We already had Digital Service Taxes
Prior to the amendments introduced by the Finance Act, 2079 to the Income Tax Act, 2058 and the VAT Act, 2052, Nepal did not have the concept of Digital Service Taxes.
In my other not-so-recent post on Direct and Indirect Tax on Digital Services we discussed how Nepal still lacks the provisions for a “Digital Permanent Establishment” (Digital PE) as per OECD’s BEPS Action Plan 1. However, come 2079, the Finance Act, 2079 introduced a Digital Service Tax (DST) mechanism based on significant economic presence. Non-resident digital service providers were required to face a 2% tax on transactions exceeding NPR 2 million annually, alongside an indirect tax at the rate of 13% under the VAT Act, 2052. This amendment defined digital services comprehensively, encompassing various IT-driven services provided with minimal human intervention. While this regulatory framework aims to capture substantial economic activity by foreign digital giants like Facebook and Google, it does not address scenarios where these providers have local agents, potentially allowing them to circumvent higher withholding rates. We also discussed how the concept of DST could raise costs for local businesses and pose questions on compliance with international tax principles and trade obligations.
In my two recent posts – Digital Service Tax: Now its here in Nepal and DST Registration in Nepal – we elaborated on the implementation of the Digital Service Tax (DST) in Nepal, introduced under Section 20 of the Finance Act, 2079 – discussing also the meaning of digital services, international approaches to DST, administrative challenges, and specific features of Nepal’s DST laws. The new DST procedures (Income Tax and Value Added Tax) issued by the Inland Revenue Department (IRD) provide detailed guidelines on registration, tax applicability, computation, filing returns, and deregistration. Notably, the definition of “consumer” and “digital services” remains ambiguous, leading to potential confusion in tax application. The procedures also outlined sanctions for non-compliance, timelines for tax filing and payment, and specifics on composite supplies. Additionally, the article highlights unresolved issues, such as the treatment of foreign service providers with local representatives and the differentiation between direct and indirect taxes.
So that summarizes the developments up to this point – until the amendment brought in by Finance Act 2081.
But “thanks” to Finance Act 2081, we now have a Digital PE
In his recent budget speech on May 28, 2024, Finance Minister Barshaman Pun announced that the definition of a resident for income tax purposes has been amended to include economic presence, even in the absence of physical presence. This change is intended to establish a foundation to prevent the erosion of the tax base due to the increasing use of international digital platforms.
From Budget Speech 2081
कराधार र दायरा विस्तार
३३२. आयकर प्रयोजनका लागि भौतिक उपस्थिति नभएको तर आर्थिक उपस्थितिलाई समेट्ने गरी बासिन्दाको परिभाषामा परिमार्जन गरेको छु। यसबाट अन्तर्राष्ट्रिय डिजिटल प्लेटफर्मको बढ्दो प्रयोगबाट हुन सक्ने कराधारको क्षयीकरण रोक्ने आधार तयार गरिनेछ ।
An amendment to the similar effect was introduced in the Income Tax Act, 2058 as well to be effective from July 16, 2024.
Income Tax Act 2058 (Amendment by Finance Act 2081)
दफा २(कद) “स्थायी संस्थापन” भन्नाले कुनै व्यक्तिले पूर्ण वा आंशिक रूपमा व्यवसाय सञ्चालन गर्ने स्थान सम्झनु पर्छ र सो शब्दले देहायका स्थान समेतलाई जनाउँछ:-
(१) व्यवसाय सञ्चालन गर्ने सामान्य क्रममा स्वतन्त्र हैसियतले कार्य गर्ने साधारण एजेण्ट बाहेक कुनै एजेण्ट मार्फत कुनै व्यक्तिले पूर्ण वा आंशिक रूपमा व्यवसाय गर्ने स्थान,
(२) कुनै व्यक्तिको मुख्य उपकरण वा मुख्य मेशिनरी रहेको वा प्रयोग गरेको वा जडान गरेको स्थान,
(३) कुनै बाह्र महिनाको अवधिमा एकै पटक वा पटक पटक गरी नब्बे दिनभन्दा बढी कुनै व्यक्तिले कर्मचारी मार्फत वा अन्य प्रकारले प्राविधिक, व्यावसायिक वा परामर्श सेवा प्रदान गरेको कुनै देशको एक वा एकभन्दा बढी स्थान, वा
(४) कुनै व्यक्तिले नब्बे दिन वा सोभन्दा बढी समयसम्म निर्माण गर्ने, जडान गर्ने वा स्थापना गर्ने आयोजनामा संलग्न रहेको स्थान तथा सो आयोजनाको सुपरिवेक्षण सम्बन्धी क्रियाकलापहरू सञ्चालन गरेको स्थान ।
(५) नेपाल बाहिर रही नेपालमा उल्लेख्य डिजिटल उपस्थिति जनाएमा उक्त स्थान वा नेपाल बाहिर सर्भर राखी विगत बाहन महिनाको अवधिमा कम्तीमा नब्बे दिन नेपालमा तथ्याड्क वा सेवाको कारोबार गरेमा उक्त स्थान ।
But seriously, why?
