By Amjad Javed Hashmi, Advocate Supreme Court
1. Legal burden to pay income tax directly falls upon a person i.e. a technical concept having very broad scope and effect as defined in section 80 of the Income Tax Ordinance, 2001 (the Ordinance). Every taxpayer has to be a person first. Most popular variations of the technical concept of a person include an individual and all its types, an association of person and all its types and a company and all its types as recognized in a given tax statute. Rights and obligations of a person are, in direct tax jurisdictions all over the world, consequently dependent upon his, its tax domicile (parallel to political domicile) or residential status and territorial sources of income. In the age of globalization and information technology; the interaction and frequency of economic interests of taxpayers have become borderless and more and more people are deriving income ‘from multiple territories i.e. their homeland as well as from other countries.
In the above background taxation of foreign source income of the persons resident of (tax domiciled in) Pakistan is inviting growing attention of tax authorities and the tax practitioners alike. It is the second major subject of the laws of international taxation in Pakistan. It recognizes and deals with two key foreign sources of a resident person: (i) salary sources and non-salary sources. Section 102 reflects upon the taxation of foreign source salary income of a resident individual. Section 103 postulates the taxation of foreign source non-salary income of a resident i.e. income from business profit and gain, income from property, income from capital gain and income from royalty, technical fee, profit on debt; and section 104 contemplates treatment of foreign source losses of non-salary income of a resident person.
2. Foreign source salary income of a resident individual is taxed in two simple ways: (i) it exempts any salary income if any resident individual has paid foreign tax in respect of the foreign source salary (ii) it deems as final discharge of his/her tax liability on foreign source salary income where any tax has been withheld by the foreign employer from the foreign source salary of its employee / individual who is also a resident of Pakistan for tax purposes.
3. Legal framework of tax treatment of non-salary foreign source of income is comparatively a tough proposition. It rests on the intersection of three inter-related technical concepts that aim to unfold the basis of taxation, the nature of taxation and the incidence of taxation:
(i) “net foreign source income”
(ii) “foreign income tax”
(iii) “average rate of Pakistan income tax”
3.1 The technical concept of “net foreign source income” is defined in absolute terms and provides the true basis of taxing foreign source income. The term “net” is not defined in law but has over-riding effect in determining the correct charge of tax. We would therefore infer that the tax basis as couched in the term “net” must be understood as the after tax “foreign income”. Working of “net” foreign income would, therefore, involve three steps: (a) computing total foreign source income, (b) computing taxable foreign source income, (c) computing after tax “net” foreign income. Total foreign source income is the aggregate sum of all the foreign sources (non-salary). Taxable income is the income after reducing from total income any admissible deductions under this Ordinance and “net income” is the “after tax” foreign income.
3.1.1 Admissibility criterion for deductions under the Ordinance is based on two tests. Firstly, the deduction must have a direct and exclusive nexus to the derivation of the non-salary foreign source income. Secondly, where the deduction is attributable to derivation of more than one head of foreign source income (other than salary) the admissibility of deductions would be based on the apportionment provisions of section 67 and the relevant Rules.
3.1.2 While computing net foreign source’ income under the given heads of income from business, property, capital gain and other sources the basic principles of computation as contemplated in section (11) have to be complied with. Income has to be computed head wise and the sum total of all these foreign sources would be the income qualifying for the purpose of foreign tax credit.
3.1.3 The technical concept of “foreign income tax” provides the incidence of foreign tax and is defined in inclusive terms. Tax withheld outside Pakistan with respect to any non-salary foreign source income would also be covered as foreign income tax. It also means that for the purpose of foreign tax credit a strict sequence of tax credit as contemplated in the provision of section 4(3) a has to be applied. For unilateral relief of foreign tax credit under section 103 the rules warrant filing of the prescribed application as well.
3.2 The technical concept of “average rate of Pakistan income tax” further qualifies the incidence of tax. It provides a comparative incidence of Pakistan tax and is dependent on the taxable income as worked out without allowing the tax credit otherwise admissible under section 103.
3.3 A correct working of both the amounts i.e. foreign tax and Pakistan tax on the same tax base of net foreign source income is the key pre-requisite for providing correct foreign tax credit as contemplated in the aforementioned provisions of section 4(3) of the Ordinance. When viewed in the background of the above analysis we may observe that the FBR’s prescribed Return Forms (IT-I & II) do not fulfil the preconditions of complex framework for allowing foreign tax credit to a resident person to arrive at his/its correct tax liability.
4. From the angle of a tax practitioner we may refer that within the above discussed legal framework the working of foreign tax credit is to be made in a statutorily prescribed and strict step by step order as shown below:
(i) work out the total non-salary foreign source income of a resident that is chargeable to tax under the Ordinance
(ii) work out the foreign income tax paid or foreign income tax withheld against total non-salary foreign source income
(iii) work out the Pakistan tax payable in respect of the total non-salary foreign source income of (ii)
(iv) apply the average rate of Pakistan income tax on the “net foreign source income” of a resident person to arrive at the figures of Pakistan tax payable
(v) compare the foreign income tax paid or foreign income tax withheld with the Pakistan tax payable in respect of the total foreign source income as worked in (iii)
(vi) give credit for lesser of the two amounts for the purpose of foreign tax credit
5. Consistent with the principles of taxation of Pakistan source income the law further contemplates that foreign source income from speculation business shall be treated as a separate head of income. It means that foreign tax credit on foreign income from speculative business would be dealt with separately. In other words, tax credit attributable to speculation business income can’t be claimed against any foreign business income, property income, capital gain income or foreign income from other sources.
6. The international tax law of Pakistan contemplates to secure its tax base. The security of Pakistan tax base is contemplated by providing that any surplus tax credit on non-salary foreign source income of speculation business that exceeds the Pakistan tax payable under section 103 (1) (b) would not be refunded, carried back to the preceding tax year or carried forward to the following tax year.
7. The international tax law of Pakistan further contemplates to allow foreign credit in a tight time frame. It stipulates that a resident person must lodge the claim for foreign tax credit within two years after the end of the tax year in which the foreign income to which the tax relates was derived. We, therefore, note that any time difference in the concept of tax year of Pakistan or the tax year of a foreign country has to be resolved in favour of the Pakistan concept of the tax year and the limitation of the two tax years has to be the counted from the end of the tax year within the dictates of Pakistan tax laws and not within the dictates of a foreign tax law. The FBR’s prescribed return do not contain the above said alarm bells to prevent time-barred foreign tax credits.
8. Computation of loss from any non-salary income source is based on the principle of indispensible nexus between an income source and the expenditure incurred for deriving it. This is an income-head specific scheme of loss recognition and quite divergent from the treatment of Pakistan source losses wherein adjustment of income or loss under various heads of income is provided.
9. The mode of treatment of loss from foreign source of income are similar to the treatment of loss from a Pakistan source income i.e the foreign loss shall be carried forward to the following year and set-off against the foreign source income chargeable to tax under that head in that year, and so on, but no foreign loss shall be carried forward to more than six tax years immediately succeeding the tax year for which loss was computed. On the principle of FIFO (first in first out), where a loss is to be carried forward for more than one tax year, the loss for the earliest year shall be set off first. The return of total income as prescribed by the FBR, we may observe again, does not provide any safeguard against any potential abuse of the above stated strict order of setting off of foreign income losses. Likewise, the principle of
apportionment as laid down in section 67 have to be invoked in trimming the foreign loss where it emanates from a common source of both foreign speculation business and foreign non-speculation business. From the above evaluation, one can conclude that the design of the tax law dealing with a resident’s foreign sources of income is fair, equitable and non-discriminatory and in tune with the dictates of international law.