When VAT ceases to be VAT—I Distorting & mutilating value added taxation

Pakistan’s principal consumption levies are called ‘sales tax’, but constitutional competence is divided: the federation taxes goods, while the provinces tax services. FBR also administers tax on specified services in Islamabad Capital Territory under separate federal legislation. Courts, tax administrators and practitioners routinely describe both the federal and provincial levies as value added taxes (VAT). The description matters. VAT is not merely another name for a tax imposed on a sale or service; it is a system with an internal logic. Once that logic is abandoned, the law may retain expressions such as ‘input tax’, ‘output tax’ and ‘tax invoice’, but the levy ceases, in substance, to operate as VAT.

Pakistan began with a conventional sales tax. According to the Federal Board of Revenue’s own historical account, it was provincial at independence, became federal in 1948 and was permanently transferred to the centre in 1952. The shift towards VAT came with the Sales Tax Act, 1990. After the Constitution (Eighteenth Amendment) Act, 2010, Entry 49 expressly excluded sales tax on services. Today the federal Act covers goods; the Islamabad Capital Territory (Tax on Services) Ordinance, 2001 covers specified ICT services; and the provinces levy their taxes under the Sindh Sales Tax on Services Act, 2011, Punjab Sales Tax on Services Act, 2012, Khyber Pakhtunkhwa Sales Tax on Services Act, 2022 and Balochistan Sales Tax on Services Act, 2015. These are legally distinct sales taxes, not one national VAT administered through one return.

VAT is a tax on final consumption, collected in instalments as goods and services pass through the production and distribution chain. Each registered person charges output tax on taxable supplies and deducts the input tax paid or payable on business purchases/services. The difference is deposited with the treasury. Where admissible input tax exceeds output tax, the excess must either be refunded or carried forward according to law.

The mechanism can be understood through a simple example. Suppose raw material worth Rs.100 is sold with sales tax of Rs.18. A manufacturer adds value of Rs.50 and sells the finished product for Rs.150 plus tax of Rs.27. The manufacturer does not pay Rs.27 again. After deducting input tax of Rs.18, the net liability is Rs.9. If a wholesaler adds Rs.30, the tax on the selling price of Rs.180 becomes Rs.32.40; after credit of Rs.27, only Rs.5.40 is payable. A retailer adding another Rs.20 sells for Rs.200 plus tax of Rs.36 and deposits Rs.3.60 after adjustment.

The treasury ultimately receives Rs.36: exactly 18 percent of the final value of Rs.200. The consumer bears the burden, while each intermediary accounts only for the tax attributable to the value added at that stage. Tax does not accumulate upon tax. This is what gives VAT its neutrality.

The Sindh High Court explained VAT philosophy with exceptional clarity in Pakistan Beverage Limited v Large Taxpayer Unit (2010 PTD 2673). Its reasoning, reproduced in Waseem Ahmed v Federation of Pakistan (2014 PTD 1733), emphasised that every intermediate transaction has a dual character: tax charged by the seller is output tax, while the same amount becomes input tax for the buyer. These are two sides of one transaction.

The Court held that output-input adjustment is “of the essence of the tax”. Without that adjustment, or an equivalent mechanism, the levy ceases to be VAT. The Supreme Court subsequently approved this description in Commissioner Inland Revenue v Arco Spinning and Weaving Mills Ltd (2021 SCMR 1308).

This is not an accounting concession granted to a taxpayer. It is the legal machinery through which tax is restricted to value addition and transferred towards the final consumer. At federal level, section 7 of the Sales Tax Act, 1990 permits deduction of qualifying input tax; section 10 deals with refunds or carry-forward; and section 23 connects the supplier’s output with the recipient’s input through the tax invoice. Provincial statutes likewise recognise output tax, admissible input tax, periodic returns and invoices, although restrictions vary. These provisions are structural, not ornamental.

