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6 Elimination Methods
CHAPTER V
METHODS FOR THE ELIMINATION OF DOUBLE TAXATION
ARTICLE 23A
EXEMPTION METHOD
(1) Where a resident of a Contracting State derives income (or
owns capital) which, in accordance with the provisions of this Convention, may be taxed in
the other Contracting State, the first-mentioned State shall, subject to the provisions of
paragraphs (2) and (3), exempt such income (or capital) from tax.
(2) Where a resident of a Contracting State derives items o£ income which, in accordance
with the provisions of Articles 10, 1 i and 12, may be taxed in the other Contracting
State, the first-mentioned State shall allow as a deduction from the tax on the income of
that resident an amount equal to the tax paid in that other State. Such deduction shall
not, however, exceed that part of the- tax, as computed before the deduction is given,
which is attributable to such items of income derived from that other State.
(3) Where in accordance with any provision of this convention income derived (or capital
owned) by a resident of a Contracting State is exempt from tax in that State, such State
may nevertheless, in calculating the amount of tax on the remaining income (or capital) of
such resident take into account the exempted income (or capital).
ARTICLE 23B
CREDIT METHOD
(1) Where a resident of a Contracting State derives income (or owns capital) which, in
accordance with the provisions of this Convention, may be taxed in the other Contracting
State, the first-mentioned State shall allow as a deduction from the tax on the income of
that resident an amount equal to the income-tax paid in that other State (and as a
deduction from the tax on the capital of that resident, an amount and to the capital tax
paid in that other State). Such deduction (in bther case) shall not, however, exceed that
part of the income-tax (or capital tax) as computed before the deduction is given, which
is attributable, as the case may be, to the income (or the capital) which may be taxed in
that other State.
(2) Where, in accordance with any provision of this Convention, income derived (or capital
owned) by a resident of a Contracting State is exempt from tax in that State, such State
may nevertheless, in calculating the amount of tax on the remaining income (or capital) of
such resident, take into account the exempted income (or capital).
110. Scope
The Article deals with the methods for the elimination of double taxation, where the
same income is taxable in the hands of the same person by more than one State. Double
taxation occurs (a) when each Contracting State exercises its claim to tax its resident in
respect of his world-wide income; or (b) one State exercises its claim on the basis that
the taxpayer is its resident and the other on the basis that the source of income is
situated within its territories. Article 4 has resolved the conflict as regards (a) when
it has defined the expression 'resident of a Contracting State' by referring to the 'tax
liability of a person under the domestic laws of the respective States by reason of his
domicile, residence, place of management or any other criterion of similar nature, and by
listing of tie-breaking rules in case a person happens to be found resident of both the
Contracting States in accordance with the aforesaid criteria. Since the taxability of the
worldwide income is dependent on the residential status and the question about that status
has been decided by rules of Article 4, the occasion for double taxation on account of (a)
above disappears. It has now got merged in (b). Solution in regard to (b) is found in
Articles (Articles 6 to 22) relating to taxation of specific nature of income and by
applying provisions of Article 23A or 23B.
Articles 6 to 22 decide which of the two Contracting States is to
withdraw its tax claims in respect of the type of income specified under these Articles.
The Articles are the mechanism to avoid double taxation through the division of the two
claims of the Contracting States and to provide for the computation of income. The object
of each is specified in the first paragraph of the respective Article, the nature of
income, which thereafter reads 'shall be taxed only in .... ' or 'may be taxed in .... '
the State of the residence or the source. The subsequent paragraphs then define the income
sought to be covered under the concerned Article and how it is to be determined. The
expression 'shall' implies imperativeness' and wherever it is used along with the words
'be taxed in a State' it conveys that the other State will have to waive its tax claim. It
implies exemption. Credit method of avoiding double taxation is not intended to be
applied. 'May' is a permissive and enabling expression
and when used along with the words 'be taxed in .... ' in the State of source it enables
that State to tax it. The residence State, however, has not been precluded from taxing it.
