Offshore income and assets of Pakistanis and the Finance Bill 2018: End of tax exemption regime -I

Concept of Jurisdiction of Tax
In every civilized society, there are two kinds of direct taxes. Taxes on income and taxes on capital gains. One of the primary objectives of any progressive fiscal policy is to collect reasonable sum, as direct taxes, for development and non-development expenditure without disturbing investment and growth. On the other hand, individuals and businesses, naturally plan their structures in a manner that there is lowest incidence of tax on their activities and transactions. In this attempt, businesses also arrange and locate their ownership structure and transactions, respectively in the manner and at locations and jurisdictions where there is lowest incidence of taxation. This discretion which requires movement of capital was previously not easily possible due to regulated foreign exchange regimes. Foreign exchange regime, now in practice, promotes free movement of funds in and out of any jurisdiction, provided the 'due tax' has been paid in a particular jurisdiction. Under the modern system, there is no restrictions on flow of funds by exchange regulators. Pakistan also liberalized the regime in 1992. Our subject, in these articles is however, restricted to taxes. The matters related to exchange regime will be discussed later on.
What is a 'due tax' in a particular jurisdiction is a big question. Thousands of pages of 'texts' have been written on this subject, and numerous decisions of the courts have tried to provide a precise reply to this unanswerable question. This attempt to collect due tax will always remain a subjective matter. Each country will attempt to grab the highest pie of the flesh.
As a policy, the free world, which we are the part, operated a relaxed system of taxation in the post Second World War period. During those days, the prime policy objective of the developed world was to attract funds and investments and promote trade instead of taxing every 'cent' that was due. Now that policy has changed. Why this change has taken place is essentially a political debate not being the subject here. Our subject is to discuss the change and its effects.
In post-2010 period, we have entered into a phase of 'change' around the world in the fiscal policy paradigm. In this article and following ones, we will be discussing in brief the changes, some of which have been adopted by us and have been incorporated in the Finance Bill, 2018. It is author's view that in this perspective Finance Bill, 2018 is a trend-setting document that will be remembered and referred for a long time.
A Change in the World Order
This author wrote over ten articles in this newspaper after the 'Panama Leaks' in 2016. Various aspects of that subject were discussed in those articles. Since then, some major actions, including political developments, have taken place, which have direct link with the subject in question. In author's view, this is the reflection of 'changed paradigm' for fiscal policies, employment, industrialization and immigration in developed countries. How that change will ultimately settle is a question that will be answered by history. Nevertheless, it is abundantly clear that almost all the economies of the developed world, including the USA, are facing heavy burden of cost of social benefits to their people, and there least possibility of increasing the burden of incidence of personal or business tax as any increase in taxation directly affects industrialization, employment, etc. This dilemma is the basis of many changes we are observing in international political and economic scene especially tax policies. The objective of the new paradigm, in short, is to gather within that jurisdiction the tax that was actually and as a policy was allowed to be avoided. In technical terms, this is sometime referred to as 'Base Erosion' and 'Re-Enforcement of Arm's Length Principles'. Nevertheless, whatever the name we suggest, the objective is one to curb possibilities of tax avoidance.
Resultantly, as a conscious decision, revised policies are being adopted with respect to 'concessions' and 'protections' provided to tax havens along with a review of regime laid down under the avoidance of double taxation treaties. This is a two-pronged approach. In short, Panama or Paradise Leaks, in this author's view, are no accidents. It is a reflection of a change in the system.
Changes in Pakistan since the Panama Leaks
In Pakistan, since 2016 some major actions have been undertaken on the subject of offshore assets held by Pakistani citizens. This includes "One Time Compliance Scheme" [commonly known as amnesty] and a major corrective change in Protection of Economic Reform Act [PERA] announced and implemented by way of Economic Reform Package introduced by four Ordinances on April 8, 2018. Unlike the common perception, this is a part of a comprehensive package of reforms on the matter of foreign exchange and ownership of foreign assets held by Pakistani citizens. The changed process has been consolidated by way of amendments in the Finance Bill, 2018 on this subject. In this article and the following ones of this series, author will like to describe the amendments made in the Finance Bill, 2018with reference to underlying economic perspective. All the amendments made in the Finance Bill, 2018 are the continuation of the particular philosophy that has direct link 'One Time Compliance Scheme'. There is a need to appropriately understand these amendments and support them, provided suitable corrections are made. We, would welcome documentation and enforcement of right of taxation of 'due' taxes in Pakistan. There should not be any avoidance of taxation at the cost of national interest.
