Transfer Pricing & Thin Capitalization In Pakistan: Section 108 FBR Guide

A complete guide to Transfer Pricing and Thin Capitalization rules under the Income Tax Ordinance 2001. How multinational corporations in Pakistan must maintain Arm's Length transactions.

By Syed Asad Hussain Zaidi · 10 September 2026

Corporate Tax Engineering and the FBR For multinational enterprises (MNEs) and large corporate groups operating in Pakistan, inter-company transactions are standard business practice. A parent company in the UK might supply raw materials to its Pakistani subsidiary, or a holding company in the UAE might provide management services to its Lahore branch. However, these transactions pose a significant risk to the Federal Board of Revenue (FBR): profit shifting. If a foreign parent overcharges its Pakistani subsidiary for raw materials, the subsidiary's profits are artificially reduced, resulting in less corporate tax paid in Pakistan. To combat this, Pakistan enforces strict Transfer Pricing and Thin Capitalization rules under the Income Tax Ordinance 2001. This guide breaks down how these rules work for Tax Year 2026-27 and how corporations must maintain compliance. --- The Arm's Length Principle (Section 108) The cornerstone of Pakistan’s transfer pricing regime is the Arm's Length Principle, codified in Section 108 of the Income Tax Ordinance 2001. The law mandates that any transaction between "associates" (related parties, such as a parent and subsidiary, or two companies sharing the same directors) must be priced exactly as it would be if the two companies were completely independent entities negotiating in a competitive open market. The Commissioner's Powers If the Commissioner of Inland Revenue suspects that an inter-company transaction was not conducted at arm's length, they possess the statutory authority to re-allocate, apportion, or re-calculate the income, deductions, or tax credits of the transaction to reflect the true market reality. For example, if a Pakistani tech subsidiary pays $500,000 to its US parent for "software licensing," but the open market rate for such a license is only $100,000, the Commissioner will disallow $400,000 of the deduction, adding it back to the Pakistani company's taxable income and imposing a 29% corporate tax on it. --- Authorized Transfer Pricing Methods The FBR does not arbitrarily decide what the "arm's length" price should be. The Income Tax Rules 2002 explicitly prescribe specific methodologies that taxpayers and auditors must use to benchmark transactions: Comparable Uncontrolled Price (CUP) Method: The most direct method. It compares the price charged in the controlled transaction to the price charged in a comparable uncontrolled transaction (e.g., selling the exact same widget to an independent third party). Resale Price Method: Evaluates the price at which a product purchased from an associate is resold to an independent enterprise. The gross margin is compared to margins earned in comparable uncontrolled transactions. Cost Plus Method: Focuses on the supplier. It adds an appropriate gross profit markup to the costs incurred by the supplier of property or services in a controlled transaction. Profit Split Method: Used for highly integrated operations where individual transactions cannot be evaluated separately. The combined operating profit is split between the associates based on their relative economic contributions. Transactional Net Margin Method (TNMM): Examines the net profit margin relative to an appropriate base (e.g., costs, sales, assets) that a taxpayer realizes from a controlled transaction. [!IMPORTANT] The taxpayer must select the "most appropriate method" based on the nature of the transaction and the availability of reliable comparable data. --- Thin Capitalization Rules (Section 106) While Transfer Pricing deals with the price of goods and services, Thin Capitalization deals with debt. Multinational groups often prefer to finance their Pakistani subsidiaries through loans rather than equity. Why? Because interest payments on loans are tax-deductible business expenses, whereas dividend payments on equity are not. By overloading the Pakistani subsidiary with debt from the foreign parent (thinly capitalizing it), the subsidiary can wipe out its taxable profit by paying massive interest payments back to the parent. The 3:1 Debt-to-Equity Ratio Section 106 of the Income Tax Ordinance specifically curtails this practice for foreign-controlled resident companies (where 50% or more of the shares are held by a non-resident). If the ratio of the company's foreign debt to foreign equity exceeds 3 to 1 at any time during the tax year, the interest paid on the portion of the debt that exceeds the 3:1 ratio is disallowed as a tax deduction. For example, if a company has 100 million PKR in foreign equity, it can have up to 300 million PKR in foreign debt. If it takes a 400 million PKR loan from its parent, the interest paid on the "excess" 100 million PKR will be disallowed, and the company will be taxed on that amount. --- Master File and Local File Documentation Following the OECD's Base Erosion and Profit Shifting (BEPS) Action 13, Pakistan introduced stringent documentation requirements under Section 108 and Chapter VIA of the Income Tax Rules. Multinational enterprises operating in Pakistan must maintain and furnish: Master File: Providing a high-level overview of the MNE group's global business operations and transfer pricing policies. Required if the constituent entity’s turnover exceeds PKR 100 million. Local File: Detailed transactional transfer pricing documentation specific to the Pakistani entity, proving that the local transactions adhere to the arm's length principle. Required if the total value of related-party transactions exceeds PKR 50 million. Country-by-Country (CbC) Report: Required for massive MNEs (global consolidated revenue exceeding 750 million Euros). It details revenue, profit, taxes paid, and employee counts across every jurisdiction the MNE operates in. --- Frequently Asked Questions (FAQs) Do transfer pricing rules apply to domestic Pakistani companies? Yes. Section 108 applies to "any transaction between associates." If two sister companies in Lahore transact with each other, they must still use arm's length pricing, especially if one company enjoys a tax holiday or is in a different tax bracket. What happens if I don't maintain a Local File? Failure to maintain or furnish transfer pricing documentation upon request by the Commissioner results in severe penalties: 1% of the value of the transaction to which the document relates. Are royalty payments subject to transfer pricing? Absolutely. The payment of royalties for trademarks, patents, or know-how to a foreign parent is heavily scrutinized by the FBR to ensure the royalty rate matches global open-market benchmarks. What is a secondary adjustment? If the FBR disallows an expense under transfer pricing, they not only tax the amount but may also treat the disallowed amount as a "dividend" paid to the foreign parent, subjecting it to further dividend withholding tax.