The Supreme Court reinforced this position in Commissioner Inland Revenue v Attock Cement Pakistan Ltd (2023 SCMR 279), examining purchases, output tax, input adjustment, returns and the monthly tax period. More recently, in Commissioner Inland Revenue v Mayfair Spinning Mills Ltd (2025 SCMR 1), it treated section 7 as a beneficial provision central to VAT. Input tax on raw material intended for taxable supplies was not lost merely because the material was later destroyed by fire.

There is another commercial feature of sales tax that deserves attention. Tax collected from customers does not ordinarily move into the treasury at the instant of every sale. It enters the common cashflow of the business and remains there until the statutory payment date. Long before the modern invoice-credit VAT emerged, courts in the subcontinent recognised this reality. In George Oakes (Private) Ltd v State of Madras, the Supreme Court of India observed that tax collected by a dealer was kept and turned over in business before being paid to the government; for that period, it became part of the trader’s circulating capital. The reasoning is reproduced in Delhi Cloth and General Mills Co Ltd v Commissioner of Sales Tax ([1969] 23 STC 419 (MP)).

This does not mean that collected tax is the trader’s income or that the trader becomes its beneficial owner. It remains a statutory liability. Commercially, however, the receipt passes through the business’s operating funds until the net liability for the tax period becomes payable. VAT legislation recognises this timing through periodic returns and net settlement rather than requiring instantaneous deposit of gross tax on every invoice.

An importer pays sales tax upfront, tying up funds in inventory until sale permits input adjustment. Manufacturers finance tax on raw materials; zero-rated exporters depend on prompt refunds; service providers face the same working-capital burden on business inputs. Pakistan’s constitutional division creates another fault line: a provincial service provider may bear federal tax on goods, while a manufacturer may bear provincial tax on services. Credit depends on the rules of the particular jurisdiction. If a legitimate cross-jurisdiction input is denied, tax becomes cost, enters the next price and cascades.

A delayed refund in VAT mode is not an administrative inconvenience. It converts a tax on consumption into an involuntary loan extracted from a producer or exporter. An arbitrary restriction on input credit produces the same economic damage. The denied tax becomes a business cost, enters the price of the next supply and creates cascading—the very evil VAT was designed to eliminate.

The invoice performs an equally vital function. A genuine purchaser demands it because the document carries a fiscal asset: the right to input adjustment. The seller’s output tax and the buyer’s input tax should match, creating an evidentiary chain across the economy. VAT can consequently generate its own compliance trail, provided the administration protects legitimate credits while acting against fraudulent invoices through due process.

Pakistan’s sales taxes, at both federal and provincial levels, have progressively moved away from this model. Federal exemptions and special regimes, provincial reduced or fixed rates without input adjustment, minimum value-addition requirements, inadmissible inputs, delayed refunds and collection devices outside the ordinary invoice-credit chain have altered neutrality and cashflow. The most consequential common departure is sales tax withholding, under which purchasers, banks, government bodies and other withholding agents divert part—or sometimes effectively all—of the tax directly to the treasury.

The federation applies withholding through the Sales Tax Special Procedure (Withholding) Rules, 2007; each province operates its own machinery. Limited, risk-based withholding can coexist with VAT. Pervasive withholding on gross transactions cannot be presumed neutral: it removes funds before net liability, input credits and refunds are determined. Across five administrations it also multiplies returns, deposits, reconciliations and audits, disconnecting collection from value addition and converting a self-adjusting consumption tax into an advance collection regime.

Part II will examine these federal and provincial withholding regimes and their economic consequences. The governing test has already been supplied by our courts: input-output adjustment is not a favour to taxpayers; it is the essence of VAT. A tax cannot remain VAT merely because its return contains boxes labelled ‘input’ and ‘output’. When credit, neutrality, the supply chain and destination-based consumption are displaced, the label survives—but the substance is gone.

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Dr. Ikramul Haq, Advocate Supreme Court, writer, literary critic, Adjunct Faculty at Lahore University of Management Sciences (LUMS), member Advisory Board and Visiting Senior Fellow of Pakistan Institute of Development Economics (PIDE), holds an LLD in tax laws. He was full-time journalist from 1979 to 1984 with Viewpoint and Dawn. He also served Civil Services of Pakistan from 1984 to 1996.