Accounting & Taxation

According to Phillips Hardwick, “Taxes are compulsory transfers of money from private individuals, groups or institutions to the Government.”

Comprehensive Definition

Tax is a compulsory amount levied by the state on its individuals to meet the development and non-development expenditures of government.

ndividuals can not demand any social benefits by paying these payments.

Though taxation provides funds to the Govt. on one side and it curtails consumption and investment spending on the other side, yet it is considered a necessary evil.

According to ADAM SMITH, the following principle must be observed for a good taxation system.

Canon of Equality or Ability

Tax should be imposed on the basis of ability to pay the tax. By equality, we do not mean the same burden for lower income group and higher income group but by equality, we mean the ability to pay the tax. As a principle, it ensure eqaully divided burden of share depending upon paying ability.

Canon of Certainty

The tax – payers must be certain about time, method of payment and amount of tax to be paid.

Canon of Convenience

By this principle, we mean that tax should be imposed at the time or in a manner which ensures the convenience of the tax – payers.

Canon of Economy

Tax should be imposed in such a way that we can get maximum collection with minimum expenditure.

Other Cannons of Taxation

Alonng with above, these canons should be followed for good taxation system.

Canon of Productivity

Imposing taxes ensuring maximum government revenue.

Canon of Elasticity

It should be elastic. The sense should be, Govt required high revnue. The tax rate should be increased.

On the other hand, while people facing hurdles any natural disasters or some economic crisis, the tax should be decresed.

Canon of Simplicity

Taxation system should be simple and there should be no ambiguity to both the parties. i.e. tax payer and tax payee. Otherwise, there is a risk of corruption.

Canon of Diversity

We should not concentrate only on the some selected sectors for taxation but this system should be diversified. Maximum sectors should be brought in the network of taxation.

Canon of Impartiality

Taxation system should be impartial i.e. the two men earning the same income have to pay the same amount of tax. In other words, the incidence of tax should be equal for each of them.

Canon of Harmlessness

Taxation system should be harmless in the sense that tax rates should not be so higher that production and investment become unattractive and profitless. Rather tax system should be framed in such a manner that it provides incentive to the people of the country to invest and work hard for their own prosperity as well as for the development of whole nation.

Canon of Economic Development

Taxation system must provide the guarantee of economic development. It should increase production, employment, economic growth, etc.

Canon of Balance

A balance must be maintained between direct and indirect taxes.

Canon of Price Stability

Taxes should be managed in such a way that level of prices must be stable. There should be no fluctuation in prices due to taxes.

Canon of Adjustability

Taxation system should be adjustable according to the changing requirements.

Canon of Equitability

Taxation system should perform in such a way that inequalities of distribution of wealth among the community of the country can be minimized. Taxation system should minimize the gap between the rich and the poor by the introduction of taxes which ensure equitable distribution of wealth.

Canon of Moderation

Principle of moderation should be strictly observed so that neither the tax-payer should be heavily burdened nor he should be almost free from national responsibility of paying the tax.

Conclusion

While observing mentioned canon of taxation, we understand that it reveals that economy should enjoy ideal taxation system.

Basically, there are two types of taxes i.e. direct taxes and indirect taxes. However, there are further types of direct and indirect taxes. A brief list of both the major taxes is as under:

Types of Direct Taxes

• Proportional taxes
• Progressive taxes
• Regressive taxes
• Digressive taxes

Types of Indirect Taxes

• Specific taxes
• Advalorem taxes
• Value added taxes

Direct Taxes

The taxes for which the burden of taxes cannot be transferred are called direct taxes. According to H. Dalton, “A direct tax is really paid by the person on whom it is legally imposed.” Income tax, wealth tax, property tax, etc are examples of direct tax.

Indirect Taxes

The taxes for which the money burden can be transferred to others are called indirect taxes. Sales tax, customs duty, excise duty, etc are examples of indirect tax.

We make a comparison of direct and indirect taxes as under:

“The direct and indirect taxes are like two attractive sisters between which a person is bound to remain indifferent.”

Professor Gladstone,

Difference Between Direct and Indirect Tax

Direct Tax	Indirect Tax
The imposition is direct	The imposition is indirect
Imposed on personal income and revenues	Imposed on the sale and purchase of goods and services
The impact burden is just on one person	The incidence burden is on different persons
The burden cannot be transferred to someone else	The burden is transferred to some other persons
Charged by the taxpayer at certain intervals like a year. After the payment, the taxpayer is listed off	Neither is charged in intervals nor the taxpayer is listed off. It is charged while acting certain acts that of purchase, etc

Types of Direct Taxes

Proportional Taxes

This taxation system is advocated by classical economists. If a uniform tax rate is imposed on all levels of income and no difference is made between the high-income groups and low-income groups, it will be known as a proportional tax.

