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Political and economic uncertainties - Unpredictability about
political and economic stability of a country may necessitate flight of capital or profit
therefrom. This flight is achieved. through the device of transfer pricing. Pakistan has
been victim of it from the very beginning due to perpetual political instability and
uncertainty.
Business Consideration - Under the dictation of business consideration or exigency
of situation, shifting of a profit has to be done as declaration of low profit in a
particular country may be beneficial.
- Indicia of transfer pricing - Presence of various circumstances allude to
shifting of profits or transfer pricing. Some of them are:
- Excessive commission, rebate or discount.
- Maximising after tax income by disguising dividends as interest.
Excessive Commission, Rebate or Discount - Commission paid or rebate or discount
allowed in respect of a transaction when the amount exceeds substantially than the normal
or when granted to a third party which is a benami is a pointer to the transfer pricing
transaction. Inflation of import or deflation of export price, or overcharging or
undercharging the normal price is compensated through the grant of concealed or third
party commission or of excessive rebate and discount. The extent of compensation equals or
tends to be equal to the artificially injected amount in the price through manipulations.
Maximising after tax income - So that taxable income is reduced significantly, the
expenditure in respect of intangibles is inflated. For that matter royalty route for
repatriation of profit is found effective. The amount agreed. upon as royalty may not be
linked to production or sale of goods or services, but be fixed arbitrarily at an
exorbitant amount. This would result in depression of the taxable profits. The profit is
thus diverted before it is subjected to tax. What could have been received as dividend is
received as royalty, and though the parent company or its affiliate is benefited
considerably in appropriating income without suffering tax, the loss is of the exchequer
and of foreign exchange.
- Tax laws and transfer pricing - Sales of goods, transfer or licensing of
technology patent rights, and provision of services are the vehicles for transfer pricing
abuses. Intra-firm transfer relating to 'these vehicles requires to be looked into and
cared for. Tax differential provides incentive for practising the mechanism of transfer
pricing. So that this mechanism may not defraud a country where income arises or accrues
of its legitimate due, the underdeveloped and developing countries have enacted laws which
aim at taxing royalty, technical fee, dividend, interest, income attributable to .services
performed within those countries over relatively long period of time. Income arising from
the sale of goods if such sale is attributable to 'permanent establishment' or to a
'business connection' in the host country is also taxable. Since income or at least a part
of it arising on account of the sale of goods, or transfer of technology or services is
subjected to tax in the host country, there remains nothing much to be done about shifting
the profits from that country to another. On royalties, technical fee, interest payments,
a fixed percentage of income is retained by the source country as withholding tax. The
provision in the tax laws for taxing such income or for withholding tax thereon is not
sufficient for preventing of the practice of transfer pricing, when the double taxation
agreements provide for the rate of withholding tax at a substantially lower rate than the
usual [many tax agreements with Netherlands by many countries have low or no withholding
tax rates]. Such low rate tax leave the income untaxed or taxed at low rate, may provide
opportunities to multinational corporations to play upon the transactions with a view to
shifting profits from one jurisdiction to another.
In case of service income many countries do not impose their tax unless the person
performing services is physically present in the country for a substantially period of
time or the services are attributable to a 'fixed base'. With respect to sale of goods,
since the countries limit their taxes to those sales attributable to 'permanent
establishment', the transactions of sale are arranged outside the jurisdiction of those
countries, and the goods are subsequently imported in them.
Non-deductibility of payments for goods, services while computing the profits of the payer
of the connected parties will not result in tax saving through the device of transfer
pricing. The net result would be that intra-firm payments are subject to tax in the host
country at a regular corporate tax rates. In Pakistan, interest and royalty payments to
affiliated enterprises are deductible.
Sometimes absolute prohibition of intra-firm transactions or restriction of expenditure in
relation thereto may be an effective measure of preventing the abuse of transfer pricing.
Pakistan has a liberal policy whereas India has a very restrictive policy with respect to
the payment of royalties to foreign enterprises. Such payments are generally restricted
upto 5 per cent of the turnover for a period upto 5 years which may be extended to 8
years, or upto 1 per cent of the projected cost in India. Pakistan has not imposed any
such conditions.
- Impact of transfer price on the economy - The impact of 'transfer price' falls
upon the economy of the underdeveloped, developing or poor country, in the sense that
there is flight of capital from it to the MNCs without getting its legitimate due.
