Tax shift hits VPS, aids equity funds

June 11, 2025 (MLN): Pakistan’s FY26 budget proposed a sweeping overhaul of savings-market taxation, ditching long-standing income-exemption benefits on Voluntary Pension Schemes (VPS) and reshaping the way mutual-fund dividends are taxed.

At the same time, the draft keeps capital-gains rules intact while introducing a proportional levy: dividends sourced from equity investments will be taxed at 15%, and those from debt instruments at 25%, calibrated to a fund’s average annual asset mix.

Corresponding changes to withholding-tax rules are on the table as well.

Mr. Mohammad Shoaib, CEO at Lucky Investment Limited, welcomed the intent behind the reform.

“These changes aim to encourage equity investments. The part of the fund allocated to equities will be taxed at 15%, while the portion invested in fixed-income sources will be taxed at 25%,” he told Mettis Global.

“It’s a good initiative, but implementation could be practically challenging,” he added. 

While supportive of the equity-side reform, Mr. Shoaib flagged a major concern over the removal of tax exemption on withdrawals from Voluntary Pension Schemes (VPS).

Previously, up to 50% of the retirement amount was tax-exempt; under the new budget, the entire amount, principal and profit, will be taxed upon withdrawal.

“This is a significant setback for long-term savings. Pakistan already has a low savings rate, and VPS was one of the few effective tools to encourage it,” he noted.

“This measure should be reversed in the Finance Bill to sustain retirement savings, which are crucial for economic progress,” he emphasised

Impact Analysis:

While the dividend tax reforms are seen as positive for the mutual fund industry, potentially boosting equity fund inflows, the pension tax change could trigger outflows.

Mr. Shoaib warned that up to Rs100 billion already invested in VPS could face withdrawals if the tax exemption is not reinstated.

Other industry officials are of the view that the overall tax framework for mutual funds, including capital gains and dividends, remains largely unchanged. However, two new elements raise questions:

• Proportional Taxation: For funds holding both equity and debt, the idea is to tax each portion at the relevant rate. But there is no clarity on how profit from bank deposits will be taxed.
• Custodian Confusion: The proposal mentions that custodians of debt securities other than PSX and NCCPL will now be responsible for withholding tax. But it is unclear whether this applies to currently tax-exempt mutual funds, especially since many use third-party custodians.

While the equity incentive is clear, the practical impact on investor behaviour and industry sentiment will remain muted until these ambiguities are resolved. 

The new tax measures may encourage greater participation in equity mutual funds, but removing the VPS tax exemption risks undermining the long-term savings culture.

In a country with already low saving rates, such schemes are essential for financial security and economic growth.

Reinstating VPS incentives in the final finance bill would be a step toward promoting disciplined, long-term investment behaviour.

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