Offshore income and assets of Pakistanis and the Finance Bill 2018: End of tax exemption regime – II

A new regime for Pakistan Assets owned by non-resident companies

Redefining Pakistan Source Income for Alienation of Assets held by Non-Resident Companies

Newly inserted Section 101A has effectively prescribed a separate regime for taxability of gain on disposal of asset in Pakistan which are held by a ‘non-resident’ company. As per author’s understanding, for this purpose, these assets have been classified into three categories, which are as under:

(i) Assets directly [actually and physically] held by a non-resident company in Pakistan. This is covered in proposed Section 101A(1) of the Ordinance. This simply means that A Ltd of BVI holds shares in B Ltd, an unlisted company in Pakistan;

(ii) Assets not directly, actually or physically held in Pakistan; however, these represent shares or interest in a non-resident company/ entity that holds the Pakistan asset. A Ltd BVI holds shares in B Ltd BVI that owns shares in C Ltd being an unlisted company in Pakistan. In this case, B Ltd will be considered to hold entire asset in Pakistan if the value of Pakistan asset in the Balance Sheet of B Ltd exceeds 50 percent of the value of entire assets owned by B Ltd (without accounting for liabilities) and its value exceeds Rs 100 million. Unlike the provisions of Section 101A(1), this is a deeming provision. These provisions are contained in

Sections 101A(3), (4) and (5). In this case, as per one interpretation, if the value of underlying assets held directly or indirectly exceed 50 percent being Pakistan asset then alienation of that ‘foreign company’ as a whole shall be treated to be the disposal or alienation of Pakistan asset being a Pakistan source income;

(iii) Assets not covered in 2 above, however, the non-resident company, wholly or principally, directly or indirectly, holds some assets in Pakistan then the income on alienation of Pakistan to that attributable extent will be treated as Pakistan source income. In our example, if B Ltd BVI owns assets around the world including Pakistan asset, which is less than

Rs 100 million and total value of such assets is less than 50 percent of the Balance Sheet of BVI Ltd then only attributable income shall be treated as Pakistan source income. This provision is contained in Section 101A(6) of the Ordinance. In this case, only an attributable portion is deemed to be taxable in Pakistan.

The aforesaid application is a prudent interpretation of the provisions inserted in the law. Under another interpretation the cases referred to in (ii) and (iii) are treated as one case. This means that if the assets directly or indirectly held are more than 50 percent of the value of total assets of the non-resident company then income attributable to that extent will be deemed to be Pakistan source income. In other words, there is no deeming geographical source if the value of Pakistan assets of the foreign company is less than 50 percent of the total value of assets owned by the foreign company. This is a very sensitive question; however, there is a need to have proper interpretation and application of law on this matter.

Notwithstanding the validity of the interpretation that is adopted in Section 101A, the said section has introduced a unique concept. This represents a very strict regime of taxation for Pakistani assets even though the same are held by non-resident entities. It is therefore necessary to see the background of this case.

Historical Background of the matter Provisions introduced appear to be a strict regime and the matter will be tested in the courts of law, especially in relation of treaty overriding provision; however, the matter of ‘situs of taxation’ is not new. This has been in practice internationally and in our treaty provisions for a long time.

The whole concept of situs of taxation erupted on account of avoidance of taxation on capital gains on alienation of immovable properties. The revised OECD Model treaty under Article 13 states in sub-article (4) as under:

“Gains derived by a resident of a contracting state from the alienation of shares deriving more than 50 percent of their value directly or indirectly from immovable property situated in the other contracting state may be taxed in that state.”

This revision in the OECD model was made in 2003. This is a very major development in the taxation system under OECD treaty mechanism. There is a reason for the same. Internationally, it was found that in many cases, gains on alienation of immovable property in a jurisdiction were avoided by placing a non-resident company over the ownership of the immovable property. Accordingly, gain on disposal of that non-resident company which was actually the gain on disposal of the immovable property was avoided.