The consequence is that one has, therefore, to look upon Article 23 of the Model for
relief from double taxation. Thus the Article containing the expression 'shall be taxed in
.... ' is a complete rule in itself so far as the tax claims of the Contracting States are
Elimination Methods concerned whereas the Article using the expression 'may' in place of
'shall' leave the problem relating to the tax claims unresolved, for the solution thereof
rule contained in Article 23 has to be applied. Thus, the conflict as regards (b) is
resolved where Articles 6 to 22 have allocated the right to one of the Contracting States
to levy tax on income as specified therein. Such allocation may be made by renunciation of
the right either by the State of residence or of the source or of the situation of the
permanent establishment or the fixed base or by sharing the right to tax between the two
States. These Articles together with Article 23 govern such allocation.
111. Exemption and credit methods
The primary responsibility for relieving from double taxation rests on the State of
residence. It can exempt foreign source income from tax, or it can allow taxpayers a tax
credit for foreign taxes paid. Exemption method and the credit method are dealt with
respectively in Articles 23A and 23B. The basic distinguishing features of these two
methods are:
- The essential feature of the exemption method is that the investor's home State grants
an exclusive right to the source State to levy tax. The State of residence does not tax
the income. Under the credit method the State of residence retains its right to tax the
total income of the taxpayer, but against tax so imposed, it allows a deduction.
- The characteristic of the credit method compared with the exemption method is that the
State of residence is not obliged to allow a deduction of more than the tax due in the
State of source.
- Under the credit method, the investor's home country treats the foreign tax within
certain statutory limitations, as if it were tax paid to itself.
- Credit method relates to tax, and the exemption method to income.
The exemption consists of two methods: (1) full exemption, and (2) exemption with
progression. Under the full exemption method income exempted is not taken into
consideration for determination of tax to be imposed on the taxpayer's rest of the income.
Under the exemption with progression such income is taken into consideration for such
determination though no tax is imposed on it.
Under the principle of credit the State of residence determines its tax on the basis of
the taxpayer's total income including income from the State of source (but excluding
income which is to be taxed only in the State of source) and then allows deduction for the
tax paid in the other State from its own tax.
There is another method, which is a hybrid between 'the exemption and foreign tax credit
systems, called a tax sparing credit method. Tax credit is allowed not only for foreign
taxes actually paid but also for taxes the developing countries forgo through the
application of their fiscal incentives.
Under the tax agreements, double taxation is avoided by the States of residence and
source. In brief, the agreements show the following pattern:
For a wide range of income categories the States determine which of them may subject the
income to their taxes (see Articles 6 to 22). The right to tax is given, sometimes, to the
country where income arises, exclusively or by way of priority. (See paragraphs (1) and
(2) of Article 8; paragraph (3) of Article 13, sub-paragraph (a) of paragraphs (1) and (2)
of Article 19, and paragraph (3) of Article 22.) In other cases, the State of residence of
the recipient of income has an exclusive right to tax (see first sentence of paragraph (1)
of Article 7, paragraphs (1) and (2) of Article 8, paragraphs (3) and (6) of Article 13,
first sentence of paragraph (1) of Article 14, first sentence of paragraph (1) and
paragraph (2) of Article 15, Article 18, paragraphs (1) and (2) of Article 19, paragraph
(1) of Article 21 and paragraphs (3) and (4) of Article 22). In many other cases both-the
source and the residence country may tax the income. In such a case the source country
must limit its tax to a certain maximum whereas the residence country reduces its own tax
on the same income according to the method specified in the agreement concerned. Thus the
basic aim of the tax agreement is avoidance of double taxation which is achieved by
assigning the exclusive right of taxation to either of the Contracting States for
different' categories of income by defining the jurisdiction and the residential
principles in the agreement. When, however, the exclusivity is not possible and
conflicting claims to levy tax are not reconciled and both States insist upon exercising
their rights, double taxation results. In respect of some income both the States retain
their right to tax, as for example, dividends, interest, royalties. The question of
avoidance of double taxation thus arises. Two methods employed are (a) the exemption
method with progression (Article 23A); and (b) the ordinary credit method (Article 23B).
