Wednesday, September 19, 2007

E-commerce and taxation: Pakistan perspective

October 13, 2003

By Ayaz Elahi Gajani
The term electronic commerce is not easily defined. However , it is broadly defined as “ the delivery of information ,products, services or payments by telephone , computer or other automated media”.The definition recognizes that e-commerce can take place through many electronic means. These include telephone, fax, automated banking machine, credit and debit cards, Internet, etc.The e-commerce has grown tremendously and continues to grow at a phenomenal rate. The WTO estimated ,in December 1999 ministerial conference in Seattle USA , that by the year 2001 there will be 300 million Internet users. Today the figure can be estimated to have crossed the figure of 400 million Internet users world wide.The value of e-commerce transactions in 2001 stood at $ 300 billion , according to WTO. The main beneficiary of this growth is the USA. According to a survey by NUA, an Internet consulting and development firm ,24 per cent of US companies were selling goods and services online in 1998.The same has grown to 56 per cent in the year 2001. Therefore it could safely be concluded that in the future E-WORLD the push of e-commerce would continue to grow at the cost of ordinary off-line business and middlemen especially of the poor countries.Implications: This greater global economic interdependence has profound implications for tax systems. For example, the base for taxes on income has become more geographically mobile and therefore more sensitive to tax differentials. This has to be recognized that the mobility of e-commerce and its geographic sensitivity to tax differentials may exacerbate harmful tax competition, between countries, with each country trying to attract a larger share of the global tax base. Different world bodies are alive to such emerging scenario. The most important amongst them are OECD and WTO.The OECD approach is coordination or “peaceful coexistence” among tax authorities. The objective is to have tax systems that are responsive to market forces, which at the same time do not interact in ways that adversely affect the international allocation of resources.At the November 1997 conference entitled “ Dismantling the Barriers to Global Electronic Commerce” held in Turku, Finland, government and business representatives met for informal discussions on the challenges posed by global electronic commerce to tax systems.Since that initial meeting much work has been done by the OECD and revenue authorities world wide to provide greater certainty on how e-commerce will be treated for tax purposes. Less than year after Turku, OECD formulated a Committee on Fiscal Affairs (CFA) who had formulated the Taxation Framework Conditions that were discussed at Ottawa conference in 1998.At Ottawa it was agreed that the following broad taxation principles should apply to e-commerce: neutrality, efficiency, certainty, simplicity, effectiveness, fairness and flexibility.The WTO approach is also similar to OECD with more emphasis on economic aspects of e-commerce. However this issue has not been able to gain as much importance comparing other sectors.The pressure is now mounting on WTO to take on the issue. Steve Cisler, an information consultant in the USA , at the conclusion of WTO Seattle conference observed that by 2005 he sees the pressure being applied on WTO to call it “WETO” (World Electronic Commerce Trade Organization) The WTO members have now begin to explore how the body should deal with the question of e-commerce. Observers say governments are skirting a very complex issue and need to become aware of the complexities involved.It is further argued that the WTO agenda was very backward-looking keeping in view the rapid economy changes brought about by advanced information technology in creating an economic system very different from the post-World War II situation for which the GATT/WTO process was designed.Before we proceed further it is very pertinent to mention the WTO Agreement on Information Technology. During the Singapore Ministerial Conference of the WTO, a proposal for the expansion of world trade in information technology products was adopted vide the “Ministerial Declaration on Trade in Information Technology Products” dated 13th December 1996.The declaration was adopted by 14 parties including the QUAD Countries (USA, Canada, Japan & EU), Singapore and Hong Kong representing about 80 per cent of the trade in these products. The agreement became effective once the number of countries joining the agreement represent 90 per cent of the trade in information technology products.Other WTO Members could opt to join the agreement as a participant. The ITA, a plurilateral agreement within the WTO, aims to expand world trade in information technology products considering the key role this trade plays in development of information based industries and the dynamic expansion of the world economy. India joined the ITA on 25th March 1997. Pakistan has not yet signed the agreement.Issues: In the