Tax policies for industrial investment

Dr. Ikramul Haq[*]

Pakistan needs rational tax policies, having both short-term and long-term goals, to achieve self-reliance, which can only be possible if rapid investment for industrialisation is ensured. The unabated and mounting fiscal deficit, which is mother of all ills, can only be reduced or eliminated through revenue mobilization, value-added exports and huge industrial investments, both domestic and foreign.

DISMAL PERFORMANCE OFINDUSTRIAL SECTOR

The performance of manufacturing sector–comprising small and medium scale manufacturing (S&MSM) and large-scale manufacturing (LSM)– has been dismally poor during the financial years 1999-2000 and 2000-2001. The manufacturing sector registered a paltry growth of 1.1 percent, as compared to a targeted growth of 5.8 percent during FY 2000. LSM has registered an overall decline of 0.7 percent in FY 2000 as compared to a growth rate of 3.6 percent in FY 1999. Indications are that the LSM index is likely to recovery slightly from its low in December 2000 till the end of the current fiscal year (1.9 percent growth for July to December 2000) but is unlikely to meet its official growth forecast of 6.2 percent for FY 2001.

The fact remains that Pakistan’s industrial sector remains structurally narrow-based. Furthermore, this narrow base is predominantly agrarian in nature, and hence susceptible to exogenous factors, such as weather. This is highlighted by the role of cotton and sugarcane in the agriculture and manufacturing sector. Together, these two crops account for nearly 20% of value added agriculture and over 30% of LSM. In the face of this reality, it is imperative that the budget makers ensure the policy of diversification as well as developing the indigenous small and medium enterprises and large-scale engineering sectors.

Tax investment incentives have in recent times become a favourite tool in development strategy both for domestic investors and for attracting foreign direct investment (FDI). The rationale for their use is that they constitute an important, if not a major element in determining investment behaviour. Unfortunately, the Pakistani budget makers have always been preoccupied with the revenue targets and never gave a serious thought of providing some long-term investment-oriented tax incentives for infrastructure development, without which economic development cannot be achieved. The foreign investors will choose a place which not only offers tax incentives, but also ensures stability, consistency and excellent infrastructure facilities. The choice of UAE for major investors in recent years is due to these factors and not mere announcement of policies on paper as has been done by our Board of Investment.

It is a matter of record that tax policies incentives announced in the Invest Policy of 1997 were never implemented on the pretext that the Central Board of Revenue (CBR) did not show its willingness. It is strange that first the policy was announced and then consensus was solicited, whereas it should have been the other way around. Incentives increase the net of tax rate of return and thereby reduce the need for large initial capital investment and also reduce risk. The availability of incentives tends to make otherwise unpromising and risky ventures more profitable.

In Pakistan tax incentives were used from 1959 onwards, and after 1991 became a major instrument of development policy. Attempts are now underway to reduce their scope and coverage under pressure from IMF. In principles, the State should not give undue tax benefits or incentives to any particular vested interest, as has been done in the past by the so-called democratic governments. However, there is a dire need to provide some well thoght for incentives in the coming budgets to promote industrial development in the country and to ensure genuine investment, both domestic and foreign.

The following are some of the tax incentives that can go a long way to ensure revival of the economy and rapid industrial growth in the country: The list is not exhaustive, but includes only those incentives which have not been highlighted by the different bodies in their tax proposals. The Government must also consider the proposals sent by different groups but with caution that those intended for self-interest should be discarded.

Immunity to industrial investment

The industrial investment should be given complete immunity from probe by the tax authorities, and the foreign exchange regulations should be waived. It will help the State to bring back the capital fled from the country and also new capital would be attracted, especially from foreign investors and Pakistanis who are keeping billion of dollars abroad. There should be a well thought for scheme to bring untaxed and undeclared money back into the industrial investment. The immunity should be conditional to investment in industry alone.

Tax holiday for infrastructure facilities

A ten-year tax holiday for enterprises engaged in developing or operating and maintaining infrastructure facilities should be announced. The infrastructure facilities which will enjoy this benefit should include roads, toll roads, bridges, rail systems, highway projects water supply projects, sanitation, sewage and solid waste management, airports, ports inland ports and inland waterways.

Exemption of withholding tax for software payment

To encourage the best use of technology and to lower the cost of doing business in Pakistan, payments for the following categories of software made to non-residents should be exempted from withholding tax. They are: site licences, software downloaded from the Internet by end-users, and software bundled with hardware.

Writing down allowances for intellectual property

Intellectual properties and their exploitation will be a significant source of competitive advantage in the knowledge economy, in the coming days.

To enhance Pakistan’s competitiveness in this respect, writing down allowances over a five-year period should be granted for capital expenditure incurred on the following categories of intellectual properties acquired on or after 30 June 2001:

–           Patents;

–           Copyrights

–           Trademarks

–           Registered designs;

–           Geographical indications;

–           Layout designs of integrated circuits; and

–           Protection of confidential information.