In the agreements entered into by Pakistan, the elimination of double taxation is
generally achieved by the ordinary credit method. However, in case of agreements with
China, Hungary, Indonesia, Greece, Austria, Denmark, Sweden exemption method is to be
followed in respect of all items of income except dividends, interest, royalties and fee
for technical services, where credit method is followed.
112.Exemption method
The State of residence has been made responsible to exempt from tax income and
capital, which in accordance with the Convention 'may be taxed' in the other Contracting
State of source. The method generally followed is the exemption method with progression,
i.e., the foreign income is not included in the basis of assessment of the domestic tax
but is only taken into account in determining the tax rate for the other taxable income.
In this the residence country retains the right to take into account the exempted income
for calculating the rate of tax applicable to the remaining domestic income (agreements
with Austria, Denmark, Sweden, contain this provision). It is only in regard to dividends,
interest, royalties, fees for technical services, there is a departure from this principle
and the method of exemption is not followed; double taxation is eliminated by crediting
the foreign tax.
The agreements with Austria, Sweden follow the source system and hence exempts foreign
income. Agreement with Japan has the source system in respect of dividends, interest and
royalties. France follows the source system in respect of business profits and so exempts
them. The agreement with UK also follows the source system and so the exemption method.
Where the source State retains its right to tax, it is done because the activity which
results in the generation of income is fully integrated in the economy of that State. It
is a generally accepted principle that the foreign resident should be subject to the same
conditions of activity, including taxation, as residents of the source State. Tax burden
should be determined exclusively and definitely by the source State, and the incentive
measures of this State designed to promote economic activities should actually benefit the
investor and is not nullified by taxation by the resident State. In order to promote
investment in these cases, the resident State may have to waive taxes in developing
countries, to the investor. The agreements, therefore, provide for the 'fictitious' credit
of foreign tax on the widest possible scale ('tax sparing').
112.1. Tax sparing - The host country in its desire to attract
foreign investment may provide extensive incentive resulting in the reduction of tax even
to nil. Since under the credit method, reduction in the tax by the home country would be
to the extent the person has paid tax, the entire benefit of incentive would then pass off
to that State as whatever benefit he would have obtained in the form of exemption of tax
could not be retained by him because it would enhance his liability to the home country by
that amount. As far as he is concerned the total outgoing remains the same, whether it is
this or that State which receives it. As for an illustration, if the tax liability in the
home country is 'X' but the person has paid 'Y' in the host country, his liability in the
former would be reduced to X - Y (Z).
The effective liability in the home country depends upon the actual payment of tax in the
host country (Y). If Y is increased, Z is correspondingly reduced or if it is reduced Z is
increased. The reduction in the quantum of 'Y' because of the incentives by the host
country would result in the corresponding enhancement in Z, and if 'Y' is nil, Z will be
equal to 'X'. The beneficiary of the incentive is, therefore, not the person who is
intended to receive it but is the home country.
In order to overcome this drawback, many tax agreements contain a special clause, referred
to as 'tax sparing cause. 'Tax sparing' refers to provisions in agreements which protect
incentives in developing countries to encourage investment in those countries. The country
of residence would grant a credit, not only for the tax actually paid but also for the tax
that would have normally been imposed but which is not so done because of tax incentives.
'Pakistani tax payable' has been defined in some of the agreements as also to include the
amount of income-tax which would have been payable in accordance with the Pakistani tax
laws but for the exemption or reduction of Pakistani tax in accordance with the laws
relating to incentives for the promotion of economic development in Pakistan which are in
force on the date of the signature of the agreement or any other provisions which may
subsequently be introduced in India, in modification of,. or in addition to, these laws.
