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Basic concepts of taxation

Basic concepts of taxation

Basic concept of taxation

These are the three questions that generally arise while hearing about Income Tax

1.    What is a tax year?

2.    What is taxable income and how it is computed?

3.    Who is person?

What is a tax year?

 

There are three kinds of tax years

1-Normal tax year

2- Special tax year

3- Transitional tax year

Normal tax year

In Pakistan, the normal tax year, often referred to as the “fiscal year” or “financial year,” runs from July 1st to June 30th. Therefore, when taxpayers in Pakistan prepare their annual tax returns, they report income and deductions based on this 12-month period.

Special tax year

A “special tax year” can refer to a fiscal or tax year that doesn’t follow the standard or normal 12-month period set by the country’s taxation authority. It’s often applicable to businesses rather than individual taxpayers and might be used in certain circumstances, like when a business is started or closed and doesn’t operate for a full standard tax year.

Transitional tax year

In some tax jurisdictions, including Pakistan, entities or individuals might not always follow the normal tax year (July 1 to June 30 in Pakistan’s case). Instead, they may use a “special tax year” or an “alternate tax year” under specific circumstances. This is often true for companies or organizations with unique operating cycles or for those that are incorporated or start operations partway through the regular fiscal year.

What is Taxable Income?

“Taxable income” refers to the amount of income that is subject to tax, after all allowable deductions, credits, and exemptions have been subtracted from the total income. The exact computation method can vary significantly between countries and individual circumstances, but generally follows a few common steps:

General Steps to Compute Taxable Income:

Determine Total Income:

Include all sources of income such as wages, salaries, bonuses, and any other income like rent, dividends, or profits from investments.

Adjust for Allowable Deductions:

Subtract any allowable deductions. These can include certain expenses, such as mortgage interest, educational expenses, or contributions to retirement accounts, depending on jurisdiction-specific tax laws.

Include Additional Income:

Add any other applicable sources of income, like social security benefits, interest, or earnings from a side business.

Apply Credits and Exemptions:

Subtract any tax credits or exemptions for which you are eligible. Tax credits might be available for certain types of investments, educational expenses, or energy improvements.

Subtract Prepayments and Withholdings:

Deduct any taxes already paid during the year through withholding or estimated tax payments.

Computation in a Specific Context (e.g., Pakistan):

In the context of Pakistan, the following approach is commonly used to compute taxable income, though it’s essential to refer to the most recent and relevant tax laws and guidelines from the Federal Board of Revenue (FBR) due to potential changes:

Income Accumulation:

Aggregate income from all the sources: salary, business income, income from property, capital gains, and other sources.

Deduct Allowable Expenses:

Deduct allowable expenses and deductions, such as specific deductions available on certain types of income like donations, investments, or education expenses.

Account for Losses:

Adjust for any losses carried forward from prior years if applicable, such as business losses or capital losses.

Compute Taxable Income:

Calculate the net taxable income by subtracting the total of deductions and allowances from the total income.

Apply Tax Rates:

Use the applicable tax rates (as per the tax slabs and rules defined by the FBR) on the net taxable income to calculate the tax liability.

Deduct Tax Credits:

Deduct any available tax credits or rebates, and account for any taxes already paid or withheld during the fiscal year.

Determine Tax Liability:

The resultant figure is the tax liability for the year, which could either be a payable amount or a refund, depending on taxes previously paid.

This process can be complex and subject to specific rules and regulations. Remember that tax laws and applicable rates can change, so always refer to the most recent tax codes or a tax professional when preparing a tax return.

Who is person?

In the context of taxation, the term “person” is typically defined in a broad sense and it can include various entities subject to tax. The precise definition can vary from one jurisdiction to another, but generally, “person” might encompass:

Individuals:

This refers to natural persons, such as yourself or any other individual taxpayer.

Corporations:

This includes businesses or other entities that are treated as separate taxable entities.

Partnerships:

This includes entities where two or more persons engage in a business venture and share profits, losses, and responsibilities.

Trusts and Estates:

These are entities where assets are held on behalf of beneficiaries or are in the process of being settled due to a person’s death.

Limited Liability Companies (LLCs) and Other Business Entities:

Depending on the jurisdiction, other types of business entities may also be treated as a “person” for tax purposes.

Government Organizations and Non-Profit Entities:

Sometimes, local government organizations or non-profit entities might be considered a “person” in tax contexts.

