves exceeded 100 percent of paid up capital. That incidence could have been avoided, if there is a minimum distribution of cash dividend equal to an amount being 50 percent of paid up capital or 40 percent of the profit for the year, whichever is less, within six months at the end of the tax year. In other words, if the par value of shares is Rs 10 then a minimum dividend of Rs 5 was effectively the way to avoid tax on undistributed reserves if profits and reserves are higher than the prescribed limit. This caveat of relationship with the paid up capital reduced the intensity of incidence of law.

In the old law, the taxable sum was ‘excess reserves’. The tax incidence was directly related to the ‘paid up capital’ of the company. This linkage was in two forms. Firstly, tax was there only when there was excess reserves being the amount in excess of 100 percent paid up capital. Secondly, incidence of tax would not have been there if there was a distribution of dividend equal to 50 percent of paid up capital. In the law as amended by the Finance Act, 2017, for reasons explained in the following paragraphs, both these relationships have been severed.

The law now enacted under substituted Section 5A of the Income Tax Ordinance, 2001 (2001 Ordinance) is straight and simple tax on ‘accounting profit after tax’ if not distributed. Now a tax equal to 7.5 percent of accounting profit after tax for the year will be levied if there is no distribution of cash dividend or bonus shares to the extent of 40 percent of that profit. In author’s view, the present law needs to be reviewed and changed for the reasons explained in the following paragraphs.

This effectively means that every company will be required to pay a minimum dividend in the form of cash dividend or bonus shares to the extent of 40 percent of accounting profit for the year to avoid additional tax of 7.5 percent of whole profit for the year.

Under the new regime, distribution will include issue of bonus shares. It is important to note that, as against general tax principles, distribution in the shape of bonus shares is also considered as income and taxed in the hands of the shareholders.

History and legacy 

Pakistan has a very old history and legacy of tax on undistributed income/ reserves.

This tax was originally levied by way of Section 23A of Income Tax Act, 1922 (the 1922 Act). The revised scheme of the 1922 Act as implemented after 1971 was quite similar in major aspects with the present amended position as it emerges after the Finance Act 2017.

Tax under Section 23A of the 1922 Act was on undistributed income, not the income as a whole, as against the current law. Under that law, there was distribution requirement equal to 60 percent of profit for the year in the form of cash dividend or bonus shares. If actual distribution was less than the prescribed level of distribution then tax at the rate of 15 percent was levied on the ‘undistributed income’ not being whole income. Furthermore, in order to incentivize the retention of a certain sum a ‘retention allowance’ of 10 percent of profit was there whilst determining the amount of ‘undistributed income’ for the year.

To summarize, an illustration of the above working is provided below:

If we compare the amended provision of Section 5A of the 2001 Ordinance after the Finance Act, 2017 it is revealed that under Section 23A of the 1922 Act, tax was on undistributed income after allowing a deemed retention allowance of 10 percent of profit and actual distribution was deducted from the income to determine the taxable sum. Under the current law, tax incidence is on whole income and actual distribution is not taken into account. As identified in the following paragraph this appears to be an omission that needs to be essentially corrected.

Tax on undistributed profit as levied under Section 23A of 1922 Act, which in author’s opinion, was not a good tax from all viewpoint, and thus was not included in any form in the Income Tax Ordinance, 1979. There are scores of articles and papers written on this subject and this tax was considered as a good option.

After the lapse of approximately 20 years, this concept of tax on undistributed profit/reserves was reintroduced by the Finance Act 1999 in the Income Tax Ordinance, 1979 by way Section 12(9A).

Under this law, reserves in excess of fifty (50) percent of profit was subject to tax at the rate of ten (10) percent, unless there is a distribution of dividend to the extent of forty (40) percent of profit or fifty (50) percent of paid up capital, whichever is lower. The provisions introduced in 1999 were substantially different from those contained in Section 23A of the 1922 Act. The amount subject to tax was ‘undistributed reserves’ and incidence could have been avoided on payment of a minimum dividend of Rs 5 per share or forty (40) percent of profit, whichever is lesser. It may be noted that issue of bonus shares was not included in the definition of distribution for this purpose. At that time bonus shares were not taxable in the hands of shareholders.

