The Republic of Iraq is slowly attracting more overseas investors who are looking to capitalize on the undoubted potential of this country. Foreign establishments carrying on business in the Republic of Iraq should carefully analyze whether their activity can potentially open the gate for Iraqi tax authorities to tax their income generated from the said activity in Iraq.
In the below article we provide a brief analysis of the main events that can lead to creation of the “permanent establishment” in Iraq.
1. General Remarks
Under the international tax doctrine, income can be subject to tax in the following countries:
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- Country of residence of a Taxpayer, or
- Country of the source of income.
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In certain business scenarios, where the country of source and country of residence claim the right to tax the same income, a risk of double taxation may occur. To prevent those situations, countries sign tax treaties describing which country should have the right to tax the income (or capital) in the given circumstances.
Also, a Taxpayer may have tax residency in more than one jurisdiction by creating a Permanent Establishment in the other country. The idea of the Permanent Establishment is used in tax legislation worldwide to identify whether a local presence of the foreign enterprise created sufficient substance in another country (country of the source) that profits generated by such presence should be taxed in that other country.
Typically, the existence of the Permanent Establishment imposes certain tax-related obligations in the country where the Permanent Establishment occurred. That includes, but is not limited to:
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- Registration for corporate tax purposes.
- Preparation and submission of periodical corporate tax returns and payment of local corporate tax on the generated income.
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The criteria for Permanent Establishment’s existence in contracting states are prescribed in tax treaties and in local legislation.
2. Iraqi Income Tax Law and a Permanent Establishment
The main legal act that regulates income tax in the Republic of Iraq is the Income Tax Law No. 113 of 1982 as amended by the CPA[1] Orders No. 37, 49, and 84 (further as the “ITL”).
Firstly, it should be emphasized that ITL does not contain a clear provision indicating the circumstances under which the Permanent Establishment will be created in Iraq. Instead, the PE construct (or taxing a non-resident) is scattered around in various articles.
According to Article 1 of the ITL, a legal person, incorporated under the Iraqi laws is considered a tax resident in Iraq. Similarly, companies that are established outside of Iraq, but have a place of management and control in Iraq are also considered tax residents.
On the other hand, non-residents, are defined as anyone who does not qualify to be a tax resident but has an income for which Iraq is the country of source. Under Article 5(2) of the ITL, a non-resident is subject to tax in Iraq, if the income arose in Iraq, even if it was technically received outside of the State.
Paragraph 3, Section 3 of the CPA Order No. 49 indicated that Iraqi lawmaker recognizes a Permanent Establishment concept since the abovementioned provision stipulates: Foreign companies that are registered in Iraq or otherwise have a permanent establishment in Iraq will be subject to tax at a fixed rate of 15% on their income in Iraq.
The usage of the “permanent establishment” term in this regulation is problematic since no other provisions use such a term, hence permanent establishment remains undefined despite being used in the aforementioned paragraph. Therefore, to maintain the completeness of the Iraqi income tax system, it appears that the term “permanent establishment” should be treated as similar to non-resident for tax purposes, which is defined in the ITL. In conclusion, non-residents that are subject to tax in Iraq shall be subject to tax at a rate of 15% on their income that can be attributable to their activity in Iraq.
Article 21(1) of the ITL provides some guidance on what sort of activity of a non-resident can result in being subject to tax assessment in Iraq. According to this provision, Iraqi tax authorities can issue a tax assessment to a non-resident if he receives any income arising in Iraq through, i.e.:
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- Factorship;
- Agency;
- Branch.
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Furthermore, clause 2 of this Article indicates that if there is a “special connection” between a non-resident and a resident allowing the non-resident substantial control over the resident, and due to this special connection, the resident is reporting lower income than it could, a non-resident may be subject to a tax assessment. In other words, Article 21(2) of the ITL hinted at the existence of transfer pricing regulations in the abovementioned scenario.
The ITL indicates that it is the role of the tax authorities to differentiate tax consequences for non-residents from trading “in Iraq” and “with Iraq” (Article 21(7) of the ITL). Whereas the former results in activity being subject to tax in Iraq, the latter does not.
Iraqi Ministry of Finance issued Instructions No. 2/2008, subsequently amended by Instruction No. 1/2014 (effective from 1st January 2015) (further as the “Instruction 1/2014”) that provides some insight on what type of activity is considered by authorities as conducted “in Iraq” (taxable) and “with Iraq” (not taxable).
Article 1 of Instruction 1/2014 stipulates that trading “in Iraq” should cover the following activities:
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- Having a branch or office in Iraq by a non-resident and a contract concluded by the said branch or office or representative or branch/office employees.
- Authorizing an Iraqi resident by a non-resident foreign supplier to sign and perform the contract on behalf of the non-resident – in this situation both parties are taxable – the resident on its commission and the non-resident on the profit generated from the contract. Such contract will be taxable in Iraq for non-residents, if:
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- It relates to clearance of shipping lists, customs dues, charges of letters of credit and its procedures in Iraq (even if the non-resident has no branch or office in Iraq).
- The contract value has been paid, wholly or partly inside Iraq in any currency.
- If the foreign supplier has been paid by barter method.
- Relates to installation or supervision of maintenance or engineering works if the activity is performed inside Iraq by a non-resident.
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On the contrary, the following activities conducted by a foreign supplier are considered as trading “with Iraq” and thus not subject to income tax in Iraq (Article 2 of Instruction 1/2014):
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- Foreign supplier residing outside Iraq and signature and conclusion of the contract takes place outside of Iraq in the name of Iraqi entity if the contract pertains to opening credit and clearance of shipment lists (or related procedures);
- If a non-resident has a branch or office in Iraq but the contract has been concluded outside Iraq and the said branch or office did not participate in the conclusion or execution of the contract. However, if the commissions are due to the branch or office as the result of the conclusion of the contract, this income should be taxable in Iraq;
- If the actual services like supervision on shipping, equipment testing or consultancy services were rendered for the beneficiary outside Iraq.
