TAXATION OF LEASING BUSINESS ANOMALIES IN THE NEW LAW

TAXATION OF LEASING BUSINESS ANOMALIES IN THE NEW LAW <!--[if gte mso 10]> TAXATION OF LEASING BUSINESS ANOMALIES IN THE NEW LAW By Dr. Ikramul Haq, Advocate, Lahore The Income Tax Ordinance, 2001 is different in application from its predecessor, the Income Tax Ordinance, 1979 (hereinafter "the repealed Ordinance"), in many ways. One of the notable differences is the treatment of leasing business in both the enactments. The repealed Ordinance artificially deemed entire "lease rentals" (section 12(19)) as income of the lessor, though it comprised partly return of capital and partly financial charges (i.e. mark-up). The new Ordinance taxes the mark-up earned by the leasing companies on capital provided under a finance lease, therefore, the treatment is the same as in the books of account of the leasing companies i.e. recognition of mark-up as income on leased out assets. The new Ordinance has eliminated taxation of finance lease on artificial basis, as there is no provision in the Income Tax Ordinance, 2001 (hereinafter "the new Ordinance") parallel to section 12(19) of the repealed Ordinance. On the contrary, section 18(1)(c) of the new Ordinance clearly provides that any Income from "lease" of tangible movable property shall be chargeable to tax under the head Income from Business. Under the established accounting principles (IAS 17) only mark-up received or receivable by the lessor is its income from finance lease and not the gross lease rentals, which is the case in operating lease. The logic behind taxing the gross lease rentals under the repealed Ordinance was that normal, initial and extraordinary depreciation allowance was allowed on leased out assets in. the hands of the lessor during the period of finance lease. The repealed Ordinance authorized the leasing industry to claim depreciation, both initial and normal, against the leased out assets. The taxable income of a leasing business under the repealed Ordinance was computed in the following manner: Example 1-computation of tax- under finance lease assessment year 2002-2003 1. Gross lease rentals during the income year (1-7-2001 to 30-6-2002): 5,00,00,000 2. Profit and loss expenses + depreciation on own assets: 1,00,00,000 3. Gross profit before depreciation on leased out assets: 4,00,00,000 4. Current year depreciation on leased out assets: 3,50,00,000 5. Add unabsorbed depreciation of earlier years: 1,00,00,000 6. Unabsorbed depreciation to be carried forward: (50,00,000) 7. Tax payable (No tax because of depreciation loss) NIL The computation of income with the same facts as in Example I for the tax year 2003 under the new Ordinance will be radically different. Before going to actual computation, it will be advisable to have a look at the relevant provisions of the new Ordinance, which read as under: Income from business-section 18(1)(c): "The following incomes of a person for a tax year, other than income exempt from tax under this Ordinance, shall be chargeable to tax under the head "Income from Business"‑ (a)... (b)... (c) any income from the hire or lease of tangible movable property Depreciation-section 22(12): "The depreciation deductions allowed to a leasing company or an investment bank or a modaraba or a scheduled bank or a development finance institution in respect of assets owned by the leasing company or an investment bank or a modaraba or a scheduled bank or a development finance institution and leased to another person shall be deductible only against the lease rental income derived in respect of such assets". Initial depreciation allowance-section 23(4): "A deduction allowed under this section to a leasing company or an investment bank or a modaraba or a scheduled bank or a development finance institution in respect of assets owned by the leasing company or an investment bank or a modaraba or a scheduled bank or a development finance institution and leased to another person shall be deducted only against the leased rental income derived in respect of such assets." The condition of allowability of depreciation allowance, both normal and initial, only against the lease rental income derived in respect of leased out assets is quite strange. The new Ordinance has no provision parallel to section 12(19) of the repealed Ordinance, yet it has imposed exactly the same condition for allowing depreciation as contained in section 23(1)(v) of the repealed Ordinance. It raises a question as to whether the new Ordinance still taxes lease rentals or only mark-up earned on finance lease operations. Section 18(1)(c) unambiguously provides that income from lease of tangible movable property is chargeable to tax as business income. The income recognition in the case of operating lease are rentals but where the transaction is in the nature of finance lease it will not he gross lease rentals but the difference between the gross (undiscounted) investment in the lease and the net investment will be unearned income (The C.B.R. admits this position in it C.No.1(1)TP-11/89 dated 30th January, 1989). But section 22(12) explicitly says that depreciation allowance shall be allowed only against the lease rentals meaning by that it repudiates the method of income recognition in respect of finance lease as set out in IAS 17. So, a leasing company engaged in finance lease operations will not be allowed any depreciation allowance on leased out assets unless it offers the entire lease rentals as income of the tax year. But under what authority of law lease rentals are chargeable to tax as income? In the absence of deeming provision like section 12(19) of the repealed Ordinance, neither the leasing companies nor the Commissioner of Income Tax can consider lease rentals as income, which will be against the explicit language of section 18(1)(c) read with section 2(29)' of the new Ordinance. The taxability of lease rentals as deemed income was based on the following fiction of law in the repealed Ordinance. 