Chapter

02

Book recommended
INCOME TAX ORDINANCE 2001

Chapters Schedules

13 7

Objectives
Knowing the tax structure of Pakistan and America. Why exemptions are provided?

Conditions for the levy of tax.

Objectives
How to take the advantage of tax depreciation.

Whether to make investment in shares or bonds.

How to claim refund in case of loss.

Exemption

Exemption

Concession in the payment of tax is called Exemption. It can be exemption of income, reduction in tax payment or reduction in tax rates

How it is provided.

How the exemptions are provided.

Chapter
Sections 41 to 51 and section 53 of the Income Tax Ordinance 2001 deals with exemptions of certain incomes, areas, industries, individuals etc Section 52 is deleted

General exemptions Section 53

Section 41 to 51 tells about the General I.

exemptions.

Specific exemptions
7

Section 53 points out towards the 2nd Schedule regarding the Specific exemptions

Types of exemptions
Total exemption For example the income of Edhi Trust, Fatmid Foundation is totally exempt.

Partial exemption The income of senior citizen is exempt upto 50%

Why exemption is provided?

1 To develop certain area. For example the earth quake areas like Balakot and Muzaferabad were exempted. To develop certain industries For example the industry relating to computer software and IT services is exempted upto 30-06- 2016. To support sick industries the industries giving persistent loss are exempted to help them standing on their own feet.

Why exemption is provided?

(cont--)
4 Relief for the pensioners Getting meager income after retirement. So, unfair to tax them. Relief for fixed income group It is the class affected most by rising the price level. Therefore, taxed at lower rate as compared to business class. Relief for the teachers and researchers As a mark of respect given 75% exemption on the total tax payable.

Why exemption is provided?

(cont--)
7 Prestigious purposes The president, prime minister, MNAs, MPAs are exempted from tax.
Induce foreign investment Concessions are given to people, investing in Pakistan because it brings prosperity to the country. To avoid excessive burden on general public The tax concession is given to Text Book Boards of all the provinces to help them to provide low price books to public, especially the students.

Why exemption is provided?

(cont--)
10 To boast up exports To rectify the balance of Trade and Balance of Payments position , exports are encouraged by providing tax concessions.
Relief for senior citizens Person who is 60 years of age or more is given 50% concession in tax payment.

11

DISADVANTAGES OF EXEMPTIONS
Reduction in Revenues
More exemptions will result in lesser revenues to the

government

Tax burden

More tax burden on few taxpayers, already paying tax

Discouraging for many people

Discourages certain people who are not given

exemptions

Complication in tax system

13

One has to remember lot of provisions for exemptions,

thus making it very complicated.

CONDITIONS FOR LEVY OF TAX

TYPES OF BUSINESS

Individuals
Partnerships, called Association of Persons (AOP) for the purpose of tax

Companies
Others like Trusts, Co-operative societies

14

CONDITIONS FOR LEVY OF TAX cont- APPROVAL

Federal Government
Provincial Governments

Local Authority

But here, we are focusing the Federal tax system

15

CONDITIONS FOR LEVY OF TAX cont-Citizenship

Exemption to foreign nationals working for an embassy

Foreigners

in Pakistan. But this exemption is on reciprocal basis.

Living in foreign country and advanced loan or sharing

Pakistani citizens

capital for a business in Pakistan. Profit or interest remitted to them is exempt.

16

CONDITIONS FOR LEVY OF TAX cont-RESIDENTIAL STATUS

Stayed in Pakistan for 183 days or more in a tax year

Resident

consisting of 365 days, starting from July 01 and ending on 30thJune next. Persons posted abroad by the Federal or Provincial government.

NonResident

Not fulfilling the above conditions.

17

CONDITIONS FOR LEVY OF TAX cont-Events Resident Non-resident

Pakistan source income

Foreign source income

Taxable income
18

A+B

CONDITIONS FOR LEVY OF TAX cont-EXEMPTION PERIOD

Number of years
Unlimited period of time

Usually ranges from 5 to 10 years.

Industries established in Export Processing

Zones.

19

CONDITIONS FOR LEVY OF TAX cont-COMMENCING AND CLOSING DATES

Example
Income from industrial undertaking exempt

for 10 years if established between 01-07-1995 to 31-12-2002.

