Understanding the CFC Regime

How foreign companies operating in Pakistan are regulated

Bilal Hassan

Pakistan has adopted the controlled foreign companies (CFC) regime by inserting section 109A into the Income Tax Ordinance, 2001, (ITO) through Finance Act 2018 so as to prevent base erosion and profit shifting (BEPS). Tax year 2019 is the first year for enforcement of the CFC regime under which income attributable to a CFC will be taxed in the hands of a Pakistani resident person. It is, therefore, essential for the Pakistani resident persons having CFCs to understand the CFC regime as it will help them make timely decisions about business operations in foreign jurisdictions. Existing entities in foreign jurisdictions with little or no substance may be removed. Similarly, business structures may be simplified by restructuring business operations, revaluating supply chain and examining potential risks to ensure better compliance of the CFC regime.

What is a CFC?

A non-resident company in Pakistan is a CFC for tax purposes if more than 50% of its capital or voting rights are held, directly or indirectly, by one or more persons resident in Pakistan; or more than 40% of its capital or voting rights are held, directly or indirectly, by a single resident person in Pakistan. However, a foreign entity, which fulfils either of the above conditions, cannot be treated as a CFC if: (a) the shares of the company are traded on any stock exchange recognized by law of the country or jurisdiction of which the non-resident company is resident for tax purposes; (b) the non-resident company derives active business income; and (c) tax paid, after taking into account any foreign tax credits available to the non-resident company, on the income derived or accrued, during a foreign tax year, by the non-resident company to any tax authority outside Pakistan is less than 60% of the tax payable on the said income. In ordinary sense, the CFCs are entities incorporated in a particular jurisdiction but are controlled by the residents of another country.

To understand the CFC regime, knowing criteria for determination of resident status is of pivotal importance. An individual is a resident Pakistani if his or her stay in Pakistan is 183 days or more. Besides, effective from tax year 2020, an individual will be resident if his stay in Pakistan will be 120 days or more, and also such an individual was present in Pakistan for 365 days or more in the preceding four tax years. For example, if an individual is present in Pakistan for 120 days in tax year 2020 and was also present in Pakistan for 90 days in tax year 2019, 130 days in tax year 2018, 80 days in tax year 2017 and 70 days in tax year 2016, such an individual will be resident for tax year 2020.

Analysis of section 109A of the ITO reveals that in ordinary sense, income of a foreign company owned by a Pakistani resident is taxable in Pakistan only when such income is received from that non-resident entity. However, section 109A(1) of the ITO is a deeming provision which essentially creates a legal fiction i.e. income of a company is deemed to be the income of controlling entity, which is to be taxed in the year it is earned not when it is actually received.

Under the CFC regime, if a non-resident is treated as a CFC then whole income attributable to that CFC will be included in the taxable income of a resident taxpayer, which could be computed for a tax year using the formula . Where A stands for income of CFC determined under the provisions of the ITO; and B is a percentage of capital or voting rights, whichever is higher, held by the person directly or indirectly in the CFC. The income attributable to a CFC will be treated as zero if capital or voting rights of the resident person is less than 10%.

Similarly, income of a CFC less than Rs 10 million will not be taxed. Moreover, income of a CFC that has been taxed under section 109A of the ITO will not be taxed again when it is received in Pakistan by the resident taxpayer. Income of a CFC shall be determined in the currency of that CFC and shall be included in the income of any resident person during any tax year by converting into Pak rupees at the State Bank of Pakistan rate applying between that foreign currency and the PKR on the last day of the tax year. Foreign tax year in relation to a non-resident company, means any year or period of reporting for income tax purposes by that non-resident company in the country of residence or, if that company is not subject to income tax, any annual period of financial reporting by that company. However, where tax has been paid by the resident person on the income attributable to CFC and in a subsequent tax year the resident person receives dividend distributed by the CFC, after deduction of tax on dividend, the resident person shall be allowed a tax credit equal to the lesser of foreign tax paid, as defined in section 103 (8) of the ITO on dividends; and Pakistan tax payable, as defined in section 103, for the tax year in which the dividend is received by the resident taxpayer.

The attributable income of the resident person shall be determined by comparing the percentage of control (whether direct or indirect) held by the said person over the CFC. The term direct control refers to direct ownership of capital or voting rights in the foreign entity. However the term indirect control is very wide in its connotation and includes indirect control by a company through subsidiary companies in which the resident person holds capital or voting rights but also includes other companies in which the resident person exercises control through ownership of capital or voting rights. For example, Mr. A owns 30% shares in A Ltd (a non-resident company) and also owns 30% shares in B Ltd (another non-resident company) which in turn owns 70% of A Ltd.

From tax year 2019 onwards, attributable incomes of CFC that are retained and not repatriated to Pakistan will subject to tax on the basis of tax rate applicable to dividends.

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What is a Controlled Foreign Company (CFC)?

A controlled foreign corporation (CFC) is a corporate entity that is registered and conducts business in a different jurisdiction or country than the residency of the controlling owners. Controlled foreign corporation (CFC) laws work alongside tax treaties to dictate how taxpayers declare their foreign earnings. A CFC is advantageous for companies when the cost of setting up a business, foreign branches, or partnerships in a foreign country is lower even after the tax implications—or when the global exposure could help the business grow. The CFC structure was created to help prevent tax evasion, which was done by setting up offshore companies in jurisdictions with little or no tax, such as Bermuda and the Cayman Islands, historically. Each country has its own CFC laws, but most are similar in that they tend to target individuals over multinational corporations when it comes to how they are taxed.

What is BEPS?

Base erosion and profit shifting (BEPS) refers to tax planning strategies used by multinational enterprises that exploit gaps and mismatches in tax rules to avoid paying tax. Developing countries’ higher reliance on corporate income tax means they suffer from BEPS disproportionately. BEPS practices cost countries USD 100-240 billion in lost revenue annually. Working together within OECD/G20 Inclusive Framework on BEPS, over 130 countries and jurisdictions are collaborating on the implementation of 15 measures to tackle tax avoidance, improve the coherence of international tax rules and ensure a more transparent tax environment.