Raising productivity – Company Stock Option Scheme

Employee stock option schemes have a significant impact on corporate performance. The schemes have been powerful tools to motivate their employees to greater innovation and enterprise.

This kind of scheme should be introduced, under which income tax exemption may be granted for up to Rs. one million worth of stock option gains arising from the exercise of the employees’ option over a ten-year period.

The scheme should be available to all companies that meet certain conditions. One key condition should be that companies will have to offer the stock options to at least half the employees in the company.

Tax holiday for broad-band networks and internet service providers

Enterprises providing telecommunication services and broadband networks, and Internet service providers which provide these services on or before 30 June 2003 should be allowed a tax holiday for five years and a deduction of 25% of profits for further period of 5 years. Pakistan must concentrate on the development of IT-based projects, which alone can make us competitive in the world markets in the coming days.

Tax break for developers of special economic zones and industrial parks

Ten-year tax holiday for developers of special economic zones and industrial parks for developing such facilities before 30 June 2006. The ten-year tax holiday may be availed in ten consecutive years during a block of fifteen years.

Rollover benefit for capital gains on sales of securities

A new provision should be introduced to exempt capital gains on the transfer of listed securities or units of mutual funds or the unit Trust of Pakistan, which have been held for a period of one year or more.

 

Confessional rate of tax for income from Central Depository receipts

A provision offering a concessional rate of tax of 5% on income received by a non-resident from bonds and Central Depository Receipts (CDRs) purchased in foreign currency from an “ approved intermediary “ should be given.

Introduction of transfer pricing regulation

Provisions to curb tax avoidance through the manipulation of transfer pricing should be introduced. Income arising from an international transaction shall be computed with reference to the arms length price. Similarly cost and expenses incurred, shared or allocated between associated enterprises in international transactions will also be computed with reference to the arm’s length price. The term “ international transaction “ should cover transactions between associate enterprises in the nature of the purchase of tangible or intangible assets, lending or borrowing of money, rendering of services and cost contribution arrangements. The definition of “ Associated Enterprise” is based on the definition of the term included in the OECD Guidelines and defines the concept in general as well as specific terms. The new transfer pricing methods must include the comparable uncontrolled price method, resale price method, cost plus method, profit split method and transactional net margin method. Provisions should also be introduced laying down requirements relating to information and documentation to be maintained, filing of a declaration by the Assessing Officer. However, the Central Board of Revenue in this regard should issue detailed rules and guidelines separately. A number of penalty provisions should be introduced prescribing penalties for income concealed through transfer pricing, and for defaults in maintaining documentation and failure to provide information or documents during the scrutiny by the tax authorities.

Modification of the definition of “ royalty”

In Pakistan’s tax treaties the term “ royalty” is usually defined to include payments “ for the use of or the right to use industrial, commercial or scientific equipment”. However, the definition in the domestic law does not include the above payments. The definition of royalty in Section 12(4) of the Income Tax Ordinance is therefore should be amended to include payments for the above-mentioned rights.

Definition of “ books of account” and “ document”

The term “ books of account” should be defined in Section 2  of the Income Tax Ordinance, 1979 and must include a reference to electronic records stored on a floppy disk, tape or any other form of electromagnetic data storage device. Most of the industrial houses on maintain accounts electronically but the tax department insists that there should be physical books of account. This shows backwardness of thinking and non-willingness to recognize the importance of IT in industry, although the CBR keeps on boosting that it is going high-tech.

Time limit to issue refund

Time limit for the issue of refunds of excess tax deducted or paid by a taxpayer should be fixed to six months. In case a return showing refund is filed, the assessment should be made with six months of filing of such return, failing with refund should be issued before the finalisation of assessment.

The economic managers while making the budget for financial year 2001-2002 must consider the fact that taxation affects the amount of capital available by encouraging or discouraging savings and foreign investment. It may also divert investment and labour from one sector to another. It affects the level and productivity of employment by influencing individual choices between work and leisure, the intensity of effort on the job and employers’ decisions on technology. Taxes affect a firm’s ability to diversify and expand through their import or input costs and managerial behaviour. They may also have a bearing on less tangible factors such as entrepreneurship and technical progress. Some empirical evidence also suggests causal relationships between the level and types of taxes and key growth determinants in the areas of investments, export, employment, productivity and innovation (Marsden, 1986).

The coming budget must concentrate on the revival of industrial sector and provide some solid tax incentives for future foreign and domestic investment. The single important reason why tax incentives for industrialisation are essential is to get macroeconomic policies right, as the alternative ways of financing government expenditure – money creation, mandating larger required reserves, domestic borrowing and foreign loans can have very harmful effects on the already ailing economy.

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[*] [*]Dr. Ikramul Haq, a leading international tax counsel, is a well-known author specialising in international tax, press, intellectual property, corporate and constitutional law. He served for 12 years as Deputy Commissioner of Income Tax. He studied literature, journalism and law, for his Masters and Doctorate degrees. He has written many books on various aspects of Pakistani law and global narcotics trade, some of which are co-authored with his wife, Mrs. Huzaima Bukhari.