Outdated tax rules are costing Pakistan millions

Entering the modern age

Unprecedented attention to international tax planning has disrupted the foundations of the most important players in global tax policy design. Leaders of strongest economies require a revision of the rules of the international tax regime that would increase tax revenue for the challenging time to restore the public trust in the system.

The OECD Base erosion and profit shifting initiative is an important step in international taxation. It fixes tax rules that give the incentive to shift profit to the place where there is a low tax rate even when there is little real business activity. The BEPS project was initiated because governments bear a fiscal burden due to shifting profit from high tax-paid jurisdictions to low tax-paid countries.

Double tax treaties are crucial in the international tax system. They help to eliminate double taxation of the same income when it is earned in source-income countries and received by resident countries. The primary objectives of tax treaties are to prevent double taxation, encourage cross-border investment by providing tax incentives and facilitate the exchange of information to combat tax evasion.

These treaties are crucial in fostering cross-border investment and trade activities by reducing tax barriers, providing certainty regarding tax rules, and preventing fiscal evasion. However, there is a wave of globalization that has led to the misuse of treaties. They have been susceptible to misuse and have become an instrument of tax avoidance, such as tax treaty shopping, which allows investors to shift profit in low- or no-tax jurisdictions even when there is little or no economic substance. 

The need to address BEPS highlights the challenge arising from the digital economy and globalization. Globalization has made it easy to move capital across countries and set up operations and invest in different places. This, coupled with the rise of digitalization, has blurred the traditional boundaries of business operation and created complexities in tax rules, making it harder to determine where tax should be paid. 

A multinational enterprise leverages the advantage of globalization, the risk of BEPS has increased, causing significant revenue loss for the government and undermining the fairness of the tax system worldwide. It is estimated that BEPS practice leads to annual revenue losses of $100-200 billion, which account for four to ten percent of global corporate income tax revenue. Moreover, tax treaty rates on dividend and interest rates are often less than the domestic rates of many developing countries. As a result of lower tax rates, many developing countries experience significant losses in withholding tax revenue; likewise, the Philippines and Pakistan suffer annual revenue losses.  

In Pakistan, the digital economy has grown over time; many social media platforms earn money without paying tax in source income countries. The current tax treaty provision does not address this issue. Therefore, there is a need to update the tax treaties by revising the definition of PE (permanent establishment), which covers digital service taxation, to ensure fair tax revenue distribution. This reform could help Pakistan collect more tax revenue through multinational digital services.

Pakistan has 66 tax treaties with various countries to address the issue of double taxation and enhance cross-border trade and investment. Pakistan has also renegotiated the treaties to reduce tax avoidance and evasion. However, some treaties still reference outdated currency values, creating opportunities for treaty shopping and escalating revenue loss. For instance, the USA signed a tax treaty with Pakistan in 1957. The tax rule mentioned in the treaty was based on an old currency of Pakistan, which provides an incentive for investors to avoid paying taxes in Pakistan and encourages foreign investors to establish shell companies without paying taxes.

In light of 15 actions proposed by BEPS, Pakistan should renegotiate treaties to remove the obstacles and adopt modern standards to attract FDI instead of traditional methods. Policymakers and tax authorities collectively work together to apply the BEPS action effectively to combat the problem of misuse of tax treaties. One reason to apply the action is that the future of tax rules is more related to changes in tax treaties, and the tax system must adjust to the global economy and revive the definition of physical business activities. This could include the new idea of a global minimum tax rate, and another is that tax should be imposed in those countries according to the consumers of the product rather than just the physical presence of the business.

In Pakistan, the digital economy has grown over time; many social media platforms earn money without paying tax in source income countries. The current tax treaty provision does not address this issue. Therefore, there is a need to update the tax treaties by revising the definition of PE (permanent establishment), which covers digital service taxation, to ensure fair tax revenue distribution. This reform could help Pakistan collect more tax revenue through multinational digital services.