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Pakistan

Huzaima Bukhari and Ikramul Haq
Huzaima & Ikram - Taxand
Pakistan

The government has introduced legislation for the taxation of Islamic financial instruments in response to the growing number of sharia-compliant products in the market, explain Huzaima Bukhari and Ikramul Haq of Huzaima & Ikram - Taxand.

In recent years, the taxation of Islamic financial instruments and various modes of Islamic financing has assumed great significance in Pakistan as more and more financial institutions have procured licences from the State Bank of Pakistan (SBP) and Securities and Exchange Commission of Pakistan (SECP) to launch Sharia-compliant products. Pakistan started large-scale Islamic banking in 1980 with full vigour.

Since then many Islamic financial instruments have been introduced, as is the case in many other countries, such as in Middle Eastern states, Iran, Indonesia and Malaysia. Many Islamic banks in Pakistan are working with zeal and enthusiasm for the implementation of Islamic mode of financing as a parallel lending and borrowing system. The world has also started recognising its importance as tax issues relating to Islamic finance were deliberated in the second and third and sessions of the UN Committee of Experts for International Cooperation in Tax Matters in Geneva.

Tax treatment of Islamic instruments

The tax treatment under the Income Tax Ordinance 2001 (the Ordinance) of various modes of Islamic financing is summarised below:

Profit sharing accounts

In 1980, all the scheduled banks in Pakistan were asked by the Central Bank to shift to profit & loss sharing accounts (PLS Accounts) from traditional interest-bearing saving accounts and instead of paying fixed interest were made to pay profit on such accounts. The obvious question was about the deductibility of such amounts in the hands of banks. Any amount paid as a share of profit under the established principles was the application of profit and not an allowable expense. Since it was a cosmetic change only, the nomenclature was changed from interest to profit and from saving accounts to PLS accounts, the government decided to amend the income tax law providing that in computing the income of the banks "any sum paid or credited to any person maintaining a profit and loss sharing account or deposit with a scheduled bank by way of distribution of profits by the said bank in respect of the said account or deposit" would be allowed as a deduction.

Since 1981, banks have been paying profits on PLS accounts at a pre-determined rate of return and such payments, though called profit distribution (sic) are treated as allowable expenses. These obviously represent interest paid on borrowed money by the banks. In the hands of recipients, the amount received as profit is not treated as dividend but profit on debt and is taxed at 10% on a gross receipt basis (presumptive tax regime), except in the case of companies.

Payments under musharakah

The banks provide capital under an agreement of musharakah with the customer. The starting point for calculating profit is the expected profit rate forecast by the customer at the time of seeking finance. If the customer's forecasts are achieved, the customer is given a good management bonus as agreed at the time of signing of the musharakah agreement. Profit left after the adjustment of the bonus is divided between the bank and customer on a daily product basis. Non-deduction of share of income paid to a bank by a customer out of profits of musharakah could affect the customer adversely as well the scheme. The government amended the law in 1983 allowing as a business deduction "any sum paid to a bank under a scheme of musharakah representing its share in the profit of that musharakah".

Modarabas

Modaraba is defined in section 2(34) of the Income Tax Ordinance 2001 to mean the same as explained in Modaraba Companies and the Modaraba (Floatation and Control) Ordinance 1980. The concept of modaraba under this law means a business in which one person participates with his money and the other one with his efforts or skills or both. All mutual funds and unit trusts by whatever name they are called are included in the definition of a modaraba. Every modaraba is floated by issuance of a prospectus for public subscription and is required to be quoted on a stock exchange to trade its certificates. However, unlike other joint stock companies, a modaraba need not hold an annual general meeting and its registers are not open to inspection by certificate holders. The directors of the management company are treated as sponsors of the modaraba and are required to comply with the legal requirements regarding filing of returns and accounts of the modaraba. A modaraba is a legal person distinct from the company that manages it, as it is also distinct from every other modaraba floated by the management company. A management company is entitled to a fixed percentage of the annual net profits of the modaraba of not more than 10% as remuneration.

A modaraba can only be floated with the permission of the registrar modaraba. Modarabas are engaged in all kinds of business activities that are approved by the Religious Board set up for the purpose of Modaraba Companies and the Modaraba (Floatation and Control) Ordinance 1980 read with Modaraba Companies and Modaraba Rules 1981. Before July 1, 1992, a modaraba's income was exempt from income tax, "if not less than 90% of the profit in a year is distributed to the holders of Modaraba Certificates" under section 37 of the Modaraba (Floatation and Control) Ordinance 1980. Modaraba certificate means a certificate of definite denomination issued to the subscriber to the modaraba acknowledging receipt of money subscribed by him. The certificate holders enjoy a capital gains tax exemption from the sale of certificates in the same manner as shareholders of listed companies are. The charging section 9 of Income Tax Ordinance 1979 (predecessor of Income Tax Ordinance 2001) was amended through Finance Act 1992 as a result of which section 37 of the Modaraba (Floatation and Control) Ordinance 1980 and all other laws were overridden to tax the income of a modaraba from assessment year 1993-1994, provided that a modaraba would not be charged to tax for the first three assessment years after commencement of its business if not less than 90% of its profits in a year were distributed to the modaraba certificate holders. A concessional tax rate of 25% was applied to modaraba as compared to 45% applicable to companies in 1993-1994.

