A Guide to Foreign Tax Credit (FTC) Under Pakistan’s Income Tax Ordinance, 2001

The Foreign Tax Credit (FTC) is a provision under Pakistan’s Income Tax Ordinance, 2001, aimed at preventing double taxation on income that is sourced from foreign countries. By allowing taxpayers to claim a credit for taxes paid abroad, Pakistan ensures that residents are not taxed on the same income both in Pakistan and in a foreign jurisdiction. This blog provides an in-depth understanding of how to claim FTC, the conditions involved, and practical examples.

What is Foreign Tax Credit (FTC)?

The Foreign Tax Credit (FTC) is a mechanism that allows Pakistani residents to offset the tax they have already paid to a foreign government against their Pakistani tax liability. This is particularly important for individuals and businesses that earn income from foreign sources, ensuring they are not burdened with paying taxes twice on the same income.

Eligibility for Foreign Tax Credit (FTC)

To be eligible for the FTC, several conditions must be met:

1. Income Tax Paid Abroad: FTC applies to income that has been taxed in a foreign country, and the tax paid must be recognized as legitimate by Pakistani tax authorities.

2. Taxable Foreign Income: The income must be taxable in Pakistan, but the taxpayer should have already paid taxes in the foreign country where the income was earned.

3. Not Available for Salary Exemption: FTC is not available for foreign salary income if it is already exempt in Pakistan due to a tax treaty between Pakistan and the foreign country.

4. Claim Period: The foreign income tax must be paid within two years from the end of the tax year in which it was earned.

5. Substantial Equivalence: The foreign tax must be a legitimate tax, similar to income tax, and not just a penalty or fine.

How to Calculate Foreign Tax Credit (FTC)

The FTC is calculated based on the lower of:

• Foreign tax paid, or
• Pakistan tax payable on the foreign income, calculated using the average rate of tax applicable in Pakistan.

Example of FTC Calculation:

Let’s walk through an example to better understand the FTC calculation:

Income Details for Mr. A (Tax Year 20X8):

Step 1: Total Taxable Income
Taxable Income = 3,600,000 + 2,000,000 + 3,000,000 = 8,600,000

Step 2: Tax Liability (Non-Salaried)

• Tax on the first 5,600,000  = 1,610,000
• Tax on the next 3,000,000 @ 45% = 1,350,000
  Total Tax Liability = 2,960,000

Step 3: Calculating Foreign Tax Credit

• Pakistan average rate of tax = 2,960,000 / 8,600,000 x 3,000,000 = 1,032,558
  FTC = 600,000 (lower of foreign tax paid or Pakistan tax)

Step 4: Adjusted Tax Liability
Total tax liability after FTC = 2,960,000 – 600,000 = 2,360,000

Conditions for Claiming the Foreign Tax Credit

1. Timely Payment: The foreign tax must be paid within two years of the end of the tax year. If the tax is not paid within this period, the FTC is not applicable.

2. Nature of Foreign Tax: The tax must be a legitimate income tax. Penalties or fines do not qualify for FTC.

3. Proof of Foreign Tax Payment: The taxpayer must provide valid documentation proving that the foreign tax was paid, such as tax receipts or foreign tax returns.

Frequently Asked Questions (FAQs)

1. What is the purpose of the Foreign Tax Credit?
   The purpose of the FTC is to eliminate double taxation on income that is taxed both in Pakistan and abroad.

2. Can FTC be claimed on all foreign income?
   FTC is available for foreign income that is taxable in Pakistan and taxed abroad, but it is not applicable to foreign salary income that is exempt in Pakistan.

3. What happens if the foreign tax is not paid on time?
   If the foreign tax is not paid within two years, the FTC will not be allowed in Pakistan.

4. Can the FTC exceed the tax liability in Pakistan?
   No, the FTC is limited to the amount of tax payable in Pakistan on the foreign-sourced income.

5. What documents are required to claim FTC?
   Valid proof of foreign tax payment, such as tax receipts or certificates from the foreign tax authority, must be provided.

6. Is FTC applicable to foreign salary income?
   FTC does not apply to foreign salary income that is exempt under tax treaties between Pakistan and the foreign country.

7. Can FTC be claimed on foreign dividends?
   Yes, if foreign dividends are taxable both in Pakistan and the foreign country, FTC can be claimed.

8. What if the foreign tax rate is lower than Pakistan’s rate?
   If the foreign tax rate is lower, the FTC will be based on the foreign tax paid. If it is higher, the FTC will be limited to the Pakistan tax liability.

9. Does FTC apply to penalties or fines paid in a foreign country?
   No, penalties and fines do not qualify for FTC.

10. Can FTC be carried forward or carried back?
    FTC cannot be carried forward or back; it must be used in the year the tax was paid.

11. What happens if the foreign country provides a refund of the paid tax?
    If the foreign tax paid is refunded, the FTC will need to be reversed in the year of refund.

12. How do tax treaties affect FTC?
    Tax treaties may provide exemptions or reduced rates of foreign tax on certain incomes, which could affect the FTC.

13. Is there a minimum amount of foreign tax for claiming FTC?
    There is no minimum limit, but the foreign tax must be a legitimate income tax.

14. What if the foreign tax paid exceeds the Pakistan tax liability?
    FTC cannot exceed the tax liability in Pakistan, even if the foreign tax paid is higher.

15. How do you calculate the average rate of tax in Pakistan for FTC?
    The average rate of tax is calculated by dividing the total tax payable by the total taxable income, and it is used to calculate the FTC on foreign income.

Conclusion

The Foreign Tax Credit under Section 103 of the Income Tax Ordinance, 2001, plays a crucial role in ensuring that taxpayers who earn foreign-sourced income are not taxed twice on the same income. By understanding the eligibility requirements, calculation methods, and conditions for claiming FTC, taxpayers can optimize their tax liability and ensure compliance with Pakistani tax laws.