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Historical Perspective
1. International tax treaties
With the rapid global growth of trade, commerce and finance in the recent years,
countries of the world cannot remain aloof from each other. The interdependence of the
countries is so great these days that any economic imbalance in one country adversely
affects the economy in another. National policies have, therefore, become international
oriented, as is normally reflected in tax legislation and practice. It is a well known
fact that any change in tax law of a country has the effect of influencing its trade and
commerce viz-a-viz its economic relations with other countries. Each country, therefore,
exercises great care and caution in the formulation of its tax law so as not to endanger
its national economic interest. Pakistan has also been cautious of this fact and in recent
years has formulated tax policies which are reflective of this attitude.
There can be no dispute that taxation is a deterrent against free flow of trade and
business expansion. As a result of favourable or unfavourable treatment by way of
taxation, the flow of trade gets regulated either adversely or favourably. The tax
structure can be an important independent factor in determining the growth potential of
the economy. It may stimulate or restrain the inflow or outflow of investment funds from
or to foreign countries. Tax laws of a country, therefore, play an important role in
international business relationship. Many international tax angularities are evened out
and many problems are solved or mitigated through bilateral "treaty". It means
any international agreement in written form, whether embodied in a single instrument or
two or more related instruments, called either treaty, convention, protocol or covenant,
concluded between two or more states governed by the international law. Such treaty is an
attempt to invoke the concept of comity of nations or of rules of international law in the
interpretation of an agreement that derives legal sanctity from the country’s own
income-tax law.
Pakistan has entered into double taxation agreements with 45 countries till December 1998.
The coming chapters will explain in detail the historical background of these agreements
as well as their impact on Pakistan's economy. This book will provide ample information to
all those who are interested to study international tax treaties with specific reference
to .taxation of non-residents in' Pakistan.
2. Double taxation agreements
The interaction of two taxation systems each belonging to a different country can
result in double taxation. It occurs when two States exercise their right to tax the same
person on the same income. This so happens for the following reasons:-
(i) The States levy taxes on incomes which has arisen or accrued abroad, in cases of their
residents.
(ii) The States do not waive or surrender their right to tax a person on the income which
has arisen or accrued in their jurisdiction by virtue of the location of the source.
(iii) A person is deemed simultaneously to be resident by the two States, in one by virtue
of his stay and in the other by virtue of any other criterion such as the source of
income, or when the source rule overlaps because two States find the same transaction to
be within their territory.
(iv) Certain States tax worldwide income of their citizens, irrespective of their being
residents of either States.
Double taxation agreements between two countries, therefore, aim at eliminating or
mitigating the instance of double taxation. Or where such treaties are not in existence,
countries have been avoiding taxing the same income twice through their unilateral action.
In some cases especially for resident persons, the unilateral tax relief is provided for
doubly-taxed income. For developing countries such treaties have further importance as
they facilitate attracting foreign investments. Thus the arrangements between the two
countries to ensure that the persons are not taxed twice over, once in one country and
again in another, on the same income, have normally been embodied in an agreement called
Avoidance of Double Taxation Agreement. Such agreements are given statutory force in each
country. They override any other enactments. Even the Parliament itself cannot alter the
wording of double taxation agreements without the consent of both the parties.
2.1. Objectives - The prime object of a double taxation
agreement is to provide for the tax claims of two Governments both legitimately interested
in taxing a particular source of income either by assigning to one of the two the whole
claim or else by prescribing the basis on which the tax claim is to be shared between them.
Double taxation agreements aim at eliminating the double taxation of certain income where
a resident of one country derives income from a source of another country. This helps
ensure facilitating international trade and commerce, flow of investment as also equitable
collection of revenue. The agreements tend to achieve the aforementioned aims by -
(a) clarifying where a country of source may tax a non-resident in respect of certain
types of income;
(b) limiting the rate of tax a country of source may apply to certain types of income;
(c) providing foreign tax credits in the country of residence against taxes paid in that
country on income having source in other country.
The other object of the double taxation agreement is to prevent tax avoidance and fraud by
exchanging information.
