Government of Pakistan Revenue Division Federal Board of Revenue has issued the circular on 20 August, 2019 in the matter of explanation of the section 109A of income tax ordinance 2001.
A new section 109A has been introduced by Finance Act, 2018, which is effective from 1st July, 2018. Return for tax year 2019 will be the first year when provision of this section will become applicable. This section states that taxable income of resident person shall include income attributable to a “Controlled Foreign Company (CFC)”
2. In ordinary sense, income of a foreign company owned by a Pakistani resident is ‘taxable’ in Pakistan only when such income is ‘received’ from that non-resident entity. Section 109A(1) of the Ordinance is a deeming provision which essentially creates legal fiction resulting in following exceptions;
(a) Corporate veil is pierced and income of a ‘company’ is deemed to be the income of controlling entity; and
(b) Income is taxed in the year it is ‘earned’ not when it is actually ‘received’. This is the consequence of the first action because when corporate veil is pierced the income becomes taxable when earned.
3. What is a CFC: In order to determine that a foreign company is a Controlled Foreign Company (CFC) either of the two conditions regarding control of the resident over foreign company has to be fulfilled:-
i) more than fifty percent of the capital or voting rights of the non-resident company are held, directly or indirectly, by one or more persons resident in Pakistan; or
ii) more than forty percent of the capital of the or voting rights of the non-resident company
are held, directly or indirectly, by a single resident person in Pakistan.
However, a foreign entity which fulfills either of the above condition, cannot be treated as a CFC if:-
i) the shares of the company are traded on any stock exchange recognized by law of the
country or jurisdiction of which the non-resident company is resident for tax purposes;
ii) the non-resident company derives active business income as defined under sub-section
(3) of section 109A; and
iii) tax paid, after taking into account any foreign tax credits available to the non-resident company, on the income derived or accrued, during a foreign tax year, by the nonresident company to any tax authority outside Pakistan is less than sixty percent of the tax payable on the said income under this Ordinance.
4. The concept of Active Business Income: “Active Income” for the purpose of exclusion from CFC regime requires simultaneous fulfillment of two conditions:-
i) cumulative income from dividend, interest, property, capital gains, royalty, annuity payment, supply of goods or services to an associate, sale or licensing of intangibles and management, holding or investment in securities and financial assets is less than 20% of the total income of the said company; and
ii) principal source of the company is under the head “income from business” in the country or jurisdiction of which it is a resident.
[The dividend income of B Ltd is 50% of the total income of the company hence exceeds threshold of more than 20% passive income therefore it constitute CFC. Whereas 100% income of C Ltd is from business (Active Income) it cannot be treated as CFC.
5. Direct and Indirect Control:
The term ‘direct control’ refers to direct ownership of capital or voting rights in the foreign entity. However the term ‘indirect control’ is very wide in its connotation. It includes indirect control by a company through subsidiary companies in which the resident person holds capital or voting rights but also includes other companies in which the resident person exercises control through ownership of capital or voting rights.
Mr. A owns 30% shares in A Ltd (a non-resident company) and also owns 30% shares in B Ltd. (another non-resident company) which in turn owns 70% capital of A Ltd. In this case A Ltd shall be treated as CFC of Mr.A through indirect control.
Mr. A owns 40% shares in A Ltd (a non-resident company) which doesn’t earn any income but holds 80% capital of B Ltd. (another non-resident company) which in turn owns 80% capital of C Ltd that earns royalty and distribute dividend to B Ltd. In this case C Ltd shall be treated as CFC of Mr.A through indirect control.
6. Attributable Income:The second question after determining a CFC is to determine the ‘attributable CFC Income’ taxable under Section 109A(1) of the Ordinance in the hand of resident person. The taxable income is income generated by a controlled company that should have been taxed ‘when earned’ instead of ‘when distributed’. The attributable income of the resident person shall be determined by comparing the percentage of control (whether direct or indirect) held by the said person over the CFC. This issue is simple to understand in this illustration where the structure is single layered.
7. Other Exclusions:
Certain other exclusions have also been prescribed by law which are:-
i) Income of a controlled foreign company shall be treated as zero, if it is less than ten million Rupees.
ii) If direct/indirect capital or voting right held by the resident person is less than 10% in the Foreign entity.
8. Other relevant rules:
i) The income of a CFC shall be determined in the currency of that controlled foreign company and shall be included in the income of any resident person during any tax year by converting into Rupees at the State Bank of Pakistan rate applying between that foreign currency and the Rupee on the last day of the tax year.
ii) Foreign tax year, in relation to a non-resident company, means any year or period of reporting for income tax purposes by that non-resident company in the country of residence or, if that company is not subject to income tax, any annual period of financial reporting by that company.
iii) The income attributable to controlled foreign company under section 109A shall not be taxed again when the same income is received in Pakistan by the resident taxpayer.
iv) Where tax has been paid by the resident person on the income attributable to controlled foreign company and in a subsequent tax year the resident person receives dividend distributed by the controlled foreign company, after deduction of tax on dividend, the resident person shall be allowed a tax credit equal to the lesser of,
(i) foreign tax paid, as defined in sub-section (8) of section 103, on dividends; and
(ii) Pakistan tax payable, as defined in section 103, for the tax year in which the dividend is received by the resident taxpayer.