Further, because of the monopolistic hold over the production and distribution of
essential consumer items such as life saving drugs, the MNCs charge exorbitant consumer
price, which not only causes great hardship to the consumers but also does immense harm to
the exchequer of the country in the form of loss of tax revenue and foreign exchange. A
small shift in internal price has comparatively a large effect on the profitability of the
MNCs. The entire profit could be reduced to nil by lowering the price to the extent of the
margin of profit, or be increased by increasing the price. Manipulation of profits becomes
possible through the device of 'transfer pricing'. It refers to the value attached to
transfer of goods, services and technology between related parties, such as parent and
subsidiary corporations or sister corporations, or between unrelated parties which are
controlled by a common entity.
To ascertain whether a particular transaction is at arm's length, or aims at shifting or
distorting income, is very difficult. This is because the taxing authority of the host
country has no access to the books of account or documents of non-residents to verify the
truthfulness of the transaction or the extent of suppression of profits. Some assumptions
have, therefore, to be made in this regard about the loss to the profits if the
transaction appears to have effected in deflation of profits.
54.1-3 Treaty shopping - The advantage taken of a double
taxation agreement between two countries by a resident of the third country is known as
treaty shopping. This is done by establishing a company or other appropriate entity in
another country whose own laws make it a suitable base for international investment and
which has the most favourable double taxation treaty available with the other country into
which ultimate investment is to be made so that access can be had to the network of double
taxation agreements of that country. Thus, in fact in order to issue bonds in the Eurobond
market, many US companies have utilised finance subsidiaries located in Netherlands
Antilles or certain other 'tax haven' countries which have a tax treaty with the United
States permitting the US parent companies to pay interest to the ultimate investors free
of US withholding tax. The US withholding tax could be reduced through establishment of
holding companies in a country with which the US has a treaty, if a foreign investor is a
resident. When a company is resident in a country which does not have a treaty with
another country, say United States, it is beneficial to finance a subsidiary incorporated
in a third country, say Netherlands Antilles. The US holding country could borrow funds
from the Antilles finance company. Pursuant to the treaty between the United States and
the Netherlands. Antilles which was in operation before its termination with effect from
January 1, 1988, interest withholding payments from the us holding company to the finance
company could have been avoided. By proper structuring of the Antilles corporations debt
and the stock ownership, the Antilles income-tax imposed on the interest income received
could have been kept to minimum.
Another illustration of treaty shopping is found in regard to royalty income. To impose a
high rate of withholding tax on such income, has been the tendency of every country. Under
double taxation agreement, the giver and the recipient of technology may pay the reduced
tax. But in case no such agreement subsists the giver in its attempt at minimising the tax
burden, may resort to, and usually does, forming a subsidiary company in the chosen
country and by granting to it a licence to exploit the technology rights. This subsidiary
country may in turn sub-licence the exploitation rights to other subsidiaries in the
group. The royalties paid to the sublicensor will, therefore, earn an advantage of
suffering low rate of tax in terms of the double taxation agreement between the countries
in which these companies and sub-licensee are located respectively. The Netherlands is
such a chosen country, which is favoured for the incorporation of the licensing companies,
because it has an extensive network of treaties.
The countries most commonly used as a base for international investments are the
Netherlands, Switzerland which have network of favourable tax treaties. The Netherlands is
very popular location for international holding company, finance company and royalty
company. Switzerland is similarly favourabIe for holding company and sale company.
Pakistan has also caught in this web. Our short-sighted, ill-informed, self-assumed
experts in CBR concluded double taxation treaty with the Netherlands without understanding
who is going to get the real benefit.
Recent trends for prevention of treaty shopping - To arrange its affairs so that
there is little tax effect, is within the domain of a person, when the law permits such
arrangement. It is perfectly legitimate for the residents of one country to set up
companies in other countries and benefit themselves of the advantage under the double
taxation agreement as is available to the residents 'of the Contracting countries, though
the benefits are intended to be granted to the residents of those States alone. The recent
trends make a departure from the approach. The new approach contends that the purpose of a
double tax treaty is only to be bilateral and, therefore, to benefit the bona fide residents
of the Contracting States, and not those of the third country. The international tax
planning like the domestic tax planning practised with a view to avoidance of tax is now
opposed by the Contracting States like under domestic laws. The test to be applied is
whether the base companies are established in the other States solely for the purpose of
enjoying the benefit of particular treaty rules existing between the States involved and a
third State. The courts have applied anti-avoidance principles formulated for domestic
laws to double taxation agreement. An illustration is found in the us decision in Aiken
Industries Inc. v. Commissioner.
