Offshore assets

This article is in continuation of the articles written by me on the matter earlier. A constructive debate has started about the Offshore Asset of Pakistanis in the post 'Panama Leaks' scenario. It is, however, not encouraging that this matter is being deliberated without complete understanding of facts and circumstances. The purpose of this article is to understand the matter in its complete context, prior to the start of other side of debate.
This article is structured to cover all aspects of the matter which are as under:
1. Legal and regulatory status;
2. Manner of accumulation;
3. Kinds of offshore assets;
4. Ownership structure and declaration;
5. Volume of assets and period of accumulation;
6. Effects positive/negative
7. Way forward and suggested actions
Legal and regulatory There is a completely wrong perception, based on certain regulatory provisions not applicable any more that a 'Pakistani Citizen' cannot hold assets outside Pakistan. That position existed before 2003, with some exception; however, in the post 2003 scenario, there is no restriction on Pakistani Citizens to hold any kind of asset abroad. This view is totally unqualified.
The second misperception is that all transfers of funds outside Pakistan by individuals need approval from the State Bank of Pakistan. Under the Foreign Currency Accounts (Protection) Ordinance, 2001 dated September 20, 2001, which is a valid law, movement of foreign currency is unrestricted if made within the ambit of that law. There is no decision of any court including 2006 SCMR 1609 that affects the fundamental rights given under the aforesaid Ordinance.
The purpose of this article is not to highlight the legal and regulatory framework; therefore, discussion on that matter will stop here with the conclusion that holding assets outside Pakistan and sending funds as per the system laid down under the aforesaid law is within the legal and regulatory framework of Pakistan. I will explain these aspects in a separate article.
Manner of accumulation Whatever is being stated in the following paragraph is an academic estimate and observation, based on ongoing practices in the country. Assets abroad, in my view, have been created out of the following sources:
1. Export Commissions to Associated Undertakings of Exporters;
2. Import Commission to Associated Undertakings of the Importers;
3. Income Earned Abroad and Retained Outside;
4. Other Commissions and Bribes;
5. Funds transferred from Pakistan through legal means; and
6. Funds transferred from Pakistan through illegal means (Hawala etc)
These are six main sources through which Pakistanis have accumulated assets outside Pakistan. Out of the same, first four are funds not transferred from here; those were generated outside Pakistan and retained there. The second two are the funds transferred from here. In the following paragraphs, I will give the estimated sum out of each head; however, it would be better to first understand the nature of transaction involved.
Export and Import Commission Under the Pakistan law, exporters are allowed to pay commission abroad at a certain percentage. At present, such percentage is 7 percent. Furthermore, there is no restriction on involving a commission agent in the import transaction.
As per apparent status of law, there is no restriction that such commission cannot be paid to an entity that is associated with the exporter. Accordingly, a portion of commission can effectively be paid to an entity that is, directly or indirectly, owned by the exporter. In this connection, it should be recognised that payment of commission is a usual practice and restrictions as to dealings with an associated entity are effectively non implementable.
Same is almost the case with the import transaction. In this case, arrangements are made with the importer and payments are generally made out of the amount remitted through L/C by the importer.
Income earned and retained outside Pakistan There is a very large number of Pakistanis living abroad. Their earnings are reflected in assets held abroad. When such Pakistanis return from abroad many of them, if not all, usually retain their assets abroad. This represents a very large sum in middle and upper middle income returning expatriates.
Other commissions and bribes This is a controversial and sensitive topic. With respect to many third world countries, there is a perception and a reality that commissions and bribes are accumulated outside Pakistan by decision makers.
Funds transferred from Pakistan through legal means A substantial portion of assets outside Pakistan have been accumulated out of funds transferred outside Pakistan. For that purpose, legal means are used. The legal means are transfer of funds out of foreign currency accounts maintained under the Foreign Currency Accounts (Protection) Ordinance, 2001. Prior to such an Ordinance, protection was available under the Protection of Economic Reform Act, 1992. Whether or not tax has been paid on such funds, is a separate subject.
Funds transferred from Pakistan using illegal means such as 'Hawala'Sending funds outside Pakistan through 'hawala' or 'hundi' is an illegal act under the foreign exchange regulations. Nevertheless, it is an undeniable fact that such a mechanism is prevalent in Pakistan, directly or indirectly, using the sources and means of Pakistani expatriates and diaspora abroad. This adverse side of foreign exchange liberalisation in 1990's was not fully catered administratively in the post liberalisation period. A substantial amount of inward and outward movement of funds takes place using this mode of transfer of funds.