One Time Compliance Scheme and Expected Change
It is important to understand that all these actions have direct relationship with 'One Time Compliance Scheme'. It is, therefore, necessary to take serious note of these amendments by all persons who own offshore assets outside Pakistan, whether declared or not. In short, these changes reflect that it would be advisable and safe if every asset is placed in 'tax record' in appropriate jurisdiction. Non-disclosure is no more an option. Secondly, in future capital gains and income on such assets will be taxed at least in one jurisdiction; therefore, it may be advisable to incorporate the original source in the books by of the concession provided under the 'One Time Compliance Scheme'.
It is this author's view the possibility of complete avoidance of tax using offshore structure is going to finish very soon. Accordingly, there is a need to fully appreciate the change in international and domestic paradigm for offshore assets of Pakistani citizens and the liberty we have availed in that respect is now not going to be retained and repeated.
Underlying Philosophy of New Tax Regime
The Way World Has Changed
International fiscal system that operated in the past, say from Second World War to2010, impliedly encouraged taxation only in the jurisdiction of the 'source of income'. There had been relaxation in identifying the 'beneficiary' of such income even though the interposed entity was only a 'Shell' structure. This relaxed philosophy in taxation had been consolidated by way of the network of bilateral treaties and deemed protection and secrecy provision in the tax haven jurisdictions, such as Cayman Islands, Panama, etc. Furthermore, there were deemed relaxations on the matters of 'anti-avoidance' provisions. As a result, there were even cases where 'Sovereigns' provided extraordinary credit for foreign investments which indirectly resembled tax avoidance measures. This includes some instances related to Luxembourg and Ireland's domestic legislations for promoting domestic investment at the cost of extraordinary tax concession. The cases of 'Starbucks Coffee' and 'Google' are examples where serious questions had been raised on the matter of substance of source of income and taxing rights. This 'Berlin Wall' has now fallen. Now a new world order in taxation regime is emerging.
In India, a serious controversy arose in the case of disposal of Mauritian company owning 'Bharat Airtel' where offshore structure was dismantled. Supreme Court of India rescued 'Vodafone', the ultimate buyer; however, the underlying controversy is not yet fully over.
Three Major Changes
The underlying theme of all these actions led to changes in the following three areas:
(i) An offshore entity interposed in another jurisdiction for the ownership of the underlying assets in one jurisdiction to be disregarded whilst determining capital gain on sale of assets. This matter is hereinafter referred to as "Disregard of Interposed Entity for Taxing Capital Gains';
(ii) The income of an entity outside the jurisdiction of the beneficial owners are to be taxed in the jurisdiction of the beneficial owners if it is a controlled entity by the resident of the first country and is engaged in passive activities actually acting as a 'conduit'. This subject is hereinafter referred to as "Taxing Controlled Offshore Entities";
(iii) Income of supply of machinery and equipment not to be treated as not taxable in the country of import only for the reason that title in the goods, in form, is transferred outside the jurisdiction of the importer. This is, hereinafter referred to as "Tax on Supply Not to be Based Solely on the Basis of Transfer of Title '.
The Finance Bill 2018 has introduced provisions in respect of all these matters. In the following paragraphs, an attempt has been made to describe these matter for persons not directly related to the subject of taxation.
Capital Gain on Disposal of Offshore Entity where underlying Asset lies in Pakistan
Understanding Tax Friendly Treaties and tax havens
At the outset, in order to understand this subject, it is necessary to identify and understand tax friendly and tax unfriendly treaties. Tax friendly treaties are treaties with those countries where there is no taxation (UAE) or no local taxation on foreign owned passive companies (Netherlands) and at the same time, there is no capital gain or any other kind of tax on disposal of that foreign-owned company even though the underlying asset is located in other jurisdiction. There are three such major tax-friendly treaty jurisdictions if we examine Pakistan's tax treaty network. These are the Netherlands, Mauritius and the UAE. This means, if there is a disposal of a company incorporated in the Netherlands, Mauritius or the UAE then such gain cannot be taxable in Pakistan even though the underlying asset of that company is a Pakistani asset. At the same time, such gain is also not taxable in the Netherlands, Mauritius and the UAE as well as in Pakistan and any other country where such assets are located. This cannot happen, e.g., with the UK, Germany or Switzerland, as in that case gain will be taxable in UK, Germany or Switzerland even if a multi-layered structure is created.
Illustration 1
Mr A is a resident of Pakistan, who owns a UAE company. UAE entity owns assets in Pakistan; say shares of unlisted companies. In case if UAE entity sells the Pakistan asset to any person then gain on sale of such asset is not taxable for the reason that gain on sale of shares by a UAE entity can only be taxed in the UAE. Since there is no tax in the UAE, therefore, this income remains non-taxable in the hand of UAE entity, even though there is a sale of Pakistan asset. [This is a treaty protection case]
Illustration 2
In the same situation, if the interposed entity is a UK entity then gain on such income can be taxed in both Pakistan and the UK. It is taxable in Pakistan for the reason that this represent sale of Pakistan asset being share of unlisted company. It is taxable in the UK for the reason that this represent gain in the hand of UK entity.
