What is employment / contract of service?
Tax Laws has not specifically defined the term employment. The meaning of term “Employment” for the purpose of Tax Laws is therefore derived from the Labor Laws. Employment is typically an earning activity consisting predominantly of the provision of labor by an individual which is also termed as “Contract of Service”. Unlike, business / profession (“Contract for Service”), employment doesn’t involve any capital and entrepreneurship related decisions. Another notable characteristic of the employment is that the risk and uncertainties associated with the enterprise is undertaken by the employer.
The following characteristics generally do indicate that the contract is in the nature of employment:
- Control over the work: The employee is bound to obey the instructions of the employee. Employers determine the terms of work, how and when the work should be done.
- Ownership of all the rights arising from the work created out of contract: The company is by default the owner of the work done by the employee
- Expenses incurred in doing the work: Cost associated with performance of work is borne by the Employer. Equipment required for performance of work is provided by the Employer.
- Liability: The Employer is liable under vicarious liability for any damages caused to the third party due to the actions of employees in the course of employment.
Should you be "Jon Doe"-ed into employment arrangement?
Labor laws are generally in the advantage of the laborer in Nepal. Also, employment is always a sensitive issue from the viewpoint of legislation, bureaucracy, administration and management, so it is generally more likely in Nepal, that an arrangement will be viewed in the form of “employment engagement” rather than not being so.
As per Para 2.1(aj) of Income Tax Directive 2066, the term employment has been defined in a manner to give preference to the form of the employment not just its substance, which again is a commonly accepted practice. This is because the tax and labor laws are construed in a way that any contract that has major elements of employment relation should be treated as employment as employment relationship gives tax benefits, labor benefits and overall labor law protection to the employee. This means that, to determine an employment relationship, when an arrangement is in “form” of employment, then it is already a sufficient test to determine if the arrangement is an employment relationship, without even going into the substance of the arrangement.
The para 47 of the Commentary from The Commonwealth of Symmetrica (which is a model tax law on which Nepal’s Income Tax Law is based) also states that “If a business/profession activity may also be characterized as employment, primacy is given to the characterization as employment. Also, as per para 46 of the Commentary from The Commonwealth of Symmetrica: “Employment” is the dominant definition (among employment and business/profession) and whether an employment exists is primarily determined according to general law.
From Labor Laws perspective, generally, employment means a position of an individual in the employ of another person. Labor Act, 2074 doesn’t specifically determine the term employment but in general and in most circumstances, including ones such as that the worker is paid regularly, follows set hours of work, is supplied with tools from the employer, is closely monitored by the employer, acting on behalf of the employer, they are considered an employee, and the employer will generally be liable for their actions and be obliged to give them benefits.
If anyone decides to characterize any arrangement of service not as “employment arrangement” it will not only have the withholding tax consequences on the employee but all very severe impacts on the employment area. Any treatment otherwise would lead to employees being deprived from: (1) Tax Benefits and exemption tax from compliances and filing requirements as per Tax Laws (2) Benefits available (leave, working hours, provident fund, gratuity etc.) under the Labor Laws (3) Protection available to the labors under the Labor Laws. So, in the context of Labor Laws, Income Tax Laws and commentaries from the concerned authorities, primacy will be given to characterizing a service agreement as employment agreement where any such arrangement of business/profession may also be characterized as an employment.
The Good/s the Bad/s and the Ugly/ies of being in an Employment arrangement in Nepal
I guess everyone knows the The Man with No Name Trilogy (1964 – 1966) Dollars Trilogy, also known as the Man with No Name Trilogy or the Blood Money Trilogy, an Italian film series consisting of three Spaghetti Western films directed by Sergio Leone and starring Clint Eastwood. This is an unforgettable western ride has not only given a taste of western craftmanship but also a quick way of discussing any topic in hand. Just like the main three characteristics of the movie, we will discuss here, the:
(i) “the good” of being in an employment engagement: the benefits
(ii) “the bad” of being in an employment engagement: the unintended benefits
(iii) “the ugly” of being in an employment engagement: the absolute worsts
"the good" of being in an employment engagement
Progressive Rate of Taxation
Unlike many countries around the world, the income taxes applicable on the employment income taxes in Nepal is based on the progressive rates. A certain limit of income falls under basic exemption where only a nominal 1% taxes are applied or entirely exempted. The the tax band follows slabs where incremental tax rates are applicable. This form of taxation system helps put the equity factor in the system. Wealthy people pay the higher taxes and poorer people pay the lower taxes.