It is imposed on all the income groups with the same proportion. e.g: If in a country, the tax rate is 10% then all the persons have to pay 10% tax irrespective of their incomes.

Progressive Taxes

The progressive tax is one whose rate goes on to increase along with an increase in income. Any change in income leads to a change in the tax rate. There is a positive relationship between income and tax rate. The tax rate on higher income is higher and on lower-income is lower.

In such a system, the individual income is divided into different slabs, and the rate of income tax is different for each slab. Along with the increase in income the slab as well as tax rate change.

Regressive Taxes

It is a tax rate that falls along with an increase in the incomes of the people. Thus, it is opposite to progressive taxes and there is a negative relationship between income and the tax rate. Moreover, in such a taxation system, the poor have to scarify more than the rich. A general sales tax is an example of a regressive tax.

Digressive Taxes

This is a soft type of progressive tax where the tax rate does not increase in the same proportion as an increase in income. The tax rate increases up to a specific level of income and beyond that level, the tax rate remains constant. Therefore, it can be said that it is a combination of proportional and progressive taxes.

Types of Indirect Tax

Specific Taxes

When any good or service is taxed on the basis of its measure, size, and weight, such tax is given the name of a specific tax.

For example $5/- per meter of cotton cloth etc. The main advantage of specific taxes is that these can be easily imposed and charged.

Anyhow, these are not beneficial because they are burdensome for the poor.

Advalorem Taxes

When any commodity is taxed on the basis of its value, such tax is given the name of advalorem tax. I.e. A customs duty of 15% on a specific electronic product of value $50000 is an advalorem tax.

In such tax, we do not consider the weight or size of the product we just consider its value. It is beneficial in the sense that it lies the burden just on rich people. Anyhow, there is some difficulty to find the exact value of products as the producers do not show it in order to avoid taxes.

Value – Added taxes

Value–added tax is related to the family of sales tax. It is imposed on that value which is obtained by subtracting the purchase value of the product from the gross sale of the product.

In other words, the gap b/w the revenues of the firm and the cost of the firm which it has to face regarding inputs, etc. are known as value-added. A tax imposed on this value-added is called a value-added tax.

Merits and Demerits of Taxes

Taxes are important for the Govt to collect, as they are running the country. They need funds to improve the nation. These funds are collected in different taxes including direct taxes & indirect taxes. Each tax type has various Pros & Cons depending upon the tax nature.

These collected amounts are further invested in different mega-level projects including infrastructure, national trade, providing a subsidy, and generating employment opportunities.

What is direct Tax? Direct taxes is a form of tax imposed by a regulatory authority i.e., Govt of a country. These taxes are directly paid to govt of the payer. There are many advantages of direct taxes as well as disadvantages of taxes from the different payer and receiver perspectives.

Merits and Demerits of Indirect Taxes

Merits of Indirect Taxes	Demerits of Indirect Taxes
Imperceptible	Against Cannon of Equality
Convenient	Against Cannon of Economy
Wide Converge	Inflationary in Nature
Elastic	Lack of Civic Sense
Less Dishonesty	Uncertain Revenue
Diversity	Bad Effect of Production and Employment
Promotes National Interest
Check Consumption of Harmful Commodities
Highest Tax Collection
Powerful Tool of Eco-Policies

Merits of Indirect Taxes

Imperceptible

Indirect taxes are imperceptible in the sense that these are paid frequently through consumption but these are not realized.

Convenient

These are convenient in the sense that we do not face any formality to pay them but these are paid by adding in the market value of the goods.

Wide Coverage

 These have a wide coverage because these are charged by all the income groups i.e. low, middle, and high. These are imposed on all types of goods i.e. necessities, comforts, and luxuries.

Elastic

These are elastic in the sense that these can be reduced on those goods whose consumption is to be increased and can be increased on those goods whose consumption is to be decreased by the government.

Less Dishonesty

There is no chance of dishonesty because indirect taxes are included in the prices of the commodities and no one can stop this consumption.

Diversity

There are in accordance with the canon of diversity because these are imposed on a variety of goods and services.

Promote National Interest

These taxes promote national interest because everyone is part of this network.

Check the Consumption of Harmful Commodities

The consumption of harmful commodities can be checked by this taxation system. The state imposes heavy duties on harmful goods i.e., cigarettes, etc.

Higher Tax Collections

The tax revenue may easily be increased by imposing heavy duties on inelastic goods whose demand does not reduce, whatever so is the price.

A powerful tool of eco-policies

Indirect taxes are used as a very powerful tool for economic policies.

