This is not the first time that there is a proposal to tax undistributed reserves of a company. Such imposition has been attempted at least twice before under sections 12(9A) of the repealed income tax ordinance 1979 and 5A of the ordinance of 2001. However, previous impositions were confined to listed companies only as against the present proposal to tax undistributed reserves of the entire corporate sector.
The previous impositions were challenged in courts as these stemmed from a bad law. The Sindh High Court crushed this imposition down on technical grounds. The departmental appeal against the order of the High Court is pending before the Supreme Court of Pakistan. Therefore, if this proposed levy is implemented, it would again be contested on constitutional grounds.
This time, as per the information available, an adjustable advance tax on shareholders is being proposed on the amount that represents the distributable reserves of that company. In short, the text of the clause is expected to be close to: “there shall be levied an advance tax on shareholders at the rate of X % on the amount of dividend that can be distributed out of reserves of the company”. “Reserves for this purpose includes all reserves of the company by whatever name called.”
This is a very unreasonable provision in the commercial sense for the reason that shareholders are being taxed for amounts that they may never receive as ‘income’. In almost all the companies a substantial portion of reserves can never be distributed as ‘cash dividend’ for the reason that such profits have already been used in capital expenditures like plant and machinery, etc., and that portion of reserves can never be distributed in ‘cash’ unless there is liquidation of the company and the sale of its assets. Thus it is an absurd law that does not match the concept of primary accounting.
Notwithstanding this position, it is the writer’s view that even if the law is implemented in the manner as stated above, the amount of reserves which are declared by the company to be not distributable as cash dividend cannot be subjected to advance collection of tax in the hands of the shareholders.
In this respect, the primary issue is that advance tax can only be collected on a sum that is income or is deemed to be income under the Ordinance. If a sum is declared not to be distributable ever as a cash dividend then that sum cannot be subjected to advance tax on dividend in any manner. It is for this reason that under the present Pakistan law only the ‘dividends in cash’ are taxable and distribution in the form of bonus shares is not taxable. The term dividend is defined as under:
(19) “dividend” includes — (a) any distribution by a company of accumulated profits to its shareholders, whether capitalised or not, if such distribution entails the release by the company to its shareholders of all or any part of the assets including money of the company;
(b) any distribution by a company, to its shareholders of debentures, debenture-stock or deposit certificate in any form, whether with or without profit, to the extent to which the company possesses accumulated profits whether capitalised or not;
(c) any distribution made to the shareholders of a company on its liquidation, to the extent to which the distribution is attributable to the accumulated profits of the company immediately before its liquidation, whether capitalised or not;
(d) any distribution by a company to its shareholders on the reduction of its capital, to the extent to which the company possesses accumulated profits, whether such accumulated profits have been capitalised or not; 3 
Prior to deletion by the Finance Act 2002 the sub-clause (b) of the income tax ordinance included the words “and any distribution to its shareholders of shares by way of bonus or bonus shares”. This means that dividend after the amendment in 2002 does not include distribution to shareholders of shares by way of bonus shares. Only are ‘cash dividends’ taxable under the Ordinance. The word ‘distribution’ as used in the aforesaid clause, unless qualified, only includes something that has actually been received by the shareholder.
Under the present definition of dividend, as a result of specific deletion as referred above, it becomes clear that distribution by way of bonus shares is not income and cannot be income under the Ordinance. Furthermore, any amount of ‘future dividends’ cannot be taxed on the ground that there are distributable reserves available with the company.
At this stage the question whether that ‘future dividend’ can be taxed or not is irrelevant. What is being suggested here is that there exists a bar against such tax on future dividends out of distributable reserves.
In order to overcome the shortcomings that future dividends cannot be treated as income, if the proposal is implemented, then the definition of income will have to be changed or enlarged. At the moment, the definition of income is as under:
(29) “income” includes any amount chargeable to tax under this Ordinance, any amount subject to collection 3 [or deduction] of tax under section 148, 4 [150, 152(1), 153, 154, 156, 156A, 233, 5 [ ] ] 6 [,] sub-section (5) of section 234 7  8 [and] 9 [any amount treated as income under any provision of this Ordinance] and any loss of income10;
If tax on reserves is introduced in the manner referred above, then a new (or amended) withholding provision would have to be introduced in the definition above and the amount deducted under that provision will be taken as and deemed to be income of the shareholder for which deduction will be made by the company. For this purpose, the extended meaning of income as laid down by the Elahi Cotton Mills Limited verdict will be used as a shield.
In this situation there is a need to understand the nature of dividend viz-a-viz the possibility of distribution. This appreciation is necessary because distribution in the form of cash dividend can only be made out of that portion of the reserves that have not been utilised for acquisition of assets etc., and are ‘free’ for distribution.
In other words, the entire amount of reserves as appearing in a company’s balance sheet may not necessarily represent free reserves that can be distributed as this figure is also containing such reserves that are not distributable as they are not available for distribution in the form of cash. Therefore, in the context of this provision, these reserves should be free reserves and, at the same time, they should not have been set aside for issue of bonus shares, etc.