Though recognising the foreign company right to treaty protection, the court denied an
interest exemption on the ground that .the interest was not 'received by' the corporation.
For similar reasons, the court refused to apply the treaty between the United States and Switzerland. In Germany too, foreign
base companies of German companies are disregarded, if no business reason or justification
for their participation in a Particular transaction could be detected. The courts in both
Switzerland and Holland have ruled that certain structures represented abuses and
consequently could be set aside.
To cope with the international tax avoidance, the countries are enacting laws or
abrogating or modifying the existing tax treaties so that treaty benefits are limited to
the actual residents of treaty countries. Third country nationals would not be able to
utilise treaties.
By far the most 'active in this respect is the United States which has a clear policy
against such third country use. It has included a provision denying treaty protection to
foreign controlled companies under certain condition in Article 16 of the US Model and has
succeeded meanwhile in including this or similar provision in its treaties with a
considerable number of contracting partners. The said Article basically provides that all
of the other benefits of the treaty shall be denied to companies or the other entities
resident in' the other country unless they are either publicly quoted or owned as to more
than 75 per cent by individual residents of that country, except in cases where it can be
shown that the establishment of the company or entity is not for the purposes of taking
advantage of the treaty. A decision of the Swiss Federal Council of 1962 denies the
benefits of tax treaties concluded by Switzerland to corporations residing in Switzerland
if they distribute more than 50 per cent of their profits to persons not entitled to
treaty protection or if they are controlled by persons not entitled to treaty protection
and distribute less than 25 per cent of their profits. These provisions were subsequently
inserted into the tax treaties concluded by Switzerland with France and Germany. To combat
the abuse of treaty shopping, the UK has introduced a number of provisions in its tax
treaties with Netherlands, Switzerland and Luxembourg imposing restrictions on the
availability of the tax credit refunds in circumstances where it is clear that the
corporate structure has been arranged in order to obtain such refunds. Denial of reliefs
relating to interest or royalties have been provided in certain treaties, where the debt
or right has been created or assigned in order to take advantage of the treaty rather than
bona fide commercial reason.
Holding companies established in a country without any business purposes or commercial
justification, but done solely to make use of its favourable treaty with the other country
as a measure for tax avoidance, cannot be ignored, irrespective of whether the treaties
contain an express abuse of provision. The business purpose test applicable to domestic
laws could well be applied to treaty laws. But as in domestic laws, the application
should be made with caution and care. Absence of business purpose may not be presumed. The
executive or the legislative branch of a Government should not, under the pretext of
preventing treaty shopping, subject to cases of taxation other than those involving
avoidance, in contravention to treaty avoidance. Thus, where a foreign subsidiary is
engaged activity in the trading and business activities in the State of its location,
though avoidance of taxes was the motive for its establishment, the decision of the abuse
of the third countries tax treaties cannot be applied. Tax avoidance alone cannot be the
basis of such application, unless it is resorted to through a company or entity or a
transaction which is either shown or lacking a business purpose.
54.1-4 Royalty and technical fee - The transfer of technology
or the right to use the technical know-how is often made conditional upon the transfer of
plant, equipment, input or their spare parts, or of services of parent company's
personnel. Such transfer of goods or services may not be necessary for the use of
technology; yet it is affected as a 'transfer price' technique, as a measure usually
adopted by the parent company to appropriate more amount as consideration for its wares
which the local laws could have' legally permitted for remittance. Royalties are also
sometimes paid to affiliates which are not entitled to them in absence of any of their
contribution to the development of technology or creation of any right in it through some
mutually agreed upon contract.