Demerits of Indirect Taxes

Against Cannon of Equality

Indirect taxes are against the cannon of equity in the sense that the rich and poor have to pay the same rate of tax.

Against Cannon of Economy

These are uneconomical because the cost of tax collection is higher than its revenue. The taxed goods pass through a number of middlemen. Moreover, Govt. has to appoint highly paid staff.

Inflationary in Nature

These are inflationary in nature because the imposition of these taxes tends to raise the prices of commodities.

Lack of Civic Sense

The producers shift the burden of tax and the consumers ultimately bear the burden. The majority of consumers do not know that they are paying taxes and observing their national responsibility.

Uncertain Revenue

Revenue collection by indirect taxes is quite uncertain.

Bad Effect on Production and Employment

Sometimes, indirect taxes adversely affect the production of commodities and in turn employment. As with the increase in price, the quantity demanded shrinks and the economy moves toward depression.

Merits and Demerits of Direct Taxes

Pros of Direct Taxes	Cons of Direct Taxes
Equitable	Painful
Certain	Promotes Dishonesty
Economical	Arbitrary in Nature
Elastic	Inconvenient
Simple	Discourages Investments & Savings
Desirable	Narrow in Nature
Reduce Inequality	Non Labor
Productive	Uneconomical
Automatic Stabilizers	Discourage Foreign Investment
Civil Sense

Merits of Direct Taxes

Equitable

Direct taxes are in accordance with the canon of equity. They are progressive in nature as their burden is equally distributed among the rich and poor. The rich pay more whereas the poor pay less. Thus, the burden is according to their income.

Certain

Direct taxes are in accordance with the canon of certainty as these are fixed at a certain rate and cannot be avoided.

Economical

These are in accordance with the canon of the economy as their cost of collection is low and maximum revenues can be collected with minimum cost.

Elastic

These are in accordance with the canon of elasticity. These are flexible in the sense that Govt. can increase or decrease its rates according to the requirements of an economy.

Simple

These are in accordance with the canon of simplicity as there is no confusion or complication in understanding them.

Desirable

These are desirable in nature and are imposed only on those persons who can afford them.

Reduce Inequalities

Direct taxes lead to an equitable distribution of wealth as these are progressive in nature. Rich are taxed heavily and vice versa.

Productive

These are productive in the sense that the revenue collected is mainly used by the Govt. in the public interest i.e. buildings, roads, hospitals, schools, etc.

Automatic Stabilizers

Direct taxes, especially income tax automatic stabilizers. During the boom phase of an economy, these tax the maximum number of individuals and vice versa.

Civic Sense

Direct taxes produce a civic sense among the people of a country. Taxpayers begin to recognize their civic responsibilities and start to take a keen interest in the activities of the state.

Demerits of Direct Tax

Along with the above-mentioned merits, direct taxes also have some demerits as well. A brief list of these demerits is as under.

Painful

Direct taxes are very painful for people in the sense that they face many hardships to earn their incomes but a big share of this income is paid in the form of tax. They get nothing from the Government against such taxes.

Dishonesty Promotes

To avoid the pain of the burden of direct taxes, the tax-payers conceal the facts which reflect their dishonesty.

Arbitrary Nature

There is an element of arbitrariness in direct taxes. These taxes leave much to the discretion of the taxation authorities.

Inconvenient

Due to certain unavoidable formalities, the payment of direct taxes is not so easy. Thus, direct taxes are inconvenient for taxpayers.

Discourage Saving and Investment

Direct taxes adversely affect saving and investment. It is because, the people know that if they invest more, they will have to pay more taxes. Direct taxes even discourage those industries and firms which produce essential goods.

Narrow-based

These taxes are imposed only on the selected group while the majority of the people remain untaxed.

Non-labor Income

It is desirable to impose the tax only on earned income. It should also be imposed on non-labor income.

Uneconomical

Generally, the collection of direct taxes is very expensive and real collection remains very low.

Discourage Foreign Investors

These taxes discourage the inflow of foreign investment.

In the Conclusion

The above discussion reveals that both the pillars of the taxation system are unavoidable and the Government must maintain a proper balance between direct and indirect taxes.

The term depreciation has no specific definition under the Income Tax Ordinance, 2001. However, we may understand its concept through general meanings given in accounting

For Example

“A decrease in the value of an asset through normal wear and tear, or obsolescence is called depreciation”

In other words, “depreciation is the process of allocating the cost of a depreciable asset over its estimated useful life by applying the rate specified in Part-1 of the Third Schedule of the Income Tax Ordinance, 2001”.

Now, question arises, what is the role of depreciation in the income tax law?

