Income Tax Ordinance, 2001 — Section 106: Thin capitalisation

106. Thin capitalisation. — (1) Where a foreign-controlled resident company (other than a financial institution 1[or a banking company)] 2[or a branch of a foreign 1 Inserted by the Finance Act, 2002 2 Inserted by the Finance Act, 2008. 200 Chapter VII – International company operating in Pakistan,] has a foreign debt-to-foreign equity ratio in excess of three to one at any time during a tax year, a deduction shall be disallowed for the profit on debt paid by the company in that year on that part of the debt which exceeds the three to one ratio.

(2)In this section, “foreign-controlled resident company” means a resident company in which fifty per cent or more of the underlying ownership of the company is held by a non-resident person (hereinafter referred to as the “foreign controller”) either alone or together with an associate or associates; “foreign debt” in relation to a foreign-controlled resident company, means the greatest amount, at any time in a tax year, of the sum of the following amounts, namely:

(a)The balance outstanding at that time on any debt obligation owed by the foreign-controlled resident company to a foreign controller or non-resident associate of the foreign controller on which profit on debt is payable which profit on debt is deductible to the foreign-controlled resident company and is not taxed under this Ordinance or is taxable at a rate lower than the 1[corporate rate] of tax applicable on assessment to the foreign controller or associate; and

(b)the balance outstanding at that time on any debt obligation owed by the foreign-controlled resident company to a person other than the foreign controller or an associate of the foreign controller where that person has a balance outstanding of a similar amount on a debt obligation owed by the person to the foreign controller or a non-resident associate of the foreign controller; and “foreign equity” in relation to a foreign-controlled resident company and for a tax year, means the sum of the following amounts, namely:

(a)The paid-up value of all shares in the company owned by the foreign controller or a non-resident associate of the foreign controller at the beginning of the tax year;

(b)so much of the amount standing to the credit of the share premium account of the company at the beginning of the 1 The words “corporate tax” substituted by the Finance Act, 2002 201 Chapter VII – International tax year as the foreign controller or a non-resident associate would be entitled to if the company were wound up at that time; and

(c)so much of the accumulated profits and asset revaluation reserves of the company at the beginning of the tax year as the foreign controller or a non-resident associate of the foreign controller would be entitled to if the company were wound up at that time; reduced by the sum of the following amounts, namely:

(i)the balance outstanding at the beginning of the tax year on any debt obligation owed to the foreign controlled resident company by the foreign controller or a non-resident associate of the foreign controller; and

(ii)where the foreign-controlled resident company has accumulated losses at the beginning of the tax year, the amount by which the return of capital to the foreign controller or non-resident associate of the foreign controller would be reduced by virtue of the losses if the company were wound up at that time. 1 [106A. Restriction on deduction of profit on debt payable to associated enterprise.-(1) Subject to sections 108 and 109, a part of deduction for foreign profit on debt claimed by a foreign-controlled resident company(other than an insurance company, or a banking company) during a tax year, shall be disallowed according to the following formula, namely: [B] – [(A+B) x 0.15] where A is the taxable income before depreciation and amortization; and B is the foreign profit on debt claimed as deduction

(2)This section shall not apply to a foreign-controlled resident company if the total foreign profit on debt claimed as deduction is less than ten million rupees for a tax year.

(3)Where in computing the taxable income for a tax year, full effect cannot be given to a deduction for foreign profit on debt, the excessive amount shall be added to the amount of foreign profit on debt for the 1 New section 106A inserted through Finance Act, 2020 dated 30th June, 2020 202 Chapter VII – International following tax year and shall be treated to be part of that deduction, or if there is no such deduction for that tax year, be treated to be the deduction for that tax year, be treated to be the deduction for that tax year and so on for three tax years.

(4)Notwithstanding the provisions of section 106, where deduction of foreign profit on debt is disallowed under this section and also under section 106, the disallowed amount shall be the higher of the disallowed amount under this section and section 106.

(5)This section shall apply in respect of foreign profit on debt accrued with effect from the first day of July, 2020, ever if debts were contracted before the first day of July, 2020.