Income from Vocational, Technical and Poly-

Example 02

technical Institutions is exempt for 5 years, if is set up between 1.7.2004 and 30.6.2008.

20

CONDITIONS FOR LEVY OF TAX cont-AGE FACTOR

Senior citizens

60 years of age or more.

Income limit

The annual taxable income should not

exceed Rs. 750,000.

21

RATES OF TAX FOR SALARIED PERSON

S. No Taxable income Rate of tax

Up to Rs 300,000

0%

Rs 300,001 to 350,000

0.75%

Rs 350,001 to 400,000

1.50%

Rs 400,001 to 450,000

2.50%

Rs 450,001 to 550,000

3.50%

18

Exceeds Rs 4,550,000

20%

FLAT RATES FOR COMPANIES FOR TAX YEAR 2011

S. No Type of Companies Tax rate

Public Listed Companies

35%

Private Companies

35%

Banking Companies

35%

Tax on Separate Block of Income

Prize on Prize bonds @10% Dividend received @10%

Dividend received by Public Company @5%

24

Separate block of income

It is the group of incomes on which the slab rates of individuals and the flat rates of companies and the partnerships are not applicable.

Examples:
Prize on prize bonds, dividend income on shares, interest or dividend received on bank accounts.

Capital Gains

Capital gain?

If a Capital Asset is sold at a price

which is more than its purchase price or Book value, the differential is called Capital gain.
Tax year Less than 6 months 10% 10% In between 6 &12 months 7.50% 8%

Tax rates for 2011 & 2012

26

Rs. 750,000. 2011

2012

AVERAGE AND MARGINAL RATE OF TAX

AVERAGE TAX RATE Total tax /Taxable income * 100

MARGINAL TAX RATE.

The tax rate applied and paid on last $ or Rupee income.

Corporate Income Taxes

Corp. Taxable Income At Least But < $ 0 $ 50,000 50,000 75,000 75,000 100,000 100,000 335,000 335,000 10,000,000 10,000,000 15,000,000 15,000,000 18,333,333 18,333,333 Tax Rate 15% 25% 34% 39% 34% 35% 38% 35% Tax Calculation .15x(Inc > 0) $ 7,500 + .25x(Inc > 50,000) 13,750 + .34x(Inc > 75,000) 22,250 + .39x(Inc > 100,000) 113,900 + .34x(Inc > 335,000) 3,400,000 + .35x(Inc > 10,000,000) 5,150,000 + .38x(Inc > 15,000,000) 6,416,667 + .35x(Inc > 18,333,333)

Income Tax Example

Taxable income $250,000 Income tax liability
= $22,250 + .39 x ($250,000 - $100,000) = $22,250 + $58,500 = $80,750 Marginal tax rate = 39% Average tax rate = $80,750 / $250,000 *100 = 32.3%

How to use tax depreciation for tax saving?

Depreciation
Depreciation represents the systematic allocation of the cost of a capital asset over a period of time for financial reporting purposes, tax purposes, or both.
Generally, profitable firms prefer to use an accelerated methods of depreciation for tax reporting purposes.

ACCOUNTING DEPRECIATION

Accounting formula

Cost of the asset

Depreciation per year =

Useful life of the asset

32

Common Types of Accounting Depreciation

TWO METHODS
Also called Fixed installment or Fixed cost

Straight-line method

method. Fixed rate of Depreciation Always calculated on cost or purchase price of the asset.
Also called Diminishing balance or Written

Declining Balance Method

33

down balance or Outstanding balance method. Fixed rate of Depreciation Calculated on outstanding balance.

Example: Straight line method

Cost of machinery Rs. 100,000, depreciated @ 10% p.a
Year 0 Depreciation calculation Depreciation for the year Outstanding balance Rs. 100,000

End of year 01

Rs 100,000 @ 10%

Rs. 10,000

90,000

End of year 02

Rs 100,000 @ 10%

Rs. 10,000

80,000

End of year 03

Rs 100,000 @ 10%

Rs. 10,000

70,000

End of year 04

Rs 100,000 @ 10%

Rs. 10,000

60,000

End of year 05

Rs 100,000 @ 10%

Rs. 10,000

50,000

Example: Diminishing balance method

Cost of machinery Rs. 100,000, depreciated @ 10% p.a
Year Depreciation calculation Depreciation for the year Outstanding balance Rs. 100,000

