By Eashal Najeeb
What is tax arbitrage?
Tax arbitrage is the practice of exploiting differences in how the tax system treats economically similar income, entities, or transactions, so as to convert a higher-taxed flow into a lower-taxed one without changing the underlying economic substance. It is, in essence, a legal sleight of hand: the taxpayer does not hide income but reclassifies or reroutes it through a more favourably taxed channel.
The arbitrage may arise from differences across several dimensions:
• Rate differentials — the same income taxed at different rates depending on its label (for example, “dividend” versus “interest”).
• Entity differentials — income routed through a vehicle taxed more lightly than the beneficial owner would be directly.
• Timing differentials — deferring recognition of income, or accelerating deductions, to reduce present-value tax.
• Jurisdictional differentials — shifting income to a lower-tax territory.
Common examples include borrowing to invest where interest is deductible but the return is taxed concessionally; routing salary through a corporate structure to access a lower corporate rate; or, as discussed below, channelling what is economically interest income through a vehicle that has it taxed as dividend income.
The defining feature is that the form of the transaction diverges from its substance, and the tax system rewards the form. Pakistan’s elite has proven adept at this. Almost every concession written into law with a legitimate policy purpose is, in time, repurposed by the wealthy as an instrument of avoidance. The growth of the mutual fund industry is a textbook illustration.
What mutual funds are meant to do
The mutual fund is, in principle, a benign and useful institution. It pools the savings of many small investors, places them under professional management, and gives ordinary savers access to diversified portfolios and capital markets they could not reach individually. A healthy mutual fund industry is meant to deepen the capital market, channel household savings into productive equity, and democratise access to professional investment advice.
In Pakistan, this purpose has been largely defeated. The industry has grown spectacularly, but not as a conduit of small-saver participation in the equity market. It has grown as a vehicle of tax arbitrage for corporations and high-net-worth individuals.
Pass-through status and the rate differential
To understand the arbitrage, one must first understand the concept of a pass-through entity.
A pass-through (or “flow-through”) entity is one that is not itself taxed on its income. Instead, the income “passes through” the entity and is taxed only in the hands of the ultimate investors who receive it. The entity is treated as a conduit rather than a taxpayer in its own right, which avoids the double taxation that would otherwise occur if both the fund and the investor were taxed on the same income. Partnerships, trusts, and collective investment schemes are commonly granted this treatment worldwide; in Pakistan, mutual funds enjoy it provided they distribute the bulk of their income to unit-holders.
The arbitrage opportunity arose from the interaction of two features of the law:
1. Mutual funds, as pass-through entities, bear no tax at the fund level.
2. Distributions to unit-holders were taxed as dividend income at a concessional rate of 15 percent, well below the rates applicable to interest income earned directly by individuals and corporations.
The consequence was straightforward. An individual or corporate investor placing money directly in a bank deposit or government security earned interest taxed at the higher ordinary rates. The same investor, placing the same money into a money market mutual fund that in turn bought the same government securities and bank deposits, earned a return that emerged as “dividend” taxed at only 15 percent. The economic substance — lending to the government and to banks at the prevailing interest rate — was identical. Only the label, and therefore the tax, had changed.
How the industry monetised the gap
The mutual funds did not merely permit this arbitrage; they marketed it. Money market and income funds were actively sold to corporates and wealthy individuals precisely as tax-efficient parking grounds for cash, with the fund acting as little more than an agent interposed between the investor and the government securities desk. In doing so, the industry abandoned its founding rationale twice over. It ceased to be a meaningful supporter of the capital market, because it was not channelling savings into equity. And it ceased to be a vehicle for the small investor, because its real clientele was the corporate treasurer and the high-net-worth individual seeking a 15 percent rate on what was, in truth, interest.
The funds had, in effect, offered themselves as vassals for tax avoidance.
The first corrective step
The Tax Policy Office eventually recognised the mischief and acted. The rate of tax on dividend income from mutual funds was increased where that “dividend” in fact represented interest income — that is, where the fund derived its returns predominantly from debt and money market instruments rather than from equities. The intent was to align the tax on the substance (interest) with the tax on the form (dividend), and so close the rate differential that drove the arbitrage.
The migration into insurance wrappers
Capital, however, flows to the path of least resistance, and the closing of one channel has opened another.
Under Pakistan’s income tax law, the proceeds and benefits received under a life insurance policy are exempt from tax. This exemption exists for a sound reason: to encourage genuine life cover and long-term family protection. It is now being abused.