Illustration 3
In case, if such interposed entity is a company incorporated in Cayman Islands then, under the present law, such entity is taxable in Pakistan, and the only concession available by locating the entity in Cayman Islands is that there is no double taxation on account of the fact that there is no tax in the Cayman Islands.
Illustration 4
In order to avoid taxation even in the case of ownership in Cayman, a multi-layered system is imposed. In this case, Cayman Islands entity owning the Pakistan entity is owned by another Cayman Islands entity. In order to avoid taxation, there is no sale of entity owning the Pakistan entity. There is a sale of company owning the Cayman Islands entity. In this manner, the gain arises to Cayman Islands entity and there is no disposal of Pakistani assets. [This is a case protected by layering]. This cannot happen at present under Section 101(9) and (10) where underlying asset is immovable property or a right in oil concession.
These illustrations reflect that if the disposal of a foreign company, directly or indirectly, leads to transfer of underlying Pakistani entity from one person to another then though Pakistan has the right to tax that capital gain, however, either on account of treaty protection or layering of ownership structure, such gain cannot be taxed in Pakistan. Under the present system, prior to the proposed amendment in the law by the Finance Bill 2018, such amounts were not taxable in situations envisaged in illustrations 1 and 4.
Reason for Introducing Tax Friendly Treaties
It is also necessary to understand the economic rationale of introducing tax friendly locations. The Netherlands, Mauritius and the UAE's tax framework had been constructed to avoid tax especially where the underlying assets is located in developing countries. Accordingly, bulk of investments in Pakistan by Western Countries are routed through Netherlands whereas, investment in India is routed through Mauritius. In this manner, when the foreign investor sells the Pakistani company then the gain is not taxable either in Pakistan or the UK, as the case may be, for the reason that investment is routed through a company in the Netherlands or Mauritius or the new entrant in the field: the UAE. It is interesting that Singapore has never been a part of this tax deferral process. In author's opinion this lead to treaty shopping which is not a desirable attitude.
For Pakistanis, the new tax haven, at the cost of Pakistan taxation system, is the UAE. There is no income tax on income and capital gains in the UAE whereas; a protection is available under double taxation agreement with the UAE. This mystery has now been partly resolved.
Indian Example and Experience
This matter, in practical sense, can be understood in better sense if we discuss the 'Vodafone' case of India.
'Bharat Airtel' is a company having telecom licenses and structure in India. This company was owned by Indian nationals through their offshore companies located in Mauritius. Vodafone acquired the ownership of the company owning Bharat Airtel [Offshore Company] not Bharat Airtel itself. This transaction was not taxable under the Agreement of Double Taxation between India and Mauritius.
Indian tax authorities held that the asset acquired by Vodafone was not in the ownership of the interposed Indian entity incorporated in Mauritius, but the assets and rights are effectively located in India. Accordingly, it was considered that the gain on disposal is taxable in India and the interposed structure be disregarded. Indian Supreme Court overruled that judgement of the Bombay High Court; however, the matter that involved around over 20 billion USD tax is practically unsettled.
In short, the underlying theme of these changes is that corporate structure outside Pakistan be disregarded whilst determining capital gains on disposal of a foreign entity if the underlying assets is located in Pakistan. In theory, the amendment is appropriate; however, there are many other factors that need to be taken into account whilst implementing the said regulations.
The Amendments by the Finance Bill, 2018
This background will assist in understanding the amendments made by the Finance Bill, 2018 on this subject of capital gains on disposal of company/entities where underlying asset is situated in Pakistan.
The amendments in simpler words are:
(i) Any gain on disposal of any foreign entity, directly or indirectly, will be taxable in Pakistan if principally or wholly the underlying asset of that foreign company/ entity is in Pakistan. This amendment has been made through newly inserted Section 101A of the Income Tax Ordinance, 2001;
(ii) In the provisions relating to anti avoidance measures, it has been stated that the Commissioner will have the right to disregard the interposed entity. This amendment has been made in Section 109 of the Income Tax Ordinance, 2001; and
(iii) An amendment has been made that provisions of any double taxation agreement [treaty] and protection provided to treaties will have no effect in implementing the aforesaid provisions. This provision has been included in Section 109 of the Income Tax Ordinance, 2001.