The absence of double 'tax agreements has effect of immediately increasing the tax charge
on remittances of profits out of foreign countries in the form of dividends, royalties and
interest. Such. remittances may suffer a discriminatory level of withholding tax
(deduction of tax at source). The remittance, if it takes the form of profit from a branch
of the head office is also subjected to tax. A number of countries viz France, Canada,
Australia and the United States levy a branch profit tax to place branches on an equal
footing with a subsidiary which would suffer withholding tax on dividend payable.
Therefore, most double taxation agreements either eliminate or reduce the risk of double
taxation. Besides, they also provide for a reduction in withholding tax rate and provide
protection to the overseas residents by means of non-discrimination clause.
2.2. Pattern of taxation - Double taxation agreements determine
which of the two contracting States may subject the income to their taxes. Sometimes the
right to tax is given to the country where the income arises, exclusively or by way of
priority. In other cases the home country of the recipient of the income has the exclusive
right to tax; while in some other the source and residence country may tax the income, in
which case the source country limits its tax to a certain medium whereas the residence
country reduces its own tax on the same income according to the period or methods
specified in the relevant double tax agreement. According to the current practice there is
a well-established pattern of taxation of various types of incomes. Tax agreements contain
provisions to the following fact:-
- Income from the business is taxed:-
(a) only in the home country, if the business undertaking carries on no activity in the
host country;
(b) only in the host country, if there is a fixed place of business i.e., permanent
establishment and to the extent it is attributable to other place;
(c) in both the countries (depending on whether the home country exempts the foreign
profit or grants a credit).
- Income from immovable property arising to a non-resident is taxed primarily in the
country of its location.
- Income from movable property such as dividends, interest or royalty are primarily taxed
in the home country, but the host country may impose a reduced tax.
- Income from personal exertion such as director's fees, service fees, pensions,
remunerations, is taxed according to various rules with varying solutions.
Thus, the primary right of the source country to impose tax on business profit and income
from immovable property has been a well-accepted principle of all tax agreements. The
primacy, however, does not mean exclusivity. In respect of income from movable property
(namely, interest, dividends and royalty) and income from shipping, the principle of
primacy is not followed. For such income reliance is placed on the principle of granting
exclusive right of taxation by the country of residence or by the source country at
reduced taxation at source. As a correlative to the right of taxation at source, the
treaty imposes obligation upon the source country to ensure that the rates are not so high
as to discourage investment and to take into account expenses allocable to the earning of
the income so that such income would be taxed on a net basis. Such obligations stem from
the appropriateness of sharing the revenue with the country providing the capital.
3. Development of double taxation agreement models
The problems relating to double taxation are by and large common, with few of them
being peculiar to particular tax situation in a country. To have a model for tax
convention (agreement) was thought a desirable necessity so that such model could provide
a frame for the drafting of a particular agreement.
Model forms for the convention applicable to all countries were first prepared by the
Fiscal Committee of the League of Nations in 1927. Later the said Committee conducted
meetings in Mexico during 1945 and in London in 1946 and proposed minor variations.
The model conventions were published in Geneva in April 1946, by the Fiscal Committee of
the UN Social and Economic Council. Model drafts were prepared by the League of Nations
known as Model Treaty of Mexico of 1943 and London Model Treaty of 1946. These drafts were
made the starting point by Organisation for European Cooperation and Development (OEED)
and its successor Organisation for Economic Cooperation and Development (OECD) (which is a
group of 24 developed countries) in attempting a draft model for the avoidance of double
taxation. The draft was published in 1963, which is called the Model Convention of 1963.
This model was being used by the developed countries as a basis for concluding bilateral
treaties. Based on practical experience, this model was revised in 1974 and 1977. The
model was reflective of the standard to be followed, and in fact is still being followed
in drafting bilateral agreements, to a great extent, modified only to the extent necessary
to cope with the special problems arising from the differing levels of development or
differing structures of tax systems of the contracting States. The OECD provided its own
commentaries on the technical expressions and clauses in the model conventions. Lord
Radcliffe in Ostime (Inspector of Taxes) v. Australian Mutual Provident Society has described the language as the international tax language.
The other models, viz., the Andean Model (concluded by member States of the Andean Group,
viz., Bolivia, Chile, Equador, Colombia and Peru), the UN Model (published by the United
Nations in 1980), the US Model (published by the United States in 1981 to serve as the
basis for treaty negotiations by the US with others) differ on whether the income be taxed
in the country of source or of the residence of the recipient.
