Accounting Article
Implementation of Value-Added Tax (VAT)
by Muhammad Ashraf | Published on 4/28/2010
Value-added Tax (VAT), or GST in VAT mode is usually implemented in robust/sustained economies but fortunately (or rather unfortunately ) these days Pakistan has become an economic laboratory of IMF which is in the process of experimenting with the effects of implementing VAT in a country passing through recessionary period. It is about to be experienced in a country which is at the moment riddled with a stalled economy, internal political problems and chaos among its provinces over the distribution even after NFC award.
This is not merely a personal opinion but has also been opined by the international press, such as Washington Post's Lori Montgomery who writes, "The latest sign: the emphatic rejection by both parties in recent days of a value-added tax, a sales tax imposed by nearly every other developed nation." After a White House economic adviser was reportedly speaking somewhat favorably about VAT, the White House this week vigorously denied that President Obama is looking to include the said tax in his deficit-cutting arsenal. "This is not something the president has proposed, nor is it under consideration," White House press secretary Robert Gibbs told reporters.
VAT isn't the only potential budget solution drawing fire. Republicans howled about cuts to Medicare in the recent health-care overhaul, and no one in Washington wants to raise taxes on the 98 percent of taxpayers whom the White House has defined as the middle class.
Anyways, VAT/GST has increasingly become steadily more important as source of revenue around the globe. In Mexico and Turkey, it contributes around 50% of Government revenues. This seems to be a trend, but a cautious one, and some commentators have asked why governments dont rely even more heavily on indirect tax revenues and introduction of VAT law in Pakistan may be the answer irrespective of recessionary economy!
But another answer is that higher indirect taxes are politically difficult to introduce as taxpayer often question the benefits of paying taxes. The link between higher indirect taxes and higher prices is obvious to anyone who buys goods and services, but the link between lower corporate tax rates and increased inward investment often results in increased employment and infrastructure development which is less well understood by robust or sustained economies instead of recessionary one! This article is endeavoring to assess the ground realities pertaining to implementation of a comprehensive value added tax.
VAT and Reduced Direct Tax Rates
Indirect taxes seem to be playing in the revenue-gathering strategies of many countries around the globe and plan to introduce VAT in Pakistan is no exception. It may be correct that this is a worldwide trend but there is a clear tendency in competition to attract and keep inward investment, to reduce their corporate tax rates and seek to make up the shortfall with increases in indirect taxes. This is rather than relying solely on growth brought about by corporate investment to expand the tax base. These tactics suggest that as well as attracting new investment, retaining current investment is a success in itself.In November 2006, Mr. Lee Hsien, the Prime Minister of Singapore while speaking to the parliament said, "if we have to bring our corporate tax down, every percentage point we bring it down will cost us $400 million a year. It is big money. Therefore, we need to consider raising indirect taxes, in other words, the Goods and Services Tax. It is now five percent; I think we need to push it up to seven percent. Even seven percent will still lower than nearly all other countries which have GST or VAT. But if we raise it from five percent to seven percent, it will give us precious extra resources to implement social programmes."
This is exactly what the Singapore Government did in its 2007 Budget, announcing a two percent cut in corporate tax rates to 18 percent from next year and an increase in GST to seven percent. There seems to be a clear deviation from this principle in Pakistans VAT introduction fiscal policy.
This nexus of introduction of VAT coupled with reduced tax rate is not based on any myth but on realities. For taxpayers, introduction of VAT has immediate consequences (discussed below). One of the advantages of VAT over direct profits tax is that they supply a steady flow of funds throughout the year, rather than lump sums at widely spaced intervals evidenced in direct taxes.
This present government failed to chalk out any strategy to communicate the benefit of a low direct tax strategy combined with principled VAT regime. It may well be in the long term interests of a country to follow this path, but voters may need persuading of the benefits of paying today for better economy tomorrow.
VAT Collection: Federation or Provinces
Prior to entering into the debate of VAT collection in Pakistan, one must look at the European Union experience. Work is underway to reform the basic structure of the tax in certain areas, such as those determining which EU jurisdiction is entitled to the VAT being collected at present. Much of the legislative debate has been focused on how to alter the system to better reflect taxation where consumption actually occurs, principally for services that can be supplied at a distance like e-commerce, telecommunication etc.The outcome of any new legislation in this area in EU will see a shift of VAT revenue from one country to another, principally from low rate countries to high rate countries. And no mention of EU VAT moderanization issues would be complete without a reference to the need to tackle the carousel/missing trader fraud issue which is costing EU governments very large sums in lost revenue. This drove urgent legislative change across EU.
