IT export sector – I

Pakistan’s IT export sector has been in the news a lot lately. The reason is because after so many years of fairly flat or nominal growth, IT exports started growing by 12-15% in 2017 and then grew by a whopping 46% in the 2021 and 23% in 2022 tax years.

I know this first hand because I have been running an IT export business myself between Islamabad and the Silicon Valley, California since 1998 when only a handful of companies provided IT export services from Pakistan.

The likely reason for Pakistan’s IT export growth in these recent years was first a higher than usual economic growth in the US7 (US accounts for more than 60% of IT exports) and other first world countries and secondly, the Covid-19 pandemic in early 2020 that most likely gave it the big boost that we saw in 2021.

Covid-19 forced companies to allow their employees to work remotely from home. This created an overall remote work culture that is essential for effectively outsourcing work to an offshore destination like Pakistan.

Pakistan benefited greatly because it is among the very few countries in the world that provides good-quality and a low-cost English-speaking skilled workforce.

IT export sector says tax exemptions are a must

Nonetheless the IT export sector has been claiming that it is the 100% tax exemptions on IT exports which are the real reason IT exports have grown and if these tax exemptions were to be taken away (which the government tried recently under IMF pressure), the IT export growth will not only stop but actually decline.

They say that without these tax exemptions, new IT export businesses will stop coming to Pakistan and will instead go to other attractive destinations in our region like India, Bangladesh, and the Philippines. They also say that the existing IT export businesses will reduce the amount of money they bring to Pakistan and will instead park this money overseas.

In the worst case, many of these existing IT export businesses (and freelancers) would move out of Pakistan just like some Pakistani textile factories relocated to Bangladesh when they couldn’t operate in Pakistan due to prohibitively high energy costs that made them less competitive.

This is obviously a very scary scenario for a country like Pakistan that is foreign exchange starved. Therefore, government officials who may not fully understand the nature of this industry get scared and keep giving 100% tax exemptions to IT exports since the late 1990s. In fact, just recently when the government imposed a tiny 0.25% to 1% withholding tax as the “final tax” on IT exports under IMF pressure, the IT export sector was up in arms.

Fortunately, nothing could be farther from the truth about the scary picture being painted by the IT export sector. Quite the contrary, these blanket tax exemptions have no relation to Pakistan’s IT export growth (this growth or lack of it is dependent on totally different factors). Let me explain why.

Anatomy of IT export sector

In order to better understand why IT sector’s fears are not based on reality, let me first explain the anatomy of Pakistan’s IT export sector. The IT export sector comprises of the corporate side, which is the real backbone of the IT export sector, and also the freelancers / remote workers.

The corporate side are the businesses which are hiring employees, training them and using them for providing services to clients, strategic partner businesses, or parent companies abroad. The majority of these IT export businesses are providing IT services like software development or other related business activities. Some of them are also providing call center services. And then there are other businesses which provide numerous IT-enabled business services. Currently, setups like data centers, IT manufacturing and warehousing, and other larger scale businesses are not very common.

Many IT export businesses are providing services directly to clients overseas or developing their own software products and selling them to clients globally. In this case, they almost always have a front foreign business entity in a first world country. This entity is responsible for finding clients, building relationships and winning business from them, and overseeing the sales and marketing side of things.

In this mix, the front foreign business entity usually has the controlling majority ownership of the overall business and the offshore business entity is a minority owner and seen as a service provider. As a result, the majority of profits belong to the foreign business entity owners and are kept there while only the offshore business entity’s profits are sent to Pakistan.

Additionally, the front business entity is either fully or partially owned by expatriate Pakistanis who are either friends or relatives of the Pakistani entity owners.

Some IT export businesses are providing back-office services to a larger well-established parent company overseas. They are able to do this because again some expat Pakistanis in that parent company are in senior management / executive positions and they influence the decision to open the offshore office in Pakistan.

Last but not least, many IT export businesses are fully Pakistan based and their owners/executives win business from overseas either through connections and other marketing techniques. Even in this case, the more successful entities open a shell front business entity overseas so their clients would feel comfortable doing business with a business entity incorporated in that country. In this case, most of profits are brought to Pakistan and only a nominal portion is kept overseas to meet business needs there. Any profits kept overseas are taxed in those countries at year-end.

The corporate side is the back-bone of Pakistan IT export sector because it develops organizational expertise and the ecosystem that is essential for growing this industry and eventually developing intellectual property (IP) and selling it globally. India for a long time stayed purely as a service providing IT export sector, but in recent years they’ve graduated to the next level and are now increasingly developing their own products and IP and selling it globally. Pakistan has very few product-based IT export businesses (my business is luckily among them).

Freelancers and remote workers on the other hand are usually skilled and experienced individuals who started their career working for a corporate IT export business and have now built enough experience to directly get work from foreign clients or employers.

Freelancers find their clients and short-term projects usually from freelancing marketplaces like Upwork, Fiverr, and more. Remote workers are a new phenomenon which has become quite popular after the Covid-19 pandemic. Remote workers find longer term contract jobs with foreign employers through placement agencies like Turing.com and others.

Freelancers and remote workers do not contribute nearly as much to the IT export sector as the corporate side (although they earn considerably more than previous local jobs). However, some of them do graduate into becoming business owners and developing their own teams and contributing. Some eventually go abroad and work in the Middle East, Europe, the US, Canada, Australia, etc. to advance their careers.

Why does IT services business come to Pakistan?

The real question is, does IT export business come to Pakistan because of any tax exemptions? The answer is a strong No. So, why does the IT Services business come to Pakistan? Let me explain why below.

One of the reasons IT export business comes to Pakistan is because Pakistan offers a high quality, low-cost, skilled English-speaking workforce. Pakistan also provides world class IT infrastructure to set up offices, like high speed bandwidth and offices in at least major cities including Islamabad, Lahore, and Karachi.

Despite recent inflation, the overall cost of doing IT export business in Pakistan is fairly competitive. Unlike the textile sector, the IT exports sector has very comfortable profit margins to absorb any such cost fluctuations and Pak Rupee devaluation also helps in this regard. This is why despite being forced to almost double employee salaries in the last 2 years, the IT Sector is still comfortably profitable.

But, all these reasons by themselves are not enough because India, Bangladesh, and Philippines also offer the same value.

So, the biggest reason IT services business comes to Pakistan are expat Pakistanis who are responsible for it. These expat Pakistanis do this because they’re comfortable with Pakistan and have roots and emotional attachment here. This is even more true with purely Pakistan based IT export businesses because their owners often have moved back to Pakistan after studying or working abroad for the same reasons.

All these expat Pakistanis choose Pakistan as their destination for purely selfish reasons because this is where they feel they’ll have full control over their business and hence the greatest chance of success. Going to an unknown place like India, Bangladesh, or the Philippines would make no sense for them. The story is the same with India, Bangladesh, and the Philippines as their expat communities have been instrumental in growing their IT export sectors.

All of this means that the chances of IT export businesses moving out of Pakistan are very low. As long as they’re able to make money through Pakistan in the same manner as other similar countries, they won’t go anywhere else.

Is there any taxation problem for the IT export sector?

Is there is any taxation problem with IT export sector that requires fixing and which could hurt its future growth if not addressed? And, the answer is a strong Yes. I suspect the IT export sector is using this genuine grievance to demand tax exemptions.

Copyright Business Recorder, 2022