3.1 Andean Model and OECD Model - The Andean Model sticks to the
source country principle, while the OECD Model recognises the priority of the country of
residence to tax income. The basic concept of the OECD Model is opposed to the principle
of source. The approach of this model is to reserve the right to tax income and gains to
the country where the taxpayer is the resident, except in cases where he has immovable
property or substantial business operations through permanent establishment in the other
country.
Since the taxability of income is dependent upon the residential status of the investor,
which in the case of developed and developing countries is always in the former because of
the flow of investment being undirectional, i.e., from the developed to the developing
countries, and thus confining the taxing rights to the richer countries, the approach of
the OECD Model is not to the liking of the developing countries. They want to share a part
of tax because the income have arisen in those countries. They want to share a part of tax
because the income have arisen in those countries. The Andean Model, therefore, seeks to
resolve the basic cause of international double taxation (the differing or overlapping
rules for locating the source) by locating the source in one country or the other but
never in both in contrast to the OECD Model which resolves it by dividing the tax 'take'
between the two countries. In doing so the OECD Model recognises, and the Andean Model
ignores, that other rule, known as the sauce doctrine, that what is sauce for the goose is
sauce for the gander.
3.2. UN Model and OECD Model - As the Andean Model is intended
to serve the purpose of Andean Group, the UN Model is intended to serve the interests of
developing countries, both are alternative to the OECD Model. It was published by the
United Nations in 1980. The UN Economic and Social Council had recommended in its
resolution in 1953 that the principle of source constituted the primary basis of tax
agreements between the developed and the developing countries. That source principle
governed the field till it was disturbed by the London and the OECD Model. The UN Group
re-established the principle of source. The Model gives greater tax rights to the country
where income arises by providing for high rates of withholding taxes on dividends,
interest, and royalties and by allowing countries to retain most of the taxing powers
available under their domestic tax laws for foreign business operating in their country.
The UN Model corresponds to the OECD Model; though its contents diverge in some important
respects.
3.3. US Model and OECD Model - The US Model was first published
in 1976, revised in 1977 and 1981, to serve as model for all treaty negotiations by the
USA. This model is designed to follow the pattern of the OECD Model as also to adapt some
traditional peculiarities of the US treaty practice.
3.4. Agreement between developed and developing countries -
Since many countries (including Pakistan) do not have their own models, they tend to
follow either the OECD Model or the UN Model tailored to the peculiar requirement of each
Contracting States or their tax laws. Tax agreements between the developed and developing
countries encourage to a considerable extent promotion of the flow of investment of
capital or technology for the economic development of the latter and thus are drafted to
provide for favourable tax treatment to such investments on the part of the countries of
the origin, both by outright tax relief and by measures which would assure to them the
full benefit of any tax incentive allowed by the country of investment.
So far as Pakistan is concerned bilateral agreement for regulating some of the problems of
double taxation began in 1947 when it entered into an agreement for avoidance of double
taxation with India in the aftermath of partition of the sub-continent. Thereafter, it has
entered into agreements with various countries and has today an extensive network of such
agreements. The pattern employed, which for obvious reasons employs similar forms and
similar language in all the agreements, is derived from a set of model clauses proposed by
the Fiscal Committee of the League of Nations and by the OECD and finally by the United
Nations.
3.5. Treaty models lead to development of international tax law -
In view of the standard OECD and UN Models used in all double taxation avoidance
agreements, a new era of genuine 'international tax law' (international tax law is the
conglomerate of tax treaties in combination with unilateral relief provisions, the study
of national tax systems as to similarities and differences) is now in the process of
developing. These have served the purpose as expressed by the Secretary General of the UN
in the regular session of 1987 of the Economic and Social Council that bilateral tax
agreements should be as uniform as possible so as to prepare the way for international tax
agreements. Any person interpreting a tax agreement
must now consider decisions and rulings worldwide relating to these agreements. The
maintenance of uniformity in the interpretation of a rule after its international adaption
is just as important as the initial removal of divergencies. Therefore, the judgments rendered by courts in other countries or rulings
given by the other tax authorities would be relevant.
For the efficient and fair application of tax agreement, attempt of the courts world over
should be to interpret its provisions consistently avoiding collision.