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3. Taxation of non-residents in the Kurdistan Region (KRI)
It has to be noted that the Kurdistan Region as an autonomous administrative entity within the Republic of Iraq has the right to introduce its regulations related to tax, which can differ from the ones binding in the rest of Iraqi territory.
In 2022, the Ministry of Finance and Economy in the Kurdistan Regional Government introduced a new tax instruction 7/2022 which organizes the tax on non-resident companies and individuals, which came into force in 2022 (further as the “Instruction 7/2022”).
Instruction 7/2022 imposes a tax on Iraqi entities engaging with non-resident companies, Iraqi individuals engaging with non-resident individuals, and the participation of the branch on the parent company cost.
The Instruction covers, in addition to taxing on the non-resident private sector, all the contracts between the government and third parties, be it a company or individual.
The non-resident tax is imposed on companies or individuals in certain cases. An example is when a non-resident company signs or implements an agreement through its branch, local representative, or employee. The branch is then subject to tax on the business conducted by the parent company.
The way the tax is imposed is as follows:
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- First: The contractor must withhold 10% from the total contract value to be paid to the tax office. The amount is released when the subcontractor acquires a tax clearance letter for the contract in question;
- Second: The tax office assumes a certain percentage of profit from the total amount of the contract. For example, in a marketing contract, the profit is set to 40% of the total contract value;
- Third: From the anticipated profit, 15% is subject to income tax. In the marketing example, 15% is paid from the 40% anticipated profit.
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4. Permanent Establishment in the OECD Model Convention – introduction
Based on Article 5 of the OECD Model Convention[2], the Permanent Establishment means “a fixed place of business through which the business of an enterprise is wholly or partly carried on”.
The above means that the enterprise needs to have a sufficient presence in the country other than the residence (“a fixed place of business”) with enough human and technological resources allowing the enterprise to “wholly or partly” carry out the business in the hosting country. Further, the OECD Model Convention contains examples of what type of activity should constitute a permanent establishment and what should not.
It needs to be emphasized that the OECD Model Convention plays the role of a template in shaping tax treaties between contracting States and the text of the final tax treaty concluded between countries is binding to determine the existence of Permanent Establishment.
5. Example of Permanent Establishment in Double Tax Treaties concluded by Iraq
Recently, the Republic of Iraq concluded several double tax treaties, inter alia with the Netherlands, the United Arab Emirates, Pakistan, Cyprus, and Hungary to name a few. The network of tax treaties concluded and binding for Iraqi tax authorities is systematically growing.
One of the analyzed tax treaties – the one concluded with the United Arab Emirates and published as Law No. 10/2019[3] contains Article 6 provision pertaining to permanent establishment. The definition of a permanent establishment in the treaty is heavily inspired by a tax treaty, however, certain deviations can be identified.
Mainly, the treaty introduces the concept of service PE, where performing services in the territory of the country of source (other than the country of residence/registration) for more than six months within 12 months, whereas this concept is not expressed in the OECD Model Convention.
Furthermore, the treaty between the UAE and Iraq shortened the period (when compared to the OECD Model Convention) during which the construction site did not create a permanent establishment. The Model Convention indicates that a site that lasts more than 12 months creates a PE, whereas the UAE-Iraq treaty indicates that a construction site will create a PE when the site lasts for more than six months within 12 months.
The introduction of service PE in the treaty that is not present in the UAE corporate tax legislation indicates the will for the Iraqi tax authorities to expand its taxing right to foreign entities deriving income from services in Iraq.
6. Conclusions
There are no clear provisions indicating what type of activity will result in the creation of a permanent establishment in Iraq for a foreign entity. Hence, the General Commission for Taxes (GCT), the Iraqi tax administration has a certain level of discretion in trying to impose a tax on foreign entities.
Iraqi tax legislation contains a list of activities that can lead to being subject to tax in the State, however, GCT always reserves the right to issue an assessment, for example by invoking Article 21(3) of the ITL. The trigger allowing the GCT to issue an assessment is rather subjective (“where it appears to the Financial Authority that the actual amount of profits of a non-resident subject to tax in the name of a resident cannot easily be determined…”), which can be exploited by the GCT.
Therefore, it is important for foreign entities willing or already operating in Iraq to familiarize themselves with Iraqi income tax regulations to assess what type of activity can result in being subject to Iraqi tax and seek advice from legal and tax experts.
Since majority of triggers opening the door for being taxed in Iraq for foreign entities can be derived from the contract, it is important to engage tax and legal experts at the earliest possible stage, i.e. when the contract is negotiated as certain clauses may help to mitigate the risk for foreign business of being taxed in Iraq.
If you would like more information about this topic then please contact us.
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PARTNER
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PARTNER
BAGHDAD | MENA Associates in association with Amereller | Princess Street 7 (Near German Embassy) District 609, Villa 3A| Baghdad | Iraq | T +964 780 000 3232
BASRA | MENA Associates in association with Amereller | Sayid Ameen Street | Bradeya | Basra | Iraq | T +964 780 000 8383
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ERBIL | MENA Associates in association with Amereller | Golan Street, World Trade Center, 10th Floor | Erbil | Kurdistan Region of Iraq | T +964 750 346 0444
RAS AL KHAIMAH | AMERELLER TAX Consultancy FZ-LLC | Ras Al Khaimah Economic Zone | P.O. Box 16462 | Ras Al Khaimah, United Arab Emirates | T +971 7 204 6255
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