The modarabas, except for their income from any trading activity, are exempted from tax. Modarabas engaged in trading activities are taxed at a reduced rate of 25%.

Leasing operations (Ijarah)

The Income Tax Ordinance 2001taxes gross lease rentals under any Islamic mode of financing. Section 18(3) of the Income Tax Ordinance, 2001 reads:

Where a lessor, being a scheduled bank or an investment bank or a development finance institution or a modaraba or a leasing company has leased out any asset, whether owned by it or not, to another person, any amount paid or payable by the said person in connection with the lease of said asset shall be treated as the income of the said lessor and shall be chargeable to tax under the head "Income from Business".

The tax treatment, then, of modarabas engaged solely or primarily in the leasing business or providing funds on a musharakah basis to industrial, commercial and trading concerns is not different from that of banks or financial institutions. It is also evident from this provision of law that contains specific reference to a modaraba. Since gross lease rentals are taxed, the legislature has provided that depreciation is admissible in the hands of the lessor under any Ijarah contract for leased out assets. Depreciation calculated for leased-out assets can only be adjusted against lease rentals. In case it remains unabsorbed, it will be carried forward till its absorption against lease rentals, as envisaged in section 59A(5) of the Income Tax Ordinance 2001. The gross lease rentals, principal as well as interest, paid by the taxpayer to a modaraba qualify as business expense.

Taxation of management fees

According to section 18(1)(e) of the Income Tax Ordinance 2001, any management fee derived by a management company (including a modaraba management company) is to be taxed as business income after admissible deductions at the corporate rate of 35%.

Banks in schedular assessment

Section 100A read with the seventh schedule of the Income Tax Ordinance 2001 provides that from tax year 2009, all the scheduled banks will be taxed separately and as per provisions contained in the said schedule. Rule 3 of the Seventh Schedule reads

Treatment for Sharia compliant banking:

1. Any special treatment for 'Sharia Compliant Banking' approved by the State Bank of Pakistan shall not be provided for any reduction or addition to income and tax liability for the said 'Sharia Compliant Banking' as computed in the manner laid down in this schedule.
2. A statement, certified by the auditors of the bank, shall be attached to the income return to disclose the comparative position of transaction as per an Islamic mode of financing and as per normal accounting principles. Adjustment to the income of the company on this account shall be made according to the accounting income for purpose of this schedule.

The implication for the scheduled banks with effect from tax year 2009 is clear: that they cannot take benefit of any reduction in income and tax liability for special treatment available for Sharia -compliant banking approved by the State Bank of Pakistan.

They will be required to attach a statement, certified by their auditors, to disclose the comparative position of transaction as per Islamic mode of financing and as per normal accounting principles. The adjustment, if any, will have to be made according to the accounting income for purpose of seventh schedule to the ordinance.

Limited availability

This analysis shows that special tax incentives are available only in the case of modarabas and all other Islamic financial instruments, including those devised under the Sharia-compliant banking code approved by the State Bank of Pakistan, are taxed in the same way as other non-Islamic interest-based transactions. It is strange to note that modarabas, despite these special incentives, have not been able to replace the conventional companies in Pakistan even after 28 years of their existence. The promulgation of Modaraba Companies and the Modaraba (Floatation and Control) Ordinance 1980 was aimed at promoting an Islamic mode of finance and interest-free business. A host of tax benefits were provided to modarabas (three years' tax holiday even when the tax was imposed for the first time in 1993, which was later withdrawn in 1999, except for trading activities) and even their taxable income is subjected to a reduced rate of 25%, yet their growth and contribution to the financial sector is negligible. It shows that either there is something fundamentally wrong with the Religious Board that devises or guides their business, or modaraba management companies have failed to compete with established corporate entities, who offer more attractive profits and returns to the shareholders and investors.

It can safely be concluded that even attractive tax benefits have failed to promote the Islamisation of economy in Pakistan during the last three decades. However, Islamic banks (so-called according to many critics ) have shown appreciable growth since 1980 . It is estimated that Islamic banking will capture 12% of the deposit market by 2012 in Pakistan.

If the government of Pakistan wants to promote Islamic banking and Sharia-compliant products, it needs to improve the existing regulatory framework and tax legislation to remove dichotomies and contradictions. The important points for consideration are:

• Change of nomenclature will have no effect. The consumers will only be attracted if they find that sharia-compliant products are more beneficial vis-à-vis non-Sharia products and instruments.
• The present sales tax treatment of sharia-compliant financial products under the Sales Tax Act of 1990 is uncertain. Tax on transfer of goods put the providers of sharia-compliant financial products at a commercial disadvantage. Consequently, customers suffer financial loss as providers pass on their burden to them. Sharia-compliant products should fall outside the ambit of sales tax.
• In Income Tax Ordinance 2001 sharia-compliant products should not be taxed in a way that is less advantageous than equivalent non-sharia financial products.
• The government must instruct its ministries of finance and law to study the existing anomalies that have been pointed out and recommend a comprehensive legislative solution after consulting all the stakeholders and experts in the field of sharia, banking, taxation and economics.

Huzaima Bukhari (huzaima@huzaimaikram.com) and Ikramul Haq (ikram@huzaimaikram.com) are senior partners of Huzaima & Ikram in Lahore, the Pakistan member of Taxand, the global network of leading independent tax firms