In this connection, it is also important to note that the reliable commentaries on treaties, like that produced by Dr Klaus Vogel, are of the view that if an income is deemed to be taxable in a jurisdiction of 50 percent ownership of an immovable property in an underlying country then whole income of such company may be taxed in that country subject to credit for doubly taxed income.

In Pakistan, this matter was originally picked up in the treaty for the avoidance of double taxation between Pakistan and the Netherlands that provided exemption from gain on sale of immovable property, including the share of a company having immovable property in another jurisdiction, if the value of such immovable assets in such non-resident company is less than 25 percent. This provision is contained in Article 13 of the treaty between Pakistan and Netherlands.

Income Tax Ordinance, 2001, as against the provisions contained in the repealed Income Tax Ordinance 1979, contains Sections101(9) and 101(10) which are extension of the concept of situs in taxation. Provisions contained in these sections provided almost exactly the same philosophy as it now contained in Section 101A except the matter that in that case such ambit was limited to assets being ‘immovable property’ and ‘interest in an oil exploration concession’. The author supported insertion of these provisions in the past on account of the fact that taxes reasonably due in Pakistan on account of capital gains on disposal of oil concession were getting untaxed in Pakistan on account of a regulatory condition that such interest are always held by an offshore company if the effective owner is a non-resident person.

Change from International System The newly proposed provision by way of Section 101A of the Ordinance is unique in the sense that this concept in the past was limited to cases where the underlying property was an immovable asset and it was thought, and rightly so, the entity interposed to avoid tax on alienation of immovable property should not lead to avoidance of taxation. Under the present regime, the said concept has been proposed to be extended to all assets whether being immovable property or otherwise. This may raise the question of nexus of taxability of Pakistan and manner of enforceability of the provision if there is indirect holding and there is no transaction or record in Pakistan on account of that alienation. For example, if the holding is direct then there will be change of ownership in Pakistan’s other asset record whereas if the holding is indirect then there would be no such recording.

Secondly, if the case of less than 50 percent holding is read in a prudent manner then there can be issue in effectively every transfer of asset by a non-resident company as the same may have some direct or indirect interest in a Pakistani enterprise. That law is almost impossible to operate.

Share and Interest The proposed Pakistan law has been drafted after taking into account the international developments in this field and there is a need to compliment the correct approach. In the proposed Section 101A, the term used is ‘share’ and ‘interest’. The term ‘interest’ is larger than share and it also includes share in Partnership and interest in a Trust. This is extremely important for Pakistani owned enterprises in the UAE and Offshore Trusts, say in BVI where interests in held as a share in Partnership with a UAE citizen or an interest in a BVI Trust. Under the proposed law, the concept of Pakistan source is applicable even if the owner of underlying Pakistan asset is a Partnership or a Trust. This aspect is extremely important with respect to structure, which Pakistanis have created out of Pakistan. The summary of these amendments is that there is no escape from capital gain tax if the underlying asset is in Pakistan except those, which are exempt from tax in Pakistan.

Principally and Wholly and Directly and Indirectly The proposed law has used two terms ‘principally and wholly’ and ‘directly or indirectly’. Both these word carry special significance. Although the model treaty has used words ‘directly or indirectly’ only whereas our Ordinance under Sections 101(9) and (10) has used both the terms. In this author’s view, use of both terms is better in the sense that both carry different connotations.

‘Principally and wholly’ relates to nature of assets of the non-resident company. This means that this provision applies if the entities assets are principally or wholly those which lie in Pakistan. As against that, the words ‘directly or indirectly’ relates to nature of ownership of that company. A Ltd may be 100 percent owned by B Ltd and the assets are held by A Ltd. In that situation, such assets will be considered to be indirectly held by B Ltd.

Alienation or Disposal Modern treaty texts use the words ‘alienation’ instead of disposal. This is a better word as it signifies commercial and substantial reality not the legal form. A lease of asset on long term may be an alienation; however, the same may not be a disposal. Nevertheless, the same would have to be distinguished with the term ‘use’, which is applicable for taxation of royalty of equipment.

