Last Friday, Pakistani authorities released their fiscal 2019 (which ends June 2019) federal budget, which includes a one-year extension of a 4 percent special tax on banks’ taxable income. The tax extension is credit negative for Pakistan’s banks because until it fully expires after 2021, it will continue to weigh on banks’ profits and add to ongoing profitability challenges.
Pakistani authorities first imposed the tax in 2015. The tax equals 4 percent of banks’ taxable income for the last accounting year and is imposed on banks’ semi-annual results. The special taxation was one of a number of changes on banks’ taxation, including the 2015 imposition of a uniform tax rate of 35 percent on all sources of income (including dividends and capital gains). Together, these taxes impose a high effective tax rate on banks of around 39 percent, which has been a drag on their earnings. (In 2015, Pakistan imposed a 3 percent special tax on corporations with income of more than RS.500 million, but the new budget introduced a gradual reduction in the corporate tax rate to 25 percent by the 2023 tax year from 30 percent for the 2018 tax year.)
The taxes on banks’ earnings have added to banks’ ongoing profitability challenges and narrowing margins from lower yields on government securities (in which the banks invest roughly half of their balance sheet) and one-off costs, including higher pension costs. Pakistan’s Supreme Court in February ordered banks to raise the minimum monthly pension to retired employees to RS. 8,000 and to apply an annual 5 percent increase starting in January 2019.
We expect all rated Pakistani banks to be affected by the tax extension, which we estimate will lower the banks’ return-on-equity ratios by approximately 1 percent. MCB Bank Limited (B3 stable, b34) and Allied Bank Limited (B3 stable, b3) are better positioned to absorb the negative effects, given their stronger profitability and capitalization (see Exhibits 1 and 2). However, as part of the budget, the authorities for the first time announced the gradual phasing out of the tax by one percentage point annually beginning in fiscal 2019. Once fully eliminated after 2021, the banks’ effective tax rate will return to around 35 percent.
The budget announcement also included authorities’ planned increase in borrowings from banks, which are a major source of financing for the government. Authorities’ project their borrowing from banks will increase by more than 70 percent to more than RS.1 trillion, which suggests that banks likely will increase their appetite for government securities (amid potentially rising interest rates) at the expense of lending to the private sector.