Tax on Undistributed Reserves

The Finance Act 2015 has introduced a tax on undistributed profits.

 According to the new provision tax at the rate of 10% of undistributed profits (deeming it to be taxable income) has been imposed on public companies, other than a scheduled bank and modaraba, that derive profits in a tax year but do not distribute a certain amount of profit for year as cash dividend within 6 months of the end of the year. The exact wording of the legislation for reference is as under:

 ‘5A. (1) Subject to this Ordinance, a tax shall be imposed at the rate of ten percent, on every public company other than a scheduled bank or a Modaraba, that derives profits for a tax year but does not distribute cash dividends within six months of the end of the said tax year or distributes dividends to such an extent that its reserves, after such distribution, are in excess of hundred percent of its paid up capital, so much of its reserves as exceed hundred per cent of its paid up capital shall be treated as income of the said company.

 Provided that for tax year 2015, cash dividends may be distributed before the due date mentioned in sub section (2) of section 18, for filing of return for tax year 2015.

 (2) The provisions of sub-section (1) shall not apply to—

 (a) a public company which distributes profit equal to either forty per cent of its after tax profits or fifty per cent of its paid up capital , whichever is less, within six months of the end of the tax year. ———– “

 Financial statements of companies with reporting period 30 June are currently being finalised and in order to provide consistent accounting treatment in the financial statements arising out of the above provision, the relevant Committee of the Institute has examined and provides its view on the accounting for the effects of tax incidence in relation to the aforesaid newly inserted Section 5A of the Income Tax Ordinance, 2001 by the Finance Act, 2015 on the subject of tax on undistributed reserves from tax year 2015.

 The legislation provides for its applicability only in cases where the prescribed company derives profits for a tax year but does not distribute cash dividends up to a prescribed amount (called ‘the Requisite Dividend’) within six months of the end of the tax year, and in respect of tax year 2015, an extended period of time (together called ‘the Requisite Time’).

 Considering that the companies at the end of their financial year are not legally obligated to tax unless the Requisite Time for payment of the Requisite Dividend has elapsed which is the key determinant for the taxation of the reserves in the given scenario; the recognition of any liability in this respect as at the financial year end is not considered necessary keeping in view the underlying substance. Accordingly, any liability in this respect should only be recognised when the Requisite Time expires without the company having distributed the Requisite Dividend.

 Adequate disclosures should be made in the financial statements where the Requisite Dividend has not been distributed by the year end but requisite dividend is proposed at the time financial statements are authorized for issue and where Undistributed Reserves are in excess of 100% of the paid up capital.

 Members are advised to take guidance from the above.

Circular 6 of 2015 -Tax on Undistributed Reserves