The issues faced by EU are not alien to Pakistan but will surface soon! For instance, if a person is registered as service provider in NWFP and delivers the service in Punjab on the instruction of a person registered in Sindh then where will the input and output be paid and claimed. This and other similar peculiar issues will crop up!
Further, one school of thought is of the opinion that if the provinces are finding it difficult to share then wouldnt that also be difficult for federation to allow input of services VAT adjustment against output of goods and federal services! Moreover, if the provincial VAT will be collected by the provinces themselves then this may tantamount to increasing the compliance cost by the businesses which are already overburdened with 47 compliances a year according to the World Bank survey conducted by PwC but actually they are around 58 if labor law compliances are included.
VAT or GST by Provinces
VAT is meant for allowing credit on expenses and purchases but it seems that even after NFC award the provinces are struggling for additional revenue owing to trust deficit. These issues were raised by a local expert in the VAT conference held by the FBR in Islamabad but was not made part of the recommendation of Dr. Hafiz Pashas report.The ground reality of operation of taxpayers is that some of the companies registered offices are located either in Sindh, Punjab or Islamabad irrespective of the fact that their operations may be carried out in NWFP or Baluchistan. Consequently, the registration domain either at registered address or operational place is the key question when provinces come to know about their actual share.
Further, continuing with the example in previous paragraphs above, if a person is registered as service provider in NWFP and delivers the service in Punjab on the instruction of a person registered in Sindh then where will the input and output be paid and claimed.
In case if it is decided that this situation will avoided by slapping 15% on output of services in the province, as suggested by Mr. Kaiser Bengali in ACCA pre Budget discussion, where the service provider is registered and without allowing any input either in Punjab or Sindh then would such fixed rate cost be acceptable to businesses or could anyone call it VAT!
The Dayton Accord (2001) of Bosnia proved disastrous and they had to revert back to central government. Bird and Abel (2007) study also concluded that transferring the right to the federating unit is preferable when regional units either do not have the capacity or are in a process to build the same.
Rate of VAT
The hottest debate in town is about the rate of VAT on essential and non essential items. As stated above, the link between higher indirect taxes and higher prices is obvious to anyone who buys goods and services. However, the approach of all Pakistan Tax Bar Association Mr. Abdul Qadir at the pre budget proposal meeting called by the chairman KCCI Budget and Tax Committee Mr.Qamar is more rational which require a scientific study. The chairman FBR has also already hinted for a rate ranging between 5 to 7%. The impact can be understood through following comparative chart.| COMPOSITE RATE | |||||
| Amount | VAT | ||||
| Sale | 5% | 1,000,000.00 | (50,000.00) | ||
| Cost of Good Sold (COGS) | 15% | (700,000.00) | 105,000.00 | ||
| Other Admissible Expenses Input | 15% | (100,000.00) | 15,000.00 | ||
| ------------ | |||||
| VAT - (Payable) / Refundable | 70,000.00 | ||||
| ======== | |||||
| SINGLE RATE TILL COGS | |||||
| Amount | VAT | ||||
| Sale | 5% | 1,000,000.00 | (50,000.00) | ||
| Cost of Good Sold | 5% | (700,000.00) | 35,000.00 | ||
| Other Admissible Expenses Input | 15% | (100,000.00) | 15,000.00 | ||
| ------------ | |||||
| VAT - (Payable) / Refundable | - | ||||
| ======== | |||||
| SINGLE RATE FOR SUPPLY CHAIN | |||||
| Amount | VAT | ||||
| Sale | 5% | 1,000,000.00 | (50,000.00) | ||
| Cost of Good Sold | 5% | (700,000.00) | 35,000.00 | ||
| Other Admissible Expenses Input | 5% | (100,000.00) | 5,000.00 | ||
| ------------ | |||||
| VAT - (Payable) / Refundable | (10,000.00) | ||||
| ======== |
VAT and Taxpayers Accounting System
For taxpayers, introduction of VAT has immediate consequences. One of the advantages of VAT over direct profits tax is that they supply a steady flow of funds throughout the year, rather than lump sums at widely spaced intervals evidenced in direct taxes.To deliver this benefit, taxpayers, in their capacities as tax collectors, have to have accounting systems that can provide accurate real time information on transactions and the associated tax liability.
Keeping systems up to date with tax authorities information requirement is a major cost and resource issue for the business sector. As indirect taxes become more important to governments, so regulators are intensifying their scrutiny of business tax systems to satisfy themselves that tax revenues are not at risk.
Further, till today, FBR has failed to issue the rules relating to registration, deregistration, filing of return, declaration, summaries, statements, record keeping, accounts, related documentation, tax invoices, credit and debit notes, refunds, prepayments, audit, alternate dispute resolution, charging of fee for processing of documentation and official acts, recovery of arrears including compounding of offence and appointment and management of e-intermediaries then how could it expect from businesses to cope with new law fortnightly.
