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The two decisions of the Supreme Court in Shri Lakshmi Silk
Mills’ case (supra) and New Savan Sugar & Gur Refining Co. Ltd.’s case
(supra), prima facie appear contradictory but on close scrutiny one finds that there is no
irreconcilability between the two. The Indian Supreme Court in latter decision
distinguished the former on the ground that -
(a) that was a case where only a part of the machinery was let out on lease and the rest
of the machinery was worked by the assessee himself;
(b) the letting out the machinery was for a short period of five months; and
(c) that was not a case of letting out the factory as such.
The Indian Supreme Court, thereafter came to the conclusion that the intention of the
assessee was not to treat the factory, etc., as a commercial asset during the subsistence
of the lease and the intention of the assessee was to go out of the business so far as the
factory and machinery were concerned with effect from the date of commencement of the
lease and that the intention was to use the income arising from royalty in its capacity as
the owner of the factory.
The decision of the Indian High Court have all
understood the subsequent decision of their Supreme Court as holding, in the particular
facts and circumstances of that case, that the assessee had clearly indicated its
intention of getting out of the business altogether which showed that it was no longer
using the company as a commercial asset.
Thus, in each case what has to be seen is whether the asset is being exploited
commercially or by letting out for the purpose of enjoying the rent. The distinction
between the two is narrow one and has to depend on the intention of the parties which
could be gathered from the conduct of the assessee and circumstances of each case. Letting
out of the business as a whole and the duration of the lease being for a long period, are
suggestive of assessee’s intention to go out of the business and earn income as the
owner of the asset. If the business as a whole is let out the income (i.e., the rent)
would not be liable to be assessed as income from business.
47.2-7 Investment income vis-a-vis business income - The
Ordinance provides taxing royalty, dividends or interest as a business income if the
receipt represents the measure of profits of business activity of an enterprise almost on
a pattern similar to that of double taxation agreement.
Section 15 of the Ordinance classifies the different heads of income for the purposes of
charge of income-tax and the computation of total income. The effect of this section is to
classify profits and gains under different heads according to the character of the source,
for the purpose of providing for each head, appropriate rules for computing the amount of
income. Income tax is only one tax and the different heads of income constitute one income
liable to assessment in an year. The heads of
income do not exhaustively delimit the sources from which income arises. Business income
is broken up under different heads for the purpose of computation of the total income. But
income by reason of such break-up does not cease to be income of the business. Each head
refers to income, profits and gains attributable to that particular source. Each head,
though separate, exclusive and specific, refers to income, profits and gains. The profits
of a company do not change their character as profit merely because they are classified
under different heads for the purpose of assessment under the Ordinance. The heads of
income describe different kinds of profit chargeable under the Income
Tax Ordinance. The list of heads is the list of’sources’. ‘Source’ and ‘heads of
income’ are used in one and the same sense and it means property, movable or
immovable, belonging to an assessee or an activity of an assessee that yields and brings
income to hi, within the meaning of the Ordinance.
* Property income - If a company owns a property, it is liable to be assessed under
the respective head as provided in the Ordinance, and not necessarily as business income.
Even though the income is derived by a company formed with the object of promoting and
developing markets, from the tenants of the shops and stalls, it is not the income from
business but is income from property. A
distinction must, however, be drawn between the letting out of land or house property on
the one hand and of plant and machinery on the other. The latter are commercial assets and
their exploitation, even by means of letting out, yields income from business. Income from
letting out the former is income from house property. House owning howsoever profitable
cannot be a business or trade under the Income Tax Ordinance, 1979. Where income is
derived from house property by the exercise of property rights, the income falls under the
head ‘Income from house property’ and is chargeable under section 19. It is the
nature of the operations and not the capacity of the owner that must determine whether the
income is from property or from trade. Where the operations involved in the activity o
earning income from house property are not different from those of an ordinary house owner
turning to profitable account the property of which he is the owner, the income derived is
the income from property chargeable under section 19 irrespective of whether operations
are carried on by a company, one of whose objects or even the sole object is to indulge in
the activity of earning income from house property. The character of income, viz, income
from house property, is not changed and the income does not become income from trade or
business if the hiring is inclusive of certain additional services such as heating,’
cleaning, lighting, or sanitation, which are relatively insignificant and incidental to
the use and occupation of the tenements. If the income falls under the head ‘Income
from house property’, it has to be assessed under section 19 only and cannot be taken
to section 22 of the ground that the business of the assessee was to exploit and earn
income or because the income was obtained by a trading concern in the course of its business.
However, if the letting is only incidental and subservient to the main business of the
assessee, the income derived from the letting will not be income from property. In such a situation, the income so received by the assessee is not derived
from the exercise of property rights only but is derived from carrying on business or an
adventure or concern in the nature of trade, because the subject which is hired out is a
complex one.
Where the assessee’s main business was to take buildings on lease and let them as
warehouses and godowns and realise rent therefrom, the income from subletting was held by
the Madras High Court in CIT v.Lakshmi Co.
assessable as ‘income from other sources’, since the subletting of property
could not be considered as trade in its popular or commercial sense, and the
assessee’s activity was also not like that of an owner of the property. An activity
might be termed business in common parlance but is not so under the Income Tax Ordinance.
In CIT v. Admiralty Flats Motel, it was held that
construction of a building and running a lodging house, is a business under the
Partnership Act, though income arising therefrom is not assessable under the Partnership
Act, through income arising therefrom is not assessable under the head ‘Profits and
gains of business or profession’. The decision of the Patna High Court in Khas Benedih Colliery v. CIT impliedly held that if
an income assessable under the head ‘Income from other sources’, the
assessee-firm cannot be allowed to have the benefit of registration as the assessee did
not have income from business and that there was no partnership. The argument that
continuation of registration of the firm had nothing to do with the leasing out of the
asset, did not find favour with the High Court. This decision was followed by the same
High Court in CIT v. Kuya & Khas Kuya Colliery Co.
* Interest income - Interest income or income from dividend or income from
investments can be business income. For instance, in the case of a bank, a particular
amount has to be kept in deposit by law. Interest income so derived will still be business
income. It was so held by the Indian Supreme Court in United Commercial
Bank Ltd. v. CIT.
In Sardar Indra Singh & Sons Ltd. v. CIT, the
assessee was carrying on business, inter alia, of bankers and financiers. It was empowered
to purchase or otherwise acquire, and to sell stock, share, business concerns and
undertakings and to invest and deal with the monies of the company not immediately
required for its business upon such securities and in such manner as might from time to
time be determined. The question was whether the profits realised by the assessee by sale
of certain shares was assessable to income-tax. The Indian Supreme Court held that the
principle applicable in all such cases is well settled and the question always is whether
the sales which produced the surplus were so connected with the carrying on of the
assessee’s business that it could fairly be said that the surplus is the profits and
gains of such business. It is not necessary that the surplus should have resulted from
such a course of dealing in securities as by itself would amount to the carrying on of a
business of buying and selling securities. It would be enough if such sales were effected
in the usual course of carrying on the business or, in the words used by the Privy Council
in Punjab Co-operative bank Ltd. v. CIT, if the
realisation of securities is a normal step in carrying on the assessee’s business.
Following the decision, the Andhra Pradesh High Court in State Bank of
Hyderabad v. CIT held that investment in securities by a banking
company is a normal step and usual method of carrying on banking business, and the income
arising from securities is to be assessed as business income.