54.1-5 Capitalisation and loan financing - Sometimes, equity
investment is guised as loan and interest charged as 'agreed upon' far exceeds-the normal
rate on trading credit. A local management company may be granted loan by its parent in
the form of machine, plant or equipment which in turn are re-loaned to a sister company
under the same management and control for a consideration. The amount of consideration
received as interest passes off to the parent foreign company through the means of the
locally managed company. This arrangement poses a problem which is difficult to be
resolved, to trace whether the loan is an equity investment and the amount received by the
parent company represents dividend, or whether the machineries, plant or equipment in fact
and in actuality represents loan. The difficulty arises because the contract of loan is a
managed affair between the related companies. If a subsidiary in one country is founded by
a parent in another, the group will pay less tax in total if the former transfers its
profits to the latter in the form of interest which is deductible from taxable profits
rather than as non-deductible dividend. A close scrutiny has, however, to be made about
the companies that seem to have excessive debt/equity ratio to find out whether part of
their loan finance is tantamount to equity finance, such as where an establishment which
has a special relationship with the company provides a larger amount of loan capital than
an independent enterprise would have done. In the case of the arm's length principle
(i.e., the price or amount which would have been agreed upon between unrelated parties
engaged in the same or similar transactions under the same or similar conditions in
the open market) part of the interest payment could be taxed as though they were
dividends.
The tendency to provide finance to the company in the form of loan rather than equity is
motivated mainly by tax consideration. Tax advantages of loan capital may induce the
parties to provide equity capital in the form of loan. This phenomenon is known as 'thin
capitalisation' or 'hidden capitalisation'. Since the tax advantage is secured at the cost
of the exchequer, the Governments have enacted laws to prevent loss to it through the
device of ‘hidden capitalisation’, especially when the 'lender' is a related
person. A high debt/equity ratio may indicate, though not necessarily always an attempt to
gain tax advantage. The intention to ponder to itself advantage through this arrangement
becomes more pronounced in multinational groups. The group will pay less taxes, if the
subsidiary which is founded in a country other than the country of the residence of the
parent, transfers profit to the parent company in the form of interest which is deductible
as a business expenditure before the profit is subjected to tax rather than a
nondeductable dividend. To masquerade dividend as interest or equity capital as
loan, the intention becomes apparent if the debt/equity ratio of an assessee is very heavy
in case an organisation which has a special relationship (for example ownership)
with the company which provides a larger amount of loan capital than an independent
institution would have done. In that case a part of the amount represents dividend but is
paid as interest. Such amount could be taxed as though dividend, on the arm's length
principle namely, by holding so much amount as loan as which would have been agreed upon
between unrelated parties engaged in the same or similar conditions in the open market.
As about the rate of interest, the same principle of arm's length transaction becomes
applicable, as the amount of consideration which would have been agreed upon in the open
market between the unrelated parties under the same or similar circumstances, as
representing interest. Arrangement of capital for the functioning of a subsidiary company
is planned with a view to saving taxes as far as possible, in the form of loan rather than
equity, because as aforesaid interest on loan is deductible before taxable profit is
determined and is, therefore, saved from being suffered to tax to the extent which the
profit does. Thus, instead of providing finances for the company in the form of equity, it
is done in the form of loan so that the capital of the company is very small or thin. This
exercise, however, becomes futile when the tax system of the country provides a high rate
of withholding tax (as a counter to tax. planning aimed at undermining its revenue), so
that it equals the value of tax deduction. The exercise, however, is not left at that. It
is then undertaken through the formation of group finance companies.
- Group finanee companies - Formation of group finance companies is notified by tax
savings. Its formation in a tax haven country may result in the accumulation of
profit because of its non-taxability or taxability at a very low rate. Or, otherwise
saving is effected through the arrangement of loan from a bank, a so-called back-to-back
loan, or through the formation of another subsidiary in a jurisdiction which
affords treaty protection.
A back-to-back loan calls for deposit in the bank of an amount corresponding to the amount
loaned to the other party. Loan is given in one country, whereas deposit is made in
another. The difference of interest paid and received by the bank is called
‘spread’. The deposit is preferably made in a tax haven country. Interest
received from the bank suffers little tax, while at the same time interest paid on the
loan granted is allowed deduction resulting in the reduction of the taxable profit and
subsequently accumulation of .profits thus saved. The 'conduit' loan involves a
preordained arrangement of being advanced to a subsidiary company incorporated in a
country with a treaty network which provides for elimination of tax on interest
thus earned or for taxing it at a lower rate than the usual. The Netherlands
is the favoured country, as the receipt of interest is protected by its treaty network
while at the same time Dutch domestic tax laws do not provide for withholding taxes. But
difficulty arises when the activity of advancing loan is deemed to be the business of the
company because of it being systematically followed or when one of the purposes for the
formation of company is to advance loan. The taxing authorities will then insist upon an
element of profit remaining within the country, by taxing it as arising accordingly in
that country either wholly or so much as is attributable to the activity in that country.