Basic Exemption with/out Savings
Also like discussed above, the income tax applicable on employment income exempts a basic level of income from taxation. During the introduction of the Income Tax Act, 2058 the basic exemption limit was 65,000 NPR for Single Option and 85,000 for Couple Option. These have been revised later in almost every Fiscal Acts as an adjustment in the form of purchasing power, inflation rates and basic expenses level of a median household in Nepal. The exemption limit can be further extended to another 300,000 or 500,000 depending on whether or not you are the participant of the SSF and making savings of such amount to the approved retirement fund. However, deduction of such savings to the approved retirement fund is limited to one third of the total taxable income. A graphical study of the benefit that can be enjoyed at various income level has been discussed in the charts below.
The employment income derived by an individual can be reduced under criteria as below. Amount that can be reduced from taxable income by individuals in Nepal are as follows:
Eligible by Resident / Non-Resident Individual?
Amount of Reduction
Donation Reduction u/s 12
Donation Reduction u/s 12Kha
Retirement Contribution Reduction u/s 63(2)
Applicable to any person (including participants of SSF)
Applicable to participants of SSF
Remote Areas Reduction u/sch 1(1)(5)
Amount up to Rs 50,000 based upon the classification of the remote area
Foreign Allowance Reduction u/sch 1(1)(6)
75% of the foreign allowances
Pension Income Reduction u/sch 1(1)(9)
Handicapped Reduction u/sch 1(1)(10)
50% of First Slab of Tax Banding
Investment Insurance Reduction u/sch 1(1)(12)
Health Insurance Reduction u/sch 1(1)(12)
Contribution to Startup Business as per Section 12Ga
A person provides seed capital up to rupees one lakh to maximum of 5 Startup Businesses and such startup business is not a related party
Private Residence Insurance Premium Reduction
Any resident natural person insures the private building in his/her ownership from resident insurance company
More on this on my other blog: Dependent Personal Services: Tax & DTAA Outlook
"the bad" of being in an employment engagement
Characterized Income Benefits
It is a general rule that the concept of cost characterizations under Income Tax Act, should also be adjusted with the inflation and time value factor of the amount on annual or regular basis. However, some characterization of the in-kind perquisites under Income Tax Act, 2059 are so nominal, that they do in no way reflect the actual intention of taxing the quantified income. Such as the Vehicle Facility provided to employee is taxable at the hands of the employee but only to the extent of 0.5% of his basic salary. This will not be a significant amount in relation to the inclusion in the taxable income. Similarly, the housing facility provided to the employee is quantified at the rate of 2% of the remuneration derived by the employee. This also is very low amount of quantification in relation to the inclusion in the taxable income. These quantifications are non-significant in relation to actual increment in taxation, but hey, until then yaay, employee is getting the better benefits here.
Non Regulation of Couple Option
Couple Option probably one of the most mis-utilized benefits in Income Tax System. Under Section 50(1) of Income Tax Act, 2058 both a resident individual and his/her resident husband or wife may opt the couple option by giving a notice in writing for the particular income year. Further, Para 11.2 of the Income Tax Directive 2066 (with third amendment 2077) provides that the action of filling in the applicable column for opting the “couple option” when filing Income Tax Return shall be treated as duly giving notice in writing. As to the employees who are not required to file the Income Tax Returns under Income Tax Act, 2058, when the employee intimates to the employer regarding the choice of “couple option”, this will be construed as notifying to the authorities in writing.
Section 97 of the Act, read with Section 4(3) allows certain employees an exemption from filing income tax return for the particular income year. All employees opting “Couple Option” may not be eligible to receive exemption under Section 97 (e.g. in cases of both working couples). In such case, the couples are liable to file the income tax return under Section 96 of the Act by consolidating the income earned by both. However, an employer is not required to consolidate total household income earned by spouse of its employee to calculate and deduct the taxes under Section 87 of ITA. This had led to the situation where both the partners opt for the couple option and take the double benefits of the exemption limit and benefits of the savings to the retirement fund, and do not submit their combined income taxes as the tax administration does not have the adequate system to track and trace the person opting the couple option and getting double benefits as such, without actually paying the correct taxes. Until such system is developed, taxpayers are in a position of advantage and this benefit has been widely misused in the context of the Income Tax administration of Nepal.
There aren’t any specific provision exempting taxation of the TADA (Travel and Daily Allowances) received by an employee. As per the prevalent position of the law, TADA can be treated as a cost incurred in the business only when the the invoices and expense receipts are provided by the employee against those advances. Only then, TADA would qualify as being an expense incurred for the business purpose and the employee would be discharged from the obligation of reporting them as their employment income. The position of the law is pretty clear. But still, generally, TADA are not taxed, why?