Inconsistencies in the decisions may result in double taxation, which the agreement
intends avoiding. Decisions of the foreign courts though may not be binding on the
domestic courts may have persuasive influence on them. These courts should persuade
themselves in accepting them, and should interpret the agreement in the same way.
3.6. Model Convention of OECD - The agreement for avoidance of
double taxation is generally patterned on the model of double taxation convention prepared
by the Organisation for Economic Cooperation and Development (1977), on the
recommendations of the United Nations Ad-hoc Group of Experts on Tax Treaties between
Developed and Developing Countries, 1980. They follow closely in format and content these
models. Words and expressions used in the agreement have a generally accepted meaning and
connote ideas as are commonly understood in the tax world all over the globe.
Normally, text of the agreement consists of seven Chapters:
* Chapter I deals with scope of the convention and consists of Article 1 dealing with
general scope and Article 2 with taxes covered.
* Chapter II determines essential definition of terms and contains three Articles, viz.,
- Article 3: General definitions
- Article 4: Resident
- Article 5: Permanent establishment
* Chapter III deals with computation of income and contains 17 Articles.
These Articles are:
- Article 6: Income of immovable property
- Article 7: Business profits
- Article 8: Shipping and transport
- Article 9: Associated enterprises
- Article 10: Dividends
- Article 11: Interest
- Article 12: Royalties
- Article 13: Capital gains
- Article 14: Independent personal services
- Article 15: Dependent personal services
- Article 16: Directors' fees and remuneration of top level managerial officials.
- Article 17: Income earned by artistes and athletes
- Article 18: Pension and social security payments
- Article 19: Remuneration and pension of Government functions
- Article 20: Payment received by students and apprentices
- Article 21: Professors, teachers and research scholars
- Article 22: Other income
* Chapter IV covers computation of wealth-tax.
* Chapter V deals with legal consequences of the rules of Chapters III and IV and methods
for elimination of double taxation in Article 23.
* Chapter VI: Special provisions in respect of the following:
- Article 24: Non-discrimination
- Article 25: Mutual agreement procedure for resolving uncertainties and differences of
opinion
- Article 26: Exchange of information
- Article 27: Diplomatic and consular activities
* Chapter VII makes the final provisions in respect of the following:-
- Article 28: Entry into force
- Article 29: Termination
4. Scope of double taxation agreements
The scope of the agreements varies from country to country, its economic policies,
advancement in development of technology, and its economic and trade relations with the
other contracting country. In some cases the agreements cannot be termed in stricto sensu
tax treaties because there is no tax levy as such in those countries which needs to be
avoided. The treaties are more in the nature of agreements to develop maritime and air
traffic relations to the best advantages of both countries. Such conventions may more
appropriately be described 'tax agreements' rather than 'tax treaties'. 'Tax treaties'
indicate comprehensive tax treaties. 'Tax agreements' indicate other treaties which
provide for, inter alia, the prevention of double taxation.
The scope of the agreements differs if the other contracting country is-
(a) industrialised or developed country.
(b) underdeveloped country.
(c) country subscribing to socialist ideas.
Agreements with the developed or developing countries are comprehensive, covering all
sources of income arising from the flow of technology or capital or transfer of services,
or exchange of teachers, research workers, students and artistes. Since the economic
interests of the developed and the developing countries are at variance, the former
countries attempt to secure maximum tax benefit by claiming the taxability of income on
the residential status of the supplier of technology or capital or services; and the
latter, by laying claim on its taxability on the basis where the income arises, i.e., the
source country. OECD Model conforms the approach of the developed countries and the UN
Model, of the developing countries.
Comprehensive double taxation agreements relate to taxes on income, capital gains and
capital, while some others, as with the erstwhile communist countries, are limited
referring only to shipping and air transport, or to estates, inheritance and gifts.
Comprehensive agreements ensure that the taxpayers in both the countries would be treated
equally and on equitable basis, in respect of the problems relating to double taxation;
secure to a resident of one Contracting State relief from the other Contracting State in
addition to what that other States provides unilaterally to all non-residents regardless
of whether its own residents have similar benefit in any other State, in exchange of
similar benefit the former provides to the residents of another; tailors double taxation
relief to particular tax systems of the two Contracting States having different tax
systems, which would have been impossible with the unilateral double taxation relief;
resolve conflict on double taxation matters by arrangements between tax authorities of the
Contracting States; make administration of tax provisions easier by agreeing to exchange
of information.
