Introduction
One of the most significant changes brought about through the recently promulgated Finance Act, 2023 has been the insertion of section 99D in the Income Tax Ordinance, 2001. This section titled as the “Additional tax on certain income, profits and gains” imposes a tax that may extend up to 50% of the income of companies who have derived income, profit or gain due to any economic factor or factors that resulted in windfall income, profits or gains. This tax will be payable in addition to the normal corporate tax as is obvious from the nomenclature used and will be applicable retrospectively from Tax year 2020 onwards without any cutoff date. The detailed modalities of this new tax have not been given and the Federal Government has been authorized to specify the sectors to which this tax will apply, the mode of computation of windfall profits and to specify the mode and manner of payment.
Though the legislature has not used the term, but this tax is a variant of Excess Profit Tax (EPT) that was introduced more than a hundred years ago and is still levied in many countries. Encyclopedia Britannica defines Excess Profit Tax as “a tax levied on profits in excess of a stipulated standard of “normal” income. There are two principles governing the determination of excess profits. One, known as the war-profits principle, is designed to recapture wartime increases in income over normal peacetime profits of the taxpayer. The other, identified as the high-profits principle, is based on income in excess of some statutory rate of return on invested capital.” An EPT is a distinct tax that is imposed upon incomes that exceed a specified amount of return on invested capital, usually above of what is deemed to be a normal income. An EPT can be implemented with the objectives of reducing income inequality, redistributing windfall gains that may result from special circumstances or government policies, or generating revenues for the government in times of crisis. EPTs may be introduced as temporary measures or made a permanent feature of a tax system.
Historical Background
EPT was first introduced during World War I by several European countries, Canada, and the United States as a revenue measure and as a means of restricting excess profits resulting from the war economy. Excess-profits taxes were again levied during World War II and the Korean War(1950–53) in most of the countries whose business earnings were affected by the war. An example is the "excess profits duty" of Great Britain in1918-1926. The tax was 80 percent of the amount of profits above the "pre-war standard of profits”, defined as either the average profit of any two of the last three years prior to the World War I, or as a fixed percentage of the capital at the end of the last pre-war year. During the rearmament period before World War II, the UK again introduced an EPT. USA in 1917 imposed a war profits tax on the difference between normal profits defined as the average profits of the three pre-war years with some adjustments on the basis of changes in capital, the tax rate was 80 percent. USA reused EPT in 1940 to1943 and the tax rate varied during this period from 30 to 95 percent. Canada in 1940 imposed a tax of 75 percent on profits exceeding 10 percent of capital.
Present day Pakistan and India being under British rule were also subjected to EPT through the Excess Profits Tax Act of 1940 with an aim to impose a tax on excess profits arising out of certain businesses in the conditions prevailing during the 2nd world war. On Independence it was adopted by Pakistan through Pakistan (Adaptation of Income tax, Profits Tax and Revenue Recovery Acts) Order, 1947 with effect from the 10th December,1947. This tax was payable for accounting periods beginning on the 1st day of September, 1939, and ending on the 31st day of March, 1946. The salient features of this tax (relevant for evaluating the tax imposed through the current budget) were as under-
1. It was imposed through a separate enactment and not made part of the Indian Income Tax Act of 1922.
2. The Income Tax Authorities and CBR were also made authorities to administer the new tax with the addition of a Board of Referees comprising of private and official members.
3. It was imposed on all businesses (with some exceptions like insurance business) on the amount by which the profits during any accounting period exceeded the standard profits, at a rate of fifty percent of the excess amount.
4. Standard profit was to be computed on the basis of a “statutory percentage”, which was eight per cent per annum in the case of companies and ten percent per annum in case of non-corporate taxpayers, of the average capital employed in the business during the accounting period.
5. In case of profits for an accounting period being lower than the standard period, the deficiency was allowed to be carried forward and adjusted against excess profits, if any, in the succeeding years.
6. Elaborate provisions were made to ensure that adjustments can be made and penalties imposed by the Excess Profits Officer in case any person has entered into or carried out any transaction or operation by which the profits have been artificially reduced.
7. The amount of the excess profits tax payable in respect of a business for any accounting period was allowed as an expense incurred in that period for computing the profits and gains of that business for assessment of income‑tax or super‑tax.
8. Complete and self-contained mechanism of issuance of notices, assessments, reopening of assessments, penalties and appeals was provided in the Act.
