By Amjad Javaid Hashmi, Advocate Supreme Court
(i) On the principal topic of international taxation regime of Pakistan it is third article in the series and deals with the third theme i.e. taxing income of a non-resident person as dictated in sections 105 and 106 of the Income Tax Ordinance (the Ordinance). On this score, the law is underwritten with globally well established principles, concepts, conditions and limitations. A bare reading of the law stimulates a host of incidental compliance enforcement issues as it combines both charging and procedural features-a rarity.
(ii) The whole edifice of taxation of a non-resident person as incorporated in sections 105 and 106 of the Ordinance, in its essence, converge to one key principle, one key purpose and one key exemption.
(a) The key principle pertains to the connectivity of income of a non-resident person to the territory of Pakistan. It ordains that a non-resident person must have a Permanent Establishment (PE) in -Pakistan within the terms of section 2(41) of the Ordinance i.e. No PE NO TAXATION. It is a well recognized and basic principle of international tax law. A nonresident is chargeable to tax in Pakistan only when it has established or the Commissioner has determined the establishment of a PE i.e. a. fixed place of business in Pakistan within the scope of any one of its seven shades as defined in the provision.
(b) The key purpose is securing and avoiding erosion of the Pakistan share of the tax base from aggressive tax planning tactics by a non-resident person in the critical areas of capital restructuring (thin capitalization) or expenditure profiling. This purpose is reinforced by prescribing a strict inadmissibility regime of payments by a PE to the head office or another PE of a non-resident person on account of specific transactions i.e. royalty, fee, head office expenditure, profit on debt, salary, travelling, expenses and service acquired. The converse inflow of these transactions i.e. receipts by a PE from a non-resident person on account of royalty, feed, profit on debt, salary, travelling expenses or services rendered has also been excluded from the taxability regime. Specific rules dealing with income from royalty and fee for technical services under rules 17 to 19 of I.T. Rules, 2002 (the Rules) are the vehicles to achieve the same objective. Anti-avoidance provisions of section 108 of the Ordinance read with rules 20 to 27 of the Rules also regulate the tax obligations of a non-resident person with the same purpose.
(c) The key exemption from the above stated inadmissibility regime is granted to a PE engaged in the banking business. A PE engaged in operating a financial institution is similarly privileged.
(iii) Determination of the taxable profit of PE of a non-resident person is a major controversy confronting all tax jurisdictions in the world. We have, in line with trends of international tax law, also given it due consideration and incorporated three principles to achieve optimum transparency and consistency in tax determination:
The principle of uniqueness.—A PE and a non-resident person are two distinct and separate legal entities to bear the burden of taxation.
(1) The principle of similarity of products/services.—A PE and a non-resident are presumed to deal with the same or similar business activities under the same or similar. conditions.
(2) The principle of competing interests.—A PE and its non resident person shall undertake ordinary business transactions like purchase, sales, supply or services with each other like two independent enterprises under arm’s length principle and with due deference to the transfer pricing regime prescribed in Rules 20 to 27 of the Rules.
(iv) The basic legal framework for computing the taxable income of a non-resident person is underwritten with the omnibus principle: “any expenditure incurred by a PE for the purpose of business” qualifies as an admissible deduction. Executive and administration expenses can also be claimed irrespective of location i.e. within Pakistan or outside Pakistan. The only limitation is that their admissibility regime is subject to the Ordinance i.e. inadmissibility provision of section 21 can also be attracted. The only condition is that such expenses must be incurred for the purposes of business activities of a PE. It is a liberal proposition when compared to the narrow regime for a resident person under section 20 wherein admissibility of deductible expense is contemplated only when it is wholly and exclusively incurred for the purposes of business. In the case of a PE any expenditure not otherwise excluded is permissible. But in case of a resident person; the indispensability & exclusivity factor is a pre-requisite.
(v) The law presumes that certain specified transactions between (i) a PE in Pakistan and the foreign head office of its non-resident person (ii) a PE in Pakistan and a foreign PE of its non-resident person are not governed under the arms length principle. Under the deriving force of the above presumption; section 105(c) (i)(ii)(iii) disallows the deductions claimed by a PE by way of payments to a non-resident person or another PE of a non resident person with respect to royalties, fees, compensation for services, profit on debt: These transactions are:
105(1)(c) no deduction shall be allowed for amounts paid or payable by the permanent establishment to its head office or to another permanent establishment of the non-resident person (other than towards reimbursement of actual expenses incurred by the non-resident person to third parties) by way of:–
(i) royalties, fees or other similar payments for the use of any tangible or intangible asset by the permanent establishment;
(ii) compensation for any services including management services performed for the permanent establishment; or
(iii) profit on debt on moneys lent to the permanent establish ment, except in connection with a banking business; and
In the case of above facts and circumstances tax authorities are empowered to reconstruct the income of a PE. No such embargo is contemplated if any expenditure is actually incurred by a non-resident person and claimed by way of payments to a third party on account of the above stated transactions i.e. royalty, fees or on use of its tangible or intangible assets. The law therefore presumes that such transactions between a PE and a third party are carried out on the principle of arms length transaction and are therefore admissible as lawful deductions
(vi) Taxable profit of a PE can also be reconstructed for a tax year to the extent the claim of an amount of head office expenditure exceeds the amount as bears to the turnover of the PE in Pakistan the same proposition as the non-residents’ total head office expenditure bears to its worldwide turnover. Head office expenditure is a special concept of international tax law and has been defined in section 105(3) in both exhaustive as well as inclusive terms as shown below:-
105(3) In this section, “head office expenditure” means any executive or general administration expenditure incurred by the non-resident person outside Pakistan for the purpose of the business of the Pakistan permanent establishment of the person, including-
(a) any rent, local rates an taxes excluding any foreign income tax, current repairs, or insurance against risks of damage or destruction outside Pakistan;
(b) any salary paid to an employee employed by the head office outside Pakistan;
(c) any travelling expenditures of such employee; and
(d) any other expenditures which may be prescribed.