5. Policy of Government vis-a-vis double taxation agreement
The policy adopted by the Pakistani Government in regard to double taxation treaties may
be summed up as follows:
* Trading with Pakistan should be relieved of Pakistan taxes considerably so as to promote
its economic and industrial development.
* There should be coordination of Pakistani taxation with foreign tax legislation for
Pakistan as well as foreign companies trading with Pakistan.
* The agreements are intended to permit the Pakistani authorities to cooperate with the
foreign tax administration.
* Tax revenues are sacrificed in exchange for the economic and industrial development of
the country, so as to permit flow of technology in Pakistan. In an effort to achieve the
highest possible incentive effect, the Pakistani Government is prepared to grant full
exemption of certain items of income and capital. This aim is achieved through the double
taxation agreement and unilateral taxation measures. Temporary loss of revenue is
tolerated in view of the long-term economic planning consideration.
In concept, the Pakistani tax agreements follows the OECD/UN Model. Depending upon whether
the agreement is with the developed, or developing, or underdeveloped country,
modifications may become necessary. For example, conventions with industrialised States
assume the existence of a permanent establishment when a construction site has been in
existence for 6 months rather than 12 months as is specified in OECD Model.
Pakistan has one of the largest network of tax treaties for avoidance of double taxation
and prevention of tax avoidance. It has tax treaties with 45 countries (concluded till
December 1998) dealing with the rules for computation and allocation between it and the
other Contracting States income arising from certain activities such as business,
independent personal services, dependent personal services, from assets such as dividends,
interest, royalties, rents, income earned as capital gains, from sources not expressly
mentioned and from business of shipping and air transport, besides covering matters of
mutual interests such as exchange of teachers, research workers, students and artists;
exempting diplomatic personnel of each other's country from tax liability; dealing with
exchange of information for preventing tax frauds and evasion, mutual assistance
procedures, etc.
Pakistan has limited agreements with eight countries, confined to profits earned from the
business of shipping and/or air transport. With 37 countries comprehensive double taxation
agreements have been concluded. Agreements on avoidance of double taxation at present
exist with the following countries: Austria, Bangladesh, Belgium, Canada, China, Denmark,
Finland, France, Germany,. Greece, Hollands, Hungary, India, Indonesia, Iran, Ireland,
Italy, Japan, Jordan, Kazakhistan, Kenya, Korea, Lebanon, Libya, Malaysia, Malta,
Mauritius, Nigeria, Norway, Philippines, Poland, Romania, Saudi Arabia, Singapore, Sri
Lanka, Sweden, Swiss Confederation, Thailand, Tunisia, Turkey, Turkmenistan, United Arab
Emirates, United Kingdom, USA and Uzbekistan.
Many of the agreements are very old. Since many changes have taken place in the
international field with regard to tax and the domestic laws of the concerned countries,
such agreements have lost their relevance in the changed atmosphere. These, therefore,
require to be renegotiated. Some have already been revised.
Pakistan had earlier an agreement with India (vide Notification' No. 28 dated 10.12.1947)
which ceased to be operative from the assessment year 1972-73 on account of the war
between the two countries. In 1989, both the countries signed an agreement for limited
purpose for avoidance of double taxation of income derived from international air
transport business.
Conventions entered into by Pakistan with various foreign countries have several common
features. The pattern in drafting of the avoidance provision is clearly discernible. The
agreements between 1959 and 1976 follow almost the same pattern. Thereafter, there have
been many changes. The year 1979 is the year of changes in Pakistani Income-tax Law
affecting the non-residents. For example, emphasis is stressed on the source of income,
and it if is located in Pakistan income is regarded to have arisen in Pakistan. For
deduction of head office expenses in case of non-residents while computing its business
income, section 24(e) of the Ordinance read with Rule 20 provides the maximum limit up to
which such expenses can be allowed. For computing income by way' of royalty or fee for
technical services or interest, sections 30 and 80AA of the Ordinance' provide that no
deduction in respect of any expenditure would be allowed. The main feature of Pakistani
tax avoidance agreement prior to 1979 is provision for limited right of taxation in
respect of investment income in the country of the source. In the case of those which have
been .concluded recently, the source rule or the doctrine of force of attraction in
respect of income by way of interest, royalty and technical service fee, has been given
predominance. Thus, there is specific departure from the OECD Model. The approach of this
model is broadly to reserve the right to tax income and gains to the country where the
taxpayer is resident. The UN Model which was published in 1980 is, therefore, followed
generally by Pakistan. It gives greater taxing rights to the country where the income or
gains arise. This is done, for example, by providing for high maximum rate of withholding
taxes on dividends, interest, royalties and similar items and by allowing countries to
retain most of the taxing powers available under the domestic laws for foreign business
operating in their territories.
