The government levies a 40% tax on windfalls. Analysts say the move will hurt the banking sector

• The government aims to widen its revenue base through new tax rules for banks.
• It also wants to punish lenders involved in currency speculation.
• Analysts predict the government’s new measure will further hurt banks.

KARACHI: Banks will now have to pay 40% tax on windfall income from foreign exchange transactions in the past two years, according to rules issued by the caretaker government, The news reported on Thursday.

The government’s decision, announced on Wednesday, was taken to widen its revenue base and punish lenders involved in massive currency speculation.

The development also comes as the government expects to secure the International Monetary Fund’s $700 million tranche of its existing loan program following the completion of its first successful review.

The Fund’s executive board is likely to approve the staff-level agreement with Islamabad on the first review of the $3 billion stand-by agreement early next month.

It is thought that the government implemented this tax to satisfy the IMF and demonstrate to the global lender that it was committed to raising tax revenue.

Pursuant to subsection (2) of section 99D of the Income Tax Ordinance 2001, the Government has decided to tax the windfall profits of banks for the years 2021 and 2022, based on a specific tax rate specified in the statutory regulatory order (SRO) which issued by the Federal Board of Revenue (FBR).

The tax authority in its SRO explains the work to be applied to calculate the 40% tax on banking windfalls on foreign exchange trading income, JS Research said in a note.

“The work incorporates an arithmetic mean of foreign exchange revenue from 2015 and calculating windfalls above the average. The tax will likely be reduced in Q4 2023 as it is due to be paid by November 30, 2023,” it said.

Analysts at Optimums Research estimated that banks’ forex trading in 2021 and 2022 generated a windfall of Rs 87.948 billion. About Rs 35.18 billion in taxes will be collected from the banks during these two years.

The Pakistani rupee’s extreme volatility and record lows against the US dollar last year led authorities to suspect manipulation by banks and exchange firms.

The country’s currency crisis had created high volatility in the local currency, which resulted in large windfalls for banks as lenders engaged in currency speculation.

The previous coalition government considered taxing banks’ foreign exchange windfall profits last year, but the idea was scrapped.

By approving a 40% tax on bank windfalls from foreign exchange transactions last week, the federal cabinet dealt a surprise blow to the country’s banks and sent shockwaves through the industry.

Why do they tax banks?

Analysts predict this new measure will further hurt banks, which are already subject to astronomically high taxes on their profitability.

However, the former central bank governor said that banks have made windfalls in Pakistan not only from their foreign exchange dealings in recent years, but mainly from the opportunity provided to them for a long time by the government and the State Bank of Pakistan to do effortless and risk-free “financial intermediation” between them.

Former SBP governor Dr Muhammad Yaqub said the central bank of Pakistan—and the IMF which remained engaged in policymaking with the Pakistan government for many years—forgot that the central bank’s discount window is meant to cover temporary and reversible liquidity needs of banks or is used by central banks as a monetary policy instrument to inject or remove liquidity from the banking sector.

However, in Pakistan in recent years, the SBP has kept it open for banks to generate liquidity and engage in risk-free lending to the government and thereby reap huge profits — and in the process neglect their key role in mobilizing deposits from private savers and risk lending to the private sector, he said.

“Regardless, there is no doubt that in Pakistan banks have earned windfall profits and made bank owners extremely rich. Such profits should indeed be taxed in countries where the tax system is fair and ensures horizontal and vertical fairness,” said Yaqub.

“In Pakistan, the FBR is used to recommending taxes based on ease of collection rather than sound fiscal principles. There are so many segments of the economy which are making windfalls but have not been brought into the tax net by the FBR. For example, the vast agricultural sector is kept out of the tax net. Several other sectors of the service sector are not subject to taxation.”

The vast informal sector of the economy escapes taxation. In such an unfair context, additional taxation of banks, which already pay high taxes, will make the tax system more unfair and in the process retard the growth of an industry that should be used as an important means of savings and investment. according to Yakub.