How to Classify Different Types of Incomes?

Understanding Pakistan’s tax system is crucial for both individuals and businesses. A key aspect involves recognizing how income is classified and how related expenses are treated. Income is categorized under various “heads,” each with specific rules. Furthermore, when expenses relate to multiple income sources, a systematic method called apportionment is required for fair tax calculation. This guide provides comprehensive insights into both the heads of income and the rules for apportioning expenses in Pakistan.

Major Heads of Income for Tax Purposes

The Pakistani tax system classifies income under the following main categories:

1. Salary Income: This is perhaps the most common head for individuals, encompassing all remuneration received from employment in the public or private sector. It includes basic wages, bonuses, allowances, perquisites, and any other compensation for services rendered as an employee.

2. Business Income: This category covers profits earned by individuals or entities from commercial or professional activities. It includes income generated from trade, manufacturing, services, or any other business venture. Taxable business income is calculated after deducting allowable business expenses according to applicable tax rates.

3. Rental Income (Income from Property): This refers to income earned from renting out owned properties, whether residential, commercial, land, or other real estate assets. The tax treatment can vary based on the property’s nature and usage.

4. Capital Gains: These arise from the profit made on the sale or disposal of capital assets like real estate, stocks, bonds, or other investments. Taxation of capital gains in Pakistan depends on factors such as the type of asset and how long it was held (holding period).

5. Dividend Income: This is the income shareholders receive when companies distribute profits. Dividends can be paid in cash or as additional shares. Dividend income is subject to tax, though certain exemptions or tax credits might apply under specific regulations.

6. Income from Other Sources: Any income that doesn’t fall neatly into the above categories is classified here. Examples include income from investments (not qualifying as capital gains or dividends), royalties, prizes, awards, or winnings. These are taxed according to relevant laws.

   

Apportioning Expenses Across Income Classes: Understanding Rule 13

While classifying income correctly is the first step, accurately determining taxable income also requires proper handling of expenses. When expenditures, deductions, or allowances are incurred for generating income under multiple heads or classes, Rule 13 of the Income Tax Rules, 2002 (read with Section 67 of the Income Tax Ordinance, 2001) provides a systematic method for apportionment. This ensures costs are fairly distributed across the relevant income streams.

How Rule 13 Works?

1. Direct Allocation: Expenditures incurred exclusively for earning income under a specific class must be allocated entirely to that class. For example, repairs specific to a rental property are allocated solely to “Income from Property.”

2. Allocation of Common Expenditures: For expenses that benefit multiple income classes and cannot be directly attributed (e.g., general office administration, utilities), Rule 13 prescribes a formula:

   Apportioned Expense = A x B / C

   Where:

   • A = The total amount of the common expenditure incurred.
   • B = The total gross receipts (turnover/sales, excluding sales tax/FED) for the specific class of income being calculated for.
   • C = The total gross receipts (turnover/sales, excluding sales tax/FED) and net gains for all classes of income to which the common expenditure relates.

   Note: For apportioning expenses related to brokerage, commission, etc., the calculation for ‘B’ and ‘C’ uses gross profit instead of gross receipts.

Classes of Income for Apportionment under Rule 13

Rule 13 defines specific “classes of income” for apportionment purposes, distinguishing between Pakistan-source and foreign-source income where applicable:

• Salary (Pakistan-source / Foreign-source)
• Income from Property (Pakistan-source / Foreign-source)
• Income from Business (Pakistan-source / Foreign-source – excluding Presumptive Tax Regime income under Section 19)
• Speculation Business (Pakistan-source / Foreign-source)
• Capital Gains (Pakistan-source / Foreign-source)
• Income from Other Sources (Pakistan-source / Foreign-source)
• Exempt Income

Key Considerations for Apportionment

• Nature of Income: The allocation basis should reasonably reflect the effort and activities involved in generating each income class. Selling expenses, for instance, should align with revenue generation.
• Common Expenditures: Defined as general/administrative costs not directly tied to a single income class.
• Certification:
  • For businesses with audited accounts, a certificate from a Chartered Accountant (CA) or Cost and Management Accountant (CMA) detailing the allocation basis is required and generally accepted if variances are within ±10%.
  • For unaudited accounts, a reasonable allocation basis must be adopted and approved by the Commissioner, again subject to scrutiny if variations exceed ±10%.
• Documentation: Maintain clear records supporting the allocation methodology.
• Reasonableness: The allocation must be fair and justifiable.
• Exclusions: Financial expenses related to non-business loans or advances are typically excluded from this apportionment process.
• Gross Receipts: Defined as net-off receipts/turnover, excluding sales tax or Federal Excise Duty (FED) paid.