End of year 01

Rs 100,000 @ 10%

Rs. 10,000

90,000

End of year 02

Rs 90,000 @ 10%

Rs. 9,000

81,000

End of year 03

Rs 81,000 @ 10%

Rs. 8,100

72,900

End of year 04

Rs 72,900 @ 10%

Rs. 7,290

65,610

End of year 05

Rs 65,610 @ 10%

Rs. 6,561

59,049

TAX DEPRECIATION
Calculated on the basis of rates given by the tax

3rd

Schedule of the Income Tax Ordinance 2001.

law of a country. For example, in Pakistan rates of depreciation are given under the3rd Schedule of the Income Tax Ordinance 2001.

Initial Depreciation

50% of the cost of an asset , used for the first time in Pakistan.

Normal depreciation
36

On Plant & Machinery, the rate is 15% and for

Computer @30% on outstanding balance..

WHY TO USE TAX DEPRECIATION ?

REDUCES TAX LIABILITY
Higher depreciation, reduces the Income and

ultimately the amount of Tax.

Every business will charge same rate of

UNIFORMITY

deprecation as given in the 3rd Schedule of Income Tax Ordinance 2001

Larger advantage in the early years like a interest

ADVANTAGE IN THE EARLY PERIOD

free loan from the Government and has value on the basis of Time Value of Money.
Give an option to replace the old asset after

OPTION TO REPLACE
37

charging full depreciation and enjoy tax depreciation on new asset again.

Tax Depreciation Methods

ACCELERATED DEPRECIATION METHODS

Initial Depreciation plus Normal Depreciation in

the first year of the use of asset/s in Pakistan

(ID & ND).

Double-Declining-Balance Method

(DDBM)

Modified Accelerated Cost Recovery

System (MACRS)
38

Half and full year conventions

Half years depreciation in the year of purchase

Half year convention

and half years depreciation in the year of sale, irrespective of the date of purchase. This convention is used in American tax system.

Full years depreciation in the year of purchase

Full year convention

and no depreciation in the year of sale irrespective of the date of purchase. This convention is used under Income Tax Ordinance 2001 in Pakistan.

39

HOW INCENTIVE IS PROVIDED IN PAKISTAN

Admissible depreciation on Plant and machinery

Depreciation rates given under the 3rd schedule of the Income Tax Ordinance 2001.

Initial Depreciation @ 50% on cost. Allowed on assets, used for the first time in

Pakistan.

Normal Depreciation @ 15% in case of

40

plant and machinery, calculate it on outstanding Balance So, major portion of the cost can be charged to P&L A/c in the first year. .

Tax Depreciation

EXAMPLE
ABC enterprise purchases a machinery costing

Rs. 200,000. Charge tax depreciation on the basis of rates given in the 3rd Schedule of the Income Tax Ordinance 2001, applicable in Pakistan. Prepare a depreciation schedule to show the calculations upto 3 years.
41

Solution: Tax Depreciation Schedule

Year Depreciation calculations 50% on cost (Rs.200,000) Plus 15% on WDV (Rs.100,000) Depreciation For the year Rs. 115,000 Outstanding balance Rs. 85,000

End of year 01

End of year 02

15% on WDV Rs.85,000

Rs. 12,750

Rs. 72,250

End of year 03

15% on WDV Rs. 72,250

Rs. 10,837.5

Rs. 61,412.5

42

Double Declining Balance Method

SECOND METHOD

The percentage rate of depreciation will be doubled

as provided in case of Declining Balance Method or Outstanding Balance Method.

43

Tax Depreciation under the American Law

THE MOST IMPORTANT METHOD Modified Accelerated Cost Recovery system (MACRS)

Method which writes off the cost of capital asset/s

faster than the other depreciation methods.

44

Table of property class

Modified Accelerated Cost Recovery system (MACRS)

Eight classes for determine the prescribed life of

assets like machinery, real estate, called Cost recovery period.