Rate of tax The proposed law has prescribed a presumptive tax rate of not exceeding 10 percent of the fair value of asset for the gain on alienation, covered under Section 101A of the Ordinance. This effectively means that if any asset in Pakistan is owned by a non-resident company or non-resident Partnership or a Trust then the same as a special transaction under

Section 101A shall be taxable at the maximum rate of 10 percent of the fair value of the asset and other provisions of law shall not be applicable in that case. Under the general law, such gain is taxable at the rate of 25 percent.

Summary of the provision A brief analysis of these provisions reveals that a completely new paradigm has been envisaged for bringing into net, the gain on disposal of Pakistan assets if the same are owned by non-resident companies. These changes have very far reaching impact on the company law and exchange regulations. What has been done is principally correct if we take into account the abuse that was being in this field; however, there is a need for certain correction and bringing the law in line with international taxation system as laid down in the treaty framework. As referred to in the aforesaid paragraphs, these amendments in Section 101A do no override the provisions of Section 107 of the Ordinance which provide an over-arching cover, except where a case of anti-avoidance under Section 109 of the Income Tax Ordinance. Such over-arching provisions can only be overridden if it can be proved that the same is part of any anti-avoidance scheme under Section 109 of the Income Tax Ordinance, 2001.

This further clarifies that there is a need for a more careful management of offshore entities by Pakistanis if the assets of such offshore companies lie in Pakistan, such as private limited companies and real estates. In short, a very significant tax regime is emerging that provides low rate of taxation only on the condition that assets are properly declared. This makes a case of a careful compliance of ‘One Time Compliance Scheme’.

A New Regime for Tax in Pakistan for Offshore Companies Owned by Pakistanis The proposed Finance Bill, 2018 has inserted Section 109A under the title ‘Controlled Foreign Company’ (CFC) in the Income Tax Ordinance, 2001. In this author’s view, this is the most important change in the taxation laws of Pakistan since 1922. Pakistan in now entering into a new phase of taxation, which is the result of the change in commercial and economic environment of the world. At the outset, it would be desirable to understand the concept of CFC in general.

The Concept of CFC A company is a legal person, formed under the respective corporate laws. It is deemed to be resident of the country where such legal entity is incorporated. The tax residence and citizenship of the shareholders/owners of such companies is not relevant for that purpose. CFC is a provision or a concept that, for tax purposes, looks beyond the corporate veil and segregate the foreign entities between those which are CFC or otherwise. CFC’s are entities though incorporated in a particular jurisdiction, are ‘controlled’ by the residents of another country. Any company that is so controlled is called CFC. If this concept is read with the discussion in the earlier paragraphs, it is revealed that this concept is the continuation of the same exercise whereby various jurisdictions are tightening the nose of taxability of persons resident in a particular country. What is being said is that not only the personal income of a resident person will be taxed, but also the income of a non-resident company will be taxed in the country of residence of that person if the foreign company is controlled by that resident person.

Present Definition of Company Under Section 83(2) of the Income Tax Ordinance, 2001 definition of a resident company includes a company where the controlled and management is ‘wholly’ in Pakistan. This means that under this Section, a company incorporated outside Pakistan can be treated as resident company if it can be ascertained that control and management is ‘wholly’ in Pakistan. This Section is however, not practically implemented for the reason that term ‘wholly’ is always answered in legal terms and substantive approach is avoided. It is interesting to note that in the original draft of this definition, there was an additional word ‘almost wholly’ in this definition. In other words, the concept of CFC had always been there in the law; however, on account of practical reasons the same was never implemented.

