How the Pakistan-US Tax Treaty Works

The United States and Pakistan share a tax treaty, formally known as the “Convention Between the United States of America and Pakistan for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income.” Signed in 1957, its primary purpose is to ensure individuals and companies with financial activities in both nations are not taxed on the same income by both countries. The agreement also aims to prevent tax evasion through cooperation between the tax authorities. The treaty establishes rules that can override the domestic tax laws of both the U.S. and Pakistan, clarifying which country has the primary right to tax different types of income and offering reduced tax rates in certain situations.

Determining Residency Under the Treaty

The benefits of the Pakistan-US tax treaty are available only to individuals and entities considered a “resident of a Contracting State.” For an individual, this means any person who, under the laws of either the United States or Pakistan, is liable to tax there by reason of their domicile or residence. For a company, residency is determined by the country under whose laws it is incorporated or managed.

When an individual qualifies as a resident of both the U.S. and Pakistan simultaneously, the treaty does not use a series of sequential tie-breaker rules. Instead, the issue of which country can claim the individual as a resident for treaty purposes is settled by mutual agreement between the tax authorities of the two countries.

Taxation of Specific Income Types

Business Profits

The treaty’s rules for business profits center on the concept of a “Permanent Establishment” (PE). The business profits of an enterprise from one country are taxable only in that country unless it carries on business in the other country through a PE. If a PE exists, the host country may tax the profits, but only the portion attributable to the PE’s activities. A PE is a fixed place of business, such as a branch, office, or factory, through which the business is wholly or partly carried on.

The treaty specifies that having a subsidiary company in the other country does not automatically create a PE for the parent company. Using a broker or other independent agent also does not constitute a PE, provided they are acting in the ordinary course of their business.

Dividends and Interest

The treaty provides for reduced tax rates on dividends and interest paid from sources in one country to a resident of the other. For dividends, the U.S. tax on dividends paid by a U.S. corporation to a Pakistani company is capped at 15%, provided the Pakistani company owns more than 50% of the voting stock of the U.S. corporation paying the dividend. This provision is designed to encourage direct investment.

Interest paid by a borrower in one country to a resident of the other is taxable only in the recipient’s country of residence. This means a Pakistani resident earning interest from a U.S. source would not be subject to U.S. withholding tax on that interest income, and vice versa.

Personal Services Income

The treaty distinguishes between income from independent personal services and dependent personal services (employment). For an individual performing independent services, such as a consultant, the income is taxable only in their country of residence unless they have a fixed base regularly available to them in the other country. If a fixed base exists, the other country may tax the income attributable to that base.

For employment income, salary and wages are taxable in the country where the employment is exercised. However, the income is exempt from tax in the work country if three conditions are met: the individual is present in the other country for 183 days or less, the services are performed for a resident of the first country, and the remuneration is subject to tax in that first country.

Pensions

The treaty addresses the taxation of pensions. Generally, pensions and similar remuneration for past employment paid to a resident of one country are taxable only in that country. However, this rule has exceptions, as the treaty specifies that its provisions do not apply to certain pensions. These include those from superannuation funds approved under Pakistani law or from U.S. employee pension plans where employer contributions were deductible. The tax treatment for these pensions would depend on other treaty provisions or the domestic laws of each country.

Relief from Double Taxation

The primary mechanism for preventing double taxation is the foreign tax credit. The agreement allows a resident of one country to claim a credit against their domestic income tax for the taxes paid to the other country. For example, a U.S. citizen residing in the U.S. who earns income from Pakistan and pays Pakistani income tax can credit that amount against their U.S. income tax liability.

The U.S. tax system includes a “Saving Clause,” which is also in the Pakistan-US treaty. This clause allows the United States to tax its citizens and certain residents as if the treaty did not exist, ensuring a U.S. citizen is subject to U.S. tax on their worldwide income regardless of where they live.

However, the article on relief from double taxation is a specific exception to the Saving Clause. This protection guarantees that even though the U.S. can tax its citizens on their worldwide income, it must still provide a foreign tax credit for taxes paid to Pakistan. This ensures that the fundamental goal of avoiding double taxation is upheld for U.S. citizens.

Claiming Treaty Benefits

Individuals and companies must take specific actions to claim treaty benefits, and the procedure depends on their filing status. A taxpayer who takes the position that a treaty provision overrules or modifies the Internal Revenue Code, resulting in a tax reduction, must disclose this on their U.S. tax return. This is done by attaching IRS Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b). Failure to disclose a treaty-based position can result in penalties.

For a resident of Pakistan who is not required to file a U.S. tax return but receives U.S. source income, the process is different. The Pakistani resident must give the U.S. payer a completed Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting. This form certifies their foreign status and allows them to claim a reduced rate of, or exemption from, U.S. tax withholding.