9. Detailed rules for computation of capital for the purposes of determination of statutory percentage were provided in the schedule to the Act.
In 1947 a new law, Business Profits Tax Act, 1947 was enacted. The features of this tax and the law through which it was imposed were similar to the Excess Profits Tax Act, 1940 but the rate of tax was sixteen and two-thirds per cent of the taxable profits.
Current Practices
About a century after the introduction of EPT in World War I, with the occurrence of the COVID-19 pandemic, the idea of EPTs reemerged, with some scholars advocating imposition of EPTs for revenue and redistribution objectives. The pandemic had uneven effects on businesses, with some making high profits. In the year following the COVID-19 outbreak, stock prices of some firms in the information technology and pharmaceutical sectors-such as Zoom, Moderna and Novavax more than quadrupled. In contrast, stock prices in the air transport and accommodation sectors dropped by more than 25 percent in the first half of 2020. EPTs gained further significance following Russia’s war in Ukraine as the hike in energy prices resulted in windfall profits in the power and oil, gas, and mining sectors. In response to surging energy prices, the UN in 2022 called for windfall taxes on oil and gas companies. The European Commission also in 2022 proposed “temporary solidarity contribution” on excess (“surplus”) profits from defined activities in the fuel sector. As reported by an IMF working paper, at least 32 countries at the moment have EPTs in the power and oil, gas, and mining sectors, mainly calculated as profit above either a standard rate of return or a specified ratio of collective revenue to collective expenses, both on a cashflow basis with no deductions for interest. The EPT is often deductible from the corporate income tax when the EPT is measured before it, and vice versa. The average top EPT rate is 58 percent.
Design of EPT
IMF’s working paper “Excess Profit Taxes: Historical Perspective and Contemporary Relevance” by Mr. Shafik Hebous, Dinar Prihardini and Nate Vernon, published in Sep 2022, while supporting a permanent well-designed general EPTs for structurally restoring efficiency and automatically taxing economic rent without the need to identify profitable sectors or firms during specific episodes emphasizes that EPTs require careful preparation and legal drafting to address potential legal and administrative implementation challenges. According to the authors total profit can be thought of as the sum of two components: i) normal return (which is the sum of the safe return and a risk adjustment); and ii) economic rent (also referred to as super normal profit). Windfall profits refer to unanticipated, fortuitous, gains typically generated by exceptional and unexpected events such as wars, natural disasters, or pandemics. In this sense, the investment took place without the anticipation of the windfall profits. Conceptually, windfall profit can be deemed to be a portion in excess of normal return. In the case of Pakistan, the marked appreciation of US dollar and the resultant profits, if any, also fall in the category of such unanticipated events and gains.
According to the working paper General EPTs, implemented through appropriately designed and drafted domestic tax law, avoid an ad hoc distorting ‘pick-and-choose’ approach. The EPT design should target excess profits of all companies. Even in case of war EPTs, it proved extremely difficult to achieve a differentiation to capture only excess profits of manufacturers of munitions or specific traders. Specific design challenges emerge with the use of sector specific taxes and potential distortions associated with ring-fencing. The overall tax rate on excess profits, is a policy choice but it can be considerably higher than the corporate income tax rate since the EPTs are not distortionary. Historically, the EPT rate reached95 percent in the United States. However, current international tax pressures in the form of profit shifting and tax competition indirectly put a limit on the EPT rate. The paper also stresses on the interaction of EPT with corporate taxes and suggest that it could coexist with the corporate income tax. However, importantly the portion of profits that is subjected to the EPT should not be subjected to the corporate income tax, while the remaining profits be taxed under the existing corporate income tax. For example, if pre-tax profits are 200,000and the excess profits are 50,000, the EPT applies on excess profits of 50,000and the corporate income tax applies only on the difference of 150,000. In practice, the already paid corporate income tax on excess profits can be credited against the EPT.
The paper also highlights the requirement of a set of rules to protect the EPT base by blocking avenues for avoidance. Anon-exclusive list of EPT avoidance possibilities mentioned in the working paper includes splitting into more than one company; changing the location of the headquarter; and/or engaging in merger and acquisition activities with loss-making companies. Additionally, the EPT has to ensure ensure tax neutrality with respect to the legal status of the business to prevent tax avoidance by switching to a non-corporate entity. Moreover, inflating the value of assets on the books raises the allowance, thereby narrowing the EPT base.
