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IMF urges FBR and Cabinet to stop giving tax incentive

Islamabad, 13 May 2024, (GNP): IMF has urged the Federal Board of Revenue (FBR) to remove the authority of the Board and the cabinet to grant tax incentives arbitrarily and to revise tax laws concerning NGOs, charitable organizations, and taxed pensioners.

Regarding pensions, the IMF suggests either taxing pension contributions or benefits. To achieve this, the IMF proposes removing the deduction benefit for voluntary payments to workers’ participation funds and eliminating the exemption for pensions, instead taxing them using one of the alternatives outlined.

Pakistan and the IMF are poised to begin crucial discussions this week, commencing today (Monday). Pakistan has formally requested a new bailout package ranging from $6 to $8 billion under the Extended Fund Facility (EFF), with the potential for augmentation through climate finance.

The IMF has presented its wishlist or agenda regarding tax incentives. It suggests that tax incentives should only be granted in cases where their economic advantages, such as increased employment and value addition to the economy, outweigh the costs to the budget.

”In the current dire fiscal situation few, if any, existing incentives would meet that test. Any remaining incentives should be well-designed and cost-based rather than profit-based,” the IMF told the FBR.

The IMF explained that cost-based incentives, like accelerated depreciation and special tax deductions or credits for investment expenses, aim to reduce the initial capital costs of investment, making projects more lucrative and encouraging new investments that might not otherwise occur.

On the other hand, profit-based incentives, such as tax holidays and preferential tax rates, are less effective in stimulating investments, particularly when profitability is low or mainly occurs later in the project’s lifecycle. They often only boost profits for already successful projects while sacrificing government revenue.

Additionally, the effectiveness of profit-based tax incentives is expected to diminish with the introduction of the global minimum tax under pillar two.

“Distortions, complexities, and inequities caused by the special tax regimes for the construction sector are particularly harmful and reduce the tax effort of a highly buoyant sector,” the IMF says and added that the special treatment of the construction sector for both sales tax and income tax purposes should therefore be removed.

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The IMF proposes eliminating all tax incentives outlined in the Income Tax Ordinance (ITO), except those mandated by legal obligations or for specific policy reasons, such as preventing cascading taxation of pass-through income. This measure is expected to generate an additional 0.2% of GDP in revenue, according to IMF estimates presented to Pakistani authorities.

To enhance the management of tax incentives and related tax policy areas, the IMF suggests revoking the Federal Board of Revenue’s discretionary power to grant tax incentives to industrial undertakings and the cabinet’s discretionary power to award tax incentives. It recommends complementing the Tax Expenditure Report with a section evaluating the costs and benefits of tax incentives.

If tax incentives are granted in the future, the IMF proposes making them time-limited and subject to regular assessments of costs and benefits. If initial costs are higher than anticipated and/or benefits are lower, incentives should be promptly withdrawn or transformed into cost-based incentives where feasible.

Regarding minimum tax reform, the IMF suggests allowing accelerated deductions to affect the minimum tax and implementing a half-year rule to restrict deductions in the year an asset is put into use. Over the medium term, the IMF proposes repealing the minimum tax as capacity for Corporate Income Tax (CIT) administration strengthens and CIT revenue increases.

The IMF urges the Federal Board of Revenue to engage with provinces to explore harmonizing the tax rate and base of the agricultural income tax with federal standards, repealing the current SME tax framework for the manufacturing sector, phasing out the special tax regime for the construction sector, and subjecting it to standard income tax regimes as quickly as feasible.

Additionally, the IMF recommends streamlining rules related to charitable donations and non-profit organizations, proposing that all types of donations and non-profit entities adhere to the same rules. This includes replacing exemptions with tax credits for certain non-profit organizations and reviewing tax credits for charitable donations and specific persons to assess potential changes to eligibility requirements.