By Amjad Javaid Hashmi Advocate Supreme Court
1. On the principal topic of basic legal framework of international taxation it is the 4th and the last article in the series. It would deal with the nature, purpose, structure, effect (use and abuse) and timing of enforcement of a double taxation treaty. According to the technical jargon employed U/s 107 of the Income Tax Ordinance (the Ordinance) it is titled as an “Agreement for the Avoidance of Double Taxation and Prevention of Fiscal Evasion”. By the time of writing this article the number of operative double taxation agreements between various countries in the world has crossed the mark of 2000.
2. In its essence a tax treaty reconciles the taxing rights of the two treaty partners on the basis of territorial source of income of a taxpayer or his/its physical residence or both. It is interesting to note that although it is the Federal Government of a country which enters into a tax treaty but contents of a treaty may, at times, cover even the provincial and local taxes as well.
3. Two key objectives of any modern tax treaty are (i) avoidance of double taxation of an income of a taxpayer attributable to two separate tax jurisdictions (ii) complementing and supplementing tax enforcement initiative of the treaty partners to help each other prevent any venture of tax evasion or avoidance by the unscrupulous taxpayer. It may also be appreciated that the terms of a tax treaty come into force only after the issuance of a formal gazette notification by the respective Federal Governments entering into a tax treaty.
4. A tax treaty has an over-riding legal effect. It means that in the event of inconsistency between the provision of a domestic law and the provision of a tax treaty, the provision of a tax treaty would prevail. It has five core functions: (a) being beneficial in character a treaty primarily provides relief (including exemption) from the tax payable under the domestic law (b) it stipulates to tax the income of a non-resident person to the extent of its Pakistan source income (c) it provides mechanism to assess the Pakistan related business operation in an extraordinary situation i.e. determining taxable income where a persons’ business operations span over multiple tax jurisdictions outside and within Pakistan. For the
purpose of such determination No only a non-resident person but his/its agents, branches and permanent establishment in Pakistan also come within such mischief (d) where a resident person is having any special relationship with a non-resident person the determination of income attributable of such special relationship for the purpose of taxing income of a resident person (e) it also ventures to exchange information about business/income transactions of a person resident of one tax jurisdiction but enjoying territorial source of income in another jurisdiction so as to prevent evasion or avoidance by way of any attempted suppression. 5. Section 107 of the Ordinance empowers the Federal
Government to enter into a tax treaty. It has already been stated that in its core effect it extends certain relief, concession or exemption to the non-resident person or classes of persons or classes of income. In the above context a question arises as to whether the constitutional validity of such relief, concession or exemption can be challenged under Article 77 (tax can be levied by an authority of law enacted by the Parliament) or Article 25 (right of equality) of the Constitution of the Islamic Republic of Pakistan. The answer is no. We are reinforced in our opinion from the two case laws of Indian Jurisdiction. In the case of Narinder Chand Hemraj v Lt. Governor reported as [1972] 1 SCR 940 it was held that:
“The reason and object of an agreement for the avoidance of double taxation or the prevention of the fiscal evasion is mainly to remove constraints on the flow of capital and technology from one country to another, so that the developing country could have access to the expertise and technical know-how of the developed country for their economic development and in the process may not unreasonably be deprived of their legitimate share in the income, as also to prevent evasion of taxes due to it on account of manipulations at international level. The executive is, therefore, enrpowered to grant exemption from tax or to permit taxation of certain income at a concessional rate. Such exercise of power accords with article 265( peri materia of Article 77) of the Constitution. The article lays down that no tax can be levied and collected except by the authority of law. Hence, the levy of tax can only be done by the authority of law and not by any executive order. Unless the executive is specifically empowered by law to give any exemption, it cannot say that it will not enforce the law as against a particular person.”