Remember it; in computing the taxable profit of a business, the income tax law permits the deduction of depreciation against the business income.

However, this deduction is subject to the following conditions:

Depreciable asset

Depreciation shall be charged only on depreciable asset.

Business use of asset

Depreciable asset shall be used in that business of a person whose taxable income is being determined.

Amount of Depreciation

Where asset is exclusively used for business

It must be computed by applying the rates specified in part-1 of the Third Schedule of the Income Tax Ordinance, 2001, against the written down value of the asset at the beginning of the tax year.

Where asset is partly used for business

Amount of depreciation allowed as deduction shall be restricted to the fair proportional part of the amount that would be allowed if the asset were wholly used to derive income from business chargeable to tax.

Example Illustration

Miss Alex owns a building having cost Rs. 600,000. He used 3/4th of its building for his business and remaining for his family residence. Compute the amount of depreciation chargeable to business.

Solution

Written down value (WDV) at the beginning (i.e. cost) 600,000.

Depreciation rate as per Third Schedule 10% of WDV

Total depreciation for the building (600,000×10%) 60,000

Depreciation chargeable to business (60,000×3/4) 45,000

Depreciation shall be charged against written down value (WDV)

Depreciation shall be charged against written down value (value at the beginning of the tax year) of a depreciable asset

How written down value of depreciable asset is calculated

Example

Where asset is acquired during the tax year:

Total cost of the asset XXX

Less: Initial allowance, if any XXX

Written down value (WDV) at the beginning of the tax year XXX

Note: In the absence of initial allowance total cost of the asset is considered as WDV at the beginning of the year.

Example:

Where asset acquired prior to the tax year is wholly used for business:

Total cost of the asset XXX

Less: Initial allowance, if any XXX

Total depreciation which has been already charged in previous tax years XXX XXX

WDV at the beginning of the year XXX

WDV when asset is partly used for business:

It shall be computed on the basis that the asset has been solely used to derive income from business chargeable to tax.

Aggregate of depreciation allowance should not exceed actual cost of the asset

The total deductions allowed to a person during the period of ownership of a depreciable asset as depreciation (u/s 22) and initial allowance (u/s 23) should not exceed the actual cost of asset

Disposition of asset during the tax year

No depreciation deduction shall be allowed to a person against income from business chargeable to tax for the tax year in which asset is disposed (sold)

What is the treatment of profit or loss on the disposition (sale) of asset?

If sale proceeds exceeds WDV, difference shows profit:

Tax Treatment

It is chargeable to tax under the head income from business

If WDV exceeds sale proceeds, difference shows loss. It is allowable as a deduction against income from business chargeable to tax.

Asset with useful life up to one year

No depreciation allowance shall be allowed for asset whose normal useful life does not exceed one year; although their replacement or renewal cost is allowed as revenue expenditure.

Depreciation allowance in case of immovable property

The cost of immovable property or structural improvement to immovable property shall not include the cost of land.

In other words, if depreciable asset consist of building, the value of land is not considered for depreciation.

For example: Mr. Lee owns a depreciable asset in the form of building having cost Rs 500,000 (including cost of land Rs. 200,000). Depreciation shall be charged against Rs. 300,000 which represents cost of building.

Depreciation allowance to lessor

Where any asset owned by lessor like:

• A leasing company;
• An investment bank;
• A Modaraba;
• A scheduled bank;
• A development finance institution.

is leased to another person. Depreciation allowance is allowed to such persons because asset is being used in their leasing business.

Limitation on depreciation allowance against leased asset

Depreciation allowance on leased asset shall be allowed against income from lease rental only. Any un absorbed depreciation shall be adjusted in the following /coming tax years.

Initial Allowance

In addition to a normal depreciation allowance (u/s 22 and part-1 of the Third Schedule), an additional depreciation allowance (u/s 23 and Part-11 of the Third Schedule) is allowed as deduction against the income from business chargeable to tax. Such an additional depreciation allowance is called initial allowance.

In nut shell, there are two forms of depreciation allowance under the Income Tax Ordinance, 2001.

• Normal depreciation allowance
• Initial allowance

Major difference between depreciation allowance and initial allowance:

Normal depreciation allowance is allowed against depreciable asset while initial allowance is allowed against eligible depreciable asset for one time in the life of asset.

Conditions Applicable to Allow-ability of Initial Allowance

Eligible depreciable asset

It is allowable on “eligible depreciable asset” only,

Place of Service

Eligible depreciable asset has been placed into service in Pakistan for the first time in a tax year.

Year of allowability

It is allowable in later of the following tax years:

• A tax year in which the asset is used first time in Pakistan; or
• A tax year in which commercial production is commenced.