In case, however, where an assessee, who has a cash surplus not immediately required for
its business, invests it in variety of securities in order to earn high rate of return and
earns income on these investments, such income cannot be said as arising from business. In
Cooper (H.M. Inspector of Taxes) v. C & J. Clark Ltd., a company was engaged in the manufacture of boots and shoes. In April
1976, it had substantial cash surplus, not immediately required for its business. As it
was empowered by its memorandum of association to invest and deal with such moneys in any
manner which it might determine, it invested them in variety of securities in order to get
a higher rate of return than offered by banks. Owing to an unprecedented increase in
minimum lending rate, the security market fell sharply as a result of which losses were
incurred on the sale of securities in early November 1976. This was followed by an
immediate purchase of further securities on which profits were realised when sold in
December 1976. There were a total of thirteen transactions resulting in a net loss. There
was no separate trading account as such. The contention of the assessee was that since
dealings in securities amounted to a trade, the loss was to be allowed as a trading loss.
The Court held that marketable securities, being income-yielding assets capable of
appreciating in value, were purchased and sold by way of investment and not by way of
trade. However, the Court declined to interfere with the Commissioner’s decision,
which had accepted the assessee’s claim, on the ground that the case fell just within
the ‘no man’s land’ of fact and degree, where it was for the revenue to
evaluate whether the activity amounted to trade or not. Where money is invested by an
assessee, because the money is lying idle and it was safer and wiser to put it in a bank,
the income earned on deposit would be incidental to the main purpose, which is
safe-keeping and not earning profits. The interest earned cannot be said to be received in
the course of business so as to make it part of the profits and gains of the
assessee’s business. In Addl.
CIT v. Vellore Electric Corpn. Ltd., the Madras High Court held that
the immediate source of income is the investment in Government securities and that this
investment and realisation of interest has no direct bearing on the business of generation
or distribution of electricity. In CIT v. Cochin Refineries Ltd., the assessee had deposited amounts in banks and other financial
institutions for a short period for the purpose of repayment of loans on due dates. The
assessee had claimed that interest received was income from business. The High Court held
that amounts of interest were receipts from other sources and not profits and gains
attributable to business. Interest earned on bonds received by an assessee, who was a
banking institution, as compensation on nationalisation of the assessee’s banking activities.
A question arises whether interest received on Government securities or dividend received
from investment in shares, which are held as stock-in trade is the income from
‘business’ [section 22] or from ‘interest on securities [section 17] or
‘income from other sources’ [section 30].
Section 16 to 31 of the Ordinance deal with the computation of total income and provides
that the total income has to be computed under what are known as heads of income. Section
17 deals with the heads of income known as ‘Interest on securities’. Section 22
of the Ordinance provides that certain income will be chargeable to income-tax under the
head ‘income from business or profession’. The income of an assessee has to be
computed, assessed and taxed under one head of income or the other. These heads of income
are exclusive and where a particular income falls within one head of income, it cannot
then be regarded as falling under any other head of income. The Indian Supreme Court in CIT v. Chugandas & Co.93 held
that the interest on securities which were held by the assessee as business assets formed
part of the assessee’s business income for the purpose of exemption from tax under
section 25(3) of the (repealed) 1922 Act. It has been pointed out that the heads of income
described in section 6 of the (repealed) 1922 Act were intended merely to indicate classes
of income. It was held that business income is broken up under different heads only for
the purpose of computation of the total income. By that breaking up the income does not
cease to be the income of the business, the different heads of income being only the
classification prescribed by the Income-tax Act for computation. In that case, the
question was not under which head the interest on securities earned by the assessee was to
be taxed, but whether the assessee was entitled to exemption under section 25(3) in
respect of interest on securities which was a different question altogether. In fact, in
that decision the Indian Supreme Court reaffirmed the correctness of the decision in the
case of United Commercial Bank Ltd. v. CIT, and reaffirmed the principle that the various
heads of income, profits and gains enumerated in section 6 of the old Act [Parallel to
section 15 of Income Tax Ordinance, 1979] are mutually exclusive, each head being specific
to cover the income arising from a particular source, and consequently, ‘Interest on
securities’, which is specifically made chargeable to tax under section 8 (now
section 17 of Ordinance) as a distinct head, falls under that section and cannot be
brought under section 10 (now section 22 of Ordinance), whether the securities are held as
trading assets or capital assets.
Since there are exclusive heads under the Income Tax Ordinance, 1979 for computation of
income earned as interest or dividend distinct from the one for profits from business or
profession, the income earned as interest or dividend cannot be assessed as business
income irrespective of the securities or shares are held by an assessee as stock-in-trade. Similarly, where an assessee is holding shares and
securities as its stock-in-trade and dividend is received by him for such stock-in-trade,
the dividend earned by him though assessable under the particular head, i.e., ‘Income
from other sources’ is really the ‘business income’.96
Dividends - The principle of taxability of investment income under the double
taxation agreements is not different from that under the Pakistani law. Though income
might be received 'in the form of' dividends or interest, it may exist as a measure of
profits. The business profit to be computed in terms of the double taxation agreement
(Article 7) is by attributing to a foreign company doing business in Pakistan a reasonable
sum of income or profit in respect of that sum of income as arising in Pakistan. The
nature of the double taxation agreement is such as being designed to attribute to the
foreign taxpayer a measure of income to represent his Pakistani business. Commercial and
industrial profits of a foreign company are not to be subjected to tax unless it is
engaged in business in Pakistan through a permanent establishment here, but the tax to be
imposed only on so much of them as is attributable to that establishment. The basis has
been provided in the agreement which requires the hypothesis that the branch is an
independent establishment dealing with an independent entity at arm's length with the head
office. The profits which emerge from a calculation based on this hypothesis are to be
deemed income derived from a source in Pakistan.
The term 'industrial or commercial profits' is usually declared to be profits from such
activities or business but does .not include income in the form of dividends, interest,
rents, royalties. Accordingly except so far as the double taxation agreement [Articles 10
and 11] makes certain stipulations about double taxation of dividends or interest, the
respective claims of taxing authorities upon items of income such as dividends or interest
are not regulated on the 'permanent establishment' principle and are left to be taxed
according to the local legislation. It is in accordance with the Pakistani principles to
tax all dividends and interest arising from sources in Pakistan or deemed to accrue or
arise in Pakistan unless specially excepted, but not to tax the foreign income of
non-residents.
The issue whether professional consultancy services
would fall under "personal services" and thus not covered by industrial or
commercial profits came for consideration before the learned judges of the Karachi High
Court in Glaxo Group Ltd. v. CIT (1992) 65-Tax-139. This case entailed the interpretation
of the provisions of Convention with the United Kingdom. The learned Judges after
considering several earlier decisions and the definition of personal service, personal
services contract and industrial and commercial profits as contained in Valentine's Law
Dictionary (3rd Edition), finally held as under in paragraph 10 of their judgement:
"........Personal services as noticed, under subclause 'd', the services to be
rendered by the assessee through its staff or staff of its associated companies is to
advise the Pakistani Company on the utilisation of its machinery and equipment etc. and
under sub-clause 'g' the advise to be given is about maintenance of high standard of
quality of the specialised product and this advice is rendered through regular inspection
by the assessee. As observed these types of advices or services can aptly be described a
technical services. What the assessee does is that it makes available its expertise
technical and special knowledge and experience to the Pakistani Company. The technical
services rendered under the aforesaid sub-clause by the assessee to be Pakistani Company
are covered by the term "personal services". Being a company, the assessee has
to render such services through its staff or staff of its associated companies,
nevertheless such services remain technical services rendered by the assessee".