The valuation of assets is very critical especially in the current age of increased importance of intangible-assets distinguishable from the tangible-capital-intensive companies that were subjected to EPTs more than a hundred years ago. Finally, reducing reported earnings through strategies of shifting profits to low tax jurisdictions, which is already a major loophole of the existing corporate income tax arrangements is also mentioned.
An Evaluation of the Additional Tax Introduced in Finance Act, 2014
If we evaluate the EPT introduced through the above-mentioned section 99D added by the Finance Act, 2023 on the touchstone of the essential ingredients of a robust EPT identified by the IMF working paper and briefly outlined above, we will find it inadequate on almost all scores. Interestingly, the Excess Profits Tax of 1940 scores quite high on these benchmarks despite having been conceived more than eighty years before the working paper. It will be useful to discuss these deficiencies one by one-
1. Possibly the most critical issue is that the tax under section 99D will be in addition to the normal corporate income tax i.e. the same income will be subjected to corporate income tax and the newly introduced Additional tax. It is a basic principle of income tax that the same income cannot be taxed twice in the hands of the same person. Unfortunately, section 99d makes a breach of this cardinal principle. Even the Act of 1940 tried to avoid this pitfall by allowing the amount of EPT payable as a deduction for computing the income chargeable to corporate tax under the Income Tax Act of 1922. The IMF policy paper discussed above provides detailed guidelines for avoiding double taxation. A simple solution would have been to exempt corporate tax on the amount chargeable to Additional tax under section99D and subject it to a higher rate that would yield the combined amount of corporate tax as well as the additional tax that is presently sought to be charged. As already discussed in the above section, the rate of tax is a policy choice and even a rate of 80% on excess profits would have been acceptable in view of the observations in the IMF working paper, but it would have avoided the element of double taxation that could lead to serious legal challenges. The choice of name of the new tax also underscores the existence of the element of double taxation.
2. Section 99D imposes additional tax on any income, profit or gains that have arisen due to any economic factor or factors that resulted in windfall income, profits or gains but it does not specify which income, profits or gains will be subjected to this tax. Will it be the taxable or total income, declared or assessed or amended income, profits or gains on which this tax will be payable? What will be the impact of changes in income after appeals, revision, rectification etc.? The answers to these questions may appear to be intuitive to the framers of 99D but there can be many controversies around these.
3. The section doesn’t incorporate any anti-avoidance provisions to prevent abuse and revenue leakages.
4. The language of the section gives an impression that it will be restricted to specific and yet unidentified sectors and not a general EPT as recommended by the IMF working paper.
5. Leaving the identification of sectors and determination of windfall gains to a notification by the Federal Government may also be problematic as it is a settled principle that a subordinate legislation cannot broaden the scope of the primary legislation and rules made under a statute cannot override or prevail upon the provisions of the parent statute and whenever there is an inconsistency between the rules and the statute, the latter must prevail. We can expect substantial controversies and litigation once the notification is issued.
6. It would have probably been better and consistent with literature on the subject if the new tax was levied through a separate enactment providing for self-contained machinery for assessments, detailed rules for computation of standard and excess profits, appeals, anti-avoidance provisions, penalties, etc.
7. Restricting the scope of the Additional tax to companies also goes against the guidelines contained in the IMF working paper and as suggested therein may lead to de-corporatization.
Conclusion
The initiative to levy tax on windfall profits needs to be welcomed. Especially, in view of the burgeoning fiscal deficits and the growing socioeconomic inequalities. The tax once implemented is likely to be stubbornly resisted by the champions of neo-liberal economics and influential lobbies that have hitherto gone unchallenged. Moreover, the endemic under reporting of incomes in Pakistan will provide unique and considerable challenges in achievement of the desired objectives. If we add to these factors, the deficiencies in the design of this tax, that may lead to intractable and protracted litigation, the roadblocks to its success appear almost insurmountable. It is expected that the government will reassess and revamp the tax policy and administrative issues required for effective implementation to make EPT a success story. It may be worthwhile to consider, omitting section99D from the Income Tax Ordinance, 2001 and enacting a separate and self-contained law for imposition of EPT after carefully debating its scope and design in view of the global experiences. It may also be advisable to resist the temptation of addressing all the design issues through the notification to be issued by the Federal Government, in view of the limited scope of subordinate legislative instruments as determined by the superior courts of the land and world over.
