Yet another feature of the Income Tax Ordinance, 2001 (the Ordinance) that stands distinct from the provisions of the repealed Income Tax Ordinance, 1979 (the repealed Ordinance) is the introduction of the limited "force of attraction" rule for the purpose of determining the attributable business income of a non-resident person in Pakistan. The said principle as introduced now in the domestic law has been part and parcel of most of the Double Taxation Treaties that Pakistan has with various other countries.
Under this principle, if a non resident being the head office of a Permanent Establishment (PE) in Pakistan engages itself in the same or similar activities, including the sale of the same or similar kind of goods in Pakistan, as that of its PE in Pakistan, then the income of the PE chargeable to tax in Pakistan would include the income earned by the head office from such direct supply / conduct of activities.
This article tends to evaluate the provisions governing the taxability of income earned by a PE in Pakistan of a non resident person.
As in most of the countries, the income tax law of Pakistan tends to tax the source / nature of activity rather than the person undertaking the same. If for instance the business of a tax payer is to earn income from letting out immovable property, such income is taxed under the head "Income from Property" and not as "Business Income". It needs to be appreciated that such source may either be absolute, as in the case of salary or property income, or denoted to be such, as in the case of royalty or interest / profit on debt.
It would be recalled that under the provisions of the repealed Ordinance, Pakistan source business income was deemed to accrue or arise to a non resident person if such income was directly or indirectly attributable to a business connection in Pakistan.
Even though the expression "business connection" has a wide and uncertain connotation, courts have interpreted the connection to be real and sufficient. Whereas a stray or an isolated transaction is generally not to be regarded as a business connection, the solution to the question is dependent upon the particular facts of each case.
Their Lordships of the Supreme Court of India have held that the expression "business connection" constitute a real and intimate relationship between business activities carried on by a non resident outside the territorial jurisdiction of India, which yields profits or gains, and some activities carried on within the country which contributes directly or indirectly to the earning of such profits or gains.
It follows that if all the operations of a business are carried out in [Pakistan], the entire income shall be deemed to have accrued in [Pakistan]. If however all the operations are not carried out in [Pakistan], only that part of the profits and gains as attributable to the business connection in Pakistan would be deemed to accrue in [Pakistan].
Conversely, if no business activity is carried out in [Pakistan], the income accruing or arising abroad through or from any business connection in [Pakistan] cannot be deemed to accrue or arise in Pakistan. {CIT v. Toshoku Ltd (1980) 125 ITR 525 (SC)}. (For understanding purposes the word India as used by the Court has been replaced with Pakistan).
Promulgation of the Ordinance has however further refined the basis of taxation of business income of a non resident in Pakistan by co-relating the same as being attributable, directly or indirectly to the PE in Pakistan of the non resident person.
Section 101 of the Ordinance while identifying the various categories of income to constitute as Pakistan source expressly provides in sub section 3 thereof as under:
"(3) Business income of a non-resident person shall be Pakistan-source income to the extent to which it is directly or indirectly attributable to;
(a) a permanent establishment of the non-resident person in Pakistan;
(b) sales in Pakistan of goods merchandise of the same or similar kind as those sold by the person through a permanent establishment in Pakistan;
(c) other business activities carried on in Pakistan of the same or similar kind as those effected by the non-resident through a permanent establishment in Pakistan; or
(d) any business connection in Pakistan."
The above provisions of the Ordinance, except for clause (d), are in consonance with the UN Model Treaty and gives tax jurisdiction not only to the profits attributable to the PE [clause (a)] but also to those arising from the transactions in Pakistan outside the PE [clause (b) and (c)].
Through such provisions the PE is in effect equated with that of the resident tax payer so that once it is found that the non resident has an existence in Pakistan, the non resident becomes subject to tax invariably on all the activities carried on in Pakistan.
However, it needs to be noted that the direct indulgence of the head office in Pakistan needs to be in activities or supply of goods of same or similar kind as that being undertaken by the PE to render such income as also subject to tax in Pakistan.