Despite the above finding, characterising the services rendered as 'technical services',
looking to the nature of the personal services, the payment was finally held not to be
exempt by the High Court for the reason that the relevant Articles of the Convention with
the UK excluded these from the definition of "industrial or commercial profits".
It is thus manifest, had the definition of 'industrial or commercial profits' not excluded
technical services from the definition, these were normally to be treated as
"industrial or commercial profits". It goes to the advantage of the Appellant
that definition of "industrial or commercial profits" at Article III(2) of the
Convention between Pakistan and Switzerland does have no such exclusion in Convention with
the UK) with the result that if the ratio of the Glaxo Group decision (ibid) is followed,
the remuneration for professional consultancy services would be covered by the term
"industrial or commercial profits". Moreover, the learned judges of the High
Court in their decision reported as (1983) 47-Tax-214 in re: Raleigh Investment Company
Ltd. have ruled that it would be incorrect to place an income under one head totally over
looking the predominant nature of the business which should be the prime factor to
determine the character of the income. The learned Judges in the course of their Judgement
elaborated that "commerce" is a word of wide implication which not only means
intercourse by way of trade and tariff but also of all "commercial
matters".
The double taxation agreement normally contains a provision to the effect 'where profits
include items of income which are dealt with separately in other Articles of this
Convention, then the provision of those Articles shall not be affected by the provisions
of this Article', as paragraph (6) of Article 7 of the UN Model Convention is dealing with
business profit. There is also another provision as a paragraph of Articles dealing with
dividends, interest, royalties, which read like this:
"The provisions of paragraph (2) shall not apply if the recipient of the dividend,
being a resident of the Contracting State, carries on business in the other Contracting
State of which the company paying the dividends is a resident, through a permanent
establishment situated therein, and the holding by virtue of which the dividends are paid
is effectively connected with such permanent establishment or fixed base.
In such a case, the provisions of Article 7 or Article 16 as the case may be shall
apply." [Article 7 deals with business profit and Article 16 with independent
persona] services.]
These two exceptions, one to Article 7, and the other to Article dealing with dividend or
interest or royalty, if read together point out to the conclusion that if a given type of
income meets the requirements of two types, the rule governing income from assets take
priority over those other governing income from activities. For example, if the business
assets of an enterprise include shares of stock in a corporation dividends derived from
those shares will be treated in general under Article 10 which relates to dividends rather
than under Article 7 which relates to business profits. If the business profits include
dividends, interest or royalties and the establishment does not have a permanent
establishment in the other Contracting State, such income would be taxed as dividends,
interest or royalty and not as a profit from the carrying on of the business, irrespective
of that investments in shares or on loan, etc., are integral or inseparable part of the
activity of doing business. If, however, these are received through a permanent
establishment and the investments are effectively connected with such permanent
establishment, i.e., the right of such income is on account of the asset of that permanent
establishment, then their taxation is determined as if business income, in pursuance of
Article 7.
Thus, this Article gives preference to the special Article, on dividends interest,
royalty, etc. It is, however, applicable to such income which falls within it (cf.
paragraph (4) of Article 6, paragraph (4) of Articles 10, 11, paragraph (3) of Article 12
and paragraph (2) of Article 21). 'It is understood that the item of income covered by the
special Articles may, subject to the provisions of the Convention, be taxed either
separately, or as an industrial and commercial profits, in conformity with the tax laws of
the Contracting States'.
47.2-8 Technical fee - A question may arise whether any
income which accrues or arises to a non-resident in respect of fee for consulting activity
in connection with installation of plant, etc., by deputing personnel .could be said as
relating to business activity or such activity be taken to mean a business connection'. It
could be argued that if a non-resident company has agreed to erect a plant for a Pakistani
company and to put it on stream and has also agreed in this regard to depute certain
technical personnel to Pakistan to render technical assistance, guidance and advice, who
would be paid salaries by the Pakistani company, and that the consultancy fee agreed to be
paid by the Pakistani company and received by the non-resident company on account of the
training given to the deputed personnel in the foreign country as a compensation for
gathering and sparing those persons for deputation in Pakistan; such fee cannot be said
associated or linked with anything done or any activity carried on by the non-resident
company in Pakistan.
Distinction between "Technical Fees"
and "Industrial or Commercial Profits".
"..... while dealing with exemption in respect of technical fees, that the Convention
with Switzerland is different from the Convention with the United Kingdom inasmuch as
while "industrial or commercial profits" in the convention with the UK
specifically exclude the 'personal services', the one with Switzerland does not separately
deal with technical or personal services. This Convention has separate Articles for
activities like: management, control or capital of an enterprise; operation of air-crafts
(etc); dividends; royality (etc) but no such independent Article deals with technical or
personal services which are to be treated as industrial or commercial profits" moreso
when the decision by the Karachi High Court in Glaxo Group Ltd. (1992) 65-Tax-139
pronounced a different verdict simply because the Agreement with the UK, had specifically
excluded the 'fee for technical services' from the scope of "industrial or commercial
profits". Consequently, the non-exclusion according to the view of the learned
Judges, means 'fee for technical services' to fall under "industrial
and commercial profits".
Fee received for rendering of technical assistance or consultancy activities and training
of Pakistani personnel, if necessary, for the construct/on of the plant, bringing it into
production, for preparation and supply of the drawing and documentation for production of
operating tools, for preparation and supply of technical documentation for production of
non-standard equipment to be installed in the plant, for rendering personnel and technical
assistance and consultancy services for the starting and in the initial run of the
production in the plant, cannot be dissociated from the activity of erection of plant.
It would thus appear in these circumstances that a non-resident company may charge a
company in two ways viz, (i) payment of salaries of the personnel deputed by it to
Pakistan; and (ii) consultancy fee for rendering technical assistance and consultancy
services. A major portion of the services was rendered in Pakistan. The consultancy fee
must be said to have arisen from the activities in Pakistan and so much income as is
attributable to such activity is taxable in Pakistan.
47.2-9 Lump sum amount received for transfer of right to receive
interest - If a company lends to its subsidiary company an amount on loan for certain
specified period, and a few days thereafter it assigns its right to receive the interest
under the loan to a finance company on some consideration, a question may arise whether
such amount constitutes income in the hands of the recipient and if it does, whether such
amount represents business income. It is an established proposition of law that a
contractual right of interest is not the source of interest, and a contractual right
severed from the principal debt is not the structure which produces the interest. The
source is the principal debt. The sale by the lender of his right to interest for a lump
sum consideration converts future income into the present income. The consideration for an
assignment of the right to future income may constitute income in praesenti in variety of
circumstances. Sale of capital asset for periodic, regular and recurrent receipts,
converts capital asset into income, with periodicity, regularity or recurrence being the
characteristic of income which can be converted
into income can reasonably be regarded as giving rise to income. But a conversion of capital asset into income is not confined to such a
sale. Right to receive interest in future on the amount of loan given now may represent a
specie of property or capital asset but realisation of consideration for its assignment
may not represent realisation of capital asset. The assignment is not unrelated to the
loan agreement. It is not unusual in a commercial world that a lender advances loan to the
borrower under the belief that he would be able to assign his right to receive the
principal amount of loan together with interest for a consideration. If his financial
position is not happy, he would not enter into a loan agreement unless he knows that a
finance company or a bank would not shortly after such agreement take an assignment of the
moneys due or to become due for a sum approximating the amount payable in consideration
for the assignment. From the taxpayer's point of view, the two transactions are essential
and integral elements in an overall profit-making schemes.