Associations:

This might include clubs, organizations, or bodies of persons, whether incorporated or not, depending on the local tax regulations.

Each of these “persons” may be subject to different rules and regulations regarding taxation depending on the jurisdiction. Tax laws often establish different tax rates, obligations, exemptions, and incentives based on the type of “person” and the activities in which they are engaged. Always refer to the specific tax legislation of the jurisdiction in question for detailed and applicable definitions and rules.

RESIDENTIAL STATUS

A person shall be a resident in Pakistan for a tax year if the person is:

i.                     A resident individual, resident company or resident association of persons for the year; or

ii.                   The Federal Government.

iii.                 A person shall be non-resident person for a tax year if the person is not a resident person for that year.

A very important point to note is that residential and non-residential status of any person is to be determined in respect of each tax year as it may change from year to year. A person can be resident in tax year 2024 (01 July 2023 to 30 June 2024) but may be a nonresident in tax year 2025 (01 July 2024 to 30 June 2025).

Resident Individual

An individual shall be a resident individual for a tax year if the individual:

a) is present in Pakistan for a period of, or periods amounting in aggregate to,183 days or more in the tax year;

b) is an employee or official of the Federal Government or a Provincial Government posted abroad in the tax year.

c) A citizen of Pakistan who is not present in any other country for more than 182 days during the tax year or he is not a resident taxpayer of any other country.

Note: The amendment is made basically for those Pakistani citizens who do not stay in one country for 182 days and remain non-resident for all the countries they reside during the year.

Rules for Calculating Days of Stay in Pakistan:

General Day Count: Every day or part of a day when a person is in Pakistan counts as a full day. This includes both the arrival and departure days. Specific Days Counted as Full: Public holidays are counted as a full day. All types of leave days (e.g., general and sick leave) are counted as full days. Days with interruptions to work in Pakistan (due to strikes, lock-outs, or supply delays) are counted. Holidays taken before, during, or after working in Pakistan are also counted. Exclusion for Transit Days: Days spent in Pakistan solely for transit (i.e., traveling between two different countries) are not counted. Explanation in Simpler Terms: Counting Days: Every day you’re in Pakistan, even if only for a bit, counts as one day. The day you come and the day you leave both count as days you’re in Pakistan. Full Days Count in Certain Situations: If you’re in Pakistan on a public holiday, it counts. Any day you take off work, like sick days, counts too. Days when you can’t work because of things like strikes or not getting supplies also count. If you take a holiday while working in Pakistan, those days count too.

Not Counting Transit Days:

If you’re just passing through Pakistan to get to another country, those days don’t count. This summarization provides a straightforward understanding and simplification of the original text regarding tax residency day counting in Pakistan. Always consult a tax professional or legal advisor to ensure accurate adherence to taxation rules.

Resident Company

A company shall be bestowed with the status of a resident company within Pakistan for a specified tax year provided it adheres to one or more of the following stipulations:

i. Incorporation Compliance:

The entity is instantiated or formulated by or in accordance with any prevailing legislative framework within the Islamic Republic of Pakistan.

ii. Locality of Control and Oversight:

The nexus of control and administration pertaining to its activities and affairs is unequivocally situated within the territorial demarcation of Pakistan at any juncture during the tax year.

iii. Affiliation with Provincial or Local Governance:

The entity is a Provincial Government or a Local Government within Pakistan.

Determination of Residential Status for Associations of Persons in Pakistan (Section 84)

An Association of Persons shall be designated as a resident association for a tax year in the event that:

Situation of Control and Management:

The oversight and management concerning the affairs of the association manifest in either an absolute or partial capacity within the confines of Pakistan at any temporal point during the tax year.

Professional Explanation:

Residential Categorization of Companies:

A company shall be denominated as a resident for tax implications in Pakistan contingent upon its incorporation or formation under Pakistani legal statutes,

Or should the entirety of its operative management and oversight be stationed within Pakistan during any period of the tax year,

Or in circumstances where it constitutes a segment of the Provincial or Local Government within Pakistan.

Residential Categorization of Associations of Persons:

An association shall be distinguished as a resident association of persons for taxation obligations within Pakistan should the control and management of its affairs, at any instance within the tax year, be stationed wholly or partially within the territorial boundaries of Pakistan.

Heads of Income

There are generally five heads of Income

Income from Salary

Income from Proporty

Income from Business(Gain from business)

Income from Capital Gain

Income from Other Source