It is almost impossible to identify the volume and assets created out of the sources of funds identified in the list above. This article is restricted to the understanding of the system; therefore, for a purpose, tax implications of the same have not been discussed. It is so because unless there is a proper segregation of various transactions, there will almost be an impossibility to enter into the debate on tax declaration and procedures to be introduced to bring such assets within the ambit of Pakistan's regulations.
Another important feature of this classification is its universality. Offshore assets, of the citizens of all the countries are created using one of the six modes identified above. In developed countries, post liberalisation, there is a general trend and necessity to remove the restrictions ensuring complete payment of tax in the country of source, including domestic declaration for income tax purposes.
Kinds and form of offshore assets There can be different classifications of kinds and forms of assets held, directly or indirectly, by Pakistani citizens abroad.
The first classification may be by the kind of assets. Major heads under the same are:
1. Real estate and other immovable properties abroad;
2. Bank deposits;
3. Investments in securities, local or abroad; and
4. Loans/receivables from other companies
The second classification is by the ultimate location of assets:
1. Assets ultimately held outside Pakistan; and
2. Interest in entities holding assets, mainly shares and real estate in Pakistan.
With regard to the first classification, particular data is available; however, the trend and observation reveal that a very large number/quantum is held in the form of real estate outside Pakistan. As said earlier, this is not an unusual trend and citizens of almost all the counties of the world have residential accommodation in big commercial cities like London, New York, Chicago, Singapore and now Dubai. Economies of these cities thrive on such investments. It is an undeniable fact that almost every upper middle class family maintains a residence in London, New York and Dubai. For Pakistanis, Dubai is a new phenomenon, and a particular class being uncomfortable with the West, has been provided a safe and comfortable place in the shape of Dubai to have a second secure house. The purpose here is not to discuss the social impact. The objective is to identify the assets held offshore.
Bank deposits is the second head. In the past, international banking system effectively encouraged the accumulation of such assets and whole thesis can be written on the ways and means designed by the banks to gather such funds. In the post 9/11 scenario, there had been some actions to monitor such deposits; OECD initiatives and Anti Money Laundering Laws are results of those actions. Still large sums of funds are held in western banks, which are beneficially owned by citizens of developing countries including Pakistan. Nevertheless, constant decrease in the return on bank deposits in the west has led to the movement of such funds from deposits to investment in real estate, etc. It is, however, important to note that bulk of funds held in banks are those which fall under classification 4 in the paragraph dealing with the manner of accumulation.
The third form of investment is acquisition of shares in companies. Since investments in western securities are relatively better documented; therefore, tainted funds are not invested in such securities. Nevertheless, a relative haven in the form of UAE has provided a conduit to invest, directly or indirectly, in such entities. Pakistanis have invested heavily in the shares of foreign companies in the last two to three decades and there is an economic rationale for the same.
The other dimension is effective investment in Pakistan. Under this legally valid system, foreign trusts and companies effectively owned by Pakistanis invest in the shares of listed and unlisted Pakistani entities. There are economic and social reasons for this approach and this trend has increased after the nationalisation of industries in 1970s when the confidence of Pakistani businessmen was effectively shaken. Rebuilding of that confidence is a separate subject; however, investment by such Pakistani held companies and trusts for long- and short-term is a reality. In this connection, it is important to note that a large part of such investment is made out of first three classifications referred to in the paragraph relating to manner of accumulation.
Ownership structure and declaration There can be multiple structures for ownership of offshore assets. There cannot be a complete and comprehensive list of structures that can be used for the ownership of assets outside Pakistan. Notwithstanding all other aspects, kind of structure has direct relationship with the disclosure to be made under corporate and fiscal regulations. A short list of the kind of ownership is as under:
1. Ownership in the personal name of the Pakistan tax resident;
2. Ownership in the personal name of non-resident relative of the resident Pakistani owner;
3. One tier ownership by a Pakistani through an offshore company in tax haven;
4. One tier ownership by a Pakistani through an offshore company in tax jurisdiction;
5. Two tier ownership by a Pakistani using an offshore company ultimately held by an offshore discretionary trust; and
6. Two-tier ownership by a Pakistan using an offshore company ultimately held by a non-discretionary trust.
All the forms of ownership are used internationally, and detailed material is available on that subject in text books and legal research papers. Panama Papers, etc are only the revelation that has brought such information in limelight; however, it appears that such information is limited to the ownership of the company by a Pakistani; no further details about the assets of that company is publically available. That aspect is not the subject matter of this paper.
