How to Tax a Permanent Establishment in Pakistan?

In Pakistan, the taxation of a Permanent Establishment (PE) of a non-resident company is governed primarily by the Income Tax Ordinance, 2001 (ITO, 2001), and where applicable, by the provisions of Double Taxation Treaties (DTTs) that Pakistan has entered into with other countries.

A Permanent Establishment is essentially a taxable presence of a non-resident entity in Pakistan. If a non-resident carries on business in Pakistan through a PE, the business income attributable to that PE is considered Pakistan-source income and is subject to tax in Pakistan.

Here’s a breakdown of how a Permanent Establishment is taxed in Pakistan:

Definition of Permanent Establishment (PE)

The ITO, 2001 defines a “permanent establishment” in relation to a person (including a non-resident company) as a place of business through which the business of the person is wholly or partly carried on. The definition is broad and includes:

• A place of management, branch, office, factory, workshop, premises, warehouse, permanent sales exhibition or outlet.
• A mine, oil or gas well, quarry, or any other place of extraction of natural resources.
• An agricultural, pastoral, or forestry property.
• A building site, a construction, assembly, or installation project, or supervisory activities connected therewith, but only if such site, project, or activities continue for a specific period (e.g., generally more than 90 days or 6 months, depending on the specific clause and potential DTT variations).
• The furnishing of services, including consultancy services, by any person through employees or other personnel if activities of that nature continue for a specific period (e.g., often exceeding 90 days within any 12-month period).
• An agent (other than an independent agent acting in the ordinary course of business) who has and habitually exercises authority to conclude contracts on behalf of the non-resident or habitually plays the principal role leading to the conclusion of contracts.
• Any substantial equipment installed or other asset or property capable of activity giving rise to income.
• Recent amendments to the domestic law have expanded the definition to potentially include a ‘virtual presence’ or business conducted through electronic mediums, regardless of physical presence, aiming to capture the digital economy.

It is crucial to note that if a Double Taxation Treaty exists between Pakistan and the non-resident’s country of residence, the definition of PE provided in the treaty will prevail over the definition in the domestic law if it is more beneficial to the taxpayer.

Attribution of Profits to a PE

Only the business income that is attributable to the PE in Pakistan is taxable in Pakistan. The ITO, 2001 and international tax principles (often guided by OECD/UN Models which Pakistan’s DTTs are based on) dictate how profits are attributed.

• Distinct and Separate Entity Principle: For taxation purposes, a PE is generally treated as a distinct and separate entity from its head office or other parts of the non-resident enterprise.It is treated as if it were an independent enterprise engaged in the same or similar activities under the same or similar conditions, dealing wholly independently with the non-resident enterprise of which it is a PE.
• Arm’s Length Principle: Transactions between the PE and its head office or associated enterprises are subject to the arm’s length principle. This means that transfers of goods, services, or intangibles between the PE and the rest of the non-resident entity must be priced as if they occurred between independent entities.
• Directly or Indirectly Attributable Income: Business income is considered Pakistan-source to the extent it is directly or indirectly attributable to the PE in Pakistan.This can include income from sales of goods or merchandise of the kind sold through the PE, or other business activities of the kind conducted through the PE.

Computation of Taxable Income

Once the attributable gross income is determined, the PE can generally claim deductions for expenses incurred for the purposes of the business of the PE, provided they are laid out wholly and exclusively for generating the Pakistan-source income attributable to the PE.

• Head Office Expenditure: A proportion of the head office expenditure of the non-resident enterprise may be allowed as a deduction, typically calculated based on the proportion of the PE’s turnover to the non-resident’s total worldwide turnover, subject to certain limitations and rules.
• Restrictions on Certain Deductions: Deductions may be restricted for certain payments made by the PE to its head office or associated enterprises, such as interest on loans used to finance the PE’s operations, royalties, or fees for technical services, as these are generally seen as internal transfers within a single entity rather than deductible expenses. However, this can also be influenced by specific DTT provisions.

Applicable Tax Rates

A non-resident company operating through a PE in Pakistan is generally taxed on its net taxable business income attributable to the PE at the corporate tax rates applicable to companies in Pakistan.

• Corporate Tax Rate: The standard corporate tax rate applies to the net profit of the PE i.e 29%.
• Minimum Tax on Turnover: In addition to the normal corporate tax, a minimum tax on turnover may also apply to the PE’s gross receipts. This minimum tax is typically applicable at a certain percentage of turnover (e.g., 1.25% or different rates for specific sectors or activities like sale of goods, rendering of services, or execution of contracts, which may range from 0.25% to 1.25%. The tax liability is the higher of the normal tax on net income or the minimum tax on turnover.
• Withholding Taxes: Various payments received by the PE (e.g., for services, supplies, contracts) may be subject to withholding tax at source under different sections of the ITO, 2001. These withheld amounts are generally adjustable against the final tax liability of the PE.

In summary, taxing a Permanent Establishment in Pakistan involves determining if a taxable presence exists based on the definition in the ITO, 2001 (considering any applicable DTT), attributing the relevant business income and expenses to that PE based on arm’s length principles, and then applying the standard corporate tax rates and applicable minimum taxes on the computed taxable income. Compliance obligations, including registration with the FBR, filing of tax returns, and maintenance of proper accounts and records, are mandatory for a PE in Pakistan.