12(19) Where an assessee, being a scheduled bank, a financial institution, or such modaraba or leasing company as is approved by the Central Board of Revenue for the purposes of the Third Schedule, has leased out, on or after the first day of July, 1985, any asset, whether owned by it or not, to another person, any amount paid or payable by the said person in connection with the lease of the said asset shall be deemed to be the income of the said assessee. Since lease rentals (which also include return of own capital of the leasing companies) was taxed as deemed income, a parallel provision was created to allow the initial and normal depreciation and/or first year allowance on leased out assets in the Third Schedule to the repealed Ordinance. Section 23(1)(v) of the repealed Ordinance that poses the same condition as is now posed by sections 22(12) and 23(4) of the new Ordinance reads as under: "In respect of depreciation, including first year allowance or reinvestment allowance or industrial building allowance of any such building, machinery, plant, furniture or fitting, being the property of the assessee, the allowance admissible under the Third Schedule, except depreciation or first year allowance on assets given on lease shall be allowed against income from lease rentals only." The new Ordinance has eliminated section 12(19) but restricted the depreciation on leased out assets only against lease rentals, even in the case of finance lease. This is a gross contradiction that immediately needs attention of all the stakeholders. If we apply the law as discussed above, the following situation will emerge on the basis of same facts as given in Example-1: Example 2-Computation of income for tax year 2003 1. Income in books against lease rentals of Rs. 5,00,00,000: 2,00,00,000 2. Less Profit and Loss expenses + depreciation on own assets: 1,00,00,000 3. Profit before depreciation on leased out assets: 1,00,00,000 4. Commissioner will disallow depreciation of relating to leased out assets in the light of explicit language of sections 22(12) and 23(4). 5. Income chargeable to tax: 1,00,00,000 6. Total tax payable if leasing company is a public company 35,00,000 7. Total tax payable if leasing, company is a private company 4,30,000 As evident from above, the new law is going to impose undue tax burden on the leasing industry. This law has been drafted so badly that the entire benefit of depreciation admissible against the leased out assets has been eliminated. One wonders at the kind of input provided to the Australian expert (sic) at the time of drafting the new law. Even the so-called experts (from C.B.R. and independent professionals on official payroll) 'have failed to point out this obvious dichotomy, which will have disastrous impact for the leasing industry in Pakistan as no initial or, normal depreciation will be available to finance' lease operations. The provisions of sections 22(12) and 23(4) need to be rationalized by inserting the corresponding provision of section 12(19) of the repealed Ordinance. Unless it is done, no leasing company will get any depreciation on assets given under the finance lease, as there is nothing in the new Ordinance that authorizes the Commissioner of Income Tax to tax lease rentals as deemed income in the case of such transactions. Conversely, the words lease rentals in sections 22(12) and 23(4) should be removed vis-a-vis finance lease. The 1990s have been a challenging period for the finance leasing industry, which has attracted many high-paid professionals, with commendable corporate, business and taxation knowledge. But with the recent reduction in the rate of corporation tax and lower interest rates, it would appear that the tax advantages of leasing have been considerably reduced. If the significant contribution made by leasing to the economy is to be sustained, it is critical that the different Government departments adopt complementary policies that enable the leasing industry to plan and develop its products. The Leasing Association of Pakistan needs to take up the issues discussed above with the Ministry of Finance and the Central Board of Revenue (C.B.R.), as the proposed taxation can be potentially harmful for the benefits of leasing as a means of addressing the problem of under-investment in the economy. The leasing industry needs to build alliances at all levels of the Government with the objective of explaining the overall benefits of leasing business for industrial and business growth, rather than entering into protracted debates and costly litigation over tax issues with C.B.R.