Rate of Initial Allowance

It is allowed @ 50% of the cost of the asset.

Note: In case of lease, it shall be restricted upto lease rental income only. Any unabsorbed amount of initial allowance may be carried forward for deduction in next years.

Asset must be owned by the person

For admissibility of initial allowance, asset must be owned by the person whose taxable income is being determined.

Eligible Depreciable Asset

“Eligible Depreciable Asset” means a depreciable asset other than the following assets:

• Any road transport vehicle unless the vehicle is plying for hire;
• Any furniture includes fittings;
• Any plant or machinery that has been used previously in Pakistan; or
• Any plant or machinery whose entire cost has already been allowed as deduction in the tax year in which it was purchased.

Some Examples of

Eligible depreciable assets	Not eligible depreciable assets
Vehicle plying for hire	Vehicle not plying for hire (only used by employees or buses used by labor)
Plant and machinery being used first time in Pakistan.	Plant and machinery previously used in Pakistan.
Structural improvement to immovable property	Unimproved land

The Third Schedule

[Part-l]

Depreciation rates specified for the purposes of section 22 shall be:

• Building (all types) 10%
• Furniture (including fitting), machinery and plan
  • (Not otherwise specified), motor vehicles (all types), ships,
  • technical or professional books. 15%Furniture (including fittings), machinery and plant

Computer hardware including printer, monitor and allied items

• (Machinery and equipment used in manufacture of IT products),
• aircrafts and aero engines. 30%

In case of mineral oil concerns the income of which is liable to be computed in accordance with the rules specified in Part-1 of the Fifth Schedule.

• Below ground installations 100%
• Offshore platform and production installations. 20%

[Part-ll]

Initial Allowance

• The rate of initial allowance u/s 23 and 23A shall be 50%
• The rate of First Year Allowance (FYA) u/s 23A shall be 90%

[Part-III]

The rate of amortization of pre-commencement expenditures u/s 25 shall be 20%

Depreciable Asset

“Depreciable asset” means any:

• Tangible movable property
• Immovable property (other than unimproved land)
• Structural improvement to immovable property owned by a person that
  • has a normal useful life exceeding one year
  • is likely to loose value as a result of normal wear and tear, or obsolescence; and
  • is used wholly or partly by the person in deriving income from business chargeable to tax.

Note: Where the total cost of any asset has been allowed as a deduction in the year of its purchase, then such asset shall not be treated as “depreciable asset”.

Unimproved Land

An open plot of land represents unimproved land. If any road or railway track or airport runway etc. is constructed on land, such land is called improved land. So, only land is not included in the definition of depreciable asset.

Structural Improvement to Immovable Property:

Structural improvement to immovable property means construction or installation of any building, road, driveway, car park, railway line, pipeline, bridge, tunnel, air port runway, canal, dock, wharf, retaining wall, fence, power lines, water or .sewerage pipes, drainage, landscaping or dam on immovable property like land.

Tangible Movable Property

It includes machinery, furniture, motor vehicles, ships, technical or professional books, computer hardware, aircrafts etc.

Immovable Property

It includes buildings like admin office, factory, workshop, cinema, hotel, hospital, school and flats or residential quarters for labour.

Random Examples

Q: What is depreciation and what are the conditions laid down under the Income Tax Ordinance, 2001 for depreciation allowance?

Depreciation

The term depreciation has no specific definition under the Income Tax Ordinance, 2001.

For example

“A decrease in the value of an asset through normal wear and tear, or obsolescence”

In other words, “depreciation is the process of allocating the cost of a depreciable asset over its estimated useful life by applying the rates specified under Part-1 of the Third Schedule of the Income Tax Ordinance, 2001”.

There are three types of depreciation allowance:

• 1) Normal depreciation
• 2) Initial depreciation allowance

 First Year Allowance (FYA)

Normal depreciation allowance

A depreciation allowance which is allowed on WDV of depreciable asset by applying the rate given in Part-1 of the Third Schedule is called normal depreciation allowance.

Conditions applicable to Allowability of Normal Depreciation:

Depreciable asset

Depreciation shall be charged only on depreciable asset.

Business use of asset

Depreciable asset shall be used in the business of a person whose taxable income is being determined.

Amount of depreciation

Amount of depreciation shall be computed with the help of rates given under Part-1 of the Third Schedule of the Income Tax Ordinance, 2001.

Depreciation shall be charged against written down value (WDV)

Depreciation shall be charged against written down value of a depreciable asset (WDV at the beginning of the tax year).

Aggregate of depreciation allowance shall not exceed actual cost of the asset

The total deductions allowed to a person on a depreciable asset as depreciation (u/s 22) and initial allowance (u/s 23) shall not exceed the actual cost of asset.

