The Future of SMEs

Tax policy needed to encourage banks to enhance loan portfolio

Bilal Hassan

The small and medium enterprises (SMEs) sector is considered the backbone of any economy due to its role in accelerating economic growth, creation of jobs and taming inflation. SME sector is of utmost significance for lower-middle income countries like Pakistan. It is responsible for 60 percent of total jobs in Pakistan. Its contribution to GDP and export revenues is 30 percent and 25 percent, respectively. Being integral part of the supply chain, the SME sector plays a crucial role in achieving sustainable economic growth.

Unfortunately, the SME sector in Pakistan has not been given due attention in the past and remains one of the neglected areas even today. The principal manifestation of this neglect can be found in poor credit supply to this sector. This can be gauged from the fact that the share of SMEs in the total private sector credit declined from 17 percent in 2006 to 7.5 percent in 2018-19 – the share of SMEs in private sector credit in Bangladesh and Turkey is 20 percent and 29 percent, respectively. Sadly, access to formal finance remains restricted to 170,000 SMEs. Therefore, a large number of SMEs are facing massive financial constraints and it signifies that triple helix model is not being best utilized in Pakistan in promoting SME sector.

It is pertinent to mention here that ensuring adequate supply of finances to SME sector by the government is one component of triple helix model. Engagement of academia/educational institutions in delivering advanced vocational and technical skills to SMEs, and of industries in providing labour and other facilities to SMEs are other two components of triple helix model.

Recognizing the role of SMEs in socioeconomic uplift of the people, the present government has taken certain policy initiatives for resolving multiple issues being faced by the this sector, especially to remove bottlenecks in accessibility of formal finance. And, to promote this important sector of economy, the Prime Minister has himself promised to enhance access of SMEs to banking credit.

To increase the number of SMEs borrowers from 170,000 to 700,000 by 2023, the government has adopted a paradigm shift in taxation policy through Finance Act 2019 concerning taxation of income of banks derived from additional advances extended to SMEs. For tax years 2020 to 2023, a reduced rate of 20 percent instead of standard rate of 35 percent is imposed on taxable income of banking companies derived from additional advances extended to the SMEs. Banking companies are required to compute taxable income arising from additional advances using the formula.

Total income subject to 20 percent tax rate = A× B/C

where A is taxable income; B is net markup income earned from additional advances for tax year; and C is total of net mark-up income and non mark-up income as per accounts.

Banking companies have been allowed special deductions under the Seventh Schedule to the Income Tax Ordinance, 2001, apart from business expenses incurred, directly or indirectly, for earning income such as depreciation, initial allowance and amortization, which have significant reducing impact on their taxable income and tax payable. Special deductible allowances include provisioning for advances and off-balance sheet items up to maximum of 1 percent of the total advances, and allowed to carry forward provisions in excess of 1 percent to the succeeding years. However, if the provisioning is less than 1 percent of the total advances, the actual provisioning is allowed and provisioning for advances and off-balance sheet items is allowed at 5 percent of the total advances for consumer and SMEs, and allowed to carry forward provisions in excess of 5 percent to the succeeding years and if the provisioning is less than 5 percent of the total advances for consumer and SMEs, then actual provisioning for the year is allowed.

Furthermore, banking companies are allowed a deduction for any expenditure (other than on account of charge for irrecoverable debt) and the liability or a part of the liability to which the deduction relates if it is not paid within three years of the end of the tax year in which the deduction was allowed, the unpaid amount of the liability will be chargeable to tax under the head income from business in the first tax year following the end of three years. However, if an unpaid liability or a part of it is chargeable to tax and is subsequently paid, a deduction will be allowed for the amount paid in the tax year in which the payment is made and adjustment of loss on sale of shares of listed companies, disposed of within one year of the date of acquisition, against business income of the tax year. Where such loss is not fully set off against business income during the tax year, a banking company is entitled to carry forward to the following tax year and set off against capital gain only. However, no loss is allowed to be carried forward for more than six years immediately succeeding the tax year for which the loss was first computed.

This is the reason that companies operating in non-banking sector are critical of special tax regime for banking companies that allows them a considerably higher costs ranging between Rs.40 billion to Rs.45 billion.

Importantly, provisions of withholding tax under Income Tax Ordinance, 2001 are not applicable to a banking company as a recipient of the amount on which tax is deductible. Moreover, tax authorities instructed such withholding agents that no tax is required to be deducted at the time of making payments to banking companies and therefore, no specific exemption certificate is required from the banks. Similarly, provisions relating to group relief as contained in section 59B of Income Tax Ordinance, 2001 will also be available to the banking companies provided the holding and subsidiary companies are banking companies and holding and subsidiary companies of 100 percent owned group of banking companies may opt to be taxed as one fiscal unit pursuant to section 59AA of Income Tax Ordinance, 2001 relating to group taxation.

It is worth mentioning that income, profits and gains of banking companies, including Shariah compliant banking companies are computed under the provisions of the Seventh Schedule to Income Tax Ordinance, 2001.

The writer serves as additional director of Intelligence and Investigation (IR), Federal Board of Revenue.

Promoting SMEs

Authorities in Pakistan have usually been striving to promote small and medium enterprises (SMEs) with a view to accelerating the pace of development and creating new employment opportunities in the country. However, the results of their efforts have not been up to expectations. However, it is quite encouraging that while distributing cheques to the recipients of subsidized business loans under his government’s Kamyab Jawan Programme on December 06, Prime Minister Imran Khan acknowledged the importance of small and medium enterprises in the country’s economic progress and their role in employment generation. He reiterated his commitment to promote SMEs and promised to enhance their access to banking credit and to reshape policies to create an environment to facilitate operations and doing business. A few days ago, the economic affairs minister spoke of the government’s efforts to push the development of SMEs, saying it was formulating a new policy and planned to increase the number of SME borrowers from 170,000 to 700,000 by 2023.

The government’s focus on empowering the youth and tapping the potential of entrepreneurship in small and medium enterprises (SMEs) should yield results. Measures like provision of soft loans, ensuring ease of doing business and formulating policies focusing on the youth are all writing a bright future of the nation.