The immediate source of income is the assignment of a right, and not the right to receive
interest which has already become due or accrued. Right to receive interest in future has
not as yet ripened into a source which has yielded interest, though such right relates to
receiving interest. The source from which interest could be derived has not yet been
ascertained; viz, the period for which the money has been retained or used or for which
the indebtedness continues. For determination of the source from which income is derived,
an enquiry has to be made into the genealogy of the product. But the enquiry, should stop
as soon as the effective source is discovered.
The moment one comes to an immediate and effective source, one ought not to go any further.
The immediate and the effective source is the assignment of a right to receive interest in
future. The contractual right to interest is not the source of interest. Such an
assignment smacks of business characteristics, or be termed as a venture in the trade. A
receipt may constitute income if it arises from an isolated business operation or a
commercial transaction entered into otherwise than in the course of carrying on the
taxpayer's business, so long as the taxpayer has entered into the transaction with the
purpose of making a relevant profit or gain from the transaction. It is not necessary to
constitute trade that there should be a series of transactions, both of purchase and sale.
A single transaction outside an assessee's line of business may constitute an adventure.
Neither repetition nor continuity of similar transactions is necessary to constitute a
transaction an adventure in the nature of trade.
If there is a repetition and continuity, the assessee would be carrying on a business and
the question whether the activity is an adventure in the nature of trade can hardly arise.
An isolated transaction can satisfy the description of an adventure in the nature of
.trade. Sometimes it is said that a single plunge in the waters of trade may partake of
the character of adventure in the nature of trade.
In other words at least some of the essential features of trade must be present in
isolated or a single transaction. If the profit is the motive in entering into a
transaction, and the intention of sale of an asset or right is apparent from the
inception, an inference of an adventure in nature becomes obvious. The presence of a characteristic, viz, the transaction since its
inception is impressed with the character of a commercial transaction entered into with a
view to earning profit, is enough to hold the transaction to be in the nature of trade. The income received from the transaction is
assessable as if income from business. It would be unreasonable to apply the conventional
test of 'income coming in with some sort of regularity or expected regularity from
definite sources' or 'income being likened pictorially to the print of a tree or the crop
of the field' to the decision of the question whether a single or an isolated transaction
can be regarded as an adventure in the nature of trade.
Thus, the contractual right to interest is not the source of interest and a contractual
right severed from the principal debt is not the structure which produces interest. The
sale by a lender of his mere right to. interest for a lump sum consideration converts
future income into present income though the nature of income may not be the same or
similar on the ground of analogical extension of the proposition that when a person
converts capital sum into annuity for future and the character of amount spent for
purchase of annuity get transformed from capital to income.
The lump sum received by the taxpayer for the transfer of his right to receive interest
represents his business income.
47.2-10 Whether investment income can be taken as business
income - Though the 'investment income' is taxed on the basis of territorial nexus,
i.e. the place where it accrues or arises, not appropriated in the manner as is done in
the case of business profit as to attribute a portion of it to the permanent
establishment, and the double taxation agreements make separate provisions as regards to
their taxability. For instance, if a foreign enterprise has investment in a host country
and derives income as dividends, interest, rent and so forth, it has, of course, to pay
tax on that income in that country. Tax is deducted at source at the time of their
payment. If, however, the domestic laws of the foreign enterprise requires it to pay tax
on such income, the double taxation agreements make provisions that while paying such tax,
the assessee would receive credit for tax it has paid in the host country. A critical
question may arise whether such income could be taken 'business profit' or be treated as
'investment income'. Income derived from 'investment' may be taxed as business
profits on the basis of the doctrine of 'force of attraction'.
* Force of attraction - The rule of 'force of attraction' enunciates that all
income arising from all sources in a country, where the foreign enterprise maintains a
permanent establishment; is subject to tax in that country. This rule permits the
enterprise, once it carries on business through a permanent establishment in the source
country, to be taxed on business profits in that country arising from transactions outside
the permanent establishment. This principle is the natural corollary of taxing an income
on the source principle. Furthermore, non-business income of the enterprise may likewise
be attracted into the taxable income of the permanent establishment. What the rule 'force
of attraction' really means is this, if a foreign enterprise has a permanent establishment
in a taxing country, any other income from sources within that country are automatically
regarded as income attributable to that establishment. The developing countries are
exponent of this rule, though they would limit its application to business profits covered
by Article 7 of the OECD Model Convention and not extend it to income from capital
(dividends, interest and royalties) covered by other treaty provisions, as also not to the
profits which could be attributed to the activities relating to purchases or to sales
through independent commission agents. Business profits, as customarily defined, do not
include interest, rent, royalties, dividends and the like, i.e., income from capital,
unless such profits are attributable to the permanent establishment. The opposition by the
developed countries to this rule stems from the undesirability of taxing income from an
activity that is totally unrelated to the establishment (which itself being not extensive
enough cannot constitute permanent establishment) as also from the uncertainty that this
rule would create for the taxpayers.
The compromise between these two opposite views was sought by providing in draft model
that the rule 'force of attraction' should be limited so that it would apply to sale of
goods or merchandise and other business activities in the following manner:
* If an enterprise has a permanent establishment in the other Contracting State for the
purpose of selling goods or merchandise, sales of the same or a similar kind may be taxed
in that State if they are not conducted through a permanent establishment.
* If other business activities, other than mentioned above, or the same or similar
activities are performed without any connection with the permanent establishment, a
similar rule as stated above will apply.
Thus, the profits attributable to the aforesaid activities are also subject to tax in
other Contracting States along with the profits attributable to the activities of the
permanent establishment itself.
If there is a permanent establishment, the dividend (interest or royalty) is to be taxed
as income of that establishment, irrespective of whether investment in the country where
the income accrues has anything to do with the carriage of business or with permanent
establishment. The mere existence of permanent establishment, which may be nothing else
than the sales office, which was enough to disentitle the benefit of reduced taxation.
This rule constricted the foreign investment and has now been limited to those cases where
the income is attributable to permanent establishment, as could be seen, for example, from
paragraph (5) of Article 10 of the agreement with Belgium:
"The provisions of paragraphs (1), (2) and (3) shall not apply if the recipient of
that dividends....being a resident of a Contracting State, carries on business in the
other Contracting State of which the company paying the dividends is a resident, through a
permanent establishment situated therein, ..., and the holding by virtue of which the
dividends are paid is effectively connected with such permanent establishment .....In such
a case, the provisions of Article 7 or Article 14 shall apply."
Pakistan has been following this draft and UN Model in its treaties with other countries.
The non-business income of an enterprise is attracted into the taxable income of the
permanent establishment or a fixed base in case of independent personal service on the
principle of 'force of attraction' if the income accrues or arises through or is
effectively connected with the permanent establishment or the fixed base.