preceding paragraphs, it has been briefly attempted to:* Review international trends in e-commerce;* Identify the potential growth and uses of e-commerce in future;* Track the developments at world forums relating to e-commerce;* Identify the concerns shown by various groups associated with regard to tax related issues.In this background it could safely be concluded that Pakistan is still at a nascent e-commerce development stage. Despite having approximately million Internet users, the volume of goods and services sold and bought online still represents a minuscule part of the total economy.However, if Pakistan follows what has happened in Europe and North America, tax authorities will soon be questioning whether our current tax systems are adequate for the expected e-commerce onslaught.Specific issues: 1. Whether the current Permanent Establishment Definition (P.E) applies to e-commerce transactions on account of goods and services bought / sold on-line ?2. What is the impact of e-commerce revolution on the application of concept of Place of Effective Management?3. Whether e-commerce would shrink the tax base of the country?4. What type of Tax Treaty Characterization issues are expected to arise from e-commerce transactions?5. Why the consumers at destination (Pakistan) should pay the consumption tax (VAT/ sales tax ) in compliance to the Consumption Tax Laws of the country of origin (eg USA,EU,JAPAN )? Despite being not in their tax jurisdiction.Due to consideration of space all the issues identified above can not be tackled in detail. Therefore, an attempt shall be made to discuss the concepts in brevity for proper appreciation of the gravity of the matter under consideration.The first issue is PE. There are two main principles under which countries including Pakistan tax income- - source and residency. Host countries usually tax the ‘profits of the enterprise’ but only so much of them as are ‘attributable’ to a permanent establishment of the enterprise in the host country,.Over the years, tax authorities in Pakistan have routinely ruled on specific cases and defined what types of profits are attributable to a permanent establishment and thus were subjected to tax. For instance, under the Income Tax Ordinance, 2001 tax is imposed on the income accruing in or derived from Pakistan”.The Pakistan Tax Statute thus, uses various operations test to determine whether the income is derived in Pakistan and liable to tax. If the business operations are carried out in Pakistan, then income derived from those activities are taxable.Prior to the appearance of the Internet and e-commerce, the permanent establishment test was quite simple; however, today, with e- commerce, business can be conducted from anywhere in the world.For instance, would a company headquartered in USA or for that matter in any other EU country but operating an E-commerce website on a server located in Pakistan be deemed or treated as conducting business in Pakistan?The Pakistan Tax Statute specifically does not answer the question that the mere presence of a physical server in Pakistan will amount to trading in Pakistan. With the Internet, the income-attribution and permanent establishment definitions have become blurred.The second issue is the ‘place of effective management’. This issue is intertwined with the first issue discussed above, i,e, the concept of PE. A taxpayer may have a number of places all over the world where business activities are conducted in phases of single business activity or otherwise The implementation of strategic decisions may take place through virtual or mobile offices moving between jurisdictions.The management may resort to taking decisions through video conferencing while physically not being present in the place where effective management rule would apply.The taxpayer could have therefore a number of places of effective management during one particular tax year, so its residence status could be amorphous.Further, the development of electronic cash will probably facilitate both electronic commerce and tax evasion since payments; no longer leave a paper trail, becoming anonymous and untraceable.The third issue i,e, “tax base erosion,” would become a frequent e- commerce problem if we will not be sure as how to tax the transactions discussed as issue one and two above . This will seriously hamper the efforts of the government to broaden the tax base.This issue is even staring in the eyes of tax collectors in the developed world. For instance, in the US, Which normally charge sales tax on retail purchases , the tax collectors are having a difficult time collecting tax on Internet transactions.The fourth issue, which stares us is the tax treaty characterization. Pakistan is signatory of various avoidance of double taxation treaties (ADTT).The problem has emerged globally as to how various treaty characterization issues arising from e-commerce transactions be addressed. Here comes the problem, which revolves around the characterization of various transactions.Whether the transaction in issue is business profit or royalty or fees for technical services? In such situations we have to revert back to the statute and if the definitions found therein controvert the definitions given in the ‘Treaty’ (ADTT) the later shall prevail. Unfortunately, lot of such treaties are not meeting the requirements of e-world. This issue is still being debated at OECD (TAG).This clearly indicate that OECD has recognized the problem and is contemplating changing various definitions given in the model tax convention.The issue in hand can be well comprehended with the help of following examples;* Whether the income received by a foreign company on account of electronically downloaded computer software is business income or royalty? or services?