Thus, tax payable is not the same thing as '.tax assessed'. It may mean tax which a person would have been assessed to pay, but for the
exemption provided in the Ordinance. The word 'payable' is used as an adjective to
describe the quality or the nature of the tax which could have been due on the amount
which is taxable under the charging section.
Canada in its agreement has agreed to allow a degree of Pakistani 'tax sparing'. A way of
encouraging Canadian investment in Pakistan, 'sparing’ means a Canadian resident,
other than an individual can receive credit for upto ten years for an amount that would
have been payable in Pakistani tax, but was in fact not payable, as a result of specified
deductions and exemptions allowed under Pakistani tax laws, given to attract foreign
investment. Tax agreements with Bangladesh, China, Korea, Canada, Kenya, Malaysia,
Mauritius, Singapore, contain a similar provision. The agreement with Bangladesh is very
exhaustive in specifying sections of the Pakistani Income Tax Ordinance, 1979 which are
responsible for granting deductions or exemptions to allow Pakistani 'tax sparing'. The
'tax sparing' is confined to the specified sections or the future sections to be enacted
which have the effect of granting an exemption or reduction of tax which the competent
authorities of the Contracting States agree as to be intended for the purposes of economic
development. But in some other agreements such as for illustration with Indonesia 'tax
sparing' is not confined to some specified sections but is extended to all which have the
effect of granting relief by way of deduction allowed in computing the taxable income or
an exemption or a reduction of tax or otherwise. The wide amplitude of the provision in
Bangladesh agreement could be inferred from the use 'of the words 'or otherwise' in
paragraph (3) of Article 23. These words are not words of limitation but of extension so
as to cover all possible ways in reduction in taxes may occur. It may cover cases where the reduction in tax liabilities arises because of
the set off of the losses under sections 34 to 38, or of the unabsorbed investment
allowances, etc., or on account of any other sections. The 'tax sparing' is confined to
the amount of tax which would have been payable as tax but for any relief-
(a) by way of deduction allowed in computing the taxable income; or
(b) an exemption; or
(c) a reduction of tax; or
(d) otherwise under the laws relating to taxation of income in force in the Contracting
State.
The reduction in tax may be on account of or by way of relief. The reason for such relief
may be varied; it may be to encourage a certain type of industry; or backward area; or to
encourage export, or scientific research and development, or to attract foreign
investment, etc. Exemptions and deductions under the Ordinance may broadly be grouped as
under:
- Tax free income [certain clauses of Second Schedule]
- Deductions from gross receipts [sections 18, 20, 23 and 31, Third Schedule and items as
Zakat, WWF, personal medical expenses etc.]
Tax sparing credit may take two forms. Either the amount of credit corresponds to the
ceiling rates agreed upon for purposes of source taxation or the amount of credit even
surpasses the ceiling rate. The first form makes sure that further reduction of source tax
below the ceiling rates benefits the recipient, the second form ensures furthermore that
the tax sacrifice of the source country, towards the common goal of providing tax
incentives, is met with a corresponding tax sacrifice by the resident State.
112.2. Dividend exemption under computation system - Domestic
law of a State may exempt taxation of dividend paid by a company which has already paid
tax on the profits which are distributed amongst the shareholders as dividend, to prevent
taxation of income doubly. Under the classical system, which recognises the legal and
independent existence of corporate personality as distinguished from the individual
shareholder, corporate profits are taxed once in the hands of the company and thereafter
also in the hands of individual shareholder on receipt of such profits as dividend. Under
such a system, 'taxation of income in the hands of the shareholders does not affect
taxation of the company's profits, the provision to the effect that taxation of company
would not be affected by the operation of paragraph (2) of Article 10 would have no
relevance. This follows as a logical corollary to the separateness and the independent
existence of a corporate personality as distinguished from the corporators.