47.3. Computation of business income - The most relevant
question in international tax practice concerning business profits relates to the facts
which make an enterprise liable to taxation on its profits in a foreign country. Tax
agreements affect the tax treatment of permanent establishment to a certain extent. The
general rule is that the computation of taxable income of the establishment is the same as
for the domestic entities, all provisions of the Income Tax Ordinance are applicable
including the provisions relating to depreciation, investment allowances, deductible
business expenses, carry forward and set off of losses, etc. Deviation, however is made
which relates to (a) taxability of income which could be attributed to permanent
establishment; (b) deductibility of expenses which could be attributed to such
establishment and non deductibility of certain payments, such as royalties and interest;
(c) other modifications, in the light of specific treaty provisions; (d) dealing at arm's
length treating the permanent establishment as if it were completely independent of the
enterprise of which it is permanent establishment.
The material provisions in regard to the computation of income under Income Tax Ordinance
of an assessee under the head 'income from business or profession' are to be found in
sections 22, 23 and 32 but these have to be subjected to section 11 and section 22 taxes
the profits and gains of any business carried on by the assessee at any time during the
previous year and such profits and gains are under section 22 to be computed in accordance
with the provisions contained in sections 23 to 25, that is to say, after making
allowances and deductions mentioned in those sections. Section 32(1) provides that income
chargeable under the head 'income from business or profession' shall be computed in
accordance with the method of accounting regularly employed by the assessee, provided that
in any case where the accounts are correct and complete to the satisfaction of the
Assessing Officer but the method is such that, in his opinion, the income cannot be
properly deduced therefrom, then the computation shall be made upon such basis and in such
manner as the Deputy Commissioner of Income Tax may determine [section 32(3)]. The section
clearly makes such regularly employed method of accounting a compulsory basis of
computation unless in the opinion of the Deputy Commissioner of Income Tax, the income,
profits and gains cannot properly be deduced therefrom.
Though these provisions provide for charging the income by way of profits and gains of
business and prescribe the manner of computation, the question as to what point of time
its chargeability arises is answered by section 11 which states that the total income of a
resident assessee from whatever source derived becomes chargeable either when it is
received by him or when it accrues or arises to him during the previous year. In other
words, taxability is attracted even when income has accrued. The receipt of income is not
the sole test of taxability under the Ordinance, but whether on receipt basis or on
accrual basis, it is the real income and not any hypothetical income which may have
theoretically accrued that is subjected to tax under the Ordinance. Section 32 only stipulates the mode of computing taxable income but it
does not determine or even affect the range of taxable income or the ambit of taxation.
For content of taxable income, one must have regard to the substantive charging provision
of the Ordinance.
It is true that under section 11 taxability is attracted not merely when income is
actually received but when it has 'accrued' and it is also true that income accrues when
it falls due, that is to say, when it becomes legally recoverable irrespective of whether
it is actually received or not. Accrued income is that income which the assessee has a
legal right to receive.
Though Income Tax Ordinance, 1979 takes into account two points of time at which the
liability to tax is attracted, viz., the accrual of income or its receipt, but the
substance of the matter is the income. If the income does not result at all, there cannot
be tax. Where income, in fact, has been received and is subsequently given up in such
circumstances it remains the income of the recipient even though given up, the tax may be
payable. Where, however, the income can be said not to have resulted at all, there is
obviously neither accrual nor receipt of income, even though an entry to that effect might
in certain circumstances, have been made in the books of account. Hypothetical income which may have theoretically accrued but
has not truly resulted to an assessee cannot be brought to charge. It is the accrual income which is chargeable to tax (whenever
the mercantile system of accounting is adopted). That accrual is a matter of substance
which is to be decided on commercial principles having regard to the business character of
the transactions and the realities and the specialities of the situation. It cannot be
determined by adopting purely theoretical or doctrinaire or legalistic approach. If,
therefore, for the purpose of determining whether there has been accrual of real income or
not, regard is to be had to the business character of the transactions and the realities
and the specialities of the situation i.e. preference to, theoretical, doctrinaire or
legalistic approach.
For income-tax purposes receivability without receipt is nothing and this principle
applies to a restricted number of cases where the provisions of the Income Tax Ordinance,
1979 or the assessee's method of accounting requires receipt as the solid test of taxability. Receivability or accrual can be
adopted only in cases where the assessee's method of accounting requires accrual as the
test of taxability. If in cases where receivability or accrual does not apply, the income
cannot be brought to charge if income has not been received.
Section 32 is an integral part of the computation of the total income by the assessee and,
therefore, it is compulsory on the income-tax authorities while computing the total income
to accept the mode of accounting regularly adopted by the assessee except in cases where
section 32(3) is applicable. Therefore,
where no method of accounting is regularly employed by the assessee, the Deputy
Commissioner of Income Tax can proceed to compute income on any basis of accounting he
chooses. A distinction has, however, to be made between a trader and a non-trader with
reference to the method of accounting and how the computation has to be made with
reference to the income of a non-trader. In computing the trader's income account must be
taken of trading debts which have not yet been received by the trader. The price of goods
sold or services rendered is included in the year's profit and loss account although that
price has not as yet been paid. One reason may be that the price has already been earned
and that it would give a false picture to put the cost of producing the goods or rendering
the services into his accounts as an outgoing but to put nothing against that until the
price has been paid. But the position of an ordinary individual who has no trade or
profession is quite different. He does not make
up a profit and loss account. Sums paid to him are his income, perhaps subject to some
deductions and it would be harsh to require him to pay tax on sums owing to him but of
which he cannot obtain payment. Thus, a
non-trader can be assessed only on receipt basis.
Therefore, in cases where no method of accounting is regularly employed by an
assessee, the method of computation will generally depend on the question as to whether
the assessee is a trader or a non-trader. If so, for example, interest income has been
received by a non-trader who is not expected to adopt regular method of accounting,
assessment can be made on receipt basis and not on accrual basis.
47.3-1 Deductibility of expenses - Expenditure incurred
wholly and exclusively for the purpose of business is allowed deduction. What is the money
wholly' and exclusively laid out for the purposes of business is a question which must be
determined upon the principles of ordinary commercial trading. In the ultimate analysis,
the question is as to whether it is the expenditure laid out as a part of the process of
profit earning. If the expenses are entailed
for initiation of business or for extension of business or for substantial replacement of
equipment, they may be treated as properly attributable to capital when they are made not
only once and for all, but with a view to bringing into existence an asset or an advantage
for the enduring benefit of the trade/business. If they are not entailed for extension of
business or for advantage of the enduring benefit to the business, but made for the
purposes of running the business or working it with a view to produce profits, they would
be chargeable to revenue account. The aim and object of the expenditure would determine
the character of the expenses. It is only in those cases where these tests also fail that
the court may consider as to whether the expenditure incurred was a part of the fixed
capital of the business, or part of its circulating business. The words used for qualifying the advantage 'as being of permanent or
enduring nature' are not to be understood in the sense that the advantage which would be
obtained would last for ever. In certain circumstances, this test of bringing into
existence an advantage of enduring nature may not serve the purpose. There may be cases
where expenses, even if resulting in the advantage of an enduring benefit; may be properly
chargeable to revenue account if the advantage consists merely in facilitating the
assessee's trading operations, or enabling him to manage and conduct his business more
efficiently or more profitably while leaving the fixed capital
untouched. If the outgoing or the expenditure is so related to the
carrying on or conduct of the business that it may be regarded as an integral part of the
profit-earning process and not for acquisition of an asset, or a right of a permanent
character, the possession of which is a condition of carrying on the business, the
expenditure may be regarded as revenue expenditure.
One of the relevant questions which the court has to ask: Is the disbursement made for
acquisition of a source of profit or income, or is it for facilitating the trading
operation, or carrying it on in a more efficient manner ?
