Charging of excess profit tax on bank companies and computation base: Some fallacies

--Abdullah - Al - Mamun ACA

The objective of this article is to clear the concept of reserve from the viewpoint of general accounting norms, which is used as a strong base along with capital for a bank company to pay excess profit tax as per Section 16C of Income Tax Ordinance 1984. The article also try to justify whether the statutory reserve should only (it is supported by Bangladesh Bank by its Explanation issued on 07 March 2011) be considered as the base for calculation of excess profit tax or all other reserves which also created by bank out of post-tax profit are to be considered. The intention of the Writer is not to criticize the regulators but to draw their attention to consider such fallacies and take reasonable steps to resolve those so that bank companies can get the reasonable treatment regarding charging of excess profit tax.

Charging of excess profit tax: An overview

The concept of charging excess profit tax to bank companies introduced first time in the Income Tax Ordinance 1984 through Finance Act 2002. As per Section 16C of Income Tax Ordinance 1984 (hereinafter referred to as Ordinance),  a banking company operating under Bank Company Act 1991, shows profit in its return of income for an income year at an amount exceeding fifty percent (50%) of its capital as defined under the said Act together with reserve, the company, in addition to tax payable under this Ordinance, shall have to pay an excess profit tax for that year at the rate of fifteen percent (15%) on so much of profit it exceeds fifty percent (50%) of the aggregate sum of the capital and reserve as aforesaid.

If we critically analyze the provision of Section 16C of the Ordinance, we will see that Bank Company Act 1991 is referred to determine the capital component only not the reserve. This view also supported by the Paripatra issued by National Board of Revenue (NBR) in 2002 for making clarification of the provision of new Section (i.e. Section 16C) inserted in the Ordinance.  The intention of NBR at that time was very clear that they would use their own professional judgment to determine the reserve for calculation of excess profit tax.

Basis for calculation of excess profit tax

As per Section 16C of the Ordinance, the following two components of a bank company used as the base for calculation of excess profit tax:

1.            Capital defined under the Bank Company Act 1991 and

2.            Reserve

Capital defined under the Bank Company Act 1991

The Section 5 of Bank Company Act 1991 deals with Definition. However, under this Section, no definition of Capital is given. Under Section 13 of this Act, also, no definition of Capital is given but the definition of “Risk-based Capital” is given. As per Section 13(2) of the Act, the paid up capital and statutory reserve of a bank company shall not be less than one hundred crore Taka (time to time increase by BB, now this amount is four hundred crore Taka), or the amount equivalent to the risk based capital that determined from time to time by the Bangladesh Bank (BB), whichever is higher.

At the end of Section 13 an explanation is given. In this explanation the definition of “Risk-based Capital” is given. As per the explanation of Section 13, Risk-based Capital means the capital required to be kept, according to the rate fixed by BB, against the total property assessed based on weighted risk on the assets of the bank concerned.

Base to be used for calculation of excess profit tax

Now the question is which capital is to be used for calculation of excess profit tax: “Paid up Capital” or “Risk-based Capital”. If we analyze the provisions of Bank Company Act 1991, we will not get a conclusive answer.

If we use our professional judgment, the answer will be Paid up Capital. Because the concept of Risk-based Capital used by BB for a special reason i.e. protecting the interest of depositors. The rationale of this concept is, bank is doing business mostly on the depositors’ money. So, as a regulatory authority it is the duty of BB to regulate bank companies for the betterment of depositors. More specifically, regulate bank companies from misuse of depositors’ money. To protect the interest of depositors, BB instructed bank companies to keep a certain amount of money against their risk-weighted assets. Currently, the capital adequacy ratio is 10% based on the risk-weighted assets.

To support Paid up Capital as the base for calculation of excess profit tax, BB issued an “Explanation” dated 07 March 2011.

Reserve – another base for calculation of excess profit tax

As mentioned earlier, Section 16C of the Ordinance referred to Bank Company Act only for Capital not for reserve and this view also supported by the Paripatra issued by NBR on 2002.

In financial accounting, the term reserve is most commonly used to describe any part of shareholders’ equity, except for basic share capital. Reserve is the profit achieved by a company where a certain amount of it is put back into the business that can help the business in their rainy days. There are different types of reserves used in financial accounting like capital reserves, revenue reserves, statutory reserves, realized reserves, unrealized reserves.

