Measures under study to hike tax collection from SMEs

ISLAMABAD: The government is considering different proposals for bringing Small and Medium Enterprises (SMEs) into the tax net during the budget for 2024-25.

The IMF has asked Islamabad to bring an upper threshold for SMEs in line with international standards. The upper threshold for the size of income/turnover according to international standards is very high ($892,857) and is not aligned with the threshold for registration for the sales tax (Rs8 million or $28,571).

The good international practice indicates that the upper threshold for SMEs should be set at relatively low level ($30,000-$50,000) to facilitate graduation from the simplified tax regime to the general tax regime. Furthermore, this threshold should normally be aligned with the Value Added Tax (VAT) threshold to aid compliance and tax administration and eliminate splitting of firms by size or bunching of firms at the threshold margin.

There are two distinctive sector-specific taxation regimes applied to entrepreneurs, one operating for retail sectors and the other for manufacturing sectors that are formally classified as SMEs. Entrepreneurs engaged in the manufacturing of goods are classified as SMEs if their business turnover in a tax year does not exceed Rs250 million (equivalent to US$892,857). Entrepreneurs with a turnover above this threshold are not eligible to be classified as SMEs. The SMEs are taxed at 7.5 per cent of their taxable income, where annual business turnover does not exceed PKR100 million and 15pc of taxable income, where annual business turnover exceeds PKR100 million but does not exceed PKR250 million. This regime benefits entrepreneurs as these rates are below the standard CIT rates of 29pc.

Entrepreneurs operating in the retail sector are grouped into two categories: Tier-1 and Tier-2 retailers. Retailers belonging to Tier-1 are required to a sales tax at the rate as applicable to the goods sold under relevant provisions of the Sales Tax Act 3(9A).

Retailers in Tier-2 pay sales tax through their monthly electricity bills, at a presumptive rate of 5pc of the electricity bill where the monthly bill amount does not exceed PKR20,000 (equivalent to US$70) and at the rate of 7.5pc where the monthly bill amount exceeds PKR20,000.

The SMEs can opt to be taxed not based on their taxable income but under the final tax regime (FTR). Under this regime, SMEs can choose to be taxed not based on their taxable income but using business turnover presumptively as the taxable base.

According to the IMF’s suggestion for bringing SMEs in the tax net, the rate for this tax is 0.25pc of gross turnover, where annual business turnover does not exceed Rs100 million (equivalent to about US$350,000 at the current exchange rate), and 0.5pc of gross turnover, if annual business turnover is between Rs100 million and Rs250 million. No business expenses are allowed as a deduction. Assuming a presumed net profit of 10pc on turnover, the tax rate on presumed net profit works out to 2.5pc and 5pc, respectively. In other words, the FTR is beneficial to taxpayers, both due to its low rates (at realistic rates of profit), greater simplicity, and reduced cost of compliance.

While the fact that sole proprietors and AOPs are taxed under the regular income tax regime with a progressive rate structure is a good international practice and reduces distortions, the existing system has a number of weaknesses. The annual non-taxable minimum allowance (about US$2,150) seems to be too low by standard of comparable countries and needs to be revised.

Secondly, the schedule of tax rates includes too many rate slabs. This not only causes compliance burden on taxpayers in the determination of relevant income threshold and tax rate, but also causes multiple bracket creeps where inflation pushes income into higher tax brackets. By comparison, there are only three tax rates for sole proprietors in neighbouring India. Further, the system does not include measures that promote transitioning from sole proprietorship and AOPs to other more sophisticated forms of legal entities. The income tax revenue data confirm that 84,600 AOPs contribute only about 8pc of income tax revenues.

In the case of Pakistan, sole proprietors and partners of AOPs are not required to make any payments to formal social security funds. The SME regime for manufacturing and retails firms features multiple shortcomings in design and coverage. Firstly, SME regime is available only to entities operating in manufacturing and retail sectors. This excludes enterprise in other sector, such as the service industry, from participation in the regime although they might be eligible in terms of the size of their turnover. Secondly, the law does not restrain any individuals from being registered as SMEs operating in manufacturing sector.

The IMF says that taxation of entrepreneurs in retail sector based on electricity bill and not on a more robust presumption of income is inequitable. It differentiates between retailers based on the use of electricity, which is unlikely to be an accurate proxy of income. Also, in a country with low enforcement of electricity meter readings, this provides an opportunity for businesses to collude with meter readers to show lower charges.