This provision is relevant to system where relief is given to the shareholders on
account of the tax already paid by the company, to mitigate double taxation. The
imputation system avoids double taxation by exempting from taxation dividends in the hands
of shareholders when the company has paid taxes on its profits. Though it is an admitted
fact that this system does not render the company as an agent of its shareholders and it
itself is chargeable to tax on its profits and pays tax in discharge of its own liability,
the company is not chargeable with income-tax on dividends. It is not assessed in respect
thereof. The reason appears to be this, that the amount which is available to be
distributed as dividend has already been demolished by tax on the company and it is
inequitable to charge it again, in order to
obviate economic double taxation. Australia, UK,
USA, New Zealand and other countries follow the imputation system. Whatever the merits,
non-resident shareholders with portfolio investments are relatively disadvantaged.
Recipients of the dividends paid out of profits which have suffered corporate tax will not
receive any imputation credit. 'Such shareholders are obliged to pay tax at a certain
percentage as agreed upon in the treaty. Though such tax will have to be allowed as a
foreign tax credit in their domestic tax assessments, the shareholders would find
themselves as if they are subjected to classical system, unlike their domestic
counterparts.
113. Credit method.
Article 23B deals with the credit method of elimination of double taxation. The State of
residence allows deduction of the amount equal to taxes paid in the source State,
on the income derived in the latter State, from its own taxes due from the taxpayer.
Foreign taxes paid on foreign source income are used to set off taxes which are due in the
residence State. The credit of tax is given (1) in respect of taxes paid in the State of
source; and (2) the taxes should be the amount on income which in accordance with the
provisions. of the Convention may be taxed in that State.
113.1. Taxes paid in the source State - Article 23B of the
Model refers to the taxes having been paid in the source State and accordingly the benefit
could be given only when is the tax paid or deemed paid and not when it 'is due or
payable. But in the context of Pakistani agreements apparently no distinction exists
between the taxes 'paid' or 'payable'. The distinctness between these two expressions
appears to have been completely lost, when one finds that in some agreement one expression
is used, while in others the other without much significance being attached to the user of
this or that expression for a set purpose. But this is not so. These expressions have
definite meaning and are operable within their spheres. Both convey the same sense,
however, if read in the context of the deeming purpose set out in the agreement as could
be discerned from inclusive definitions of these expressions in these agreements. The
expression 'tax paid' has been defined in many agreements and has imported a fiction as to
include the tax which would have been payable. 'Tax paid' is deemed to include any amount
which would have been payable as tax but for any relief by way of deduction allowed in
computing the taxable income or an exemption or a reduction of tax or otherwise under the
laws of the concerned State. The definition of the
expression 'tax payable' is similarly worded.
Though for the purposes of the fiction there is no difference between the expressions 'tax
paid' and 'tax payable', these have different and distinct connotations outside that
fiction. 'Tax paid' cannot be read as 'tax payable'; and would mean only if tax has been
paid and not due or payable or would have been payable otherwise than as contemplated by
the fiction. Fiction is created for a definite purpose and its scope cannot be extended
beyond what the fiction carves out. Legal fiction created for a definite purpose should be
limited for that purpose and cannot be extended beyond their legitimate needs. The word
'deemed' refers to what is supposed to be' and not what actually is’.
Taxes payable are supposed to have been paid or have been paid in
actuality. Even the expression 'tax payable' wherever used, would mean tax due to be
payable as a result of an order or demand .from the income-tax authorities or of a
statutory obligation. 'Tax payable' would not mean that tax that could have been payable
had there been no exemptions or rebates. This is precisely for this reason that a deeming
provision is needed. The word 'deem' is sometimes used to impose for the-purpose of a
statute an artificial construction for a word or phrase that would not otherwise prevail.
Sometimes it is used to put beyond doubt a particular construction that might be otherwise
uncertain. Sometimes it is used to give a comprehensive description that includes what is
not obvious what is uncertain and what is in the ordinary sense impossible.
The meaning of the word 'deemed' must depend upon the context in
which it is used. In the context of
'tax sparing' the expression 'deemed' could be read to impose an artificial construction
to the expression 'tax paid' or 'tax payable' that would not otherwise have prevailed.