(6)In this section

(a)“foreign-controlled resident company” means a resident company in which fifty per cent or more of the underlying ownership of the company is held by a non-resident person either alone or together with an associate or association; and

(b)“foreign profit on debt” means interest paid or payable to a non resident person or an associate of the foreign-controlled resident company and includes

(i)interest on all forms of debt;

(ii)payments made which are economically equivalent to interest;

(i)expenses incurred in connection with the raising of finance;

(ii)payments under profit participating loans;

(iii)imputed interest on instruments such as convertible bonds and zero coupon bonds;

(iv)amounts under alternative financing arrangements such as Islamic finance;

(v)the finance cost element of finance lease payments;

(vi)capitalized interest included in the balance sheet value of related asset, or the amortisation of capitalised interest;

(vii)amounts measured by reference to a funding return under transfer pricing rules; 203 Chapter VII – International

(viii)where applicable, national interest amounts under derivative instruments or hedging arrangements related to an entity’s borrowings;

(ix)certain foreign exchange gains and losses on borrowings and instruments connected with the raising of finance;

(x)guarantee fees with respect to financing arrangements; and

(xi)arrangements fee and similar cost related to the borrowing funds.] 204 Chapter VII – International PART IV AGREEMENTS FOR THE AVOIDANCE OF DOUBLE TAXATION AND PREVENTION OF FISCAL EVASION 107. Agreements for the avoidance of double taxation and prevention of fiscal evasion. —1[2[(1) The Federal Government may enter into a tax treaty, a tax information exchange agreement, a multilateral convention, an inter governmental agreement or similar agreement or mechanism for the avoidance of double taxation 3[or assistance in the recovery of taxes] or for the exchange of information for the prevention of fiscal evasion or avoidance of taxes including automatic 4[and spontaneous] exchange of information with respect to taxes on income imposed under this Ordinance or any other law for the time being in force and under the corresponding laws in force in that country and may, by notification in the official Gazette, make such provisions as may be necessary for implementing the said instruments.”;] and] 5[“(1A) Notwithstanding anything contained in any other law to the contrary, the Board shall have the powers to obtain and collect information when solicited by another country under a tax treaty, a tax information exchange agreement, a multilateral convention, an inter-governmental agreement, a similar arrangement or mechanism.] 6[(1B) Notwithstanding the provisions of the Freedom of Information Ordinance, 2002 (XCVI of 2002), 7[subject to clause (a) of sub-section (3) of section 216 of this Ordinance] any information received or supplied, and any 1 The sub-section (1) substituted by Finance Act, 2015. Substituted sub-section (1) read as follows: “(1) The Federal Government may enter into an agreement with the government of a foreign country for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income imposed under this Ordinance and under the corresponding laws in force in that country, and may, by notification in the official Gazette make such provisions as may be necessary for implementing the agreement.” 2 Sub-section (1) substituted by the Finance Act, 2016. The substituted sub-section (1) reads as follows: “(1) The Federal Government may enter into an agreement, bilateral or multilateral with the government or governments of foreign countries or tax jurisdictions for the avoidance of double taxation and the prevention of fiscal evasion and exchange of information including automatic exchange of information with respect to taxes on income imposed under this Ordinance or any other law for the time being in force and under the corresponding laws in force in that country, and may, by notification in the official Gazette, make such provisions as may be necessary for implementing the agreement.” 3 Inserted by the Finance Act, 2021. 4 The words “and spontaneous” inserted through Finance Act, 2020 dated 30th June, 2020 5 Inserted by the Finance Act, 2015 6 Inserted by the Finance Act, 2015 7 The words inserted by the Finance Act, 2019. 205 Chapter VII – International concomitant communication or correspondence made, under a tax treaty, a tax information exchange agreement, a multilateral convention, a similar arrangement or mechanism, shall be confidential 1[ ].

(2)2[Subject to section 109, where] any agreement is made in accordance with sub-section (1), the agreement and the provisions made by notification for implementing the agreement shall, notwithstanding anything contained in any law for the time being in force, have effect in so far as they provide for 3[at least one of the following] –

(a)relief from the tax payable under this Ordinance;

(b)the determination of the Pakistan-source income of non resident persons;

(c)where all the operations of a business are not carried on within Pakistan, the determination of the income attributable to operations carried on within and outside Pakistan, or the income chargeable to tax in Pakistan in the hands of non-resident persons, including their agents, branches, and permanent establishments in Pakistan;

(d)the determination of the income to be attributed to any resident person having a special relationship with a non-resident person; and

(e)the exchange of information for the prevention of fiscal evasion or avoidance of taxes on income chargeable under this Ordinance and under the corresponding laws in force in that other country.

(3)Notwithstanding anything4[contained] in sub-sections (1) or (2), any agreement referred to in sub-section (1) may include provisions for the relief from tax for any period before the commencement of this Ordinance or before the making of the agreement. 1 The expression “subject to sub-section (3) of section 216” omitted by the Finance Act, 2016 2 The word “where” substituted by the Finance Act, 2018. 3 Inserted by the Finance Act, 2016. 4 Inserted by the Finance Act, 2016. 206 Chapter VIII – Anti-Avoidance CHAPTER VIII ANTI-AVOIDANCE