ATIR rules on taxability of split contract arrangements under Pakistan-China Double Tax Treaty

Engineering, procurement and construction (EPC) contracts and split contract arrangements (involving offshore supply contracts and onshore service contracts) have remained a key focus of Pakistani tax authorities. The tax implications for these transactions are influenced by the design of the transaction in question and the provisions of the applicable Double Tax Treaties (DTTs).

Recently, Pakistan’s Appellate Tribunal Inland Revenue (ATIR second tier appeal forum) has allowed an appeal against the tax authority’s order for recovery of withholding tax, deductible while making payment for the offshore supply of machinery (ITA 377/KB/2019). As per the facts, the appellant, a Pakistani renewable energy project, imported machinery and equipment from a Chinese manufacturer. The onshore contract (construction, assembly and installation services) was signed separately with an associate of the equipment supplier, also resident in China and executed through a branch office registered in Pakistan, constituting a permanent establishment (PE). The taxpayer was held assessee-in-default due to the following facts:

• The supplier of machinery and the provider of onshore service were associates.
• Both offshore and onshore agreements were similar in language and signed by the same person.
• The contract is essentially in the nature of an EPC contract and the location split of the EPC contract was made to avoid taxes due in Pakistan.
   

The tax authority inferred that the offshore supplier and onshore service provider, being PE of a separate company of the same group, must be considered a single entity for tax purposes. Lastly, the tax authority maintained that the offshore contract is subject to tax in Pakistan as per DTT between Pakistan and China, which is based on the UN Model Tax Convention (UN MTC) and contains a ‘force of attraction’ rule.

ATIR decided the appeal in favour of the taxpayer and relied on precedents involving DTTs with Germany and Italy to conclude that offshore supply contract/portion of composite contract cannot be subject to tax in Pakistan due to overriding effect of relevant DTTs.

Moreover, ATIR held that:

• The requirement to obtain specific withholding tax exemption was inapplicable in case of payments for import of goods where title to goods is transferred outside Pakistan and supply is not made between associates.
• Tax authority was not authorised to discard the associated entity and treat Pakistani PE as the PE of offshore supplier for invoking force of attraction rule.
• The so-called force of attraction rule is not applicable for taxation of EPC contracts in view of the guidance provided under the UN MTC.
• The concept of Cohesive Business Operations (CBO) introduced in domestic tax law, including related amendments in the definition of PE and source rules for business income and restriction on exemption from withholding tax, may affect the tax position prospectively, i.e. from 1 July 2018 onwards.
• In case of any conflict between domestic law and a DTT provision, the latter overrides the former. DTT override is applicable insofar as it provides for tax relief otherwise not available under the domestic law. In the context of attribution of profits to a PE, existing DTT does not contain any specific reference to the concept of CBO in Article 5.
   

ATIR has addressed a key issue involved in the taxability of EPC/splitting of contracts under the Pakistan-China DTT. The amendments relating to CBO are not tested yet, however, the judgement may still apply insofar as it has been held that the definition of PE as per DTT supersedes the domestic law.

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