45

Characteristics of MACRS

3,5,7 YEARS CLASS a. Double Declining Balance (DDB) method will be used b. Then switch over to Straight Line (SL) method for the remaining period when depreciation under SLM is equal to or greater than DDB method. c. Half year convention is used in the year of purchase and in the year of sale, irrespective of the actual date of purchase. d. For 3 years property class, the calculation will go up to 4 years.
46

Depreciation Example
Lisa Miller of Basket Wonders (BW) is calculating the depreciation on a machine with a depreciable basis of $100,000, a 6-year useful life, and a 5year property class life. She calculates the annual depreciation charges using MACRS.

Normal Depreciation Rate

100% / 5 years = 20%

Double Declining Rate = 40%

48

MACRS Example
Depreciation Depreciation Net Book Year Calculation Charge Value 0 ----$100,000 1 .5X40%X $100,000 $ 20,000 80,000 2 40% X $80,000 32,000 48,000 3 40% X $48,000 19,200 28,800 4 $28,800 / 2.5 Years 11,520 17,280 5 $28,800 / 2.5 Years 11,520 5,760 6 $28,800 / 2.5 Yrs X .5 5,760 0

MACRS Schedule
Recovery Year 1 2 3 4 5 6 7 8 Property Class 3-Year 5-Year 33.33% 20.00% 44.45 32.00 14.81 19.20 7.41 11.52 11.52 5.76

7-Year 14.29% 24.49 17.49 12.49 8.93 8.92 8.93 4.46

Comparison between two tax methods

ID & ND in Pakistan
It is easier

MACRS In America
It is complicated

Full year convention is used

Number of years are irrelevant In First year, 57.5% on plant and machinery can be charged as depreciation to Profit and Loss account. So, huge advantage in the first year. Due to WDV in ID & ND, the cost cannot be converted to zero quickly,
51

Half year convention is used

Number of years are relevant For 5 year property class asset , depreciation for first year is only 20%, then increases to 32% in second year. In MACRS due to SLM, it can be converted in to zero very quickly.

Can you solve this exercise?

Lisa Miller of Basket Wonders (BW) is calculating the depreciation on a machine with a depreciable basis of $100,000, a 4-year useful life, and a 3-year property class life. She calculates the annual depreciation charges using MACRS.

Which one is better? Bonds or Shares, from tax point of view.

1.53

Corporate Income Taxes

Corp. Taxable Income At Least But < $ 0 $ 50,000 50,000 75,000 75,000 100,000 100,000 335,000 335,000 10,000,000 10,000,000 15,000,000 15,000,000 18,333,333 18,333,333 Tax Rate 15% 25% 34% 39% 34% 35% 38% 35% Tax Calculation .15x(Inc > 0) $ 7,500 + .25x(Inc > 50,000) 13,750 + .34x(Inc > 75,000) 22,250 + .39x(Inc > 100,000) 113,900 + .34x(Inc > 335,000) 3,400,000 + .35x(Inc > 10,000,000) 5,150,000 + .38x(Inc > 15,000,000) 6,416,667 + .35x(Inc > 18,333,333)

INTEREST two perspectives

Interest expense paid by a company against issue of bonds.

Interest income received by investor against his investment in bonds.

55

Interest Expense deductibility

Interest paid on

INTREST EXPENSE

outstanding debt or bonds is tax deductible.

The after-tax cost of debt is: (Interest Expense) X ( 1 - Tax Rate)

56

Cash Dividend

DIVIDEND DISTRIBUTED

Cash distribution of earnings

to shareholders is not a tax deductible expense.

Thus, debt financing has a tax advantage

57

CONCLUSION

TAX SAVING OR TAX SHEILD

For a profitable tax paying Company ,the use of

debt in its financing mix or capital structure results in significant tax advantage and it is called Tax shield or Tax saving.

58

Example

Johnson Corporation has operating income of $120,000, pays interest of $60,000 and also pays dividend of $20,000. What is Companys tax liability?

Solution
Step 1

Operating income $ 120,000

Step 2

Interest expense
Taxable income

( 60,000)
60,000

Step 3

Calculation of Tax
Tax on $50,000 Tax on $10,000@25% =$ 7,500

Step 1

Step 2

= 2,500

Total Tax
Step 3

= 10,000

INTEREST INCOME

Interest income is totally taxable in the hands of recipient.

Dividend Income

30% of the dividend is taxable

It means that 70% of the amount is exempt.