- Formation of subsidiary - For diversion of profits, the formation of a subsidiary
company is another device. Such an instance is found from the facts of a case, CIT v. Assam Consolidated Tea Estates Ltd. The
assessee was a non-resident company incorporated in UK and had been carrying on business
in India by running tea estates. Another subsidiary company to the assessee was
incorporated in UK pursuant to the agreement entered into between the said subsidiary and
the assessee, the assessee transferred and conveyed to the subsidiary the business in
India and the subsidiary company issued to the assessee certain shares and redeemable
unsecured loan stock under an instrument as consideration for the said sale. The question
was whether the aforesaid interest payable on the unsecured redeemable loan stock was
assessable under section 4(1)(i) of the Act. [Paralleled to section 9 of the Income Tax
Ordinance, 1979].
The Calcutta High Court held that the assessee was not carrying on any business in India
whatsoever. Though previously the assessee owned and ran the business but the same was
transferred to the subsidiary and in the relevant assessment year the same were owned and
ran by the subsidiary and not by the assessee which was an entity separate and distinct
from the subsidiary. Even otherwise, there was no continuity of any business of the
assessee in the hands of the subsidiary had been established. The interest under the loan
stock was, therefore, held as not accruing or arising in India from any business
connection in India.
54.2 Methods for determining arm's length price of goods -
In 1979 the OECD produced a report entitled 'Transfer Pricing and Multinational
Enterprises', which identified three following main methods for determining arm's length
price of goods sold by one enterprise to another:
- Uncontrolled price method
- Resale method
- Cost plus method
- Uncontrolled price method - The market price for the same or similar goods has to
be found out in an open market which is uncontrolled market. The price under this method
is the price at which the same kind of inventory is sold/purchased by unaffiliated parties
under the same or similar conditions.
- Resale method - This involves subtracting a mark-up from the price at which the
goods were sold to independent customers. Or if the resale price is the price at which the
goods which have been purchased from a related company is sold to an unrelated company. A
normal mark-up for profit to be earned by the reseller is determined based on the gross
profit percentage of the sale of the same or similar goods which was purchased from and
sold to by a comparable reseller unrelated companies.
- Cost plus method - This involves determination of the cost of the goods to the
vendor and to this be added a normal mark-up for profit to be earned by the supplier.
The revenue authorities apply the uncontrolled price method to arrive at arm's length
price, under the anti-avoidance legislation, as does the Income Tax Ordinance, 1979
provide. It is to be followed by the resale price method. It is only as a last resort that
the cost plus method is used. The uncontrolled price method comes closest to the actual
price in the market place.
Resale price method is preferred over the cost plus method in that it approximates the
market place. Two figures for each method are required to be ascertained; in the latter
both depends on estimation (the sellers' cost and the sellers' mark-up); while in the
former at least one is fixed by the open market (the price at which the goods are resold
by the related purchaser) whereas only one, i.e., reseller's mark-up needs estimation.
54.2-1 Arm's length method is the most favoured - To curb the
abuse of transfer pricing the arm's length method is the most favoured of all others
adopted by respective country, as it attempts to approximate the market. This method is
ideally suitable. for commodities which are subject-matter of f request trade in the open
market. When such commodities are the subject of transactions between the two related
parties, open market price may provide a ready reference to testify whether these
transactions are dictated by considerations normally found between two parties dealing at
arm's length, or these are controlled or influenced by intra-firm relationship. However,
for intra-firm dealings in semi-finished, intermediate or capital goods, the difficulty
may arise because of the absence of the general availability of the open market price for
those or similar goods. Estimation of the price on the hypothetical supposition of the
existence of an open market and a willing purchaser and a willing seller may pose a
problem. As there could be bona fide difference of opinion about the estimation of
open market price, because reasonable people acting fairly, reasonably and objectively may
arrive at figures which vary considerably from each other, the formulation of such
estimate has to be made with some care and caution. For that, attempt be directed to
estimate the open market price under the resale price method or the cost plus method or
any other available method, and if there is not much of difference between the figures
arrived at, average would represent as approximating the open market price. Or, in the
alternative, a more manageable and expeditious means of resolution of the market price may
be found out, especially when stakes are high.