Creation of reserve

Equity reserves are created from several possible sources, which are as follows:

r              Reserves created from shareholders’ contributions, the most common examples of which are:

t              Legal reserve fund – it is required in many legislations and it must be paid as a percentage of share capital.

t              Share Premium – amount paid by shareholders for shares in excess of their nominal value.

r              Reserves created from profit, especially retained earnings, i.e. accumulated accounting profits, or in the case of nonprofit making organization, operating surpluses. However, profits may be distributed also to other types of reserves, for example:

t              Legal reserve fund from profit – many legislations require creation of the fund as a percentage of profits. In Bangladesh, as per the Section 24 of Bank Company Act 1991, a bank company shall have to transfer not less than 20% of its profit before tax to “Statutory Reserve Fund” in each year until the sum of statutory reserve and share premium will be equal to the paid up capital of the bank.

t              Remuneration reserve – will be used later to pay bonuses to employees or management.

t              Dividend equalization reserve – will be used later to pay dividend to shareholders in a consistent manner. According to BRPD Circular Letter No. 18 dated 20 October 2002, in case of declaring dividend in cash at a higher rate i.e. more than 20%, a sum equal to the amount of dividend in excess of 20% shall have to be transferred to the Dividend Equalization Reserve Fund, which shall be treated as “Core Capital” of the bank.

t              Translation reserve – arises during consolidation of entities with different reporting currencies.

t              General Reserve – created out of distributable profit to meet up various purposes as and when required, even it can be used to pay dividend to the shareholders.

Reserve mentioned in the Bank Company Act 1991

The Section 5 of Bank Company Act 1991 deals with Definition. However, under this Section, no definition of Reserve is given. Under Section 13 of this Act, also, no definition of Reserve is given. Under Sub-section 2 of Section 13, only the provision of statutory reserve is included along with paid up capital.

Again in Section 24 of this Act, only the requirement of maintaining statutory reserve is given. It is mentioned that a bank company shall have to transfer not less than 20% of its profit before tax to “Statutory Reserve Fund” in each year until the sum of statutory reserve and share premium will be equal to the paid up capital of the bank.

Therefore, the Bank Company Act 1991 makes discussions only on statutory reserve of a bank company not other reserves. The   rationale may be this Act want to provide more emphasis on this reserve to protect the interest of depositors. Based on this Act, BB provided an Explanation (dated 07 March 2011) to NRB and mentioned that reserve means only statutory reserve.    Although this Act makes discussion only on statutory reserve, it does not mean that a bank company does not have any other reserves. Of course, a bank company has other reserves i.e. retained earnings, share premium, dividend equalization reserve, and general reserve.

Base to be used for calculation of excess profit tax

Now the question is which reserves are to be used for calculation of excess profit tax: only “Statutory Reserve” or “other reserves e.g. retained earnings, share premium, dividend equalization reserve, and general reserve” will also be taken into consideration. If we analyze the provisions of Bank Company Act 1991, we will only get the statutory reserve.  However, this limitation of the Act has been addressed in the “Bank Company (Amendments) Act 2013”. As per Section 13(2) of the Bank Company (Amendments) Act 2013, reserve includes share premium, retained earnings, and statutory reserve.

If we use our professional judgment, the answer will be all reserves i.e. reserves created from shareholders’ contributions e.g. share premium and reserves created from distributable profit (i.e. post-tax profit) e.g. retained earnings, dividend equalization reserve, and general reserve.  The justification is, share premium is the contribution made by shareholders (most likely same as paid up capital) and all other reserves are created from distributable profit, more specifically out of post-tax profit.  If all reserves are considered, in many cases, additional tax would not be payable by the bank companies. Tax on tax profit is also unethical and irrational and contradicts with normal tax norms.

Observation and Recommen-dation

The writer is drawing kind attention to the regulatory authorities, specially, NBR and BB to consider the following issues:

r              Consideration of all reserves created from distributable profit for calculation of excess profit tax

Currently NRB (also supported by BB through its Explanation dated 07 March 2011) is considering statutory reserve only as the base for calculation of excess profit tax. All other reserves created from distributable profit (more specifically from post-tax profit) should also be considered. That is, retained earnings, dividend equalization reserve, general reserve and other reserves created from post-tax profit needed to be considered.

The limitation of Bank Company Act 1991 regarding inclusion of other reserves has already been addressed in the latest Bank Company (Amendments) Act 2013. As per Section 13(2) of the Bank Company (Amendments) Act 2013, reserve includes share premium, retained earnings, and statutory reserve.

r              Consideration of reserves created from shareholders’ contributions

The reserves created from shareholders’ contributions should also be considered as the base for calculation of excess profit tax. The most typical example of reserve created from shareholders’ contributions is share premium. It is very similar to paid up capital as per the source is concerned. Since paid up capital is considered as the base for calculation of excess profit tax, share premium should also be used.

