Labyrinth Part 1

The Sorry Salon

In Greek Mythology, The Labyrinth in Crete was home to a fearsome minotaur. Every year 7 young Athenian men and women were sacrificed to the minotaur to keep the beast at bay.

Many Pakistani business owners find themselves trapped in a similar predicament with the FBR filling the role of the mythical beast and Pakistan’s ever changing and increasingly ambiguous tax laws acting as the labyrinth which business owners must traverse simply to stay afloat.

Over the years and beholding to a diverse set of interest groups, the tax code has mutated into a sometimes unenforceable and a sometimes-comical tangle of conflicting incentives and deterrents.

This is the first in a three part story of how three Pakistani business navigate this labyrinth.

Vera Spa

Vera Spa is an up-and-coming salon in the upscale suburbs of Islamabad catering to the city’s socialites and busy professionals. The salon has enjoyed rapid growth in the past couple of years. Initially the salon traded as a sole proprietorship under a different name. Initially the business paid taxes at a rate of 12% on an annual income of three million. This wasn’t that much of a burden and filing was a straightforward process. However, in the last 2 years, the cost of electricity doubled, most of the products and equipment used in the salon was imported. Not only did these items triple in cost due to heavy devaluation of the rupee but they became increasingly scarce. The salon also had to increase salaries so employees could keep up with sky rocketing inflation. Despite all these challenges the salon did well and by the end of 2023 had tripled its pretax profits to almost 10 million a year. This also meant that based on Pakistan’s progressive income tax rates, the salon was taxed at almost 26%, almost the same as large muti national corporations with Billions of rupees in revenues. The owner was wary of opening a new location as additional profits could take the business into the realm of paying 30% income tax rates on total profits, impacting the viability of new salons.

Thus, using a newly created category of small companies in the tax code, the owner dissolved the business and incorporated a new corporate entity as Vera Spa (Pvt) Limited. As a small company the company paid a fixed rate of 20% on all income. On top of that the owners could afford to pay themselves a salary which was tax deductible for the business and infact even taken out a loan from the company for personal use which didn’t attract any tax obligations. This worked very well, and Vera Spa was able to open 3 new locations without worrying about an escalating tax burden. However, to qualify to be a small company the revenue needed to be below 100 million rupees, otherwise the tax rate would increase to 29%. When the time came to open a fourth location, the owner decided to open it under a new small company registered for this purpose. This worked very well and as the business grew the owners simply opened more small companies. Although dividends from these companies were further taxable, at 15%, the owners never took out any dividends. Instead, they simply took out loans from the businesses to fund their living expenses, a transaction that attracted no tax implications.

However, all was not rosy. This convoluted structure substantially increased the cost of compliance and filings for these companies. At one point the accountants got exhausted filing 12 different sales tax returns and income tax returns at the end of each month. Furthermore, all the companies had to have different bank accounts, which became a hassle to manage. Instructions to pay vendors and payroll had to go out to several banks simultaneously while ensuring that all banks had sufficient funds to pay. The owners also soon realized that businesses of a similar size could attract investors and approach banks to borrow to further grow their business, but their convoluted legal structure of several independent small companies, most with loans to their owners did not lend itself much credibility in front of investors and banks. This limited their access to capital. They had considered changing this on several occasions, but the tax hike was simply too much to stomach.

Their business trudged on like a barely functional automobile haphazardly assembled from an assortment of appliances and car parts, waiting for the day when rationality would resume.