Corporatisation through tax incentives

November 05, 2007
www.dawn.com

By M. Iqbal Patel


The Central Board of Revenue (CBR) constituted a task force in August 2006 to review the enabling tax environment for holding companies and formulate proposals in line with the international best practices to facilitate group consolidation of the fragmented corporate ownership.The Asian Development Bank (ADB) felt that the actual formation of holding companies is impeded by tax policy distortions that can result in double taxation of corporate income of affiliated firms within a holding company. However, its opinion that our tax policy distortions are limited to the holding companies, was not correct.In fact, our tax statute is plainly discriminatory while imposing taxes. Lawmakers manage to keep themselves and the ‘milk cows’ out of reach of the tax regime which has been the main reason of the narrowed tax net and its negative effects on the overall tax revenue generation. It is time to remove these distortions from the tax policy.According to the Sec3 of the Companies Ordinance 1984 (CO), a company shall be deemed to be a subsidiary of other company which directly/indirectly controls, beneficially owns/holds more than 50 per cent of its voting securities or otherwise has power to elect and appoint more than 50 per cent of its directors. The other company shall be called a holding company. Despite such liberal laws, only 115 holding and subsidiary companies have been formed so far.The government, no doubt, offers several tax incentives to encourage corporatisation and to sustain economic growth..In order to encourage conversion of sole proprietorship and association of persons/partnerships into companies, sections 95/96 of the Income Tax Ordinance 2000 provide that no gain or loss will arise when a resident individual or a resident association person disposes the assets of a business to a resident company subject to fulfilment of the conditions provided therein. Moreover, Sec 97 does not recognise any gain/loss on disposal of assets between wholly owned companies subject to certain conditions.The Finance Act, 2007 introduced Sec 97A for non-recognition of such a gain/loss arising of out disposal of assets of one company to another under the Scheme of Arrangement and Reconstruction. All these measures are provided to encourage individual/family owners of companies to consolidate their businesses so that a strong corporate sector is developed to meet the international challenges.Besides, the tax benefits for corporatisation, the Finance Ordinance 2002 introduces u/s (2A), a scheme of amalgamation/merger of banking or non-banking financial institutions. Subsequently, the benefit of the scheme has been extended to insurance companies and industrial undertakings. The major benefit as a consequent of merger as provided u/s 57A is that accumulated business losses of amalgamating company are allowed to be set off or carried forward against the business profits of the amalgamated company for a period of six tax years.In addition, the ordinance provides for group relief to a subsidiary of a holding company listed on stock exchange in Pakistan, owning and managing an industrial undertaking and an undertaking engaged in providing services. Accordingly, a subsidiary is allowed to surrender its losses to the holding company for a set off against its business profit subject to the conditions specified.Thus the government has been using the income tax as a tool to encourage growth of corporatisation. However the data shows that since the concept of amalgamation was introduced in 2002 till 2006, only 40 amalgamations have taken place. Similarly, till 2006 not a single company has availed the benefit of group relief. Such a scenario calls for a review of the present tax policy towards corporatisation.If one looks at the performance of the companies listed on the Karachi Stock Exchange (KSE), it is certainly very poor. Out of 653 companies, 189 are placed on defaulter’s counter while no trading takes place in another 200 companies.. Thus 60 per cent of the listed companies are dormant while only few of the rest of 40 per cent declare profit or pay dividend to their shareholders.All these companies have made public disclosures of their performance in their audited accounts in accordance with International Accounting Standards along with positive reports on compliance with corporate governance requirements duly reviewed by auditors. This scenario indicates that tax policy as a tool for corporatisation does not yield the desired objective due to ineffectiveness of corporate sector regulations, supervision and above all, their ‘culture’.The task force evaluated the impact of these incentives on corporate sector and correctly pinpointed out that the key problem was the fragmented ownership/ management in the corporate sector which has failed to achieve the objectives of creating an efficient corporate sector. However, their prescription to enforce the concept of group taxation and group relief is not a proper treatment for curing the disease.The Finance Act, 2007 substituted the provision 59B relating to group relief. The scheme permits the holding company to absorb losses of its subsidiary/subsidiaries among themselves to set off against their current profits for three years subject to fulfilment of the conditions specified. It also provides transfer of cash to the loss surrendered subsidiary company equal to the amount of tax payable on profits against the loss suffered. Such transferred cash being tax-free.The scheme is defective in being discriminatory in nature and would encourage a loss culture in the sector. Under the scheme, acceptance of loss of a subsidiary for set off by a holding company is neither subject to approval from shareholders nor the transfer of cash to loss surrendered company subject to the consent of shareholders.Moreover, neither there is a provision to the fact-finding of causes of loss sustained by a subsidiary through independent auditors nor the holding company is required to submit any plan for rehabilitation of the subsidiary company to CBR or SECP Thus the substitution in more liberal form in the ordinance to enforce group relief without any provision of check and balance would encourage loss culture in the sector rather than promote formation of holding companies.The core issue of inefficiency of corporate sector is the family and individual ownership. There is a dire need to adopt appropriate measures in the CO so that the sector would play its role in the competitive environment of the international market effectively. Presently, CO allows boards of directors--even of the listed companies the ownership of which is subscribed by the public—to appoint family members including wives/daughters/sons as sponsors. A house built on a weak foundation is bound to collapse. Similar is the case of the companies which have members on their board of directors having no business experience or required education.The main responsibility of managing a company’s affairs rests with its directors. The Cadbury Committee spells out the responsibilities of its directors to include setting up of the company’s strategic aims, supervising the business and reporting to its shareholders. Thus a company’s success depends on an effective board comprising of directors having the requisite education, experience and vision.The CO should lay down the proper conditions for becoming a director of a company and the Securities Exchange Commission of Pakistan should consider the measures which would help build the structure of a strong corporate sector.