A clause is normally found in all double taxation agreements, that in determination of the
profits of a permanent establishment there shall be allowed as deduction expenses which
are incurred for the purpose of the business of the permanent establishment. The
expression 'for the purpose of the business' has been subject-matter of discussion before
the Indian Supreme Court in CITv. Malayalum Plantations Ltd. Its range is very wide, wider than that of the expression 'for the
purpose of earning profits'. It may take in not only the day-to-day running of the
business but also the rationalisation of its administration and modernisation of its
machinery, it may include measures for the preservation of the business and for the
protection of its assets and property from expropriation, coercive possession or assertion
of hostile title. It may also comprehend payment of statutory dues and taxes imposed as a
pre-condition to commence or for carrying on of a business; it may comprehend many other
acts incidental to the carrying on of the business. However, wide the meaning of the
expression may be, its limits are implicit in it. The purpose shall be for the purpose of
the business, that is to say, that the expenditure incurred shall be for the carrying on
of the business and that shall incur it in his capacity as a person carrying on the
business. It cannot include sums spent by the assessee as an agent of the third party,
whether the origin of the agency is voluntary or statutory, in that event, he pays the
amount on behalf of another and for a purpose unconnected with the business.
The limit and scope of the expression 'for the purpose of the business' is laid down by
the purpose for the expenditure is incurred and that purpose shall be 'for the purposes of
the business', that is to say, the expenditure incurred shall be for the carrying on of
the business and the assessee Shall incur it in his capacity as a person carrying on the
business. There must be a direct and intimate connection between the expenditure and the
business, i.e., the business and the character of the assessee as a trader.
The purpose of a contract, agreement or arrangement must be what it is intended to effect
and that intention must be ascertained from its terms. These terms may be oral or written
or may have to be inferred from the circumstances but, when they have been so ascertained,
their purpose must be what they effect. The
word 'purpose' means not the motive but the effect which it is sought to achieve the end
in view. The word ‘effect’ means the end accomplished or achieved. If an arrangement has a particular purpose, then that will be its
intended effect. If it has a Particular effect, then that is its
purpose.
Head office expenses - Non-resident carrying on any business in Pakistan through
their permanent establishment should normally have been entitled to a deduction, in
computing the taxable profits, in respect of general administrative expenses incurred by
the foreign head offices insofar as such expenses can be related to their business in
Pakistan. It is extremely difficult to scrutinize and verify claims in respect of such
expenses, particularly in the absence of account books of the head office which are kept
outside Pakistan. Foreign companies operating through branches in Pakistan sometimes try
to reduce the incidence of tax in Pakistan by inflating their claims in respect of the
head office expenses. With a view to getting over these difficulties, section 24(e) read
with Rule 20 of Income Tax Rules, 1982 lays down certain ceiling limits for the deduction
of the head office expenses in computing the taxable profits in the case of non-resident
taxpayers. Section 24(e) and Rule 20 are reproduced as under:
"Section 24(e) "Nothing contained in section 23 shall be construed as to
authorise the allowance or deduction of any expenditure in the nature of head office
expenditure, in the case of an assessee, being a non-resident, in excess of such limits as
may be prescribed.
Explanation.- As used in this clause, "head office expenditure" means
executive and general administration expenditure incurred by the assessee outside Pakistan
for the purposes of the business or profession, including expenditure incurred in respect
of-
(a) any rent, local rates and taxes (excluding any foreign tax corresponding to any tax
leviable under this Ordinance), current repairs or insurance against risks of damage or
destruction of any premises outside Pakistan used for the purposes of the business or
profession;
(b) any salary paid to an employee employed by the head office outside Pakistan for the
purposes of the business or profession;
(c)any travelling by such employee for the purposes of business or profession; and
(d) such other matters connected with executive and general administration as may be
prescribed;"
"Rule 20. Deduction of head office expenditure in the case of non-residents.- In
the case of an assessee, being a non-resident, no allowance shall be made in computing the
income chargeable under the head "Income from business or profession", in
respect of so much of the expenditure of the nature of head office expenditure referred to
in as bears to the turnover of the assessee in Pakistan the same proportion as its total
head office expenditure bears to its total world turnover."
It would thus be seen from the language of the Rule that while the outer parameter of the
'head office expenditure' is exhaustive, the inner parameter is inclusive. In other words,
in order to constitute 'head office expenditure', the expenditure of the kind mentioned in
the definition has necessarily to be of the nature of 'executive and general
administration expenditure'. The expression 'executive and administration expenditure'
means not only what is ordinarily understood by the expression but also the expenditure of
the four types referred to in the definition. At best it can be said that any expenditure
which falls under the category of 'executive and general administration' expenditure'
automatically falls under 'head office expenditure', whether it is expended directly as
such or is incurred indirectly in one of the four manners referred to therein, as an
interpretation clause which extends the meaning of a word does not take away its ordinary meaning. Section 24(e) applies to non-resident
assessees. Its effective provision which is non obstante, viz, "Nothing contain in
section 23 shall be so construed as to authorise any expenditure ...... as in excess of'
visualises the limits contained in Rule 20.
The expression 'the amount of such much expenditure ... as is attributable to the turnover
............. in Pakistan' means that the expenditure should be incurred not only in
connection with the business in Pakistan but also with the business outside Pakistan. The
expression 'so much of the expenditure . . . means that a part of the expenditure must not
be attributable to the business in Pakistan. It
contemplates that at least a part (however small it might be) of the expenditure is
referable to the business outside Pakistan. If the entire expenditure, whether allowable
or not, is wholly and necessarily incurred for the business in Pakistan (and there is no
business outside Pakistan at all), section 24(e) becomes inapplicable. And because of
non-applicability of section 24(e), the non obstante clause in Rule 20 cannot apply.
Section 24(e) will not, therefore, apply in cases where the exclusive business activity of
a non-resident assessee is in Pakistan.
In certain treaties (e.g. Pak-UK Treaty), it is
specifically provided that the expenses whether incurred in the State in which permanent
establishment is situated or elsewhere shall be allowed if reasonably allocable to the
permanent established. In other treaties (e.g. Pak-German Treaty), the words "whether
incurred in the State in which the permanent establishment in situated or elsewhere"
are missing. The assessing officers have to go by the language of each treaty. In a recent
case reported as 1996 PTD (Trib) 244, the Income Tax Appellate Tribunal of Pakistan held
as under:
"....in the presence of treaty for avoidance of double taxation the resort to Rule 20
of the Income Tax Rules is not justified. Under section 163 of the Income Tax Ordinance,
1979 the provisions contained in the agreement for avoidance of double taxation shall
prevail over the provisions contained in the Income Tax Ordinance.
As we have seen it is provided in he treaty for avoidance of double taxation that the
expenses reasonably allocable to the permanent establishment including executive and
general administration expenses are to be allowed. Thus, it is incumbent on the assessing
officer to examine the details of the expenses to find out if they are reasonably
allocable to the permanent establishment or not."
47.3-2 Non-deductibility of expenses - As regards
non-deductibility of the expenses relating to royalty and interest, paragraph (3) provides
prohibition to the effect that if the amount has been paid otherwise than towards
reimbursement of actual expenses, such expenses are not to be allowed deduction. The
relevant clause says that no such deduction shall be allowed in respect of amounts, if
any, paid (otherwise than towards reimbursement of actual expenses) by the permanent
establishment to the head office of the enterprise or any of its other offices, by way of
royalties, fees or other similar payments in return for the use of patents or other rights
or by way of commission, for specific services performed or for management, or, except in
the case of banking enterprise, by way of interest on moneys lent to the permanent
establishment.