Two Principles of Taxation of CFC CFC taxation is not a new concept in international tax arena. The US was the first country that exercised this right way back in 1960 and they have tried almost all models in this. There are in principle two approaches to deal with CFCs. These are:

1. Piercing the Veil Approach; or

2. Deemed Dividend Approach.

In the case of lifting the veil method, if a non-resident company is treated as CFC under the domestic regulation then it is considered that income earned by that company has been earned by the owners of non-resident company, as if the non-resident company never existed. For example, if A Ltd of Pakistan holds 100 percent shares in B Ltd of Netherlands, which holds 75 percent of shares in a UK company viz. C Ltd. If B Ltd and C Ltd are treated as CFCs then income earned by B Ltd and C Ltd may be treated as income of A Ltd as if B Ltd and C Ltd never existed. In other words, the income of B Ltd and C Ltd will be taxed in the hands of A Ltd at the time they arose.

As against that, in the case of deemed dividend approach, any dividend declared by C Ltd will be taxed as dividend for A Ltd when the same is distributed by B Ltd.

The analysis of newly proposed section 109A reveals that for the purposes of Pakistan law, the first approach of piercing the veil has been adopted. Its repercussion has been discussed in the following paragraphs.

What is deemed to be a CFC under the newly-inserted Section 109A of Ordinance?

Under the proposed law, the following cases will be treated as CFC for Pakistan tax purposes:

(i) One resident person holds more than 40 percent of capital or voting rights in a non-resident company;

(ii) Two or more persons holds more than 50 percent capital or voting rights in a non-resident company;

(iii) Less than 60 percent of taxes paid by that non-resident company are taxes paid to a foreign authority;

(iv) Non-resident company is not a listed entity in that jurisdiction; and

(v) Non-resident company is not engaged in ‘income from business’ in the year of jurisdiction, and more than 80 percent of the income of the non-resident company is a ‘passive income’ being income from dividend, interest, property, capital gains, royalty and annuity payments or deemed passive income being, supply of goods and service to an associate, sale and licensing of intangibles and management services, holding of investment in securities and financial assets.

All conditions to be cumulatively applied.

In case, if a non-resident is treated as CFC then whole income of that CFC will be treated as income of the resident person, attributable to non-resident’s holding by the Pakistan resident persons. Income once taxed on CFC basis will not be taxed again on receipt basis.

CFC and Treaty Provisions There is unanimity of view that if any domestic legislation adopts a ‘deemed dividend approach’ then the same shall not considered to be against the treaty provisions, as contained under the OECD treaty framework.

On the other hand, there are serious views that ‘piercing the veil’ approach, as adopted by Pakistan under the proposed 109A, is in conflict with Article 10 of the Model treaty. There are views to overcome that conflict which is a technical debate, not to be discussed in this article; however, this is an important subject in the international taxation law in recent times and various alternates are being developed, which are expected to culminate in the view that CFC even with piercing of veil approach may be treated as valid.

Seriousness of Subject for Pakistanis We all are aware of the ownership and transactions of Pakistani citizens through companies/Partnership and trusts held outside Pakistan. There are many cases where:

* Pakistani residents hold shares in Pakistani listed entities through non-resident enterprises which will now be treated as CFC;

* There are many Pakistani residents who own properties in offshore jurisdictions, like the UAE, through entities incorporated in UAE, which will now be treated as CFC;

* There are many trading and other companies, which supply goods to Pakistani enterprises, which will now be treated as CFC.

If we summarize the subject it appears that after the proposed amendment a person who is a resident in Pakistan cannot avoid taxation of passive income earned by companies incorporated outside Pakistan, which was possible under the past regime. In the following articles, on this matter, this subject will be demonstrated in detail. Nevertheless, this aspect can be explained by an illustration.