These provisions can now be easily related to what has been discussed in the aforesaid paragraphs. The first amendment means that there has been an extraordinary extension in the territorial right of taxation by Pakistan tax authorities in respect of taxability of foreign entity if the underlying asset of that foreign entity was a Pakistan asset. At the outset, it can be stated that it is extraterritorial.
This matter if applied in relation to illustrations referred above means that any entity that is interposed between Pakistan asset and the seller of asset will be disregarded whilst determining Pakistan's source of income. This is a very wide and substantive change.
There is a concept of taxability of a 'person' in Pakistan. Income can only be taxed in the hand of the person owning the asset.
A company, whether foreign or local, is a person identified in the taxation laws.
In another substantive section of law, there is a distinction between 'resident' and 'non-resident' person for taxation purposes. A company is treated as a non-resident if the company is incorporated and the control and management is held outside Pakistan. If the underlying owner of that company is a Pakistani, the company cannot be treated as resident unless it is incorporated in Pakistan and control and management is in Pakistan.
A non-resident can only be taxed for Pakistan source income. If it can be established that entity selling the asset is a non-resident company, and the asset sold is also a non-resident asset being the share of the first layer company as reflected in Illustration 4 then the same is not taxable. The amendment made through Section 101A has provided an exception in the subject of geographical source of income, and it has been provided that if the underlying asset is, directly or indirectly, in Pakistan then the asset will be treated as Pakistan source income. The fundamental question that will be tested by the courts of law is whether this change through Section 101A of the Ordinance can override the whole concept of 'person', 'non-resident' and the right of taxation of Pakistan. Notwithstanding all other provisions on the matter, the primary question is the manner of operation of this provision of law where the transaction undertaken and person undertaking the transaction is outside the territorial nexus and ambit of Pakistan's geographical boundaries. Even if some nexus is created by way of extension of scope through Section 101A of the Ordinance, the practical enforcement of this provision is a subject in question.
The text of the Amendment
In order to fully understand the subject, it would be advisable to reproduce the amendment introduced in the Finance Bill, 2018 on this subject by way of insertion of Section 101A of the Ordinance. The proposal, as per Bill, states as under:
"101 A. Gain on disposal of assets outside Pakistan.- (1) Any gain from the disposal or alienation outside Pakistan of an asset located in Pakistan of a non-resident company shall be Pakistan-source.
(2) The gain under sub-section (1) shall be chargeable to tax at the rate and in the manner as specified in sub-section (10).
(3) Where the asset is any share or interest in a non-resident company, the asset shall be treated to be located in Pakistan, if -
(a) the share or interest derives, directly or indirectly, its value wholly or principally from the assets located in Pakistan; and
(b) shares or interest representing ten per cent or more of the share capital of the non-resident company are disposed or alienated.
(4) The share or interest, as mentioned in sub-section (3), shall be treated to derive its value principally from the assets located in Pakistan, if on the last day of the tax year preceding the date of transfer of a share or an interest, the value of such assets exceeds one hundred million Rupees and represents at least fifty per cent of the value of all the assets owned by the non-resident company.
(5) Notwithstanding the provisions of section 68, the value as mentioned in sub-section (4) shall be the fair market value, as may be prescribed, for the purpose of this section without reduction of liabilities.
(6) Where the entire assets by the non-resident company are not located in Pakistan, the income of the non-resident company, from disposal or alienation outside Pakistan of a share of, or interest in, such non-resident company shall be treated to be located in Pakistan, to the extent it is reasonably attributable to assets located in Pakistan and determined as may be prescribed.
(8) The person acquiring the asset from the non-resident person shall deduct tax from the gross amount paid as consideration for the asset at the rate of fifteen percent and shall be paid to the Commissioner by way of credit to the Federal Government through remittance to the Government Treasury or deposit in an authorized branch of the State Bank of Pakistan or the National Bank of Pakistan, within fifteen days of the payment to the non-resident.
(9) The resident company as referred to in sub-section (7) shall collect advance tax as computed in sub-section (10) from the non-resident company within thirty days of the transaction of disposal or alienation of the asset by such non-resident company:
Provided that where the tax has been deducted and paid by the person acquiring the asset from the non-resident person under sub-section (8), the said tax shall be treated as tax collected and paid under this sub-section and shall be allowed a tax credit for that tax in computing the tax under sub-section (10).
(10) The tax to be deducted under sub-section (8) or to be collected under sub-section (9) shall be the higher of-
(a) 20% of A, where A = fair market value less cost of acquisition of the asset; or
(b) 10% of the fair market value of the asset.
(11) Where tax has been paid under sub-section (8) or (9), no tax shall be payable by the non-resident company in respect of gain under sub-section (8) of section 22 or capital gains under section 37 or 37A.";
(To be continued)