In other words, incomes arising out of activities not being similar in nature to those of the PE remain outside the purview of charge of Pakistan tax. Reference in this regard is made to an infamous decision of the learned Income Tax Appellate Tribunal cited as (1999) 80 Tax 17(Trib.) wherein the assessee, being a company incorporated under the laws of Italy, entered into a contract with a local corporation for the supply of plant and machinery and its subsequent erection, testing and commissioning.
Whereas the local corporation was required to import the plant and machinery directly from the assessee, the erection and commissioning activities were to be performed in Pakistan through the branch office.
The taxation officer however while finalising the assessment of the assessee under the repealed Ordinance, for the relevant assessment year, treated the entire receipts of the assessee, including its receipt from the supply of plant and machinery, to Pakistan tax denoting it to be attributable to the business connection in Pakistan in terms of sub section (2) of section 12 of the repealed Ordinance, read in conjunction with Article 7 of the Double Taxation Treaty with Italy. Article 7 of the said Treaty pari materia correspond to section 101(3) of the Ordinance.
The learned Tribunal however declined the stance of the Department imposing tax on the receipts of the assessee arising out of the direct sale of machinery to the corporation as being in the nature of same or similar kind of activities as conducted by the branch office (PE) with the following observation:
"We have given careful consideration to the facts and circumstances of the case supra and we find that Article 7 of the Convention supra provides that profits of an enterprise of a contracting state shall be taxable only if it carries on business in Pakistan through a PE but only so much of such profits as is attributable either (a) to that PE or (b)(i) to sale of goods or merchandise of the same or similar kind as those sold through that PE, or (b)(ii) to other business activities of the same or similar kind as those effected through that PE.
Thus the impugned receipts of the respondent enterprise outside Pakistan for supply of equipment stipulated in the Agreement from outside Pakistan are neither on account of carrying on business attributable to the PE nor attributable to any sale of goods or other business activity of the same or similar kind that is effected through the PE.
As stipulated in the terms of Agreement supra the respondent has neither carried on any business of sale of foreign equipment and materials, including spare parts, through the PE nor has received any amount outside Pakistan attributable to any sale of goods or merchandise of the same or similar kind as those effected through the PE because it has effected only the other business of unloading from ship, loading on trucks and transportation of imported equipment and material from Port to site; local purchase of spare parts; erection and commissioning of such equipment."
This principle is popularly known as the limited "force of attraction" rule where under income attributable to direct sale / supply of goods or merchandise or conduct of activities of same or similar kind as those of the PE render such income as also attributable to the PE in Pakistan of such non resident person.
It is important to note that the application of the principle has been restricted to business income and not extended to income from investment, such as dividend, interest, royalties and rents, which basis of taxation are determined on other principles provided for under the Ordinance.
Having discussed the basis for determining Pakistan source business income attributable to a non resident person now let us analyse the circumstances under which a non resident is construed to have a PE in Pakistan.
Clause (47) of section 2 of the Ordinance defines the expression "permanent establishment" to mean as under:
"permanent establishment" in relation to a person, means a place of business through which the business of the person is wholly or partly carried on, and includes;
(a) a place of management, branch, office, factory or workshop, premises for soliciting orders, warehouse, permanent sales exhibition or sales outlet, other than a liaison office except where the office engages in the negotiation of contracts (other than contracts of purchase);
(b) a mine, oil or gas well, quarry or any other place of extraction of natural resources;
(c) an agricultural, pastoral or forestry property;
(d) a building site, a construction, assembly or installation project or supervisory activities connected with such site or project;
(e) the furnishing of services, including consultancy services, by any person through employees or other personnel engaged by the person for such purpose;
(f) a person acting in Pakistan on behalf of the person (hereinafter referred to as the "agent"), other than an agent of independent status acting in the ordinary course of business as such, if the agent;
(i) has and habitually exercises an authority to conclude contracts on behalf of the other person;
(ii) has no such authority, but habitually maintains a stock-in-trade or other merchandise from which the agent regularly delivers goods or merchandise on behalf of the other person; or
(g) any substantial equipment installed, or other asset or property capable of activity giving rise to income.