54.2-2 Arms length method and intangible services -
Determination of price at arm's length for transfer of intangibles such .as services,
patent or copyrights poses a difficulty inasmuch as comparable price in the open market
for the same or similar services or rights is not normally available. Such difficulty may
not be so prominent, when the service provided is of commercial and technical in nature.
It is possible in that case to establish an arm's length charge by reference to the amount
charged between unrelated parties for similar services. But if the service is neither
commercial nor technical, but somewhat specific performed specifically for the benefit of
the affiliate, such as special marketing surveys, financing studies, advertising, employee
training services, special legal and management consultant services, comparable open
market transactions are rather impossible to find out. In that situation, it is proper to
determine the cost to the parent company in supplying or performing the services. To this
be added profit mark-up appropriate, when the services form an integral part of the
business of the parent, and not where it is not so. However, the tax authorities should
look through the transaction with care to see whether the charges for services are imposed
on the subsidiary merely as a device of withdrawing profits from it first as a direct
charge and subsequently as a constituent of the price of goods sold to the subsidiary.
Right to use patent and arm's length method - Normally the right to use the patent
or other intangible right is transferred for a consideration charged as lump sum or based
an turnover/production or both. Whether such consideration is reasonable and approximates
open market place especially when the parties to the transaction are related has to be
determined under the arm's length approach in a manner similar to the one adopted for
determination of the price for goods or services. A scrutiny of agreements between the
licensor and the unrelated parties under similar transactions under similar circumstances
involving the same and similar intangible property, would indicate about what the open
market price for the intangible is. However, if such transactions are absent, reliance has
to be placed on various factors which are determinants of a free market price, such as
prevailing royalty rates, nature of the patent or other intangible prospective profits to
the licensee, and the costs to the licensor. The most important of all these factors is
the prospective profits to the licensee. The earning capacity of an asset is the criterion
which is normally resorted to in the absence of transaction for similar or same goods
under similar or same condition to determine its market value.
54.2-3 Arm's length method under Pakistani Income Tax Ordinance,
1979 -- The Income Tax Ordinance, 1979 contains provisions to prevent the abuses
associated with the transfer of profits through the agency of payment as commission or
interest or through any transactions between the 'related parties. Thus, where an assessee
incurs expenditure in respect of which payment has to be made to any related persons the
amount to the extent it is excessive and unreasonable is not allowed deduction. The mere existence of agreement between
the two parties about the sale of consideration for the supply of goods or services does
not mean that the income-tax authorities have no discretion but to accept and to hold that
the payment has been made wholly and exclusively for the purposes of business. Although
payment may have been made and there might be a valid agreement or contract, it is still
open to the authorities to take into consideration all the relevant factors to show
whether the payment made is wholly and exclusively for business purposes, viz., the normalcy of the expenditure having regard to the 'practice in
the trade, the existence of any other extraordinary and abnormal circumstances in the
arrangement or special reasons or circumstances which may suggest that the transaction was
abnormal and the like. The business expediency should be the criterion for the expenses.
In applying this test however, reasonableness of the expenditure has to be adjudged from
the point of view of the businessman and not of the income-tax department. The department
can however come to the conclusion that either the alleged payment is not real or that it
is not incurred by the assessee in his character of a trader or it is not laid out wholly
and exclusively for the purpose of the business of the assessee, and to disallow it. Expenditure in regard to colourable or sham
transactions transacted with a view to appropriating the funds of a flourishing concern to
their own use by those who control the assessee and its affairs, cannot be allowed deduction. If the circumstances indicate that the
expenses as incurred are not dictated by commercial expediency but are inspired by
profit-hunting motive, because of the close relationship between the parties to the
transaction, such expenditure cannot be allowed as deduction.
