The undesired event:
The Federal Board of Revenue (FBR) through a letter dated October 31, 2022 has clarified that income from rental property situated outside Pakistan is taxable in the hands of a person resident in Pakistan. This means that if Mr A is a tax resident in Pakistan and he earns rent from a property in the UAE then such rent is taxable in Pakistan even if the said rent is also taxed in the UAE.
A credit under the law will be allowable to Mr A if the amount is doubly taxed. In this author’s view, there is no ambiguity and confusion on this matter as per the generally acceptable interpretation of international tax laws, including the Agreements for Avoidance of Double Taxation, which Pakistan has signed with other countries, hereinafter referred to as treaties.
In Pakistan, like many other issues, this subject has again been confused by conflicting decisions made by the Appellate Tribunal Inland Revenue. This ambiguity is causing a serious loss to the exchequer as there are a very large number of Pakistanis who own properties outside Pakistan and earn rental income from such properties.
It is not equitable that such income is not taxed in Pakistan when salaries, etc., are taxed with a very low threshold. This problem is further aggravated by the fact that a particular interpretation of Agreements for Avoidance of Double Taxation is adopted to decide matters, which are well settled at the international forums.
In a recent decision released by the ATIR on October 23, 2024, it has been held that income from the UAE cannot be taxed in Pakistan even if the recipient of such rental income is a Pakistan tax resident, as such income cannot be charged to tax by way of application of Article [6(1)] of the DTA between Pakistan and the UAE. In this respect it is important to note that there were two earlier conflicting decisions on this issue, where the latter being a detailed judgment that has decided the matter against the taxpayer.
Pakistani tax law:
Section [11(5)] of The Income Tax Ordinance, 2001, Provides as under:
“The income of a resident person under a head of income shall be computed by taking into account amounts that are Pakistan-Source income and amounts that are foreign-source income.”
International practice and interpretation:
In the famous case of Azadi Bachao Andolan, the Supreme Court of India explained the nature of bilateral tax treaties as under:
“According to Klaus Vogel, Double Taxation Conventions establish an independent mechanism to avoid double taxation through restriction of tax claims in areas where overlapping tax claims are expected, or at least theoretically possible. In other words, Contracting States mutually bind themselves not to levy taxes or to tax only to a limited extent in cases when the treaty reserves taxation for the other Contracting State either entirely or in part.
Contracting States are said to waive ‘tax claims’ or more illustratively to divide ‘tax sources’, ‘taxable objects’, amongst themselves“.
Double taxation avoidance treaties were in vogue even from the time of the League of Nations. The experts appointed in the early 1920s by the League of Nations explained this method of classification of items and their assignments to the Contracting States. While the English lawyers called it ‘classification’ and ‘assignment rule’, the German jurists described it as ‘the distributive rule’ (Verteilungsnorm).
To the extent that an exemption is agreed to, its effect is in principle independent of both whether the Contracting State imposes a tax in the situation to which the exemption applies, and irrespective of whether the State actually levies the tax.
Commenting particularly on the Convention between Germany and the US for the Avoidance of Double Taxation, Vogel argues: “Thus, it is said that the treaty prevents not only ‘current’ but also merely ‘potential’ double taxation”. Further, according to Vogel, “only in exceptional cases, and only when expressly agreed to by the parties, is exemption in one of the Contracting States dependent upon whether the income or capital is taxable in the other Contracting State, or upon whether it is actually taxed there.”
The Agreements for Avoidance of Double Taxation are international agreements. These agreements are signed after negotiations and each jurisdiction decides its own right to tax its residents. In order to provide consistency and ease in application international models have been developed.
The most common model is the one developed by the Organisation of Economic Cooperation and Development (OECD). It is good that the UAE-Pakistan tax treaty has been developed on the OECD model. Now the question is whether or not courts should adopt a meaning which is completely different from what has been agreed under those frameworks and their accepted meanings internationally. This would be very detrimental for the international tax practice of Pakistan.
The author is not aware of any decision in any domestic and international court where any other interpretation has been adopted. A case of the Supreme Court of India reported as (2004) 267 ITR 654 is usually referred to as a case where a different interpretation is considered to have been adopted.
We need not to enter into an exercise in semantics as to whether the expression “may be” will mean allocation of power to tax or is only one of the options and it only grants power to tax in that State and unless tax is imposed and paid no relief can be sought.
Reading the Treaty in question as a whole when it is intended that even though it is possible for a resident in India to be taxed in terms of Sections 4 and 5, if he is deemed to be a resident of a contracting State whether his personal and economic relations are closer, then his residence in India will become irrelevant. The Treaty will have to be interpreted as such and prevails over Sections 4 and 5 of the Act. Therefore, we are of the view that the High Court is justified in reaching its conclusion, though for different reasons from those stated by the High Court.
The exact issue under consideration:
The matter relates to interpretation and application of Article [6(1))] of the treaty which is an adopted version from OECD Model treaty. The same text has been used in the UN Model treaty.
Insofar as the application of the distributive principles in the OECD Model Tax Convention and UN Treaty frameworks is concerned, there are only two methods of taxing rights by a person for the doubly-taxed income. These are:
a. In the first case, a certain income treaty provides that a source of income arising ‘may be taxed in that other State’, which means that the country of residence may or may not tax such income under its domestic laws. However, the treaty binds that if the income is doubly taxed a credit will be allowed for such doubly-taxed income.