Non-inclusion of share premium as a reserve was a limitation of Bank Company Act 1991. Such limitation has been duly addressed in the latest Bank Company (Amendments) Act 2013. Section 13(2) of the amended Act duly considered share premium as a reserve.

r              Definition of Capital and Reserve not given in the Act

The Bank Company Act 1991 does not provide any definition of “Capital” and “Reserve” in Section 5 (this Section is designed for Definition) of the Act and also not addressed in relevant Sections i.e. Section 13 and Section 24 of the said Act.

Moreover, the latest Bank Company (Amendments) Act 2013 also does not provide any definition of “Capital” and “Reserve” in Section 5 (this Section is designed for Definition) of the Act. In Section 13 of the Act, only the “Explanation of Capital” is given, which is not conclusive. Definition /Explanation regarding reserve has not also been addressed in Section 13 and 24 of the said Act.

In Section 5 of Bank Company (Amendments) Act 2013, a clear and conclusive definition regarding “Capital” and “Reserve” of a bank should be incorporated. These definitions may also be incorporated in Section 13 or Section 24 of the said Act in lieu of Section 5 of the Act. However, the definition of Capital” and “Reserve of a bank company may also be provided by BB through its Circular or Explanation.

r              All reserves are not included in the last Amendments of Bank Company Act

Under Section 13(2) of the latest Bank Company (Amendments) Act 2013, only share premium, statutory reserve and retained earnings are considered as reserve. The dividend equalization reserve, remuneration reserve, general reserve and other reserves crated out of distributable profit is not considered or recognized.

Since dividend equalization reserve, remuneration reserve, general reserve and other reserves are created from the same source like retained earnings and statutory reserve, these may also be included in the Bank Company (Amendments) Act 2013.

r              Amendments of Explanation issued on capital and reserve of a bank company

The Explanation issued by BB on 07 March 2011 regarding the capital and reserve of a bank company should be reconsidered. Most of the bank companies are now struggling for calculation of excess profit tax made by NBR based on the said Explanation. Most of bank companies’ assessment is pending due to not resolving the said issue.  It is needed to be amended as per the provision of Section 13(2) of the latest Bank Company (Amendments) Act 2013 and considering the norms regarding reserves mentioned in Financial Accounting.

r              No justification regarding payment of excess profit tax is given

The concept of charging excess profit tax to bank companies introduced first time in the Income Tax Ordinance 1984 through Finance Act 2002. However, no justification regarding charging of such additional tax to bank companies given by NRB through its Paripatra issued in 2002 or by any other means. The excess profit tax is nothing but the imposition of further tax on post-tax profit. Tax on tax profit is unethical and irrational and goes against the normal tax norms.

Banking Industry is providing taxes on income at the highest rate (except Tobacco and Telecom Industry); currently the tax rate is 42.5%.  Since banking industry is the largest taxpayer industry in Bangladesh, based on the current condition of the industry, NBR may reconsider the provision of imposing excess profit tax upon this industry.

Concluding Remarks

There is no difference between the reserves created and kept by other companies with those of bank companies. So, all kinds of reserves created from shareholders’ contributions (e.g. share premium) and reserves created from distributable profit (e.g. retained earnings, dividend equalization reserve, and general reserve) should be considered for calculation of excess profit tax for bank companies mentioned in Section 16C of Income Tax Ordinance 1984. It is quite arbitrary and unlawful when statutory reserve, general reserve, dividend equalization reserve, and retained earnings created from profit and only statutory reserve is considered for calculation of excess profit tax.  If these reserves are not considered, it will create huge tax burden upon the shoulder of bank companies.  The said reserves are also needed be incorporated in the latest Bank Company (Amendm ents) Act 2013.

In considering with the global meltdown, existing macro-economic condition, and volatile political environment in Bangladesh, NBR may reconsider the provision of imposing excess profit tax upon the banking industry. Most of the bank companies’ assessment is pending due to not resolving the excess profit tax issue. NBR may use the concept of reserve mentioned in financial accounting and may also use the components of reserves mentioned in the latest Bank Company (Amendments) Act 2013 to resolve the pending tax assessment of bank companies which has not yet finalized/ cleared due to dispute regarding calculation of excess profit tax.

However, Bangladesh Bank as the guardian of all bank companies in Bangladesh can play an instrumental role to resolve the pending tax assessment of bank companies by providing further Explanation of “Capital” and “Reserve” of a bank company.

The author is the faculty and Associate Member of ICAB and Senior Manager, Finance Division, Eastern Bank Limited