This was also not a good tax; accordingly, this provision in the Income Tax Ordinance, 1979 was not carried forward in the Income Tax Ordinance, 2001.

Nevertheless, this concept was introduced again after 15 years in 2015 vide Section 5A of the 2001 Ordinance. Provisions of Section 5A of the 2001 Ordinance are almost identical to those contained in 12(9A) of the Income Tax Ordinance, 1979, except that under Section 5A of the present Ordinance tax incidence commences only if reserves after adding the current year’s profits exceed 100 percent of paid up capital of company as against 50 percent of paid up capital in the 1979 Ordinance. Nevertheless, in line with Section 12(9A) of the 1979 Ordinance, law was not applicable if there is a distribution equal to Rs 5 per share or 40 percent of profit, whichever is lower. Furthermore, consistent with section 12(9A) bonus shares were not included in distribution for this purpose.

An analysis of present law transpires that after the amendments introduced in 2017 the status of revised/substituted law is now closer to the provisions as contained in Section 23A of the Income Tax Act, 1922and not Section 5A of 2001 Ordinance or Section 12(9A) of 1979 Ordinance. This tax is on undistributed profit for the year, and has no relation with the reserves and paid-up capital. The incidence of tax requires fundamental correction as explained in the following paragraphs.

Reasons for change in section 5A of the 2001 ordinance by the Finance Act, 2017 

It appears that change in Section 5A of the 2001 Ordinance was made on the ground that there is a perception that companies with large amount of reserves/profit are absolved from the rigour of this law on account of relationship of incidence of tax with the paid-up capital of the company in the manner referred above. With low amount of capital, a distribution equal to Rs 5 per share was enough to avoid any incidence of tax irrespective of the level of profits and reserves. This rationale may sound reasonable only if the intention of tax policy is to manage the corporate action of distribution of dividend. One may plausibly argue that fiscal and corporate objectives cannot not be intermingled. We have tested all the options in the past, where there was relationship with capital and otherwise; and both were ultimately removed from the legislature. There is a need to examine the law as proposed in the light of the comments made in the following paragraphs.

Perceived rationale of tax on undistributed profit/reserves

There is no fiscal policy basis to tax undistributed profit or reserves. Such amount represents the taxed profits in the hands of the company and does not represent disposable income in the hands of shareholders. Therefore, there is no such tax incidence on undistributed reserves/profit in most of the developed and developing jurisdictions.

The rationale framed for the levy of this tax even as made at the time when Section 23A of the 1922 Act related to the corporate perspective. The Finance Minister at that time, in his speech for the Budget of 1965-66 stated that Section 23A which was not applicable to private limited companies was so made applicable in order to induce such companies to convert into public companies.

The rationale given with respect of this tax at that time was purely non-fiscal and the same appears to be applicable for re-introduction of this tax in 1999 and 2015. Though not specified, it is clear that such provisions have been repeatedly introduced and removed in relation to the corporate policy of distribution of profits by companies. There is a general perception that companies accumulate reserves and do not distribute the same as would have been desired by the minority shareholders or the persons who were not in control of the company. The primary question is whether or not the present amendment is the solution of this grievance of the minority shareholders. The writer’s answer in this respect is in the negative.

(To be continued)

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                                                   Rupees

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Income                                                500

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Dividend Distributed:

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Cash Dividend                                         100

Bonus Shares                                          100

Minimum dividend required: 60 percent of income       300

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Calculation of Tax

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Profit for the year                                   500

Less: Dividends                            200

Retention allowance (10% of 500)            50      (250)

Undistributed Income                                  250

Tax at the rate of 15%                               37.5

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