113.2. In accordance with the provision of this Convention --
The words 'in accordance with' mean being in agreement with or harmony with, in conformity
to. The expression when used with reference to
taxation of income, may mean its taxability by the State in pursuance of the right given
to it in the agreement, though the other State may also have the right to tax it according
to its own domestic laws. The agreement contains Articles 6 to 22 which deal with the
taxation of income. Exclusive right has been given to one State in respect of an item of
income. Whereas
right has been given to both in respect of some other items. The agreement thus uses such
expressions 'may be taxed' or 'shall be taxed only' in the State of source or of
residence. Only where both the Contracting States have the right to tax an income, and
they have that right in pursuance of the provisions of the agreement, the question of
elimination of double taxation arises. The Convention with Great Britain defines this
expression to include tax which are the subject to the Convention and imposed on income is
expressly mentioned in the Convention. This definition is inclusive. Thus only when is the
tax paid (deemed to be paid) on the income derived by the taxpayer which may be taxable in
the source State, deduction is allowed. If the tax has not been paid (or deemed paid) or
the income is exempt in the residence State, deduction is not permissible. There are
certain items of income which are taxable in the source State, according to the provisions
of the Convention, such as those referred to in Article 8, paragraph (3) of Article, 13,
sub-paragraph (a) of paragraphs (1) and (2) of Article 19, paragraph (3) o Article 22. The
expression used in these paragraphs is 'shall be taxable only with reference to the type
of income dealt with by them which suggests that income is taxable in the State of source;
the State of residence having no right to tax. In respect of such items credit of tax is
not to be allowed in the State of residence.
The credit will only be available for foreign taxes for which the taxpayer is personally
liable and which has actually been paid or deemed paid. Personal liability may mean any
payment made on behalf of the taxpayer by his agent or representative, as also direct
deduction, e.g, withholding taxes.
113.3. Rules for credit method - Article 23B sets out the
rules of credit method, but does not provide for the rules about the operation of the
credit method and computation of the amount of credit. Many agreements, therefore refer to
the domestic laws for the rules of operation and computation of credit. The common
features of foreign tax credit systems is that creditable foreign taxes cannot exceed the
‘home’ or ‘residence’ country' tax on the foreign income.. Failing
such a foreign tax credit limit, the excess credit arising could be offset against tax on
domestic income, reducing home country’s revenue collections. Under the foreign tax
credit system, therefore, foreign source income derived by the resident of a State is
subject to that State tax. However, upto an amount not exceeding that State tax payable
thereon, foreign tax paid is credited against the tax liability arising from the receipt
of foreign income.
113.4. Credit method and Income Tax Ordinance, 1979 - The
Income Tax Ordinance contains details of foreign tax credit system, in section 164. The
rules enshrined therein relate to income which has arisen to a taxpayer in a country with
which Pakistan has no agreement for the relief or avoidance of double tax, and income-tax
thereon has been paid in the country. In relation to income which has arisen in a country
with which Pakistan has agreement, the relief is granted in terms of that agreement. In
the absence of a provision for relief or of avoidance of double taxation, provision of
section 164 becomes applicable. Wherever provision exists, it corresponds to the rules as
contained in section
The rule as contained in section 164 read with Seventh Schedule is copied in content in
the tax agreements.
The following requirements have to be satisfied in order that an assessee is entitled to
claim deduction on the doubly taxed income, under section 164 of the Ordinance:
- The assessee must have been the resident in Pakistan in the relevant assessment year.
- ·Income must have accrued or arisen to him during that income year outside Pakistan.
- In respect of that income, which has accrued or arisen outside Pakistan, he must have
paid by deduction or otherwise tax under the law in force in the country in question.
If the above conditions are fulfilled, the assessee will be entitled to deduction from the
income tax payable by him in Pakistan of a sum calculated on such doubly taxed income at
the Pakistani rate of tax or at the rate of tax of the said country, whichever is lower.