(vii) The law also discourages the financing of business operations of a PE by its non-resident principal. Where any PE ventures to claim expenditure by way of payment made to its non-resident principal on account of profit on debt or any insurance premium on such debt against financing of its operations; the Commissioner is empowered to reconstruct the taxable profit of a PE to the above said extent.
(viii) Pakistan is a capital starved economy. Capital import is
therefore, encouraged in the tax policy but not at the expense of eroding the tax base. Multinational Companies (MNCs) while investing in developing countries like Pakistan choose the lend heavily to their foreign controlled resident company (FCRC); and the interest accruing thereto achieves twin objectives of repatriation of capital by way of tax free interest income in their home jurisdictions and minimization of taxable income of their FCRC in host jurisdictions. This tax avoiding tact is recognized by the law and is titled as thin capitalization according to the jargon of tax discipline. In line with the modern trends of anti-tax avoidance measures; Pakistan has capped the foreign debt-to -foreign equity ratio at 3:1. Tax authorities can reconstruct the taxable income of a FCRC where at any time during a tax year a deduction against profit on debt is claimed in excess of the above said prescribed foreign debt-to-foreign equity ratio.
(ix) A strict regime regulates the capital restructuring of a FCRC of a non-resident person. It stipulates that where fifty percent or more underlying ownership of a FCRC is held together by (i) a non-resident (ii) an associate of a non-resident (iii) associates of a non-resident the above said capping of foreign-debt-to foreign equity of 3:1 would be attracted. It means that tax authorities must invoke the provisions dealing with section 85 of the Ordinance to enforce the capping formula correctly.
(x) Transparency into the above said regulatory regime of capital restructuring of FCRC has been achieved by defining the fundamental concepts of foreign debt as well as foreign equity in the context of accounting discipline. Foreign debt is worked on gross basis i.e. an aggregate of debt obligations of a FCRC towards a non-resident person or to a third person. Foreign equity is on the other hand, worked on net basis i.e. a sum of the amounts representing (i) paid up value of shares (ii) the credit of the share premium account of a non resident person and (iii) accumulated profit in asset evaluation reserves as reduced by the sum representing any debt obligation issued to FCRC by the non-resident person or its associate plus the losses incurred in case of its wound up.
(xi) The above evaluation of the fundamental structure of taxation of a non-resident person is more or less consistent with the practices and developments in the international tax laws. For us a major distortion is the most favoured status granted to the banking industry because we do not see any such parallel in other tax jurisdiction and it deserves an urgent tax policy review particularly when we note that over the past 10 years the banking industry in Pakistan has boomed into a cash rich cow.
(xii) We found a major weakness in the law design in term of express gap between the law and rules. We found missing an effective scheme of procedural enforcement measures venturing to realize the goal of securing the tax base of Pakistan according to the dictates of substantive law. Regretfully we also noted that the very design of annual tax return from tax year 2003 to tax year 2011 has failed to incorporate the above discussed anti-tax avoidance implications of the provisions dealing with the taxation of non-residents. To bridge the above said gap we suggest immediate redesigning of the annual tax return. We also recommend introduction of subordinate legislation on following counts to effectively reinforce the substantive law of sections 105 and 106: (i) prescribing filing of a schedule showing the prescribed working of the head office expenditure along with annual tax return (ii) prescribing filing of working of ratio between worldwide turnover and head office expenditure of the non-resident person as against the head office expenditure claimed by a PE (iii) prescribing annual filing of a non-resident person’s global associates within the scope of section 85 (iv) prescribing filing of a 365 days schedule to help tax authorities find as to on what days of a tax year foreign debt-to-foreign equity ratio has exceeded the prescribed 3:1 ratio (v) prescribing filing of an annual schedule of expenditure bifurcation with regard to both expenditure admissibility regime of section 20 and inadmissibility regime of sections 21, 105 and 106 (vi) prescribing filing of a schedule of non taxable receipts of a PE within the dictates of section 105(1)(d) of the Ordinance. The proposed alignment of the substantive law and rules would not only add urgently needed consistency in tax enforcement but would also help Pakistan in becoming a smart player in the ever growing tax competition in the context of active (mostly corporate) as well as passive (mostly individual) income of a non-resident person.