* Whether the use of software in above situation is a patent or copy right?* In above situations , what is the essential consideration?* What shall be the nature of payments made by the Pakistani concern towards acquiring the services of foreign industry expert, through Internet communication? Whether such consideration is for fees for technical services? In this situation the foreign expert also demanded money through Internet by way of Credit Card.There can be hundreds of such situations as above, for which answers are to be found.Others: The income tax base erosion problem, as discussed above is beginning to attract the legislatures of many countries, particularly the developed states in the west. Even our neighbouring state India is alive to address the issue.In September last year, a high-powered committee on electronic commerce and taxation specifically addressed the e-commerce income tax base erosion issue in India where the said committee concluded as under:“What is crucial is that e-commerce represents a fast growing base, which the country cannot afford to exclude from the direct tax net. The committee is of the view that there is not a case for exempting e-commerce from direct taxation,”The countries, including Malaysia, are also actively looking at various possible systems on taxation for the Internet era to make sure that they do not miss this important source of revenue.The European Union (EU) is ahead in this by recently imposing value-added tax (VAT) to firms outside of its 15-nation regional grouping selling digital services like software and music downloads to Europeans, to create a fair business environment between European companies that are already paying taxes in their countries of origin and their online competitors from abroad.Conclusion: There remains no ambiguity that fast growing e-commerce has raised enormous tax issues. In this scenario, traditional rules of taxation based on source, derivation and physical presence will be rendered ineffective, resulting in significant loss of tax revenue.This is going to hit the roots of Pakistan tax regime challenging the relevance and application of tax laws and principles. These issues, therefore needs to be addressed seriously. Pakistan need to re-study its existing system of taxation and implement necessary measures if the country does not want to lose tax revenues when its citizens conduct transactions via electronic commerce (e-commerce).The following measures can be taken realizing the increasing impact of e-commerce to the economy: The formulation of a national tax strategy to address tax conflicts arising from e-commerce transactions.In formulating the strategy, the government will need to closely follow leads from findings of the OECD on e-commerce taxation and WTO.In formulating such national e-commerce tax strategy, the government will need to create an environment where it can monitor tax revenues and yet not impede the development and advancement of e-commerce.Apart from developing a national strategy, the government will need to prepare Pakistan for an eventuality of a global system of taxation, which may arise when governments of the future can no longer depend on national borders to define their right to tax revenues from businesses transacted within their own boundaries.The committee of experts be constituted , both from public and private sectors, with the specific objectives to address the above issues, for safeguarding the economic sovereignty.Companies and consumers should be made aware that e-commerce, though a different mode of doing business, involves similar concept of traditional business transactions.3- Proper and forceful representation at international forums like OECD and the WTO, which are already seized with such matters as discussed above.4 Training of Pakistan tax officers to equip and make them understand the complexities involved in e-commerce business and its taxationHowever, with increasing cross-border transactions and until international consensus on the taxation of global trade is achieved, less developed countries, as Pakistan will find themselves at the losing end in terms of revenue collection from businesses conducted within their own territories.On the other hand, developed nations with the technological infrastructure to carry on business in a borderless world will have the upper edge.