The entitlement of an assessee to deduction extends to 'such doubly taxed income'. This
expression requires elaboration as regards its scope and extent.
113.5. 'Such doubly taxed income' - The words 'such doubly
taxed income' can have reference to tax which the foreign income bears once again the
burden of income tax by its being included in. the total income chargeable under section
9, read with section 2(44), which defines it as the total amount of income referred to in
section 11 computed in the manner laid down in the Ordinance. A reference to section 11
would -show that the income which accrues or arises to an assessee outside Pakistan during
such year is to be included in the total income. The income which has thus accrued or
arisen to the assessee without Pakistan and is subjected to tax under the law in force in
that territory, is included in his total income attracting the levy of charge under the
Ordinance. The income is again taxed under the Ordinance, and is therefore, a doubly taxed
income. Or, it could mean that the income from the same or similar head or source which
has accrued or arisen to him outside Pakistan during such year and upon which tax is paid
by him, can be considered to be doubly taxed if under that head it is again chargeable to
tax under the Ordinance. In other words, it is the criterion for determining an income as
doubly taxed income, the head or the source of income under the Ordinance to be considered
with the same head or the source of income in respect of which tax is paid under the
foreign law, or is the emphasis on the tax paid by deduction or otherwise under the law in
force in a foreign country in respect of which relief is being given by reason of the
inclusion of that income in the total income of the assessee which is again subjected to
tax under the Ordinance.
113.6. Income must have suffered tax outside Pakistan, and is also
subjected to tax in Pakistan - The expression 'such' refers to the income which
accrued or arises outside Pakistan during the previous year. The expression 'doubly taxed
income' in its plain grammatical meaning, refers to foreign income taxed under the
Pakistani law. The word 'such' in the phrase 'such doubly taxed income' has therefore
reference to the foreign income which is again being subjected to tax by its inclusion in
the computation of the income under the Ordinance and not the same income under an
identical head of income under the Ordinance. The main requirement, therefore, is that the
income must have been taxed outside Pakistan and the same income must have again be
subjected to tax under the Income Tax Ordinance, 1979 in Pakistan. If any portion of the
foreign income is not subjected to tax in Pakistan, then, the assessee will not be
entitled to claim deduction on that part of the foreign income which is not subjected to
tax in Pakistan. This fits into the real scheme and intent of section 164 read with rule
209 of Income Tax Rules, 1982, which is to the effect that in respect of any income, a
person should not be doubly taxed, once outside Pakistan and again in Pakistan. If the
income taxed outside Pakistan is subjected to tax again in Pakistan, then, the provisions
of section 164 would come into operation and the assessee can claim appropriate relief on
the doubly taxed income. Mere inclusion of the
foreign income in the total income does not mean that the foreign income is subjected to
tax. The criteria are not only that the foreign income be included in the total income,
but it should also be subjected to tax in Pakistan, i.e., it has suffered tax. The real
test, therefore, is whether the income in respect of which tax deduction is claimed by the
assessee is subjected to tax under the Income Tax Ordinance. The amount, if included in
the total income and after having been so done, is excluded wholly or partly by way of
deduction or otherwise because of its nature in accordance with any other provision of the
Ordinance, and, so does not form part of the net income to that extent on which tax has
'to be determined, then, so much of the income as is excluded cannot be said to have
suffered tax or subjected to tax. As for illustration, if a citizen of Pakistan has earned
remuneration in foreign currency (equivalent to say Rs. 1,00,000) for any services
rendered by him outside Pakistan, the entire amount of Rs. 1,00,000 forms part of his
gross total income because of section 11. For the doubly taxed income, of Rs. 1,00,000 the
assessee can claim appropriate relief under section 164 on fulfilment of requirements of
Rule 209 which are as under.
"Rule 209. Application for relief in respect of tax paid in another country. -
An application for relief by way of credit against Pakistan tax for tax paid by a person
resident in Pakistan in an income year in any other country shall be made in the following
form, namely :-
APPLICATION FOR UNILATERAL RELIEF UNDER SECTION 164 OF THE INCOME TAX ORDINANCE
Income year ...............
