Given the enormous tax revenue target of PKR 9.1tn for FY24, the government is contemplating imposing new taxation measures in the upcoming budget.

In this regard, one of the proposals is to tax the undistributed profits (reserves) of corporates to 5% for listed companies and 7.5% for unlisted companies. Pertinently, this tax will be adjustable for the shareholder against the advance tax paid on future dividends by the company.

Below is the sensitivity with four potential scenarios and their revenue impact on the government.

There are precedents for such a tax measure

To recall, a taxation measure was introduced in 2017, whereby if 20% of the profits were not distributed, a 5% tax was imposed on the accounting profit before tax for the year.

Prior to that, in 2015, a taxation measure was introduced whereby if 40% of earnings or 50% of paid-up capital (whichever is lower) were not distributed, a levy was imposed at the rate of 10% on the reserves which are more than 100% of paid-up capital. This measure faced legal implications, and because of that, it was modified in 2017.

Legal implication on retrospective or prospective undistributed profits? – It is yet to be seen

Under the current circumstances, it is yet to be seen whether the imposition will be on a retrospective basis whereby those companies that have failed to distribute profits in prior years will be penalized, or only those that will not distribute profits in the forthcoming year.

It is likely that any levy on retrospective years’ reserves may have legal implications as it is the discretion of the shareholders and sponsors to decide how to utilize the reserves for either growth or distribution purposes.

Moreover, as the proposed tax is advance tax paid on future dividends it may be difficult to implement as shareholders may change in the future

Proposals

The two likely proposals in the upcoming budget about reserves would be:

Tax on companies that have not distributed profits recently (1, 2, or 3 years; timeline yet to be decided), and

Tax on undistributed reserves of all companies across the board.

In the first case, there is a likely scenario that if a company has announced a 20-40% payout of its earnings or its paid-up capital, or commits to such a distribution either through dividend or bonus, it will be able to avoid the aforementioned tax. However, failure to do so will result in a tax being imposed on the existing reserves (difference in the minimum payout of 20% or 40% and actual payout).

While in the latter case, it has been proposed that a flat tax will be imposed on the undistributed reserves of all companies, irrespective of any precedent or expected announcement of payout.

We view that the first scenario would be more likely where the additional tax would be imposed on the current year accounting profit contingent to dividend or bonus distribution (recall 2017 taxation, discussed on slide 3), while the latter would have very high chances of legal implications.

Companies at the PSX have been quick to react

Given the looming threat of a hit from the aforementioned levy, listed companies have either already announced an increase in their authorized capital (to potentially offer bonus shares to existing shareholders), or they have announced an EOGM / emergent board meeting scheduled in the upcoming days.

Courtesy – AHL Research