Mr A is a Pakistan tax resident. He owns a trust in British Virgin Islands. Through that trust, Mr A beneficially owns substantial control in a listed company in Pakistan. At present, the dividend from Pakistani listed company is taxed in Pakistan, at the time of remittance of the same from Pakistan. Nevertheless, the same is not taxed in the hands of Mr A unless the same is distributed by BVI Trust to Mr A. Since BVI Trust will now be a CFC under the proposed regulation, the income of BVI Trust will be taxed in Pakistan at the time it arose to BV I Trust. This effectively means that under the revised structure, the said amount will be taxed twice once at the time of declaration of dividend from Pakistan and again at the time of income of BVI Trust. This effectively means that concept of double taxation on dividend, as was applicable to local holding, is now effectively being applicable to foreign entities only.

From the practical view point, it is therefore, important to see the structure of ownership of Pakistani enterprises and redo the structure after taking into account the ‘One Time Compliance Scheme’ that is available up to June 30, 2018.

Taxability of Supply under Overall Implementation Contract

The third major change proposed by the Finance Bill, 2018 is amendments in provisions relating to taxability of a supply of goods [generally plants] where installation, etc. are also undertaken by the same entity or companies that are associates.

In this author’s opinion, there is no major change in law as far as withholding provisions as contained in Section 152(7) are concerned where consequential amendment has been proposed. The major amendment has been made in the section relating to geographical source of income as contained in Section 101 of the Ordinance. It is too serious to be ignored or taken up lightly. The newly inserted sub-section (3) states:

“(e) Import of goods, whether or not the title to the goods passes outside Pakistan, if the import is part of an overall arrangement for the supply of goods, installation, construction, assembly, commission, guarantees or supervisory activities and all or principal activities are undertaken or performed either by the associates of the person supplying the goods or its permanent establishment, whether or not the goods are imported in the name of the person, associate of the person or any other person.”

What is the issue? Under the generally acceptable principle of taxation that has been acknowledged even in the amended provisions of law, where the title in the goods is transferred outside Pakistan, the gain or loss on such supply falls beyond the nexus of Pakistan taxation. Accordingly, though being payments to non-resident, such amounts are not subject to tax.

Tax department in many cases, especially in the developing countries, is of the view that in the case of supply of plants, which generally requires installation, etc. whole contract including supply of plant should be taxed in Pakistan as there is no effective supply unless activities undertaken in Pakistan are taken into account. In their view the concept of transfer of title is being abused. They further state and demonstrate that whilst splitting the same, substance of the transaction is disturbed and there is inequitable attribution of income that should be taxed in the country where the plant is supplied. There had been a long debate on this subject and various concepts, such as ‘turn-key contracts’, etc. have been designed to overcome this potential abuse. Notwithstanding the merits and demerits of the case, there is no denial that in certain cases, there can be an abuse; however, this is purely a factual matter that should not be entangled too much in the law and primary sanctity of the law need not be disturbed.

This matter generally arises in the case of large plants where various components are supplied under a Letter of Credit, being a part of overall arrangement, and the supplier or its associates are engaged in installation and other supervisory activities related to such installation in Pakistan. Tax department contents that it is a ‘project’ in Pakistan, and whole consideration should be subject to withholding tax and whole income should be taxable in Pakistan. On the other hand, the fact remains that there is a supply of equipment in the name of the Pakistani buyer and the title in the plant passes outside Pakistan, even though the supplier or its associates may be engaged in the installation and other activities.

What has been disturbed? The apparent reading of Sections 101(3) and 152(7) as amended has disturbed the primary consideration relating to nexus of taxability. In the un-amended provision, there was a concept of withholding tax on a contract that covered all activities and the same was referred to as an ‘overall arrangement’. However, in the amended provision, it has been specifically stated that provisions of withholding tax will remain applicable, even if (i) title in the goods is transferred outside Pakistan and (ii) the importer is a person other than supplier. This, in summary, means that once it is determined that a supply is made in relation to an ‘overall arrangement’; the aforesaid two primary principles of taxation will be overridden and whole contract will be considered to be a geographical source of the supplier or its associate in Pakistan.