So, in short, this amendment in the definition of permanent establishment introduces a new concept in tax laws called “Digital PE”.
Essentially, the definition of a Digital Permanent Establishment (PE) is as follows: it refers to the presence of a person who, while being outside Nepal, exhibits significant digital presence within Nepal. This also encompasses situations where a person maintains a server outside Nepal but engages in data or service transactions within Nepal for at least ninety days over the past twelve months.
The concept of a Digital Permanent Establishment (Digital PE) is evolving within the international tax framework, primarily driven by the OECD’s efforts to address challenges posed by the digital economy. A Digital PE generally refers to a significant economic presence in a country without a physical presence, focusing on the digital activities that generate substantial revenue in that country.
There are many approaches to tax the economically significant digital service transactions within a tax jurisdiction. Also alluded by the Tax Challenges Arising from Digitalisation –Interim Report 2018 these mechanisms includes:
- Modification in the “Exception to PE”
- Modification in the definition of “Agency PE”
- Revision in “Transfer Pricing Guidelines”
- Introduction of “Digital CFCs”
- Collection of “Indirect Taxes”
- Introduction of “Significant Economic Presence”
For more extensive discussion see my other post here: Direct and Indirect Tax on Digital Services (Some Approaches to Tax the Digital Services)
Nations such as India, the United Kingdom, France, Italy, and several others in the EU have embraced the notion of Digital Service PE for taxing economically impactful digital service transactions. Nepal, too, has adopted a similar approach, employing the “Significant Economic Presence” test since its inclusion via the Finance Act 2079 amendment. However, the recent inclusion of Digital PE in Nepal’s tax law’s list of recognized permanent establishments raises numerous questions, which we’ll delve into shortly – below.
Consequence of being a “PE” in another tax jurisdiction
More discussion on the concept of Permanent Establishment here in my other post: A Dummy’s Guide to Permanent Establishment
Naturally the transaction between associated enterprises should be made at a price determined under arm’s length principle. This is generally the minimum rule prescribed by the domestic tax laws of any country.
Not all establishments of a foreign enterprise in another tax jurisdiction qualifies for being a permanent establishment. Even then, these establishments and foreign enterprises are associated enterprises and transfer pricing guidelines apply to them. Its application will however be limited to the extent of determining the reasonableness of the value and substance of a transaction being made between an enterprise and its foreign establishment.
The real burden of having a PE in another tax jurisdiction is that the operation in the foreign establishment will be viewed as a distinct operational segment of the enterprise and the transfer pricing guideline will be applied to reasonably determine the revenues and expenses attributable to that unit. Such profits attributed to the establishment will be subject to taxation in the particular tax jurisdiction where the establishment is located. A permanent establishment (PE) also generally gives rise to income or value-added tax liability in a particular jurisdiction.
But, is Digital PE - a host of complications?
Which leads to the flurry of puzzling questions:
- Why the introduction of Digital PE in Nepal when we’ve already established a mechanism for taxing digital transactions through the “Significant Economic Presence” concept since the Finance Act 2079 amendment? Unlike several EU nations and India, who adopted the “Significant Economic Presence Test” without tweaking the PE definition, why is Nepal’s tax law taking the extra step of redefining PE to encompass Digital PE?
- The fundamental implication of being a PE is that the entity is deemed a resident for tax purposes. Given our existing provisions for Digital Service Tax (DST), will the regular tax regime applicable to a PE also apply alongside DST? Must units qualifying as Digital PE register for tax purposes in Nepal as permanent establishment and adhere to tax-related obligations just like other PE forms, especially considering the absence of any apparent exception?
- Is this Nepal’s endeavor to shift from DST, reliant on significant transaction thresholds, to another facet of Digital Service Taxation via Permanent Establishment? If so, might we anticipate amendments to the Income Tax Rule and Value Added Tax Rules to either eliminate DST provisions or marry and reconcile them with this novel Digital PE concept?
- Is it an endeavor to instead encompass those “digital PEs” that are not infact covered by the taxation principle of the Digital Service Taxes? This could be one way of looking at this new provision because the prevalent DST related provisions apply exclusively to business-to-consumer (B2C) transactions. Business-to-Business (B2B) transactions were not subject to DST, so this provision specifically could have been introduced to bring the non-resident digital service providers under the purpose of the taxation system of Nepal. Although this option seems to be the most plausible explanation, should a non-resident digital service provider be treated as a Digital PE in Nepal, what would become of its B2C transactions within Nepal? Will those be treated as a local transaction – because in other situations they would normally be treated as local transactions – and therefore not under the purview of DSTs – but under the purview of other withholding, direct and indirect tax requirements.
These questions are crucial to ponder because the rationale behind introducing Digital PE alongside existing PEs in Nepal, without amending DST provisions, remains unclear. Lets await amendments to the Income Tax Rule and Value Added Tax Rules, hoping they will address these concerns surrounding Digital PE.