Everyone was eagerly awaiting this year's Budget 2025-26, which was presented on the 10th of June. Rather than focusing on the usual discussions surrounding pensions, government employees' salaries, the Public Sector Development Programme (PSDP), or allocations for education and health, this article aims to shed light on a less discussed but highly relevant aspect: taxation policies concerning international investors, both those currently operating in Pakistan and those considering entering the market. This shift in focus is important because the current budget includes some promising announcements that, in our view, serve the national interest. However, the real questions remain: when will these promises be implemented, and when will they become reality?
Since independence, Pakistan has introduced numerous tax regimes, many of which remain in place. Yet the aims behind these regimes have not been fully achieved. Now, I would like to steer the discussion toward my main topic. Historically, Pakistan began signing international investment agreements in the 1950s. The first such agreement was signed with Germany in 1956, followed by treaties with the United States, the United Kingdom, and others. Today, Pakistan has signed a total of 68 Double Taxation Agreements (DTAs) with various foreign countries. These agreements, initiated under frameworks provided by organisations such as the Organisation for Economic Co-operation and Development (OECD) and the United Nations (UN), often come with conditions that typically include reduced tax rates, tax holidays, and other incentives for foreign investors.
Treaties often lock in fixed tax rates on royalties, dividends, and interest payments, with rates varying from one partner country to another. For instance, the Pakistan-US tax treaty is based on an outdated currency system where 1 anna = 1/16 of a rupee
When we analyse these arrangements from an economist's perspective and review the relevant literature, it becomes evident that such treaties have led to significant revenue losses for Pakistan. Despite their intent to attract investment, the fiscal costs have outweighed the benefits in many cases.
In this context, the recent budget deserves appreciation as it appears to serve the national interest. One notable announcement was the introduction of the "Digital Presence Proceed Tax Act, 2025". This legislation aims to close long-standing loopholes. Currently, if a foreign business operates in Pakistan without a permanent establishment and there is no applicable tax or investment treaty, that business's income is not taxed - even if it sells goods and services through digital platforms. This gap has allowed many companies to avoid taxation, contributing to an expanding tax gap.
To address this issue, Pakistan intends to introduce a Digital Tax Service, similar to measures already implemented in several other countries. Under the new law, income earned through digital means within Pakistan's jurisdiction will be taxed, regardless of the physical presence of the company. This represents a significant step forward and, in our view, a more effective policy measure than continuing to rely on traditional investment treaties.
These treaties often lock in fixed tax rates on royalties, dividends, and interest payments, with rates varying from one partner country to another. For instance, the Pakistan-US tax treaty is based on an outdated currency system where 1 anna = 1/16 of a rupee. Additionally, royalties and interest payments are often fully exempt under these agreements, making them highly unfavourable for Pakistan's revenue interests. All these factors demonstrate that the treaties are not beneficial for the country. In fact, such treaties have arguably contributed to capital flight from Pakistan and have also facilitated illegal activities such as round-tripping, where domestic investors move their capital abroad via shell companies only to reinvest it in Pakistan as foreign investment to exploit the tax benefits meant for genuine foreign investors. A study conducted in Pakistan by Dr. Zafar Mahmood found that between 1972 and 2013, reverse capital flight amounted to about $30 billion.
In response to increasing concerns about tax avoidance by multinational corporations, the OECD and G20 launched the Base Erosion and Profit Shifting (BEPS) initiative, comprising 15 action plans. Pakistan joined the inclusive framework of BEPS and has committed to implementing four minimum standards, including preventing treaty abuse (e.g., treaty shopping), improving dispute resolution under tax treaties, and creating the Multilateral Instrument (MLI) itself. Many developing countries, including Pakistan, have experienced capital flight and tax base erosion due to treaty shopping by multinational enterprises. To counter this issue, Pakistan adopted key provisions under the OECD BEPS framework and became a signatory to the MLI. While these reforms serve as policy interventions to analyse shifts in tax revenue or foreign direct investment (FDI) patterns, the tax gap continues to rise.
The Digital Presence Tax Act, 2025 reflects a progressive shift in Pakistan's tax policy, aligning it with the realities of a rapidly evolving global digital economy. It sends a clear message that Pakistan is ready to adopt and modernise its fiscal framework, ensuring that all economic activities within its jurisdiction - whether physical or digital - contribute fairly to the national exchequer. This move is likely not only to increase tax collection but also to create a level playing field for local businesses that have long operated at a disadvantage compared to tax-exempt digital giants.
Overall, Budget 2025-26 demonstrates a much-needed awareness of the loopholes embedded in outdated international agreements and shows a willingness to adopt targeted and enforceable reforms. While challenges in implementation remain, this policy direction is commendable. If executed effectively, it will strengthen the country's fiscal base, reduce illicit capital flows, and boost investment confidence in a more transparent and equitable system. It is now up to the authorities to translate this vision into action and ensure that promises made on paper become realities on the ground.