6. Double taxation agreements vis-a-vis Income Tax Ordinance,
1979
The basis of taxability under the double taxation agreements is the territorial nexus.
The computation of total income for that purpose should be in accordance with and subject
to the provision of the Ordinance. The Federal Government is empowered by section 163 of
the Income Tax Ordinance, 1979 to enter into an agreement with any foreign Government for
granting relief from taxation of an income twice, or for avoidance of double taxation, or
for exchanging information for the prevention or evasion or avoidance of income-tax, or
for recovery of income-tax. When such agreements are the consequences of the authority
exercised by the Federal Government under a provision of the Ordinance, the computation of
income of an assessee is subject to the terms of such agreements.
The charging section 9 of the Ordinance refers to 'subject to the provisions of this
Ordinance', meaning by all sections of the Ordinance including section 163. Section 11 of
the Ordinance defines the scope of total income. Thus provisions of section 9 and 11 are
expressly made subject to the provisions of the Ordinance, which means that they are
subject to the provisions of section 163 of the Act. By necessary implication they are
subject to the terms of double taxation agreement.
The double taxation agreement and the Income Tax Ordinance thus form a single statute. The
expression 'subject to' conveys the idea of a provision yielding place to another
provision or provision to which it is made subject to. The Indian Supreme Court in
K.R.C.S. Bala Krishna Chetty & Cons & Co. v. State of Madras held that the use of the words ‘subject to' has reference to
effectuating the intention of the law and the correct meaning is 'conditional upon' The
words ‘subject to the provisions of this Act' suggest about the paramountcy of these
provisions and their mandatoriness, and may mean liable to these provisions.
If, however, there is a conflict between the provisions of the Income Tax Ordinance, 1979
and those of the double taxation agreement, the latter would prevail. First, on the basis of the doctrine of generalia non derogant. This
doctrine is attracted where there is a conflict between a special and general statute and
an argument of implied repeal is raised. Secondly, section 163 impliedly provides that the
laws in force in either country will continue to govern the assessment and taxation of
income in the respective country, except where the provisions to the contrary have been
made in the agreement. Thus, where a double taxation agreement provides for a particular
mode of computation of income, the same should be followed, irrespective of the provisions
in the Ordinance. Where there is no specific provision in the agreement, it is the basic
law, i.e., the Income Tax Ordinance, 1979, will govern the taxation of income. Thirdly,
the Central Board of Revenue has issued a circular that the Assessing Officers should give
effect to the provisions of the double taxation avoidance agreement in case the provisions
of the agreement are not in conformity with the provisions of the Income Tax Ordinance,
1979. Such circular instructions has mandatorily to be followed by all the Assessing
Officers and are binding upon them. Above all the
most important of all is the consideration that double taxation agreements are the
treaties between two sovereign States and they, therefore, should be implemented
faithfully even if their provisions may conflict with municipal laws.
The Pakistan taxation laws do not empower the Government of the Islamic Republic of
Pakistan to conclude agreements in respect of taxes on capital. The Wealth Tax Act, 1963
does not contain any provision to this effect in contrast to section 163 of the Income Tax
Ordinance, 1979. Therefore, Pakistan could not conclude any agreement of avoidance of
double taxation in respect of taxes on capital. However, in this book while reproducing
OECD and UN Models those provisions relating to taxes on capital have been included just
for academic purposes. It must be kept in mind that unless the taxation laws of Pakistan
are amended empowering the Federal Government to conclude such agreements no possibility
exists for avoidance of double taxation on capital. Hence the non-residents of these
countries with which Pakistan has double taxation agreements are not entitled to claim any
exemptions (unless it is specifically provided in the statutes) on account of assets
chargeable to Wealth Tax Act, 1963, Corporate Assets Tax, Capital Value Tax and Federal
Education Fee.