It would be noted that the expression "permanent establishment" has been extensively defined so as to cater to the varied circumstances under which a no resident is presumed to have a PE in Pakistan.
It needs to be appreciated that the definition is not exhaustive, but illustrative in nature and may include other instances where the non-resident is considered to have a PE in Pakistan.
The OECD (Organisation for Economic Co-operation and Development) Model Treaty, however, commenting on the girth of the term establish that the three pre requisites of "place-of-business test", "permanence test", and "business-activity test" must be satisfied before a person is denoted to have a PE in a particular territory.
Therefore, just as an independent agent of a non resident person, acting in the normal course of its business activities is represented not to be a PE of the non resident person, so also a subsidiary company of a non resident person in itself, by virtue of its holding, is not regarded as a PE of such a non resident holding company.
In general term the expression "permanent establishment" connotes extension of business activity in another territory, as if doing business in that jurisdiction.
The expression postulates the existence of a substantial element of an enduring and permanent nature of a foreign enterprise in another country which can be attributed to a fixed place of business in that country and it could be of such nature that it would amount to virtual projection of a foreign enterprise of a country into the soil of another country.
The expression, inter alia, includes a person who represents a PE and who in himself represents "a fixed place of business".
Such person may either be an individual or any other judicial entity. The basic purpose of identification of such existence is to determine the right of the Revenue of a particular territory to tax the income of an enterprise of another territory.
Whereas most of the entrants to the definition are similar to the definition of the term as contained in the UN Model Treaty, entrants (e) and (g) are note worthy. It is interesting to note that the domestic law does not specify the time frame over which the services are rendered by the non resident person in Pakistan, through employees or otherwise, whereby it is considered to have a PE in Pakistan.
This means that if the employees of a non resident are present in Pakistan under a contract with the local company for providing consultancy services for even a single day, then, in terms of the said sub clause (e), such a non resident would be considered to have a PE in Pakistan.
However, such a presumption appears principally in contrast to the concept of fixed / permanent place of business of the non resident. As such it is suggested that the tax authorities should revisit the particular sub clause and determine a time frame of say six months stay in Pakistan, either singularly or under multiple arrangements, for the purpose of determining the existence of PE in Pakistan.
Sub clause (g) of the said definition is perhaps introduced to cater to the e-commerce situation, whereby ownership of any asset, property or installation of substantial equipment in Pakistan is construed to constitute a PE in Pakistan of the non resident person.
However, existence of such a substantial equipment, asset or property must have a direct nexus to the earning of income by such an enterprise. Therefore, a satellite, established within the territories of Pakistan and capable of generating revenues from Pakistan, through transmission of signals, would be considered to be a PE of the non resident in Pakistan.
However the issue whether or not the website hosting in Pakistan capable, of deriving revenues through advertisements or otherwise on such websites constitute a PE in Pakistan still remains unaddressed just as much as the question of an ISP providing internet related services to a non resident remains un answered.
Both the OECD and the UN Model Treaties have their own views regarding application of the PE rule in relation to e-commerce business and it is high time that guidance is sought in this regard and appropriate amendments be brought into the definition to specifically cater to the e-commerce business activities.
Having dealt with the principles of taxation of business income attributable to the PE in Pakistan of a non resident person, let us discuss the manner in which the taxable business income is computed in relation to such a PE.
The general rule is that all the provisions of the Ordinance as applicable to a resident enterprise are applicable to the PE; including the provisions relating to depreciation, deductible business expenses, carry forward and set off of losses, etc. Distinction however is made with respect to the following items, as provided for under section 105 of the Ordinance:
a) Treating the PE as completely independent of the enterprise of which it is a PE, and hence establishing the arm's length principle in relation to transactions amongst them.
The Ordinance propagate the principle that in order to determine the attributable profits of the PE, the head office and the PE should be viewed as distinct and separate enterprises, engaged in the same and similar activities under same and similar conditions and dealing wholly independently with the non resident of which it is a PE.
Thus all the transactions entered into between the two parties are to be evaluated on the doctrine of arm's length; as if between two independent organisations.
b) Expenses which could be attributable to the income of the PE are allowable deductions. All the expenses incurred for the purposes of the business activities of the PE, including executive and administrative expenses so incurred, whether in Pakistan or elsewhere, are allowed as deduction.
