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The foremost factor in deciding whether any Pakistani-source income is taxable in the hands of a taxpayer is the determination of residential status in the relevant tax year.
The tests for determination of residential status either in the light of a Double Taxation Agreement (DTA) or the general Pakistani income tax law are specifically provided in legal parlance.
In deciding whether a person should be regarded as the "resident" of Pakistan or some other country, or both, the Income Tax Ordinance, 2001 (ITO 2001) follows general world practice in ignoring the nationality of a taxpayer and concentrating instead on where the person resides. For this purpose the law deals with individuals separately from businesses. This article is an endeavour to explain the importance of the term "residence", to unveil the legal aspects of the concept "residence" as embodied in the ITO 2001 and its significance, apart from the worldwide practice.
Jurisdiction to tax: Nowadays, countries around the globe tax the income of a person based on the following three concepts: Source jurisdiction, residence jurisdiction, and the combination of source and residence.
As we all know income may be taxable under the tax laws of a country because of a nexus between that country and the activities that generated the income. According to international usage, a jurisdictional claim based on such a nexus is called the "source jurisdiction". All countries imposing an income tax exercise source jurisdiction; that is, they tax the income arising or having its source in their country.
A country may also impose a tax on income because of a nexus between the country and the person earning the income. A jurisdictional claim over income based on a nexus between the country making that claim and the person subject to the tax is called the "residence jurisdiction".
Person subject to residence jurisdiction of a country generally is taxable on their worldwide income, without reference to the source of the income. That is, the person is typically taxable on both the domestic source of income and the foreign source of income.
The ITO 2001 adopts a combination of the source and the residence jurisdiction. The source jurisdiction is exercised through the withholding tax regime and the concept of permanent establishment while the residence jurisdiction is explained in central concepts of the ITO 2001 (sections 81 to 84).
Notion of residence: Residence is of pivotal importance in every situation involving the tax jurisdiction and chargeability vis-a-vis a foreign element. This is because the general rule is as follows:
1. Someone who is the resident in Pakistan is liable to the income tax on worldwide income (sub-section 5 of section 11), but:
2. Anyone not resident in Pakistan during the tax year is only taxable in Pakistan on the Pakistani source of income (sub-section 6 of section 11).
Residence of individual: An ideal test of residence for an individual must be aimed at obtaining a clear, certain and fair result. Certainty is highly desirable because the tax consequence for resident and non-residents are very different, and the individuals need to know whether they are residents or non-residents. Countries around the globe employ the following two tests:
1. Facts-and-circumstances test
2. Arbitrary test, often tied with the number of days.
In many countries, residence is determined under a very broad facts-and-circumstance. In effect, the government seeks to determine from objective manifestations whether an individual has established his or her allegiance to the country by joining its economic and social life. The most significant manifestation of allegiance is probably the maintenance in the country of dwelling or abode that is available for the taxpayer's use. Also relevant, however, might be the place where the individual engages in income-producing activities, the location of his or her family, the social ties maintained in the country, the individual's visa and immigration status, and the individuals actual physical presence in the country.
Some countries, including Pakistan, use an arbitrary test tied to a number of days of presence in the country, for determining the residence. Section 82 of the ITO 2001 lays down a period of 182 days or more in a tax year, apart from the concept of deemed resident individual in the case of an employee or official of the federal government or a provincial government posted abroad in the tax year.
This is a common, but defective, rule or presumption. Under this concept an individual present in a country for at least 182 days of a tax year is a resident for that year. The 182-day test is probably enforceable in Pakistan because it exercises tight control over its borders, otherwise it is extremely difficult to enforce in countries where many individuals are frequently entering and leaving the country without border checks.
Many individuals with substantial economic ties to a country can plan around 182-day test. It is worthwhile to note that there are 365 days in a tax year and 182 days does not even pass the 50 per cent number of days test. This shows the beggar-thy-neighbour policy of the CBR. This would also lead to the problem of dual resident, as normally the tax laws of the countries around the globe carry 183 number of days test.
Now the question is how this will be resolved. To avoid situations in which a person is considered resident in both the countries, the OECD Model treaty provides a series of tiebreaker rules to give the residence jurisdiction to one country and is as follows:
1. Place where an individual has permanent home.
2. Country in which the centre of the individual's vital interest is located.
3. The place of individual's habitual dwelling.
4. Country of citizenship.
If these tiebreakers are ineffective in making the individual a resident of only one country for treaty purposes, certain tax officials (the competent authorities) of the two countries are mandated to determine the residence by mutual agreement. Most modern treaties follow the OECD Model Treaty rather closely on these tie-breaker rules.
The problem inherent in the ITO 2001 is much more than a dual resident problem - sole creation of the beggar-thy-neighbour policy. One of the most obvious exemptions is to our citizens earning abroad. Hence, we need to follow the arbitrary test method due to the reasons discussed above but with following amendment in clause (a) of section 82:
"Individual present in a country for 183 days or more and 184 days or more in case of leap year in a taxable year is resident for that year".
Residence of legal entities: There are following four types of legal entities under the ITO 2001:
1. The provincial government and the local authorities are deemed to be the resident per clause (c) of section 83. Now let's move on to the issue of company residence.
The residence of company is generally determined by the following two methods around the globe:
1. Place of incorporation test (clause (a) of section 83).
2. Place of management test (clause (b) of section 83).
The place of incorporation test provides simplicity and certainty both for the tax authorities and the taxpayer. It also allows a taxpayer to freely choose its initial place of residence. In general, a company cannot freely change its place of incorporation without triggering a tax on the gains that may have accrued on its property, including the intangible property that may have a very high market value.
The place of management test is less certain in its application, at least in theory. For many companies engaged in international operations, management activities may be conducted in several countries during any particular taxable year.
In practice, most countries using that test employ practical tests, such as the location of the company's head office or the place where the board of directors meet, to determine the place of management test. This test is normally been used by the former colonies of the UK.
As stated earlier, per section 83, the ITO 2001 uses both the tests separately not in conjunction with each other. As a place of management test is easily exploited for tax avoidance reasons because a change in the place of management generally can be accomplished without triggering any tax.
Now let's move on to the residence status of the association of persons. An association of person is the resident if its controls or the management of the affairs is situated wholly or partly in Pakistan at any time in the year. The place of organization test is missing in the ITO 2001, which has solely relied over the place of the management test. As we all know that determining the residence of a partnership is sometimes difficult because of the informality with which a partnership can be established, although the share of income is exempt in the hands of a non-resident partner.
In Pakistan, only professional firms are treated as transparent or flow-through entities; that is, the partners are taxed on their share of the income of a partnership, hence, there is no difficulty arising and the issue of residence is irrelevant because the partnership is not a taxable entity [section 92(2) and (3)]. If there is a non-resident partner in that firm then the member's share shall be as much of the total income or loss of the association as is attributable to Pakistani-source-income [section 93(1)(b) and 93(3)].
Conclusion: The concept of residence in the ITO 2001 is almost compatible with the concept defined in the developing countries' law. The CBR should amend clause (a) of section 82 to encompass the self-respect and dignity of Pakistan, as these policies are normally termed as the beggar-thy-neighbour policy.
The number of days should be increased to 183 or more and 184 or more in case of a leap year. The 182-day test leads to double taxation of individuals from the countries having no double taxation treaties with Pakistan. As far as the association of persons is concerned, the CBR should incorporate the place of organization test similar to the place of incorporation of the companies.
