Pakistani Startups’ Guide to Offshore Holding Companies
[NOTE: As of February 10, 2021, State Bank of Pakistan has changed the legal provisions discussed in this guide. The updated law can be found here. I will be publishing an updated guide soon.]
As international venture capital investment and interest is rising in Pakistan, this post aims to provide an overview of the current regulatory environment around setting up offshore holding companies.
A Pakistani tax resident cannot own shares in a company outside of Pakistan without obtaining prior approval from State Bank of Pakistan (SBP). This approval can only be given to a company incorporated in Pakistan (not an individual) to own shares in an entity abroad. Provided the said company complies with the criteria (detailed below). Individual founders cannot own shares in a holding company abroad if they are tax residents of Pakistan.
The requirement to obtain SBP approval before owning shares in an entity abroad is due to a Federal Govt policy which has been encapsulated in the nearly two decade old FE Circular No.12 dated 01 September 2001 replicated in Paragraph 13, Chapter XX of the Foreign Exchange Manual. The restriction is on “residents of Pakistan” from making “equity based investment” in companies outside of Pakistan, without the prior approval of the SBP.
Note: I have used quotations marks for terms that have been directly replicated from the relevant laws and are not defined.
The applicant needs to satisfy the following requirements to get an approval to own shares in an entity abroad:
1. be a company incorporated in Pakistan.
2. only make investments (own shares) in a foreign company that is conducting a similar business activity that is already being pursued by the applicant.
3. be “financially sound” as per its audited financial statements of the last 3 years (1 year if the Investor is an “IT company”).
4. Ensure that “the proposal should be economically viable as evidenced from a feasibility report. It should have the potential for future earnings of foreign exchange coupled with other advantages to the country such as employment opportunities for Pakistani nationals and improvement in national human resources.”
5. the funds for the investment (acquisition of shares) must be “legitimate” and tax paid, and the applicant must have a “clean record of loan repayment”.
To meet the above criteria, even if an individual founder sets up a fully owned Pakistani company with the intent to hold shares in the entity abroad, it is still highly unlikely to meet the remaining criteria since this company would be new and will not have any track record of being “financially sound” or have conducted any business activity.
It is important to highlight the exception to the above:
“Small investments by individuals in a few shares of listed companies abroad including participation by Pakistani employees of subsidiaries of foreign companies in Pakistan in their share option plans would, however, be permitted without the detailed scrutiny outlined above.”
What is an offshore holding company (HoldCo)?
The term ‘offshore holding company’, in this context, is used for an entity outside of Pakistan that fully owns operating companies (OpCo) in each country where the business operates. The HoldCo is owned by the founders and investors.
Why are HoldCo’s required?
HoldCo’s are primarily set up because most prospective international investors have comfort investing in specific countries. Institutional investors are typically constrained by a limited mandate which does not allow direct investments in certain countries.
Further, HoldCos are required if the business operates in multiple countries / markets. In such situations, it is a necessity to have the HoldCo in a country which does not have a restrictive capital control regime. It allows the HoldCo to quickly establish OpCos — and transfer funds between them — in different countries without having to obtain prior approvals. This enables rapid growth and expansion.
Who is a “resident of Pakistan”?
SBP interprets the term as a tax resident of Pakistan. A person is resident in Pakistan for income tax purposes:
- if the individual is present in Pakistan for a period - or multiple periods - aggregating to 183 days or more in a tax year (between 1 July through 30 June) irrespective of their nationality; or
- if the individual is present in Pakistan for an aggregate period of 120 days in any one tax year and in the preceding four tax years the aggregate stay is 365 days or more, or
- in cases where one is an employee of the federal government of Pakistan or a provincial government posted outside Pakistan during the tax year.
Equity acquired in an entity outside of Pakistan by an individual while she/he was not a tax resident of Pakistan is not subject to these restrictions even if the said individual later becomes a tax resident of Pakistan.
What does it mean to make an “equity based investment”?
This is the most confusing part of the law. Even though the law clearly uses the words “investment” and “investor”, it has been interpreted by the SBP to include shares given to founders without any monetary / cash consideration being paid by them.
Distinction needs to be made between situations where no funds are being sent from Pakistan to acquire equity in a company outside of Pakistan, and where funds are being sent from Pakistan. The former (sweat equity: no funds leaving Pakistan) should be subject to a reporting requirement only, whereas the latter (funds sent from Pakistan to acquire shares) should be subject to an approval under the current regime.
Why should the Govt of Pakistan allow resident founders to set up businesses outside of Pakistan?
The most obvious benefit to Pakistan is the foreign direct investment. Even if the investment is being made at the HoldCo level, the money is then brought into Pakistan and is used to operate and grow the business. This involves hiring and nurturing talent (job creation) and creating opportunities for local vendors (increase in business activity). For example, Uber and Careem invested/spent hundreds of millions of dollars in Pakistan to grow their business.
More importantly, why should residents of Pakistan be restricted from owning shares in entities abroad? Nonresidents of Pakistan (even if they are Pakistan nationals) do not have any such restriction. If we continue to penalize and restrict Pakistan tax residents, why would any capable founder move to Pakistan instead of staying abroad? Discriminatory policies such as these will not help reverse the brain drain which Pakistan desperately needs.
Any concerns around tax evasion on income being made abroad by Pakistani residents can be allayed by introducing a tax regime that works in conjunction with reporting requirements on the HoldCo by virtue of its shareholding in the OpCo. Any dividends and profits made by the Pakistani OpCo will be taxed in Pakistan.
I would be amiss if I did not acknowledge that SBP faces a challenging task of regulating foreign exchange given Pakistan’s current economic climate. Policy will have to regulate for legitimate concerns regarding outflows. However, it is imperative that such regulation is not at the expense of progress. Given the available talent and a large market, Pakistani startups are in a unique position to expand across markets in the MENA region. This presents a huge opportunity for Pakistani founders who are currently restricted from unlocking substantial amounts of capital from some of the best institutional investors across the globe.
Why can’t we just relax the criteria and make the SBP approval process easier?
Hypergrowth businesses need to move fast. A mandatory regulatory approval adds considerable uncertainty to transactions. It would make investments conditional upon such approvals which could be delayed due to various unforeseen circumstances. In any event, these applications need to be routed through banks since SBP does not deal with applicants directly. More on this here:
DISCLAIMER: All views expressed are my own and do not necessarily represent the organizations or institutions that I am associated with. This guide is not intended to be a substitute for formal legal advice. The information in this guide is updated as of 12 July 2020. There are many factors that need to be considered when setting up a holding company and would require legal advice in the relevant jurisdictions.