A retrogressive taxation system

October 23, 2006
By Sabihuddin Ghausi
DOES Pakistan’s taxation system promote or retard manufacturing growth? Is it industry-friendly? And one final question: Is the tax burden fairly distributed?An attempt was made to find answers to these questions from trade leaders and business executives, a former senator and a senior official responsible for the promotion of industrial development.The taxation system is not fair in the sense that it does not raise revenues proportionate to the incomes generated by different sectors of the economy. This was the virtual consensus. More than 60 per cent of the revenue is contributed by the manufacturing whose share in the GDP has remained stagnant for decades at around 17/18 per cent.The services sector that includes retail and wholesale trading, transport, construction, real estate, and stock trade is either under-taxed or spared of taxation altogether. Yet, it is the biggest sector comprising 50 per of the economy. Then comes agriculture with 23-24 per cent of the GDP that generates only 1.2 per cent of tax revenue.“We will try to change this taxation system to make it business and manufacture-friendly, bring equity and justice and create a system where any one who works more would earn more’’, says Taj Hyder, a former PPP Senator now engaged in organising weekly study circles of his party workers to debate the current socio-economic and political issues.The former Senator is convinced that the taxation system is hurting industry, impeding business growth and virtually ignores those who are creative and hard working.Businessmen did not mince words when calling the taxation structure, ‘retrogressive, exploitative, inflationary and expansionary’’ that alienates a section of society by creating in them a feeling of being discriminated against, while “others’’ are treated as favourites.However, there are business leaders and multinational executives who feel convinced that the government has started responding to their difficulties and is gradually drawing up a business-friendly taxation structure.‘Pakistan’s taxation structure manifests deep mistrust between the government and the businessmen’’ observed a business leader while pointing out to the load of withholding and presumptive tax that constitute almost 90 per cent of the tax—income tax.“You pay 1.5 per cent of your export proceeds, no matter you earn profit or suffer loss’’ he said , adding that “six per cent withholding tax on import is a final tax settlement’’. These and many other such taxes are levied because businessmen want to avoid hassles in tax assessment and tax collectors find it convenient to meet their collection targets. However, the real victims of this system are millions of consumers who have to bear the inflationary impact of these levies, which are treated as indirect taxes by business.‘ The government mainly focuses on revenues and employment generation remains a secondary goal when it comes to taxing industry’’, Majyd Aziz, President of Karachi Chamber of Commerce and Industry said.Mr Ameen Bandukda, chairman of SITE Association of Industry, is more vocal in declaring the taxation system as “anti-industry”. He refers to the unending problems of the biggest sector—textiles as an example. He advocates revamping of the taxation structure before it is too late.The slump in the exports in the first quarter of this fiscal year is the direct outcome of the taxation which pushed up production cost to a level “where our exports are gradually becoming uncompetitive and foreign products are flooding the domestic market’’, said another businessman.Mohammad Idrees, Textile Commissioner who has been an industrial development officer his whole life, identifies the taxation system as one of the many factors responsible for the plight of the textile industry. There are other factors that hurt industries such as outdated management practices, flawed production and marketing techniques and lack of prudent decision making by the businessmen.The taxation system is business friendly, says Qazi Sajid, Chief Executive, German chemical company who is also on the board of a dozen companies. He also sees a lot of improvement in tax system over the last few years which has resulted in “virtual end of direct contact’’ between the tax payer and the tax collector.“My company and others where I am on the board now files our tax returns on internet and that’s all’. There is virtually no hassle in getting refund of extra advance taxation.“No excise inspector is there now in our factory without whose signature, in the past, we could not move our production outside the factory gate’’, he said.Qazi refuses to believe that taxation has impeded the growth of manufacturing and production. The large-scale production touched the record highest of 18 per cent about a year ago and still maintains a reasonable growth rate.‘The industry consumes almost Rs5 billion worth of chemicals as against hardly Rs1 billion a few years ago. Growing appetite for chemicals consumption, he said, is one indicator of industrial growth.Ameen Dadabhoy, a ruling party Senator, concedes that agriculture, stock exchange, real estate, retail, wholesale trade, construction and landed gentry are virtually outside the tax net and it causes a heart-burning.“I tried hard to bring all these sections of society under the tax net while participating on the Senate Finance Committee’s deliberations. He reiterates his intention to continue to strive in this direction.Engineer M.A. Jabbar, a former FPCCI vice president, wonders as to how the government can tax at import or at production stage when no business transaction has taken place.. “World over, you are allowed to install your manufacturing facility, buy inputs, produce goods and after these goods are sold in the market, the government taxes you on your income’’.Imagine the plight of the common men from whom the government collected Rs3.5 trillion in six years (1999-00 to 2005-06) by implementing the World Bank and IMF sponsored reforms and compare this collection with Rs1.9 trillion in the entire decade of 90’s. Now President Musharraf has announced that his government’s intends to collect Rs1 trillion in 2007-08.Tax recovery went up by roughly 11 per cent every year in the last six years, but the tax-to-GDP ratio remained dismally low— at 10 per cent of the GDP. What does this mean? It means that tax is not being recovered from all sectors of the economy.While a large section of population is being over-taxed, an entire class of elite has been given a free hand to speculate in trading on easy bank loans and earn tax-free income.A crippling tax burden on a few sectors is leading to expansion of black economy and is reducing social acceptability of the tax system. It is time to develop a tax structure based on equity that would increase revenues and spur economic growth.