Meaning of Overall Arrangement In the present circumstances, the word and the concept that would require interpretation and practical application is ‘overall arrangement’. If we study the same, it transpires that the amended provisions stipulate that in an overall arrangement, in substance, the right and title of goods though in legal form will be deemed to be transferred if other activities, subsequent to supply, including performance guarantees are undertaken by the supplier or its associates. In this author’s view, this simplistic view is not enough for the same. The substantive transfer of title can only be considered as valid if there is no recourse of the buyer against the supply of equipment by way of a guarantee of operation until other activities are not completed. It is important to note that in the un-amended provisions, there was also a concept of ‘guarantee’ in this subject. In this situation, it is expected that there will be a serious litigation on this aspect, as the term ‘overall arrangement’ is too wide to define and there is no internationally recognized definition of this concept. In short, what is effectively being said that in an overall arrangement, the risk and rewards are being transferred on completion of the project and not at the time of import of equipment. This is in this author’s view, a conflict with internationally accepted ‘INCOTERMS’ and there will be a need to encompass the practical meaning of an overall arrangement.

Treaty Override Through an amendment in Section 107 of the Income Tax Ordinance, the overriding principles relating to treaty have been subjected to

Section 109 of the Ordinance that relates to re-characterization of an anti-avoidance transaction. In this author’s view, the enlargement of taxable nexus with respect to ‘overall arrangement’ is a subject covered under Section 109 of the Ordinance. Under Section 107 of the Ordinance, there are clear overriding provisions relating to attribution of income to Pakistan. In this situation, the aforesaid provisions will require a judicial interpretation especially in relation to supply under an overall arrangement. Without prejudice to the same, there is no doubt that in some case, the concept of transfer of title is abused to avoid Pakistan taxation and appropriate corrective measures are undertaken to curb that abuse.

Conclusion and summary Discussions in the aforesaid paragraphs reveal that the 2018 Finance Bill has laid down a completely different and progressive regime for taxation of transactions and income of resident persons from offshore companies and entities. The contents in the aforesaid paragraphs can be summarized as under:

(i) International taxation system that prevailed after the Second World War is over. A new regime is emerging in post 2000 period and many events after that period, including ‘Panama Leaks’ and ‘Paradise Papers’, are part of that overall process of dissolution of concessions and protections provided to the tax friendly countries and tax havens. The concept of ‘secrecy’ is being challenged;

(ii) The aforesaid change is the economic need of the developed world. Such countries cannot afford to lose taxes, being avoided by use and abuse of tax havens and tax friendly treaties on account of constant current account deficits;

(iii) ‘Counter terrorism’ actions also force the international community to bring in maximum transparency for the developing countries, like Pakistan;

(iv) As a part of overall scheme to bring in foreign assets of Pakistani citizens within the Pakistan’s tax system, the provision relating to gain on disposal of Pakistan assets by offshore companies held by Pakistanis has been fundamentally changed. Now, it is not possible to keep such income outside the ambit of taxation in Pakistan;

(v) Similarly, a detailed concept of ‘Controlled Foreign Company’ has been introduced whereby income of a non-resident company controlled by a Pakistani citizen, despite arising outside Pakistan, can be taxed in Pakistan even though not being a Pakistan income and not repatriated to Pakistan. In short, it is not possible for resident Pakistani to keep their earning untaxed outside Pakistan;

(vi) The concept of taxation of a composite contract has been changed with an attempt to tax whole consideration in Pakistan; and

(vii) Tax treaties may not always be available to protect a case where there is an underlying tax avoidance in a transaction or a scheme.

All these changes reveal that all Pakistani citizens should re-examine their foreign structure as the concessions and protection previously available may not be there after July 1, 2018. This therefore, requires that the opportunity provided by ‘One Time Compliance Scheme’, which is expiring on June 30, 2018 be availed. It is author’s view that in future, there will be a documented economy around the world including gulf countries. There is a serious need to examine the assets, transaction and structure created in tax havens and treaty friendly jurisdictions, including UAE. This chance may not be available in future.