The Income Tax Ordinance, 1979 makes provisions to enable the tax authorities go behind
the arrangement between a resident and non-resident to find its real intention and
substance as to whether such an arrangement is intended to divert income as if arising or
accruing at a place different from where it could have normally arisen or accrued but for
such arrangement. These provisions are contained under Chapter VIII, in section 79 (income
from transactions with non-residents); section 84 (avoidance of tax by certain
transactions in securities). Section 79 specifically proclaims the concept of transactions
at arm's length and echoes the uncontrolled price method concept in the Pakistani context,
Section 79, therefore, provides that where a business is carried on between a resident and
a non-resident and it appears to the Deputy Commissioner of Income Tax that conditions are
made or imposed between them in their commercial or financial transactions are different
from those which would be made between independent persons and resultancy to a resident
person either no profits or less than the ordinary profits which might be expected to
arise in that business are accruing, the officer shall determine the amount of profits
which may reasonably be deemed to have been derived therefrom and include such amount in
the total income of the resident. Section 79 consists of two limbs. The first, prescribes
the condition on which charge arises, viz., there should be a business as carried on
between the resident and .a non-resident, the course of business is so arranged as to
produce no profits or produce less than the expected profits. Such arrangement has been
made possible because of the close connection between them and this arrangement may be
responsible for no profits or reduced profits in the opinion of the Assessing Officer. The
second limb imposes the charge; empowering the officer to determine the amount of profits
[see Rule 24 of Income Tax Rules, 1982] which may reasonably be deemed to have been
derived therefrom and then to include such amount in the total income of the resident
assessee. The expression 'profits in the charging part of the enactment is associated with
the words which may reasonably be deemed to have been derived' and this association has
its origin in the preceding clause "produces to the resident either no profits or
less than the ordinary profits which might be expected to arise under independent
conditions". The word 'condition' has reference to business and it is this business,
therefore, that is the subject of charge under section 79. To construe that the word
'condition' has reference to the arrangement between the non-resident and the resident,
would on the grammar of it, be untenable and it is impossible to conceive how an
arrangement relating to the conduct of business can, as such, be the subject-matter of
income-tax apart from the business in which profits and gains are made.
However, in case when evidences have been circumstantial or inferential appeal leading to
reasonable belief that export price has been depressed or import price inflated, or there
has been undercharging or overcharging the normal price, the Deputy Commissioner of Income
Tax may proceed to make assessment in terms of section 79 taking cognizance of the close
connection and arrangement between resident and non-resident.
The words 'profits', 'have accrued to one of the enterprises' thus similarly convey that
the enterprise must be carrying business or profession the income of which is taxable in
its hands, and the commercial transactions between the two enterprises are controlled or
managed in such a manner as to cause variation in the profits of the aforesaid enterprise
which could not have been possible had these two enterprises been not thus arranged their
transactions. Commercial or financial relations between the two enterprises as such cannot
be subject-matter of income-tax, apart from the business or profession in which profits
and gains accrue or are made. The depression of profits could be effected through various
transactions relating to sale or purchase of goods, services, grant of commission rebates,
masquerading equity financing and thus distributing dividend in the form of interest, etc.
- Article 9 of the OECD Model and section 79 - Section 79 of the Ordinance and the
Article in tax agreements empower the tax authorities to ascertain whether the
relationship between the two enterprises has diverted the course of carrying on business
or profession from the normal course as to prevent profits from accruing. This authority
extends to all cases in which either by design or inadvertence taxable profits in whole or
in part of an affiliate is other than what it would have been had the transaction dealt at
arm's length. However, while dealing with such assessees, the authority should not
entertain a confusion between 'arm's length' and "fair prices'. The former relates to
the control of internal prices and the latter is part of anti-monopoly measures.
- Courts' approach - But even without section 79 or the Article in the tax
agreements, the courts in Pakistan relying on Indian case have been upholding the revenues
right to disregard any device practised by the assessee towards payment of legitimate
taxes which would have become due to it but for such devices. If by reason of transaction
the business is reduced so as to divert the profits which the person would otherwise have
received, and if such a transaction is affected with the dominant object of avoiding or
reducing the liability, it would be competent of the tax authorities to go behind the
transaction and assess the profit which might have been received by the person but for the
transaction. The traditional approach of
maintaining the assessee's right to arrange its fiscal affairs in a manner so as to reduce
tax burden has been eroded considerably during the recent years. If the parties have
chosen to conceal by a device the legal relation or the nature of the transaction, it is
open to the taxing authority to unravel the device and to determine the real character of
the relation or the transaction.