The purpose of identification of various forms is to highlight the fact that in all circumstances, the owner of the property in cases 1 and 2 above, the shareholder in cases 3 and 4 above and beneficiary in case 5 and 6 above may be a Pakistani citizen.
Jurisdiction of the offshore entity is important, as in many jurisdiction corporate and fiscal regimes provide inherent protection against information to be kept and possibility of an inquiry or audit, as the case may be. This results in placement of such companies and entities in jurisdictions like Jersey, Bahamas, Panama, etc. In this connection, it is important to note that all such jurisdictions operate under the disguise protection of the western economic system. The problem with countries like Pakistan is multi-dimensional. In the developed economies, domestic documentation, tax compliance and tax policies place practical impossibility in abuse of benefits that can be achieved by using less regulatory environment in such jurisdictions. In Pakistan, both compliance and policy aspect effectively promote the abuse of such benefits. Now we have an effective tax haven only one and a half hour flight away, with which we have also signed a double taxation treaty providing effective protection to many aspects which are not warranted.
Another aspect that needs to be very clearly identified and understood is the distinction between the forms listed in 1 to 4 above and those identified in 5 and 6. In the latter case, ultimate ownership is held by a 'foreign trust'. That trust may be discretionary or non-discretionary, and the property is held in the name of trust not being any individual. Benefit to a Pakistani can only arise through that trust. There are multiple implications of using that method; however, international corporate and fiscal system distinguishes between the direct ownership of an asset and that held by way of a beneficiary in a trust. This layering effectively distributes the legal ownership and beneficial ownership in a permitted and legal manner. This, therefore, suggests that whilst examining various ownership situations for corporate, fiscal and foreign exchange purposes, the trust ownership should be legally distinguished with others. It is highly unfortunate that there had been very limited or no development in matters relating to trusts and, in general, even the regulators are not entirely clear about the manner of reporting, etc, in such cases.
Volume and period of accumulation It is very difficult to estimate the volume of such assets and the period within which such assets have been accumulated. Whatever is being stated in the following paragraphs is only an academic estimate. Nevertheless, we are aware of the statements about Pakistanis' bank accounts in Switzerland and property investments in Dubai. Those statements are not the basis of the estimates given in the following paragraphs. These estimates are entirely based on deductions made with reference to the volume of transactions referred in the modes of funding in paragraph above.
1. Export Commission: Estimated average exports in the last twenty five years; the rate of commission allowable; and the percentage of commission paid to associated companies / entities is estimated at: US $18 billion x7%x50%x25 years=
US $15.75 billion;
2. Import Commission: Estimated average imports in the law twenty five years; the rate of commission generally prevalent is estimated to be: US $20billionx5%x25 years=US $25 billion;
3. Income Earned Abroad: There is no exact estimate of such retention, however, if it is estimated that only around US $1 billion is retained abroad then such amount will work out at around US $25 billion; and
4. Funds sent out from Pakistan. Estimated GDP of Pakistan is around US $280 billion. The undocumented GDP is conservatively estimated at around USS 80 t0 100 billion. If only 3 to 5 percent of that GDP is siphoned out of Pakistan then it means that around US $2 to 4 billion is sent outside Pakistan by legal or illegal means. Thus, assets accumulated out of the same are conservatively estimated at US $2 billion x 25 years=US $50 billion.
If we add only these four sources, which are all business related, then the total sum is around US $115 billion. This excludes the funds accumulated through commissions and bribes.
There is another perception that such accumulation of foreign asset has taken place in the last 25 years. The first three heads were there since inception. Nevertheless, the fourth head has multiplied manifolds in post 1970's due to a collapse of taxation system,failure of asset recording and abuse of foreign exchange.
Effects negative/positive Notwithstanding the view that if such assets have been created out of untaxed income then Pakistan government has the right to tax the same, the aforesaid analysis reveals that except for item 4 referred in paragraph above, the amount does not in principle represents a sum taxable in Pakistan.
These are assets of Pakistanis. The option for the policy makers is either to create an environment of chaos and harassment or channelize these assets into assets for Pakistan.
Purpose of this first part of the series of articles is to let the people of Pakistan understand the issue under consideration. It is observed that this purely financial and fiscal matter that may lead in part onto criminal proceedings in certain cases is not being discussed and deliberated properly. Conclusions and findings are being given without even identifying some of the aspects discussed above. I believe that professionals will shed more light on the subject so that a proper solution can be identified for an issue that has arisen in line with the title of my first article on the subject: 'Panama Leaks - A blessing in disguise'.