Untaxed incomes and budget deficit

January 29, 2007
By Yousuf Nazar
EFFECTIVE taxation of agriculture income and imposition of capital gains tax on short-term stock trading and real estate investments can raise at least an estimated Rs200 billion (equivalent to about 66 per cent of the budget deficit) in additional government revenues.Large areas of economy get away with paying no tax at all. The culprit is the lack of will of the successive rulers (past and present) who have never attempted to address the core issues and mobilise political support to undertake the tax reforms that are essential to reduce fiscal deficits.Pakistan must widen its tax net to raise sorely needed revenues for the development of a decrepit physical infrastructure and for educating and training one of the six largest and youngest (albeit relatively illiterate) working populations in the world. This will also reduce the dependence on foreign aid, especially at a time when the democrats-controlled US Congress is considering a ban on US assistance to Pakistan if Islamabad fails to halt the resurgence of Taliban inside its territory. During FY 2005-06, the government’s collections from direct taxes amounted to Rs224.6 billion or about $3.7 billion. The trading volume at the Karachi Stock Exchange averaged around $500 million a day during 2006 or about $120 billion (almost equal to Pakistan’s GDP) for the entire year. Stockbrokers do not pay taxes on capital gains and nor do those who make millions and billions on property and land deals. The income tax collection from agricultural estates is a paltry Rs1 billion or so per annum.It is not difficult to understand why the government is so poor and runs budget deficits that result in higher interest rates and inflation – a form of regressive tax on the middle and poor classes. Pakistan has one of the lowest tax to GDP (gross domestic product) ratios in the world and this ratio has declined in the recent decade despite growth in the absolute amount of taxes. As the size of the economy has grown, so has the volume of taxes but is the situation any better than it was ten years ago?According to the data released by the Ministry of Finance last week, the tax collections (direct and indirect) amounted to Rs383 billion during the first half of FY07 (July-December, 2006) as against Rs324 billion in the corresponding period last year as given below:Rs billions Per centincreaseover2005-06Direct taxes 151.6 45.4of whichwithholdingtaxes 73.0 21.7Indirect taxes 231.8 5.5Sales tax 143.5 8.1Custom duty 59.8 (2.8)Excise duty 28.5 12.5Total 383.4 18.4That the share of direct taxes (withholding taxes accounted for approximately fifty per cent of direct taxes) has gone up to 39.5 per cent is good news and it appears that the Central of Board of Revenue (CBR) is working hard. However, withholding taxes include tax deductions on bank withdrawals and stock trading (introduced in 2005-06 budget) – activities with hundreds of billions in turnover. Hence, it is not surprising that direct tax collections have gone up.However, the indirect taxes’ 5.5 per cent growth is negative in real terms given the inflation rate of nine per cent. Due to a liberal import policy and tariff reductions, custom duty collections are down 2.8 per cent despite a 9.1 per cent increase in the imports.Moreover, over 50 per cent of the increase in the indirect taxes is attributable to the (largely public sector) oil and gas industry that has been booming due to higher energy (petrol/gas) prices. Notwithstanding these issues and going beyond the six months data, the real picture of government’s domestic finances has not changed much during the past decade. In fact, it has gotten worse and is a major cause of growing income inequality and social tensions. Let’s see why?The most relevant indicator to determine if a tax regime has improved is the tax to GDP ratio. As GDP or country’s income grows, so does the volume of taxes. But if the growth in taxes lags behind that of the GDP, tax to GDP ratio declines. This is usually due to an increase in tax evasion and/or because major sectors are exempted from paying taxes.As shown in the graph, the tax to GDP ratio that stood at 12.64 per cent in 1996-97 has steadily declined to 9.97 per cent to in 2005-06 and even if this year’s target of Rs835 billion in tax collections is met, this ratio will not be significantly higher than 10 per cent.Failure to increase this ratio has caused the fiscal deficit (excluding the impact of earthquake and grants) to grow both in absolute and relative terms as shown below:Fiscal year Total deficit As per cent(Rs. billion) of GDP2003-04 129 2.32004-05 217 3.32005-06 259 3.42006-07budget 294 3.4An inequitable and unfair tax regime is the principal cause of not just low taxes to GDP ratio and persistent fiscal deficits but also for creating distortions in the economy that are harmful for investment in manufacturing in particular