Certain mutual funds, acting in concert with a number of insurance companies, have begun placing the funds of high-net-worth individuals into what are presented as life insurance policies but are, in economic reality, investments in mutual funds. The insurance “wrapper” is a formality; the substance is portfolio investment, much of it in the same money market and government securities as before. The investor thereby converts taxable investment income into tax-free insurance proceeds. The arbitrage has simply migrated from the dividend label to the insurance label.
This practice is now widespread across both the insurance and mutual fund industries. It once again defeats the very purpose of the mutual fund as an institution. The troubling feature is the silence around it: neither the regulators nor the industry associations — neither the mutual fund body nor the insurance association — have raised any concern. The result is that corporates and wealthy individuals are once more receiving, tax-free, what is effectively interest income from the money market.
The scale of the growth
The phenomenal expansion of the industry is itself evidence that something other than ordinary capital-market development is at work. Mutual funds do not grow nearly sevenfold in a few years on the strength of small-saver equity participation alone.
The figures are striking. The size of Pakistan’s mutual fund sector surged almost seven times over six years, with assets under management rising from Rs578 billion in 2019 to Rs3.93 trillion by June 2025. The trajectory was not even smooth: mutual fund deposits jumped from Rs2.70 trillion in June 2024 to Rs4.43 trillion in December 2024, then fell by over Rs500 billion to Rs3.93 trillion by June 2025. Tellingly, a senior SECP official attributed that swing to the federal government’s incremental tax of up to 16 percent on banks with an advance-to-deposit ratio below 50 percent as of 31 December 2024 — in other words, the surge and the reversal both tracked a tax incentive, not investment fundamentals. By December 2025, the industry had resumed its climb, with total assets under management posting 11 percent year-on-year growth and having roughly tripled over three years.
The composition is the indictment
If the scale is striking, the composition is damning. An industry that existed to deepen the equity market has done almost the opposite.
Around half of the industry’s total assets are invested in money market instruments, while only 14 percent is allocated to equities — a profile reflecting a strong preference for liquidity and fixed-income returns rather than long-term participation in the stock market. Looking at the underlying allocation, the most recent breakdown shows asset management companies placing about 45 percent of capital into government securities, 29 percent into banks and development finance institutions, 11 percent into equity, and the remainder elsewhere; and money market funds remained the dominant category at Rs1.77 trillion, with income funds at Rs917 billion and equity funds at only Rs392 billion.
Once government securities held directly are combined with the sovereign paper held indirectly through money market and income funds, the industry’s effective exposure to government borrowing rises well above these headline figures — on a fully consolidated view, the overwhelming majority of assets ultimately finance the government. This is the heart of the matter. A sector meant to fund private enterprise through the equity market has instead become a tax-advantaged lending desk for the state. It is at once absurd and alarming.
The reckoning, and whose fault it would be
The danger is that when the regulators finally awaken, they will overreact, and their corrective measures will be crude and knee-jerk rather than surgical.
Two such reactions are foreseeable, and both would be destructive:
Withdrawal of the funds’ tax exemption. If pass-through status were revoked and mutual funds taxed at the entity level, the central attraction of the vehicle would vanish. The arbitrage would die, but so would the industry; it could not survive the loss of its tax advantage. That outcome, however, would be of the industry’s own making. By converting a capital-market institution into an arbitrage instrument, it would have invited the very measure that destroys it.
Taxing insurance proceeds. Equally, the authorities might respond to the insurance-wrapper abuse by taxing the receipts of life insurance policies. This would be disastrous for the insurance sector, penalising genuine policyholders alongside the arbitrageurs and undermining the legitimate incentive to insure. Yet here too, the insurance industry would have brought the calamity upon itself by lending its tax-exempt status to a scheme of avoidance.
In both cases the lesson is the same. A tax concession is a public trust, granted for a public purpose. When an industry hollows out that purpose and treats the concession purely as an arbitrage opportunity, it forfeits the moral and political claim to keep it. The eventual withdrawal, however clumsy, will not be an injustice done to the industry. It will be the industry’s own calling.
(Miss Eashal Najeeb is a knowledge seeker and researcher affiliated with the University of Durham, UK. Email: [email protected])
Disclaimer: The opinion expressed in this article solely reflects the author’s views. PkRevenue does not assume any responsibility for the author’s thoughts, interpretations, or opinions.