Such a provision finds place in agreements with a number of countries, but does not find
place in some other double taxation agreements, Pakistan has so far contracted. Thus,
deductibility is confined to the expenses incurred by way of royalties and fees or by way
of commission for specific services performed or by way of interest on moneys lent to the
permanent establishment if these represent reimbursement of actual expenses incurred by
the head office or the enterprise or any of its other offices. Such a clause perhaps is
necessary to prevent shifting of profits through the agency of payment of royalties, fees,
commission or interest.
If any amount is received by the permanent establishment on similar account as mentioned
above, in excess of the actual expenditure incurred by it, the excess cannot be taken into
consideration for the determination of the profits of the permanent establishment.
The Income Tax Ordinance, 1979 does not allow as expenses all the deductions a prudent
trader would make in computing his profit. The money may be expended on grounds of
commercial expediency but not of necessity. The test for necessity is whether the
intention was to earn trading receipts or to avoid future recurring payments of a revenue
character. Expenditure in this sense is equal to disbursement which, to use a homely
phrase, means something which comes out of the trader's pocket. In finding out what
profits there be, the normal accountancy practice may be to allow an expense any sum in
respect of liabilities which have accrued over the accounting period and to deduct such
sums from profits. But the Income Tax Ordinance, 1979 does not take every such allowance
as legitimate for purposes of tax. A distinction is, therefore, to be made between an
actual liability in praesenti and a liability de futuro which, for the time being, is only
contingent. The former is deductible but not the latter. What a prudent trader sets apart to meet a liability, not
actually present but only contingent, cannot bear the character of expense till the
liability becomes real. Contingent liabilities
do not constitute expenditure and cannot be the subject-matter of deduction even under the
mercantile system of accounting. Expenditure which is deductible for income-tax purposes
should be existing at that time. Thus,
deductions cannot be allowed on a mere provision and in the absence of agreement or actual
payment, or a statutory provision, no deduction could be claimed or allowed.
47.3-3 Arm's length method - Only the business profits which
is attributable to permanent establishment is taxable in the host country. The agreements
go on to say how this amount is to be ascertained. It is by means of a given hypothesis.
The hypothesis is the presumption about the income or profits which the permanent
establishment might be expected to make if it were a distinct and separate enterprise
engaged in the same and similar conditions and dealing wholly independently with the
enterprise of which it is a permanent establishment. Thus, the establishment in the host
country has to be treated as if it were completely independent of the head office and were
dealing at arm's length with it, and thereafter profits estimated on the basis which such
an independent enterprise might be expected to derive on its own. The controlling
influence or supervision the head office may be exercising in its transactions or
commercial relations with the permanent establishment has to be ignored, and these
transactions are to be evaluated and their effect ascertained on the doctrine of arm's
length, as if between the two independent organisations. The purpose of this provision is
to attribute to a foreign company doing business in Pakistan a reasonable sum of income or
profits in respect of that business and so to tax that sum as income arising in Pakistan.
The taxing provision is designed to attribute to the foreign taxpayer a measure of income
to represent the income of his Pakistani business.
If once an establishment is conceded to be a permanent establishment, the other part of
the regulation applies and the tax is imposed only on so much of them as is attributable
to that establishment. Nothing much is left by
way of discretion to the taxing authorities to decide the basis on which attribution of
income is to be made, other than those provided in the tax agreements. The normal
provision in all the agreements is to the effect that the profit which emerges from the
calculation based on the basis of the hypothesis that the branch is an inindependent
enterprise dealing as an independent entity at arm’s length with the head office, is
deemed to be income derived from or is attributed to that source which is taxable in the
host country. Other mode of determination of taxable income is excluded. The foreign
enterprise could be taxed on income thus determined and no other criterion can be applied.
The 'arm's length' rule thus provides that the profits attributable to a permanent
establishment are those which would be earned by the establishment if it were wholly
independent entity dealing with its head office as if it were distinct and separate
enterprise operating under conditions and selling at prices prevailing in the regular market.
The profits so attributable are normally the profits shown in the books of the
establishment. Nevertheless, the 'arm's length' rule permits the authorities of the
country where the permanent establishment situates to rectify the accounts of the
enterprise, so as to reflect properly income which the establishment would have earned if
it were an independent enterprise dealing with its head office at arm's length. The
application of the arm's length rule to the allocation of profits between the home office
and its permanent establishment presupposes that domestic legislation authorises
determination of the basis of arm's length principle. Section 79 of the Ordinance
proclaims and reiterates the concept of arm's length rule.
The transactions between the foreign enterprise and its permanent establishment are
examined thoroughly with a view to ascertaining whether they are at arm's length; so as to
prevent shifting of profits by the enterprise to the country which offers the more
favourable tax treatment. The application of the arm's length rule is particularly
important in connection with the difficult and complex problem of the deductions to be
allowed to the permanent establishment. It is an accepted principle that in calculating
the taxable profits of a permanent establishment allowance will have to be made for all
expenses, wherever incurred for the purposes of the business of the permanent
establishment, including executive. The expression 'For the purpose of business' is wider
in scope than the expression 'for the purpose of earning profits. It is enough to show that the money- has been expended not of necessity
and with a view to a direct and immediate benefit to the trade, but voluntarily and on the
ground of commercial expediency and in order indirectly to facilitate the carrying on of
the business.
48. Apportionment method
Paragraph (4) of the Model provides for apportionment of profits between the
subsidiary and the parent company in the Contracting States, as to find out how much of it
could be said attributable to the permanent establishment. An apportionment of the total
profits of the enterprise to its various parts has to be made on the principle similar and
somewhat akin to arm's length approach, viz, the profits which the permanent establishment
might be expected to make if it were a distinct and a separate enterprise engaged in the
same or similar activities under the same or similar conditions and dealing wholly
independently with the enterprise of which it is a permanent establishment. It is,
however, alternative to the arm's length approach. The latter seeks to approximate the
open market whereas the object of the former is to establish a division of the overall
profits notwithstanding how the open market operates. The object of the apportionment
method is not to determine the market-price for an intra-company transactions, but to
establish a fair or proper division of the world profits of an enterprise. Various methods
for that matter are suggested, total sales or total payroll and sales and payroll within
taxing jurisdiction. Profits could be apportioned under a formula that averages the three
ratios of local sales, assets and labour costs to their worldwide equivalents. Once a
method is chosen and adopted, it would be operative for the determination of profits as
attributable to permanent establishment year after year unless there is good and
sufficient reason to the contraw [paragraph (5) of the Model].
Since the apportionment method does not depend upon variables which are difficult to
evaluate as in the case of arm's length method, it yields predictable result. It requires
an established formula for its determination and, therefore, it is certain and simple. Its
certainty, simplicity and predictability have led its worldwide acceptance in preference
to arm's length method. It is for this reason, perhaps, OECD 1977 Model Tax Convention
and, UN Tax Treaty Guidelines include the apportionment method as an acceptable way to
determine the profit attributable to permanent establishment. However, all that is not too
rosy about the method. It is beset with problems and its application may lead to
conflicting and competitive claims of the respective countries. This is because of the
absence of uniform apportionment formula; each country tends to resort to that formula
which is more favourable to it. For example, if a country is relatively high wage country,
it would prefer the formula which is dependent upon labour cost. While the other country
may favour other factors. Even if the countries agree to use one uniform formula, still
there could be conflict in interpreting various variables; for instance about total sales,
total profits, allocation of sales to the respective country. The sale has many stages to
go through before it could be said having been completed, viz, the place of entering into
a contract, the place of handing over the object, the place of completion of contract, the
place of passage of sale consideration, the place of production of the goods, etc. For
allocation of sales, which stage should receive prevalence over the other is a matter of
interpretation which may lead to conflict between the countries. Conflict may concentrate
on the passage of title or on substantial connection test or on the basis of ultimate use.