Sale of depreciable asset during the tax year

No depreciation deduction shall be allowed to a person against income from business chargeable to tax for the tax year in which depreciable asset is sold.

Asset having useful life upto one year

No depreciation allowance shall be allowed for asset whose normal useful life does not exceed one year.

Depreciation allowance in case of immovable property

The cost of immovable property or structural improvement to immovable property shall not include the cost of land for computation of depreciation.

In other words, if depreciable asset consist of building, the value of land is not considered

Depreciation allowance to lessor

Where any asset owned by lessor like:

• A Leasing company;
• An Investment bank;
• A Modaraba;
• A Scheduled bank;
• A Development finance institution.

is leased to another person. Depreciation allowance is allowed to such persons because asset is being used in their leasing business.

Limitation on depreciation allowance against leased asset

Depreciation allowance on leased asset shall be allowed against income from lease rental only. Any un absorbed depreciation shall be adjusted in the following tax years

Initial Depreciation Allowance

A depreciation allowance which is allowed on cost of eligible depreciable asset @ 50% in the tax year in which asset is being used first in Pakistan or in the tax year in which commercial production is commenced, whichever is later is called initial allowance.

Conditions Applicable to Allow-ability of Initial Allowance

i) Eligible depreciable asset

It is allowable on “eligible depreciable asset” only.

ii) Place of service

Eligible depreciable asset has been placed into service in Pakistan for the first time in a tax year.

iii) Year of allow-ability

It is allowable in later of the following tax years:

• A tax year in which the asset is used first time in Pakistan; or
• A tax year in which commercial production is commenced.

Rate of Initial Allowance

It is allowed @ 50% of the cost of the asset.

Asset must be owned by the person

For admissibility of initial allowance, asset must be owned by the person whose taxable income is being determined.

3) First Year Allowance (FYA)

A depreciation allowance which shall be allowed on cost of plant, machinery and equipment installed in an industrial undertaking set up in specified rural and under developed areas notified by the Federal Government after the 1st July, 2008 @ 90% is called First Year Allowance.

Conditions Applicable to Allow-ability of First Year Allowance (FYA)

Plant, machinery and equipment

It is allowable on plant, machinery and equipment installed by an industrial undertaking.

Place of service

The asset has been placed into service in rural and under developed areas as specified by the Federal Government.

Year of allow ability

It shall be allowed on the asset used after 1st July, 2008.

Rate of First Year Allowance (FYA)

It is allowed @ 90% of the cost of the asset.

Asset must be owned by the person

For admissibility of FYA, asset must be owned and managed by an industrial undertaking working in rural and under developed areas.

Note: FYA and initial allowance are substitute to each other. In other words, if FYA is allowed, than initial allowance shall not be allowed.

Set Off of Losses are The adjustment of losses from one head against the income, profits or gains of any other head of income during the same tax year is called set-off of losses.

Carry Forward of Losses are The losses are not fully adjusted against the income of the same tax year and such losses are transferred to the next tax year, this process of transferring un- adjustable losses to the next year is known as carry-forward of losses.

Now the question arises, whether such adjustment of losses during the same tax year or transfer of losses to the next year is performed according to the will of the taxpayer or law has provided any specific procedure? 

Remember it, Income Tax Ordinance, 2001 has provided the specific procedure for adjustment and carry forward of losses sustained by a taxpayer during the tax year. 

Procedure of Set-Off of Losses

Losses under different heads of income may be set-off under the following procedure: 

1) Salary

Salary may not be in negative. So, there is no possibility of loss under the head ‘salary’ 

2) Property

Gross rent received is taxable under the head income from property as a separate block of income. So, we may not set-off any loss against income from property.

3) Losses under the head Business

To set-off and carry forward of losses, we shall classify the business losses into two categories:

• Non-speculation business losses
• Speculation business losses 

Non-Speculation Business

Where a person sustains loss under the head “Income from Non- Speculation Business”, such loss may be set-off against any other income from non- peculation business, salary, income from speculation business, capital gains and income from other sources). 

For example: Mr. Akmal incurred a loss under the head ‘Income from non- speculation business’ he may set-off such loss against any other income from non-speculation business, salary, income from speculation business, capital gains and income from other sources) 

Speculation Business

Where a person sustains loss under the head ‘Income from Speculation Business’ such loss may be set-off only against income from any other speculation business. If there is no other income during the current tax year under the head speculation business, speculation loss shall be carried forward to the next year. 

In other words

Where a person sustains loss under the head “Income from Other Sources”, such loss may be set-off against any other under this head, salary, income from speculation business, income from non-speculation business and capital gains.