In the case of East India Tabacco Co. v. State of AP reported as [1962] 13 STC 529 (SC) it was held that:
“But in deciding whether taxation law is discriminatory or not, it is necessary to bear in mind that the State has a wide discretion in selecting persons or objects it will tax, and the statute is not open to attack on the ground that it taxes some persons or objects and not others. It is only when within the range of its selection, the law operates unequally, and that cannot be justified on the basis of any valid classification that it would be violative of article 14 (peri materia of Article 25)”
6. Basic framework of 58 full scope tax treaties net works so far signed by Pakistan is, by and large, based on four agreed international tax practices/principles: i. Jurisdiction to tax- No country can make law to tax a non-
resident who has no connection to it for the purpose of
earning a foreign source income. ii. Non-discrimination that a non-resident from a treaty country should not be treated worse than residents.
iii. The Arm’s Length standard – All tax treaties provide that the transactions between related parties may be adjusted by the tax authorities to the arms length standard the terms of transaction as would have been negotiated between two un-related parties.
iv. Foreign tax credits – Most of the tax treaties provide for an exemption to foreign source income or a credit for foreign taxes paid. It may be noted that the Ordinance provides for a foreign tax credit even in absence of a tax treaty.
7. The structure of a double taxation agreement follows any one of the three popular treaty models i.e. U.N, OECD and U.S. highlighting the fine areas of distinction in the above stated models are beyond the scope of this article, but by and large a tax treaty agreement observes a set pattern of indexing, heads of income (salary, dividend, property, business, royalty, fee for technical services) and the underlying principles as enshrined in the UN or OECD models. It may be appreciated that the Government of Pakistan have entered into tax treaty agreements with all its major
trading partners’ i.e. USA, China, Europe. 8 Ordinarily, taxing laws operate prospectively the world over. But owing to the beneficial character of double taxation agreement the Ordinance duly recognizes that for the purposes of a tax treaty the Federal Government may provide tax relief for any period before the commencement of the Ordinance i.e. prior to July 2002 or even before the making of any tax agreement.
9. It is now well established that any relief claimed by a person and found to be contrary to the objectives of a tax treaty can always be questioned and denied to by the respective tax jurisdictions of the treaty partner countries. Vodaphone case of India is an interesting case study on this theme wherein the issue of avoiding the withholding taxes obligations through treaty shopping has been dealt with. OECD Model commentary on this score stipulates measures to prevent improper use of treaty benefits through following four approaches of examination:-
1. Look through approach – Treaty benefit may be denied to a company not owned, directly or indirectly, by residents of the State of which the company is resident (see OECD Commentary, article 1, paragraph 13). This approach seems an adequate basis in relation to countries which levy no or very low taxation and where little substantive business activities would normally be carried on, although subject to an exception for bona fide business activities (see OECD Commentary, paragraph 14)
2. Subject-to-tax approach Treaty benefits in the State of source are granted if the income in question is subject to tax in the State of residence (OECD Commentary, paragraph 15). The Commentary says that whilst this seems adequate with respect to normal international relationship, this approach might well be adopted in a typical conduit situation. The safe guarding provision of this kind required that one or more residents of the third country have substantial interest in such company in the form of participation or otherwise or exercise of management or control of such company. The emphasis is on “substantial interest” by non-residents person claiming treaty benefits. Bona fide activities are, however, excluded.
3. Channel approach-The approach deals with conduit problem in a more straightforward way by singling out cases of improper use with reference to conduit arrangements themselves. Treaty benefit could be denied if substantial interest in the company is owned by residents of the third country and more than 50 per cent of the income is used to satisfy claims by such persons (including interest, royalties, development, advertising initial and travel expenses, and depreciation of any kind of business assets including those on immaterial goods and processes) (see OECD Commentary, paragraph 21)
4. Exclusion approach The approach includes denying treaty benefits (such as dividends, interest, capital gains or director’s fees) to specific types of companies enjoying tax privileges in their State of residence (see OECD Commentary, paragraph 21)”
10. From the above said basic evaluation it can be inferred that double taxation treaties are based on convergence of both customary international tax law as well as domestic tax law but the provision of a tax treaty is conferred a higher status. It is also evident that tax treaties are driven by single tax principle: income from cross-border transaction should be subject to tax once only.
These treaties are also driven by benefit principle which assigns the primary right to tax active business income to source jurisdiction and the primary right to tax passive income to resident jurisdiction. In a given treaty, whenever the primary jurisdiction refrains from, the residual taxation by other (residence or source) jurisdiction is possible and may be necessary to prevent under taxation. A cumulative reading of the whole series of articles. would show that our domestic tax law is coherent with the international tax regime as found in tax treaties and the domestic tax laws of both the developing and the developed countries of the world.