The country of residence has the right to exempt such income; however that does not arise from the aforesaid wording. If it is to be so provided then either the wording in the treaty would have to be changed or an exemption is to be provided in the domestic laws.
b. For other cases, the treaty provides that income shall be taxable only in the state of residence of the taxpayer. Unless the income is arising for PE, etc.
The word ‘shall’ is not the opposite of the word ‘may’. That the word ‘shall’ indicates obligation is a fact. The word ‘may’ either grants permission (“Yes, you may enter”, for example) or indicates possibility (“If I do well on the remaining exams, I may still pass the class”). It is therefore clear that whenever the word ‘may’ is used in the treaty framework it grants permission to the other state to charge tax.
It is important to note that the word ‘may’ has been used without the word ‘only’ as against the other position the word ‘shall’ has been used with the word ‘only’. The famous writer of international taxation has highlighted that this subject becomes absolutely clear when the word ‘only’ is properly understood.
When the sentence used is ‘shall be taxable only in the state of residence’ then it means that the possibility of taxation in the other state is absolutely blocked or finished. It is therefore when the other sentence ‘being taxed in that other State’ is used there is no use of the word ‘only’. This means that possibility or option remains open.
This subject has to be examined in the light of the situation, which was being tackled in these Articles. For example, for business income, wherever arising, it was decided that only the state of residence will have the right of taxation. On the other hand, for rent it was decided that the place where the property is situated will have the right in all circumstances; however, if the owner is a resident of other state then it is left to that other state to decide the fate of tax on such income.
The only way through which this situation can be written in precise English is the one that is placed in the English version of the treaty. The words for the first situation are ‘shall only’. And the word for the other is ‘may’. The extended usage would have been ‘taxed in the other contracting state if so provided in the domestic legislation of that state’.
As a principle bilateral treaties are not concerned with domestic legislation. They only provide inter-state relationships. Both OECD and UN Models have decided that with respect to rent, interest, capital gains and dividend the country of residence would not absolve its right to tax these income in other states, however if so required can exempt that under its domestic laws.
In case of the interpretation adopted by the ATIR in the latest judgement is applied then it would mean that Pakistan has no right to tax interest, capital gains, rent, technical fees, royalties arising outside Pakistan to the person resident in Pakistan.
In other words, it would mean that OECD has prescribed that if there is a treaty under the OECD Model then the country of residence cannot tax interest, capital gains, rent, dividend arising to its residents in case there is an agreement for double taxation. This is a completely inconceivable idea that dismantles the whole framework on a completely wrong premise.
UAE-Pakistan Tax Treaty:
This subject can be further elaborated by the terms used in the Pakistan-UAE Treaty. In that treaty instead of two terms as used in OECD four terms have been used. These are:
a. May be taxed in that other State.
b. Shall be taxable only.
c. Independent Personal Services 1. Income derived by a resident of a Contracting State in respect of professional services or other independent activities of a similar character shall be taxable only in that State except in the following circumstances, when such income may also be taxed in the other Contracting State:
(a) If he has a fixed base regularly available to him in the other Contracting State for the purpose of performing his activities; in that case, only so much of the income as is attributable to that fixed base, may be taxed in the other Contracting State;
d. Dependent Services: Notwithstanding the provisions of paragraph 1, remuneration derived by a resident of a Contracting State in respect of an employment exercised in the other Contracting State shall be taxable only in the first - mentioned State if:
The manner laid down in (c) above can be treated to lay down a different principle which can also be construed to have a different effect on the explanation as given above. However, when the matter is seen in complete context then it appears that context is the same. The right to tax is also there to the state of residence for the income arising in other state. The word ‘also’ in this Article does not mean that it has the meaning as if the word ‘only’ would have been there in other Articles.
There is no confusion on the matter of application of these Articles. Exactly, the same terms have been used in UAE-Pakistan tax treaty, except for independent and dependent services. In the OECD Model these Articles have been omitted and replaced by a new Article on ‘Income from Employment’.
It can by no stretch of imagination be perceived that whenever it is said that a certain income ‘may be taxed’ in a particular State, it may mean that the said income is not to be taxed in that particular State or only the other contracting State has the power to tax the said income. The reason is simply the fact that the treaties are drafted by the people possessing a high degree of legal prudence. If this is the case, who has stopped them to provide in the relevant Article the taxability in the intending state by using the words like ‘shall be’ or ‘will be’? What was the need to use such gibberish language? Such an interpretation will be a defeat of all common principles of interpretation of statutes or of simple agreements.
Solution:
The only solution to the problem is an early decision by the High Court. The High Court whilst making such a decision is to be guided by the international practices of interpretation of treaties, which is completely settled. The Federal Board of Revenue (FBR) should be aware that till the time the latest order of the Tribunal is in the field the taxpayers are entitled to take benefit of the decision and any action by the FBR, including any circular, etc., will have no binding value for the judicial authorities.–(The writer is a former FBR chairman)
Copyright Business Recorder, 2025
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