The courts have upheld the revenue's right to disregard transaction and look upon its
substance, if it is undertaken as an anti-avoidance tool. The tax consequences of the
interlocking, interdependent and predetermined transactions are to be judged by reference
to its substance. A preordained series of transactions into which there are inserted steps
that have no commercial purpose apart from the avoidance of a liability to tax which in
the absence of those particular steps would have been payable, have to be ignored and the
authorities could look to the realities and tax that amount of income which is intended to
be escaped or shifted through such devices.
In determining whether the transaction is genuine, the courts will have to consider all
surrounding circumstances, including the economic purpose of the transaction and the
question whether or not there is a tax avoidance motive behind it. The acts which
dissimulate the true nature of a contract or of an agreement under the appearance of
provision giving rise to or disguising either a realisation of a transfer of profits or
income or permitting the avoidance of taxes are not valid against the tax authorities. In
order to set aside the acts of an assessee as being ineffective, such acts should have a
fictitious character, or. if not, these have no other motive than to avoid or alleviate
the tax burden which the assessee, if he had not carried out these acts, would normally
have had to pay having regard to his actual situation and activity.
54.3. Relief from taxation on account of arm's length method - In
case, however, there is variation in the computation of profits on the basis of the
estimation of open market price and by applying the doctrine of arm's length price, or
where a part of interest has been disallowed on the ground that such payment (disguised
dividend) is made as interest because the equity capital was hidden as borrowed capital,
such inflation of profit be not subjected to tax doubly, once in the country of the source
and again where the profit is intended to be shifted. Normally, tax agreements take care
of such a situation. But even where the agreements providing for corresponding treatment
do not exist, the recipient country should give relief for any double taxation of profits
or of interest as if the payment is in fact dividend. This is based on the principle that
the application of the rules designed to deal with hidden equity capitalisation should not
normally increase taxable profits of an enterprise to an amount greater than the profits
which would have accrued in an arm's length situation.
In case provision similar to the one mentioned above does not exist in a treaty the
national tax authorities should decide through mutual agreement for the elimination' of
double taxation. Where, however, no treaty exists, the domestic tax laws should be
flexible as to provide itself unilaterally.
In a recent case, 1997 PTD (Trib.) 13, the Pakistan Income Tax Appellate Tribunal
held as under:
"Briefly stated the relevant facts are that the respondent is a multinational
pharmaceutical company deriving income from manufacture of various drugs. In all the
assessment years under consideration the assessing officer observed that the respondent
imported certain raw material from the associated undertaking, M/ s. Hoechst Germany, on
much higher rates as compared to the rates obtaining in the open market. The assessing
officer therefore issued notice under section, 62 of the Income Tax Ordinance calling upon
the respondent to show cause as to why appropriate addition may not be made by recourse to
the provision contained under section 79 of the Income Tax Ordinance, 1979.
".... the conduct of C.B.R. whereby the agreement arrived at by its own official has
been acted upon in part in respect of the Assessment year 1990-91 onward and backing out
from the commitment in respect of the earlier assessment years although specifically
referred in the letter, dated 3rd march, 1993 by the Finance Minister, Government of
Germany in the letter addressed to the C.B.R. intimating the terms of mutual agreement
(which has never been denied or refuted by the C.B.R.) is not in conformity with the
conduct of a civilized law-abiding and Hon'able Member of the comity of nations which
Pakistan is. He has contended that such conduct on the part of C.B.R. would adversely
affect the credibility of the Government of Pakistan in its international transaction sand
commitments which is not in the larger interest of the State.
For the foregoing reasons it is held that the issue relating to the transfer pricing is
not to be dealt with in accordance with the provisions contained in section 79 of the
Income Tax ordinance, 1979 or on any other mutual consideration of fact or law but has to
be dealt with in accordance with the mutual agreement arrived at between the Government of
Germany addressed to the Government of Pakistan and in the same manner as acted upon in
respect of the assessment years 1990-91 to 1993-94. The findings relating to the additions
under section 79 in all the assessment years under appeal are, therefore, set aside and
the assessing officer is directed to decide the issue in the light of directions and
observations made above.