Assessment year
To
The Deputy Commissioner,
Circle----------Zone----------
I,----------of-------------hereby declare that I have paid taxes on income by deduction or
otherwise in the territory of--------- amounting to in respect of income from sources
therein for the income year ending -----------amounting to--------- and that Pakistan tax
amounting to Rs.-------is also payable on the said income.
2. I further declare that I was resident in Pakistan for the period on the basis of which
the doubly taxed income stated above is assessable in Pakistan.
3. I now apply for relief by way of tax credit amounting to Rs.-----------under section
164 of the Income Tax Ordinance, 1979. My income from all sources to which the Ordinance
applies during the income year ending on----------19.------amounted to Rs.------- only, as
shown in my return of income attached herewith/already submitted.
Signature
Name
Address
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If any particular slice of foreign income is not subjected to tax in the assessment made
in Pakistan, it is not possible to treat such foreign income not subjected to tax in
Pakistan also as forming part of the doubly taxed income for the purpose of section 164. The relief by way of
deduction of tax under this section should, therefore, be confined to the amount doubly
taxed in accordance with the provisions of the Ordinance and not to the full amount which
forms part of the total income, to the extent it does not bear tax in the country. The
Legislature intends prevention of double taxation but not extension of additional benefit
in respect of that portion of income which has not suffered tax in Pakistan.
113.7 The rule in nutshell - The rule is: foreign source
income derived by a Pakistani resident is subjected to Pakistani income-tax and the
foreign tax paid is credited against the Pakistani tax liability arising from the receipt
of foreign income upto an amount not exceeding Pakistani tax payable thereon. The tax
liability is determined by applying the rate of Pakistani tax, which means the rate
determined by dividing the amount of the Pakistani income-tax after deduction of any
relief due under the provisions of the Pakistani Income Tax Ordinance, 1979 but before
deduction of any relief due under the agreement with foreign countries or under section
164., by the total income.
Foreign tax liability in respect of foreign income is determined by applying the rate of
concerned country, which means income-tax and super tax actually paid in the said country
in accordance with the corresponding laws in force in the said country after deduction of
relief due, but before deduction of any relief due in the said country in respect of
double taxation, divided by the whole amount. of income as. assessed in the said country.
Since the calculation of relief due is dependent upon the discrepancy between the
Pakistani rate and foreign rate of tax, the problems associated with the computation of
income, exclusion from or inclusion in the total taxable income of some items of income,
carry forward and set off of losses of the earlier years, etc., under the domestic laws of
a foreign country or the Pakistani laws are not relevant for granting relief to a taxpayer
in respect of the doubly taxed income, under the credit method.
The basic concept is that the resident taxpayer pays at least as much tax as he would have
done had such income been locally sourced. The effect is to impose a 'tax
neutrality' on the decision as the sourcing of income discouraging the exploitation of the
overseas lower tax rates by the Pakistani residents. It neither encourages nor discourages
foreign investment where the foreign tax credit is available. The combined effect of
source and residence taxes on foreign source income is the same as the residence tax on
domestic source income so long as the tax rate in the source country is not in excess of
the tax rate in the residence country.
As regards setting a foreign tax credit limit, Pakistan has been adopting a
country-by-country limit in preference to a world-wide limit. Countries like America,
Japan, Australia use the world-wide limit, i.e., the 'overall limitation', under which the
maximum foreign credit is set at the amount of their tax that would be payable on all
foreign source income. The loss from one country is set off against the income from
another country, thus reducing the amount of foreign tax potentially available.
Under the country-by-country limit, i.e., 'per country limitation', the foreign tax credit
is computed on country-by-country basis and the amount of taxis limited to the amount of
tax that would be payable on the income from each country. The excess credit from high tax
countries cannot be used to offset low taxes in other countries.
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