VAT Liability Concept
The determination of VAT liability revolves around some important terms like input, output, adjustment (increasing and decreasing) for creditable purpose and second hand goods. Like Sales Tax Act, 1990, the VAT liability is also determined deducting the input from output. The liability may either be increased or decreased by any of the following adjustments.- Cancellation of Supply
- Alteration in consideration for supply
- Return of supply
- Fundamental variation in the nature of taxable supply
- Bad Debt
- Goods applied for a private purpose
- Registration or cancellation thereof
- Change of rates
- Advance payment of tax at import stage
- Withholding by Government and Large Taxpayers
Inadmissible and Defered VAT Input
Unlike the Sales Tax Act, 1990, the list of inadmissible input is exhaustive, that is, input of reverse charge, purchase or import of passenger vehicle or its spare parts or repair thereof, entertainment expense and membership of club etc. Further, taxpayers will be treated to have incurred input tax (deferred VAT input) at the time of sale of second hand taxable goods.VAT Audit and Associated Person
The suggested legislation prescribes various types of audit like routine, normal, forensic etc but when, how and under what circumstances it will be conducted was absent suggested by senator Haroon and Professor Khursheed Ahmed. Further, they also rightly pointed out about the application of the concept of open market price and its implication over associated persons.Grossing Up
The concept of grossing up of transaction for VAT is included in the law where the tax is borne by the taxpayer. Surprisingly, the formula of grossing up does not exclude withholding income tax. Consequently, the vicious cycle of grossing up computation would never end. The relevant provisions require afresh thought!Legal Deficiencies
There seems to some conceptual drafting and typographical errors in the federal law. For instance, federal list services include carriage of goods or passengers but in the presence of FED and other indirect taxes it would be cumbersome for end consumers to bear the cost. Further, VAT law seems to be a deviation from policy of registration of taxpayers as it intends to give a separate registration number instead of relying over taxpayer registration number [formerly NTN] issued under the Income Tax Ordinance, 2001.Moreover, the concept of Federal VAT services is missing in provisions relating to imposition of tax, person liable to pay tax, value of supply and time of supply. Further, it is beyond imagination to understand the rationale why the concept of exempt and zero rated supply was not incorporated in ancillary or incidental supplies.
In more furtherance, there seems to be a gross conceptual drafting error in sub-section (3) of section 18. The number 332 used in section 24(4)(d) should be corrected to 32 while clause (e) and (f) should be shuffled up to give the section numbering effect. Further, the Rs1,000 limit set is refund and carry forward sections is too low.
Conclusion
The Dayton Accord (2001) of Bosnia proved disastrous and they had to revert back to central government. Bird and Abel (2007) study also concluded that transferring the right to the federating unit is preferable when regional units either do not have the capacity or trying to build the same. EU has not yet concluded on distribution of taxes! Consequently, the centralized dual VAT system of Germany where revenue is shared with the state is the best system (TAT 1988).For taxpayers, introduction of VAT has immediate consequences. To deliver this benefit, taxpayers, in their capacities as tax collectors, have to have accounting systems that can provide accurate real time information on transactions and the associated tax liability. Keeping systems up to date with tax authorities information requirement is a major cost and resource issue for the business sector.
As indirect taxes become more important to governments, so regulators are intensifying their scrutiny of business tax systems to satisfy themselves that tax revenues are not at risk. Contrary to this, FBR failed to issue the necessary rules then how could it expect from businesses to cope with new law fortnightly.
Multiple rates for essential items will be deteriorating as this would result in unnecessarily blockage of funds of businesses in the shape of refunds meaning thereby cost of funds to businesses which will further increase the inflation. The ultimate solution is that the whole supply chain rates of essential items should be extended to business involved in essential items supply chain.
One school of thought is of the opinion that if the provinces are finding it difficult to share the services VAT then wouldnt that also be difficult for federation to allow input of services VAT adjustment against output of goods and federal services!
The ground reality of operation of taxpayers is that some of the companies registered offices are located either in Sindh, Punjab or Islamabad irrespective of the fact that their operations may be carried out in NWFP or Baluchistan. Consequently, the registration domain either at registered address or operational place is the key question when provinces come to know about their actual share.
In case the provinces decides that they will slap 15% on output of services where the service provider is registered and will not allow any input then would such fixed rate cost be acceptable to businesses or could anyone call it VAT!
This present government has failed to chalk out any strategy to communicate the benefit of a low direct tax strategy combined with principle based VAT regime. It may well be in the long term interests of a country to follow this path and respective assemblies may need to reconsider this instead of passing the bill in haste, but voters may need persuading of the benefits of paying today for better economy tomorrow.
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