When the State owes the taxpayer: a question of trust

Every September, as the annual income tax return is due for filing, a friend calls me. Like many taxpayers, he thinks about income tax only once a year, when his return must be filed. His questions are usually simple, though the answers often lead to larger issues. This year, he asked about section 7E of the Income Tax Ordinance.

For readers unfamiliar with tax law, Section 7E was introduced in 2022 as a federal income tax linked to certain immovable properties held by resident persons. It created a “deemed income” from property: even where a qualifying property generated no actual income, the law assumed income arose from its value and taxed it. Controversial from the outset, the provision was challenged before various courts. My friend wanted to know what had finally happened.

I told him that the Federal Constitutional Court of Pakistan (FCCP) had struck down Section 7E as unconstitutional and held it void ab initio, i.e., invalid from the beginning. His response was immediate: “Then what happens to the tax I paid in earlier years?” That simple question led to a much longer conversation.

If the tax was not due, should the same stands refundable?

In principle, money paid under a provision now declared invalid from inception should come back. “So, I will get a refund?” he asked. “In principle, yes,” I replied, before explaining the procedure. If the Section 7E liability was included in an earlier return that was never amended, the taxpayer may first need to correct that tax position perhaps by seeking permission to revise the return or, where an order exists, by filing for rectification. The resulting refund must then be claimed and processed and may be adjusted against any outstanding tax liability.

“How long will this take?” he asked. I offered an optimistic answer: “If everything moves quickly, perhaps a few months.” He smiled, as taxpayers often do when tax professionals say “if everything moves quickly”. Then he asked whether the government would pay interest for having held his money for years. Tax law does provide compensation when a refund that has become due remains unpaid beyond the prescribed period. The difficulty is determining when the refund legally becomes “due”; compensation does not necessarily run from the original payment date.

That was when his curiosity moved in another direction.

But what happens when the government wins?

My friend then recalled the super tax controversy. In broad terms, super tax is an additional income tax imposed on persons and businesses above specified income levels. Its application to certain earlier periods and final-taxed incomes led to substantial litigation. Taxpayers challenged different aspects of the levy, but the major constitutional controversy was ultimately decided substantially in favour of the State.

He had followed some of this through our earlier discussions. “When the government won, did it wait for taxpayers to decide when to pay?” Obviously not. Once tax becomes legally recoverable, the machinery of the State moves towards collection: demands are enforced, payments pursued and delay may attract further consequences, including questions of default surcharge.

Then came the central question: “If the government wins, it wants its money quickly. If the taxpayer wins, why must he begin another process to get his own money back?” There are legal answers, but he was really asking about fairness.

An old property deal came back to mind

His question reminded me of a property transaction years ago. The agent proposed an agreement to sell, which the seller felt protected almost every right of the buyer: it prescribed his obligations, the consequences of non-performance and the safeguards for the buyer. “What kind of agreement is this?” he asked. “Everything protects the buyer. What about the seller?” His irritation reflected a simple principle: an agreement cannot create confidence if its protections, remedies and obligations operate mainly in one direction. A durable arrangement must balance the legitimate rights and obligations of both sides.

The same principle applies to taxation, part of the wider social contract between citizen and State. Taxpayers accept the State’s right to impose lawful taxes, demand information, examine returns and recover unpaid amounts. In return, if the State expects prompt payment when money is due to it, taxpayers may reasonably expect equal efficiency when money was never due. Otherwise, the relationship resembles that one-sided property agreement.

A small refund I still remember after more than twenty years

Another memory returned. I filed my first income tax return around 2003, during my first job, and it showed a small refund. I did not repeatedly visit a tax office or file a series of applications. After a relatively short time, a refund voucher simply arrived at my address. More than two decades later, I still remember it although I did not then think in terms of “tax morale”, “process equity” or the taxpayer-State relationship. Looking back, that voucher conveyed all three. The system found that I had paid too much and returned the excess. For someone entering the tax system, the message was powerful: the authority was not there only to collect; it would also return what was not due. I have remained within the system ever since.

It would be an exaggeration to attribute two decades of compliance to one small refund. Yet such experiences shape how institutions are perceived. Tax morale is not built only through appeals, penalties, audits or enforcement; it develops through experience.

The argument over self-adjusting refunds

Our tax history adds another dimension. Taxpayers have sometimes adjusted refunds from earlier years against tax payable with a later return. The authorities have disputed this, arguing that a refund shown in a return must first be formally determined through the prescribed process before it can be adjusted. Taxpayers respond that, where a refund is undisputed, requiring fresh payment while the government retains an old refund makes little practical sense.