4) Losses under the head “Income from Other Sources”

For example: Mr. Shabbir incurred a loss under the head “Income from Other Sources” he may set-off such loss against any other income under this head, salary, income from speculation business, income from non-speculation business and capital gains. 

5) Loss under the head “Capital Gains”

Where a person sustains loss under the head “Capital Gains”, such loss may be set-off only against any other income from the head capital gains. If there is no other income under this head, during the tax year, loss under such head shall be carried forward to the next year.

In other words

We may categories the losses under different heads of income in the following manner:Briefly speaking: 

Category “A” 

• Loss from non-speculation business
• Loss from other sources

Loss from any head under category “A” may be set off against all categories like “A”, “B” and “C” 

Category “B”

• Loss from speculation business

Loss from category “B” may be set-off only against any other income from category “B”.

Category “C” 

• Loss from capital assets

Loss from category “C” may be set-off only against any other income from category “C”

Important Notes

i) Where a person incurs losses under more than one head of income, including “Income from Business”, the business loss shall be set-off at last.

ii) If an income from a source is exempt from tax, the loss from such source may not be set-off or carry forward. 

Set Off of Losses of Companies Operating Hotels: [56A]

Subject to sections 56 and 57, where a company registered in Pakistan or Azad Jammu and Kashmir (AJ&K), operating hotels in Pakistan or AJ&K, sustains a loss in Pakistan or AJ&K for any tax year under the head “income from business” shall be entitled to have the amount of the loss set off against the company’s income in Pakistan or AJ&K, as the case may be, from the tax year 2007 onward.

Carry Forward of Loss

Where the loss is not fully adjusted against the income of same tax year and it is transferred to the next tax year, such process of transferring loss to the next tax year is known as carry forward of loss. However, a taxpayer may carry-forward loss only under the following heads: 

Carry Forward of Loss under Non-speculation Business

Any un-adjustable loss under the head non-speculation business may be carried forward upto 6 years immediately succeeding the tax year in which loss was incurred. 

Notes

i) Where more than one tax year’s losses are being carried forward, the loss of the earliest tax year shall be set-off first. 

ii) Any amount of unabsorbed depreciation shall be allowed as deduction against the incomes of following tax years. There is no limit of six tax years for carry forward of unabsorbed depreciation. Where losses and un-absorbed depreciation occur together, the losses shall be adjusted first and depreciation shall be adjusted last. 

Carry Forward of Speculation Loss

Any un-adjustable loss under the head speculation business may be carried forward upto 6 tax years immediately succeeding the tax year in which loss was incurred to set-off only against the profits and gains from the speculation business only. 

Where more than one tax year’s losses are being carried forward, the loss of the earliest tax year shall be set-off first.

Carry Forward of Capital Loss

Any un-adjustable capital loss may be carried forward upto 6 tax years immediately succeeding the tax year in which loss was incurred to set-off only against the profit and gains from the capital assets only.

Where more than one tax year’s losses are being carried forward, the loss of the earliest tax year shall be set-off first. 

Set-off and Carry Forward of Losses of Banking Company

A banking company may set-off and carry forward its losses upto a period of 10 years if the following conditions are fulfilled:

• The banking company is wholly owned by the Federal Government as on 01- 06- 2002 
• It has been approved by the State Bank of Pakistan (SBP) for banking business. 
• Loss occurred during the period of 01-07-1995 to 30-06-2001. 

Group Taxation: [59AA]

1) Holding companies and subsidiary companies of 100% owned group may opt to be taxed as one fiscal unit. In such cases, besides consolidated group accounts as required under the Companies Ordinance, 1984, computation of income and tax payable shall be made for tax purposes.

2) The companies in the group shall give irrevocable option for taxation under this section as one fiscal unit.

3) The group taxation shall be restricted to companies locally incorporated under the Companies Ordinance, 1984.

4) The relief under group taxation would not be available to losses prior to the formation of the group.

5) The option of group taxation shall be available to those groups companies which comply with such corporate governance requirements as may be specified by the Securities and Exchange Commission of Pakistan from time to time and are designated as company entitled to avail group taxation.

6) Group taxation may be regulated through rules as may be made by the Board.

Set Off and Carry Forward of Losses under Group (Group relief):[59B]

1) Subject to sub-section (2), any company, being a subsidiary of a holding company, may surrender its assessed loss (excluding capital loss) for the tax year (other than brought forward losses and capital losses), in favour of its holding company or its subsidiary or between another subsidiary of the holding company:

Provided that where one of the company in the group is a public company listed on a registered stock exchange in Pakistan, the holding company shall directly hold 55% or more of the share capital of the subsidiary company. Where none of the companies in the group is a listed company, the holding company shall hold directly 75% or more of the share of capital of the subsidiary company.