EXAMPLE

INTREST INCOME

DIVIDEND INCOME

XYZ Industries has operating income of $200,000 in

20X1, it has received $12,500 as interest income from its investment in bonds and another $10,000 as Preferred dividend from Koyo Corporation. What is the Companys tax liability for the year?
64

SOLUTION

INTREST INCOME
Particulars

DIVIDEND INCOME
Amount

Operating income Interest income Dividend income Taxable income

65

$200,000 12,500 3,000 215,500

TAX LIABILITY

INTREST INCOME
Particulars Tax on $100,000 Tax on 115,500@ 39% Total Tax

DIVIDEND INCOME
Amount $22,250 45,045 67,295

66

How it is dealt in Pakistan

INTREST INCOME

DIVIDEND INCOME

A. In Pakistan Interest income and Dividend income are treated as SEPARATE BLOCK INCOME and taxed at the rate of 10% for individuals. B. For companies the tax rate is as under a) Public Companies @ 5% b) Private Companies @ 10%

67

How to claim refund in case of loss?

Adjustment of losses in Pakistan

SET OFF OF LOSSES CARRY FORWARD OF LOSSES

69

a. There is the concept of Set off and Carry forward of losses which is applicable in Pakistan. b. Set off of losses means adjusting the losses, against the profit of the any other business in the same year. c. Carry forward of losses means that if certain amount of loss remains unadjusted in the current year, it can be carried forward to the next year/s for such adjustment. This process can be extended upto 6 years

Adjustment of losses under American tax system

LOSS CARRY BACK

CARRY FORWARD OF LOSSES

A loss in any year can be carried back for 2 years and if remained unadjusted, can be carried forward for 20 years (2+20 or it can be 3+18). The loss must be carried back to the earliest of the 2 years, applied to the limit of the earning in that year then applied to the next year to the limit and so on.
70

Corporate Losses and Gains Example

Lisa Miller is examining the impact of an operating loss at Basket Wonders (BW) in 2011. The following time line shows operating income and losses. What impact does the 2011 loss have on BW?

2008 $150,000

2009 $150,000

2010 $100,000

2011 -$500,000

Corporate Losses and Gains Example

The loss can offset the gain in each of the years 2009 and 2010. The remaining $250,000 can be carried forward to 2012 or beyond.
2008 $150,000 $150,000 2009 $150,000 -$150,000 2010 $100,000 -$100,000 0 2011 -$500,000 $250,000

-$250,000

EXAMPLE
LOSS CARRY BACK

CARRY FORWARD OF LOSSES

a. The Kenneth Parks Companys taxable income and tax payments/liability for the year 20X1 through 20X7 are given in the next slide. b. Apply the process of carry back and carry forward of losses on the basis of (2+20) and calculate the amount of refund which the company can claim. c. Also apply the process of set of and carry forward of losses as applicable in Pakistan.
73

Information provided:
YEAR TAXABLE INCOME $ 60,000 20,000 40,000 (150,000) 50,000 60,000 100,000 TAX PAYMENTS $12,250 3,400 6,850 ------8,250 11,250 35,350

20X1 20X2 20X3 20X4 20X5 20X6 20X7

Solution
Year Adjustment of loss
Total loss (150,000) Adjustment of profit 60,000 Unadjusted loss c/f (90,000) Unadjusted loss b/f Adjustment of profit Unadjusted loss c/f Unadjusted loss b/f Adjustment of profit Unadjusted loss c/f (90,000) 20,000 (70,000) (70,000) 40,000 (30,000)

Tax refund
$12,250

20X4

20X4

3,400

20X4

6,850

20X5 Total

8,250 / 50,000 * (30,000)

4,950

27,450

Quick quiz
1. What is meant by exemption? How it is provided? What are the disadvantages of providing exemptions? 2. Explain different conditions for the levy of tax? 3. Differentiate between accounting and tax depreciation. Why to use tax depreciation ? 4. Solve the numerical exercise using MACRS under American tax system and Initial and Normal depreciation under Income Tax Ordinance 2001 in Pakistan.

Quick quiz
5. Solve the numerical exercise involving the interest and dividend taxation both from company and investors point of view. 6. How we can claim refund in case of loss by using carry back and carry forward of losses? How the process of set off and carry forward of losses can be applied under Income Tax Ordinance 2001?