The issue has generated litigation with varying outcomes. I do not intend to reopen it here, but it suggests a solution for Section 7E: instead of leaving taxpayers to make unilateral adjustments and inviting fresh disputes, why should the tax administration not itself make verified amounts available?

September provides an opportunity

The timing matters. Individuals are approaching the September 30 deadline for filing Tax Year 2026 returns. Many will calculate their liability and pay the balance due, while some may still have money with the State that they paid under Section 7E, a provision now held invalid from the beginning.

Why not connect the two?

FBR already holds much of the necessary information: who declared a Section 7E liability, the amount declared and, in most cases, whether it was paid. Rather than requiring each taxpayer to seek revision, apply for a refund and pursue follow-up, FBR could create a special mechanism. In straightforward, verified cases, it could determine the amount and place it in the taxpayer’s online account as a credit. The taxpayer could then use that recognised credit against tax payable with the current return. This would not be a unilateral claim: the State itself would have verified and recognised the amount.

It could help the State as well

This may also be practical for the government. Refunding every Section 7E payment in cash could affect fiscal cash flow. Where the same taxpayer owes tax for the current year, however, offsetting a verified Section 7E credit would achieve substantially the same result without an immediate refund cheque. If a taxpayer paid Rs200,000 under Section 7E and now owes Rs500,000, FBR could recognise the earlier amount and collect the remaining Rs300,000.

There would be no dispute over unilateral adjustment and no immediate cash refund. The old amount would be settled, the current liability collected and, more importantly, the taxpayer would experience a system that works both ways.

Technology should work both ways too

This raises a wider question about technology in tax administration. Digitisation is usually discussed as an enforcement tool: it can identify discrepancies, trace assets, compare transactions, find non-filers and generate notices. But if technology can identify money owed by the taxpayer to the State, it should also identify money owed by the State to the taxpayer. A system capable of generating a demand should also generate a credit.

FBR’s data should not be used only to enforce obligations but also to facilitate rights.

Not every case will be simple

Not every case will be straightforward. Some taxpayers may have outstanding demands; others may face amended assessments, pending proceedings or payment-verification issues. Such cases can follow the ordinary process. But complexity in some cases should not justify complexity in all. Where straightforward cases can be identified electronically, they should be resolved quickly. A clear FBR circular setting out the procedure, eligibility conditions and treatment of credits or refunds would itself reduce uncertainty.

This is really about process equity

Tax fairness debates usually focus on who pays and how much, whether equal incomes should bear equal tax or greater capacity should attract proportionately more. Equally important, however, is fairness in the process. People may accept an unfavourable outcome more readily when the procedure feels fair. Conversely, even a legally sound tax system loses credibility if its processes consistently favour the institution administering it. If a judgment for the State prompts immediate recovery, while one for the taxpayer merely opens another lengthy process, the relationship feels unequal. The law may explain the difference; tax morale responds to the experience.

The economics also work in both directions

There is also an economic principle at work. When a taxpayer retains money owed to the government, tax law treats delay as costly; that is one reason default surcharge exists. Money has a time value. But it does not lose that value when the direction is reversed. A taxpayer who paid money never lawfully due has likewise lost its use.

A business might have used it as working capital; an individual might have invested it or met household expenses. The law may separately determine when compensation becomes payable and at what rate. The broader point is simple: the cost of withholding another’s money cannot matter only when the taxpayer holds government funds.

What kind of tax relationship do we want?

Pakistan needs tax revenue, and its fiscal constraints are serious. A sustainable system cannot allow those legally required to pay simply to opt out; enforcement remains necessary. But enforcement and trust are not alternatives. A mature tax system needs both. When I suggested that FBR could itself recognise my friend’s earlier Section 7E payment against his current liability, his response was immediate: “If they do that themselves, that would actually feel good.”

Those words capture something tax reform often misses. Governments devote considerable effort to making people comply; they should also consider what makes people want to remain compliant. My 2003 refund cost little, yet I remember it more than twenty years later. Section 7E now offers FBR a similar opportunity at scale. It could leave taxpayers to pursue ordinary refund claims.

Legally, that may suffice. Or, recognising the unusual position of a federal tax collected for years and then declared invalid from inception, it could issue a clear procedure, identify verified payments, allow appropriate adjustment against current liabilities and expedite cash refunds where no adjustment is available.

If the money was never lawfully due, returning it is not a concession. Yet how it is returned can send an important message: the tax relationship is not that one-sided property agreement.

The taxpayer must honour his side of the bargain, and the State must honour its side. Sometimes, returning money may collect something far more valuable: trust.

Copyright Business Recorder, 2026