Courts have interpreted that the expenditure needs to be of revenue nature and must bear the element of commercial expediency.
Further, deduction in respect of general administrative expenses incurred by the head office for and on behalf of the PE, because of the inherent nature of their verification and authentication, has been restricted to a maximum of such amount as bears to the PE in Pakistan the same proportion that the non resident's (head office) total head office expenses bears to its world wide turnover.
However, in terms of most of the Double Taxation Treaties that Pakistan has with various countries, such head office expenses are allowed without any restriction.
c) No deduction is permitted in respect of certain payments, such as royalty, fees, profit on debt, etc when paid to the head office. The essence of such disallowance is perhaps for the reason that a person cannot make a profit by contracting with himself.
Since in legal terms both the enterprise (ie the head office and the PE) are but one, the amount of royalty, fees or other similar payments including compensation for any services performed by the head office for the PE and profit on money lent to the PE (except in connection with a banking business) are not allowable deductions for the PE.
However reimbursement of actual expenses incurred by the head office to third parties, for and on behalf of the PE, is permissible as deduction. On the same footing, receipts in the nature of sources identified above, received by the PE from the head office, also do not constitute the income of the PE.
Further, in order to avoid transaction fragmentation, receipts and payments by the PE from and to another PE of the head office also remain non-deductible.
Also, profit / interest paid or payable by the head office on debt borrowed to finance the PE or the insurance premium paid or payable in respect of such debt is also disallowed to the PE for the purpose of computing the amount of taxable income chargeable under the head "Income from Business" of the PE.
8. Keeping the domestic provisions of law relating to taxability of business income in Pakistan attributable to the non-residents in their perspective now let us analyse the contents in the light of the Double Taxation Treaties that Pakistan has with different countries.
To date Pakistan has signed such anti avoidance agreements with 53 countries. Most of the Treaties, while adopting the UN Model Treaty format, cater to both the "attribution" and the "attraction" aspects of the PE for the purpose of determining business income of a non resident person chargeable to tax in Pakistan.
However certain agreements, including those signed with the US, the UK, Germany, France and Japan, continue to subscribe to the OECD Model and tends to tax only the profits that are directly attributable to the PE of the enterprise of such a contracting state.
Further, the meaning of the term PE as defined in the Treaties specifically exclude certain circumstances under which an enterprise is not considered to have a PE in Pakistan. The exclusion list particularly includes the following circumstances as not to constitute a PE under the respective Treaties:
-- the use of facilities solely for the purpose of storage or display of goods or merchandise belonging to the enterprise;
-- the maintenance of stock of goods or merchandise belonging to the enterprise solely for the purpose of storage or display;
-- the maintenance of stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;
-- the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of preparatory or auxiliary character.
Since taxation of business income of a non-resident is directly co-related to the existence of the PE in Pakistan, such exclusions are particularly significant from an investment and tax planning perspective.
Further, the manner in which the definition of the term has been developed do not particularly attend to the e-commerce activities which has expanded businesses beyond the territorial jurisdiction of a contracting state with the effect that even if the non resident, under the domestic provisions of law, is represented to have a PE in Pakistan, there is suitable margin to establish otherwise in terms of the Treaties.
With WTO just round the corner and each and every country trying to make the most out of it, it is well beyond the eleventh hour to have a revisit of the various Treaties to facilitate and endorse foreign investment, at the same time taxing what is justly due.
9. The Revenue Canada's Advisory Committee in its report issued near the end of the preceding century observed that "a fundamental principle of a sound tax policy is that the tax should be economically neutral as well as equitable. A tax is neutral or efficient when it does not induce the tax payers to change their behaviour in response to the tax."
Even though the Ordinance has suitably been drafted to represent an efficient and economical tax structure, the Treaties do not particularly support the system and unless and until proper steps are taken to harmonise the effect, there would always be means to circumvent the tax effect of certain transactions giving rise to Pakistan source income.
Comments
Comments are closed.