How much of the reserves is a distributable reserve ‘in cash’ is a decision of the Board of Directors of the company. It is for this reason that classification of ‘Capital Reserves’ under the Fourth Schedule of the Companies Act, 2017 ‘includes’ any other reserve not regarded as free for distribution by way of dividend’.
In this issue, the definition and the nature of ‘capital reserves’ for accounting and other purposes are irrelevant. What is relevant and needs to be considered is whether withholding provisions which are applicable only to ‘cash dividend’ can be applied to the amount, which has been declared as not distributable in the form of cash by the company. This is the shield that bars the imposition of the proposed tax in advance.
There is another classification of ‘revenue reserves’ under the same Fourth Schedule to the Companies Act, 2017. This stipulates that for the purposes of classification of reserves under Act, reserves have to be placed either under capital or revenue reserves. There is no residuary provision.
If an amount is placed under non-distributable reserves, then the withholding provisions under the Income Tax Ordinance, 2001 cannot apply on those reserves. Even if it is considered that there can be a view that there is a possibility of reversal of reserves classified as non-distributable to distributable, the amount cannot be subjected to withholding till the time the said reversal is implemented
The concept of ‘free reserves’ was used in the Companies (Further issues of capital) Regulations 2018. This was the carry-over from the old corporate law. That provision dealt with the amount of premium that can be received on shares. The law states as under:
(2) In case of a listed company, a premium may be charged on right shares up to the free reserves per shares as certified by auditors of the company and the said certificate shall be submitted to the Commission and securities exchange along with announcement of right issue:
Explanation.— For the purposes of this regulation the expression “free reserves” includes any amount which, has been set aside out of revenue or other surpluses after adjustment of all intangible or fictitious assets, is free and that it is not retained to meet any diminution in value of assets, specific liability, contingency or commitment known to exist at the date of the balance sheet, but does not include-
(i) reserves created as a result of revaluation of fixed assets;
(ii) goodwill reserve;
(iii) depreciation reserve to the extent of ordinary depreciation or otherwise as admissible under the Income Tax Ordinance, 2001 (XLIX of 2001);
(iv) development allowance reserve created under the provisions of the Income Tax Ordinance, 2001 (XLIX of 2001);
(v) provisions for taxation to the extent of the deferred or current liability of the company;
(vi) capital redemption reserve; and
(vii) unrealised capital gain.
This definition of ‘free reserves’ is an adoption from earlier laws and the Indian law; it makes sense in the context that it has been used in this provision. Here the objective is to identify the real reserves of the company as the accounting and other provisions allow to carry on the credit of the financial statements amounts taken to be reserves, which are actually not the real earnings of the company. These are for example revaluation gains, goodwill reserves on acquisition, unrealized capital gains, etc. This definition of reserves does not in any manner affect the subject as discussed here. Since this definition was not in line with the accounting and corporate concepts, therefore this has been deleted in the revised regulations issued in 2020. The revised regulations state:
A listed company may issue right shares at face value or at premium to face value provided the directors and substantial shareholders of the company undertake in writing that:
In the light of the aforesaid, it is the Board of Directors that decides and announces as per the requirements of the corporate law that “a sum equal to Rs X out of total reserves of the company are set aside as reserves for issue of bonus shares, reserves for redemption of shares and/or any other name as permitted under the Companies Act, 2017 to the effect that such reserves are not to be distributed in the form of cash dividend.” This means that under the corporate laws of Pakistan this reserve is not in any way a ‘revenue reserve’ or a ‘distributable reserves’ of the company on which withholding provisions can apply.
In the past, the legislature had also deemed the amount issued as bonus shares as income. This definition as referred above was not carried through in the Income Tax Ordinance, 2001. It is, however, the writer’s considered view, that the placement of an amount in the non-revenue reserve cannot be subject to tax even if bonus shares are treated as income. This assertion is made for the primary reason that there has to be some receipt in cash or kind at present for it to be treated as ‘income’ subject to tax.
1 There is a view that this reversal is not possible
a) Our opinion is based on the facts and assumptions stated above. Any inaccuracy therein could have a material impact on our recommendations or conclusions and should, therefore, be intimated to us immediately.
b) Our opinion is based on the law as of date. Tax and other laws (referred above) are subject to changes from time to time and as such any changes may affect the advice contained in our opinion. We have no responsibility to update our advice for events and circumstances occurring after the date of this opinion, unless specifically requested by you.
c) The tax advice is a matter of interpretation of law and is based on our experience with the tax and other relevant authorities. Accordingly, it cannot be said with certainty that the opinion expressed above will be accepted by the tax and other relevant authorities.
d) We do not, in giving this opinion, accept or assume responsibility for any other purpose or to any other person to whom this opinion is shown or in whose hands it may come, unless expressly agreed by us in writing.
Copyright Business Recorder, 2023