48.1 Insurance business - Collection of premiums by an
insurance enterprise of a Contracting State in another Contracting State, or the activity
of insuring risks means the existence of permanent establishment in that other State. Once
it is established that the insurance enterprise has been collecting premium or insuring
risks in the other State, the existence of permanent establishment is presumed, and the
profits attributable to that establishment becomes taxable in that State.
It is axiomatic from the terms of double taxation agreements that the profits of an
enterprise of a Contracting State shall be taxable only in that State unless the
enterprise carries on business in the other State through a permanent establishment
therein, only to the extent as is attributable to it. For attribution, a presumption has
to be made as to what profits could have been expected from it, if it were a distinct and
separate enterprise in the same or similar activities under the same or similar
conditions. It is not left to the will of the income-tax authorities to decide the basis
on which that attribution of the profit is to be made. Article 7(2) by its terms provides
a basis which in effect requires a hypothesis that the permanent establishment is an
independent enterprise dealing an independent entity at arm's length with the principal.
The profits which emerges from a calculation based on this hypothesis are deemed to be
income derived from sources in the Contracting State.
48.1-1 Computation of income from insurance business in Pakistan - Section
26(a) of the Ordinance, deals with the mode of computation of profits and gains of
insurance business. It provides, inter alia, that the profits be computed in accordance
with the rules contained in the Fourth Schedule to the Income Tax Ordinance, 1979, which
provides the manner of computation. The profits and gains of any business of insurance
other than the life insurance shall be taken to be the balance of the profits disclosed by
the annual accounts, copies of which are required, under the Insurance Act, 1938, to be
furnished to the Controller of Insurance, subject to adjustments mentioned therein. Thus
notwithstanding to the contrary contained in the provisions of the Income Tax Ordinance
relating to computation of income chargeable under any other head, the profits and gains
of any business of insurance is to be computed in accordance with rule 5 contained in the
Fourth Schedule. In the case of a life insurance company, the different classes and
categories of income, viz, income from house property or capital gains or income from
other sources are not separately computed in accordance with the computation sections for
the respective heads of income. Thus, the effect of section 26(a) is to render the heads
'Income from house property', 'Interest on securities', 'Income from other sources'
irrelevant as far as general insurance businesses are concerned. The entire income of an insurance company including interest on
securities, income from house property, income from other sources is computed in
accordance with section 26(a) read with rule 5 of the First Schedule. Thus, though income
chargeable under the head 'Income from house property' is generally computed on a notional
basis on the annual value as determined under section 19 of the Ordinance, the actual rent
and not in notional one is taxable for insurance business. Tax is calculated on a figure that is deemed to be .profits, though
not so in fact. It is being treated 'as being income', that is, as if it were income
derived from business, though not so in fact.143
Applicability of certain provisions is excluded by section 26(a). The other provisions
which deal with allowable deduction unless they are expressly excluded will have to be
held applicable in the case of an assessee who carries on an insurance business. The special mode of computation of income of an insurance company
.engaged in life insurance business under the Fourth Schedule to the Income Tax Ordinance,
1979 treating its entire income as income from the business cannot be imported into the
calculation of tax under the Finance Act. Merely because the income of a general insurance
company has to be computed in a Particular manner, it could not be said that the total
income does not include say dividend income from other Pakistani companies if it has
received such dividends. The dividend income
which is included in the gross total income of an insurance company does not lose its
quality and character as income by way of dividend
and accordingly such income is entitled to relief in tax rates provided in Part V of the
First Schedule to the Income Tax Ordinance, 1979. But a question arises whether in case of
a non-resident assessee income arising or accruing from investment could be taken as the
business or industrial profits of the permanent establishment.
The double taxation agreement says that when a non-resident has a permanent establishment
in a country, it may be taxed in that country on the profits it makes out only on so much
of them as is attributable to permanent establishment. The agreement goes on to say how
this amount is to be ascertained. It is by means of a hypothesis, by treating the
establishment as if completely independent of the principal and dealing at arm's length
with it. The profit is to be estimated is the amount which such an independent enterprise
might be expected to derive on its own. Thus, when income is derived not from business as
such as, but from investment the total income is taken as business profit. The critical
question therefore arises is whether it is a tax on the profits of the business so as to
come within the provisions of the double taxation agreement about 'business profits' or
whether it is tax on investment income so as to come within the relevant provisions
dealing with dividends, interest, rents and so forth.
In case of insurance company resident in Pakistan, there cannot be any difficulty about
applying the double taxation agreement. It is resident in Pakistan and is taxed on its
total income from its fund, wheresoever this income is derived and it is given credit for
the tax paid by it in another country on the income from investment there. But with a
company resident in a foreign country the position is different. Apart from taxing
business income, as arising from the activity of the carrying on business, the investment
income which is not sourced from such activity is also taxed as business income. Income of
a permanent establishment is taxed on a hypothesis, as if it were completely independent
of the foreign principal, and were dealing at arm's length with it. If this company is
completely independent, then being an insurance company, its in. come has to be assessed
in Pakistan in the same manner as is done of a resident insurance company in terms of
section 26(a), the entire income of an insurance company including interest on securities.
income from house property, income from other sources. is to be computed in terms of that
section read with rule 5 of the Fourth Schedule and such specific income are not computed
separately in accordance with the computation section, for the respective heads of income.
The tax is calculated on the figure that is deemed to be profit, though not so in fact
which is treated as if it were income derived from the business though not so in fact. The
expression 'profit' may be given the meaning it has under the Income Tax Ordinance, 1979
under section 26(a). According to this view. therefore, if the permanent establishment in
Pakistan is the projection of a foreign insurance company, its income in Pakistan is
taxable in Pakistan, as business income. though it might consist of income derived as
dividend, interest or rent. The other view is that double taxation agreement provides that
where profits include items of income which are dealt with separately in other Articles of
the agreement, then the provisions of those Articles are not affected and income is
computed according to them. The nature of income to be taxed must represent the income of
the business in Pakistan, i.e., the amount of business income which could be attributed to
the permanent establishment. Its effect is not to charge investment as such or any
specific investment. The rule of attribution is applicable to business profits. The other
income cannot be attributed to the hypothetical independent enterprise without violating
the very hypothesis which the Article in the double taxation agreement is designed to lay
down as the basis of taxability. Such income cannot, therefore, be taxed in terms of
section 26(a) of the Ordinance. Income earned by way of dividend, interest or rent are not
the business profits within the meaning of the agreement. Business profits do not include
income in the forms of dividends, interest, rents, royalties, etc. [see paragraph (7) of
Article 7 of the double taxation agreement with Bangladesh as for illustration]. Such
income, therefore, cannot be regulated on the 'permanent establishment’ principle.
These are left to be taxed according to the respective provisions of the agreement.