and productive activities in general. The uneven mismatch between sectoral contributions to growth and tax revenue lies at the heart of this regressive tax regime.The following table compares the per cent contribution or share of some key sectors in national income (or GDP) to their per cent share in national taxes in 2005-06.Share in GDP Share in TaxesAgriculture 22 1Manufacturing 18 62Wholesales &Retail Trade 19 3Agriculture with 22 per cent of national income contributes to just one per cent of the taxes while manufacturing sector shares bulk of the burden. Now why should the local capital go to manufacturing when it can find tax shelter in land, agriculture, stock investments or in just trading goods and services?The growing deficit can be reduced by extending the tax net to three major areas. First is obviously agriculture income, which was taxed - for the first and only time in history - in January 1977 by late Zulfiqar Ali Bhutto but General Zia never implemented the law. Even merely a 10 per cent tax on income from agriculture, which accounts for 22 per cent of national income, would yield Rs. 160-190 billion in income tax revenues. It is grossly unjust that while a salaried person pays not just income tax but more and more withholding taxes on utilities and bank transactions, large landlords’ incomes should go completely untaxed.Two other main areas are property and stocks. It seems that the government by levying very nominal capital value tax (CVT) on real estate and stocks (CVT has little economic justification and discourages active trading which is necessary for market efficiency and development) has tried to divert the public opinion from the more fundamental and much larger issue of the exemption of tax on capital gains from property and stocks.The most common international practice is to exempt capital gains tax on one property (usually the primary residence of a household) if it is held for a certain number of years or tax it at a lower rate by treating it as a long-term capital gain. Any other capital gains resulting from buying and selling of property are treated as usual income and taxed accordingly. Uniform indexed values and low standard rates are and can be used to value and tax properties to avoid the usual issues of understatement of values and corruption. Few years ago, India imposed capital gains tax on property at 20 per cent based on an indexation system. Property taxes account for about 10-11 per cent of total tax revenues in the United States, United Kingdom and Japan.Based on the assumption of even three per cent of the total tax revenues, there is a potential to raise Rs. 20-24 billion from property taxes in Pakistan. There is little justification to continue to exempt capital gains from property especially when it comes to gains on plots and houses whose aggregate values run into hundreds of millions of dollars.Last and not the least is the matter of capital gains tax on stocks. Apologists of this exemption argue that its imposition may deter foreign investors. This assertion is simply a distortion of facts. Foreign investors’ share of investment in average daily volume at the Karachi Stock Exchange is about 3.5 percent. Nearly 70 per cent of the trading activity is speculative and does not result in actual delivery of shares. The brokers themselves undertake almost all of this speculative trading and there is no reason why it should not be taxed like any other business income.True the foreign investors hold about 17 per cent of the float-adjusted market capitalisation but most foreign investors can use international tax laws and double-taxation treaties to avoid paying taxes on genuine long-term investments. Therefore, imposition of capital gains tax on the short-term trading profits of local investors (mostly brokers) would make little difference to foreign investors.India grants exemption from capital gains tax only if the stocks are held for a period of one year but taxes short-term capital gains at 30 per cent. Even if we assume that short-term capital gains account for just one per cent of the value traded on our stock exchanges, a 30 per cent tax would still yield Rs22 billion compared to about a billion rupees being collected from CVT on stock market trades.Given the vastly untapped tax revenue potential in the above three sectors, the least the government can do is to make a start by (a) bringing the ‘big fish’ under the tax net even at initially low tax rates, (b) lowering tax rates on manufacturing concerns and salaried persons to bring more equity and (c) reducing the number of small taxes to streamline the tax administration. This may lend some credibility to its claims of reforming the tax regime. Unless it is prepared to do so and bring some fairness to the tax regime, it should not complain about the tax evasion culture since unfair tax regimes do not generally command legitimacy and compliance from taxpayers.