2) The loss surrendered by the subsidiary company may be claimed by

the holding company or a subsidiary company for set off against its income under

the head “Income from Business” in the tax year and the following two tax years

Subject to the following conditions, namely:

• There is continued ownership for five years, of share capital of the subsidiary company to the extent of 55% in the case of a listed company, or 75% or more, in the case of other companies;
• A company within the group engaged in the business of trading shall not be entitled to avail group relief;
• Holding company, being a private limited company with 75% of ownership of share capital gets itself listed within three years (3) from the year in which loss is claimed;
• The group companies are locally incorporated companies under the Companies Ordinance, 1984;
• The loss surrendered and loss claimed under this section shall have approval of the Board of Directors of the respective companies;
• The subsidiary company continues the same business during the said period of three years;
• All the companies in the group shall comply with such corporate governance requirements as may be specified by the Securities and Exchange Commission of Pakistan from time to time, and are designated as companies entitled to avail group relief; and
• Any other condition as may be prescribed.

3) The subsidiary company shall not be allowed to surrender its assessed losses for set off against income of the holding company for more than three (3) tax years.

4) Where the losses surrendered by a subsidiary company are not adjusted against income of the holding company in the said three tax years, the subsidiary company shall carry forward the unadjusted losses in accordance with section 57.

5) If there has been any disposal of shares by the holding company during the aforesaid period of five (5) years to bring the ownership of the holding company to less than 55% or 75%, as the case may be, the holding company shall, in the year of disposal, offer the amount of profit on which taxes have not been paid due to set off of losses surrendered by the subsidiary company.

6) Loss claiming company shall, with the approval of the Board of Directors, transfer cash to the loss surrendering company equal to the amount of tax payable on the profits to be set off against the acquired loss at the applicable tax rate. The transfer of cash would not be taken as a taxable event in the case of either of the two companies.

7) The transfer of shares between companies and the share holders, in one direction, would not be taken as a taxable event provided the transfer is to acquire share capital for formation of the group and approval of the Security and Exchange Commission of Pakistan or State Bank of Pakistan, as the case may be, has been obtained in this effect. Sale and purchase from third party would be taken as taxable event.

Set Off of Business Loss Consequent to Amalgamation: [57A]

1) The assessed loss (excluding capital loss) for the tax year, other than brought forward and capital loss, of the amalgamating company or companies shall be set off against business profits and gains of the amalgamated company, and vice versa, in the year of amalgamation and where the loss is not adjusted against the profits and gains for the tax year the unadjusted loss shall be carried forward for adjustment upto a period of six tax years succeeding the year of amalgamation.

2) The provisions of sub-section

(4) and

(5) of section 57 shall, mutatis mutandis, apply for the purposes of allowing absorbed depreciation of amalgamating company or companies in the assessment of amalgamated company and vice versa.

Provided that the losses referred to in sub-section

(1) and unabsorbed depreciation referred to in sub-section

(2) shall be allowed set off subject to the condition that the amalgamated company continues the business of the amalgamating company for a minimum period of five years from the date of amalgamation.

2A) In case of amalgamation of Banking Company or Non-banking Finance Company, Modarabas or insurance company, the accumulated loss under the head “Income from Business” (not being speculation business losses) of an amalgamating company or companies shall be set off or carried forward against the business profits and gains of the amalgamated company and vice versa, up to a period of six tax years immediately succeeding the tax year in which the loss was first computed in the case of amalgamated company or amalgamating company or companies:

Provided that the provisions of this sub-section shall in the case of Banking companies be applicable from July 1, 2007.

3) Where any of the conditions as laid down by the State Bank of Pakistan or the Securities and Exchange Commission of Pakistan or any court, as the case may be, in the scheme of amalgamation, are not fulfilled, the set off of loss or allowance for depreciation made in any tax year of the amalgamated company or the amalgamating company or companies shall be deemed to be the income of that amalgamated company 7 or the amalgamating company or companies, as the case may be, for the year in which such default is discovered by the Commissioner or taxation officer, and all the provisions of this Ordinance shall apply accordingly.

Losses of Business Exempt from Tax

There are two types of business exempted from tax:

Business Permanently Exempt from Tax

Losses of such business may not be set-off or carried forward. Under the Income Tax Ordinance, 2001, if an income from a source is exempt from tax, the loss from such source may not be set-off or carried forward. 

Business Exempt for a Specific Period (Tax holiday)

A loss incurred during the exemption period may be carried forward and set off after the expiry of exemption period. Such losses may be carried forward upto a period of six years.