The reason for this could be the hangover of the Income Tax Act 2031. Income Tax Act, 2031 specifically excluded medical allowance, daily or travelling allowance, remote area allowance, pocket allowance or leader allowance received by delegates on a foreign tour, casual expenses, Dashain expenses, any amount received in the form of reimbursement, telephone facility granted by the employer institution and also the gratuity and pension, consolidated home leave, sick leave, decoration, medal awarded by His Majesty’s Government, Government corporation, institution devoted to the public utilities and other institution as prescribed; from inclusion in the employment income. These income were also not subjected to application of any withholding income so were not subjected to income tax. The Tax Rates were defined by Annual Finance Acts rather than in Act. Further to this, Income Tax Act, 2058 provides that, the payments of the prescribed small amounts which are so small and thus unreasonable or administratively impracticable to make accounting for them, are not considered to be the income derived by an individual under Section 21 and Section 8(3)(gha) of the Income Tax Act. Under Rule 6 of Income Tax Rules, 2056 while paying small amounts are identified to be the payments not more than Rs.500 at a time in consideration of tea, stationary, tips, rewards, emergency medical treatment and similar other payments prescribed by the Department.
Hence, the reason that TADA are generally not subjected to the taxation under employment income is not due to a particular exemption provision, but rather a hangover of the previous Income Tax Laws and wider definition applied to the meaning of “small payments” under Rule 6 of the Income Tax Rules, 2059.
"the ugly" of being in an employment engagement
High Effective Rate of Taxation
The employment income tax in Nepal could very well go upto 36% of the taxable income, if you are doing well in earnings. Its too damn high. And add to that, the compulsory minimum Social Security Contribution that you will have to make, forgoing further the cash in hand. We pay in taxes and social securities no less than the developed Nordic counties and still get the same old huge manholes in our public roads. And that’s just one kind way to put it. You could pay more than a third of your total gross income into taxes, spend the other one-thirds and even if you are living thriftly like a beggar, you won’t be able to save more than a third of your income, even when you are earning good. This is really awful.
It’s true that employment income is taxed on the gross income, unlike corporate income taxes, which are taxed on the net profits. On the other hand, the tax rates is really high and so are the social security contribution rates. On top of that the reductions as discussed earlier in above para, although many, doesn’t have much do do in the reduction of taxable income as whole. Like in foreign countries Nepal should also practice allowing reductions for savings like investment insurance and capital expenses incurred for constructing residential houses and investments in national interest projects as a reduction from the taxable income so that it could provide relief and increase in the capital expenditures in the country as a whole.
Couple Option Limit
In Nepal the actual distinction of the Single and Couple option in terms of tax benefits is very low. The increment in exemption limit to the person option Couple Option is very nominal and the tax benefits arising out of it is very minimal and certainly not able to assist the families with couples and dependents who the option should actual benefit to. To make the application of the Single and Couple Option more meaningful and advantageous, the benefit to the people opting the Couple Option should be increased in terms of both the (i) exemption limit and (ii) reduction of taxation income by way of savings to approved retirement fund. The provision of the couple option should also be regulated properly so as to prevent the abuse of the benefits under Couple Option as discussed in above para.
No opportunity to set off business losses with employment income
Employment Income is taxed in gross basis. Generally no deduction are allowed to be reduced from the employment income. Only some specific reductions, as discussed above are allowed to be deducted from the employment income. The taxation principle on employment income is completely different from the business and investment income. Business and investment income is taxed on the net profit basis and also the losses incurred in one year are allowed to be carried forward to set off with the profits generated from other activities under rules of loss quarantine under Section 20 of the Income Tax Act, 2058. However, under employment income, on the one hand, the rate of taxation is really high and on the other hand the losses generated from the other activities are not allowed to be set off from the employment income.
Although it is not in the nature of the employment income to be allowed expenses/losses for deductions, one way of providing relief could be that, a person generating and managing both employment income and self owned proprietorship could be allowed an opportunity to set off the losses and adjust the tax paid in one income head with the other. This could be a huge incentive for people to pursue a self owned small businesses along with employment activity, or even to people opting couple option, where one partner is involved in operating household business while the other is engaged in the employment income. Just a thought !!
Impact in Cash Flows
Everyone knows being in an employment and paying taxes is really a torture. Let’s visualize that with the help of graph. Let’s assume various annual income level from NPR 200,000 to NPR 5,200,000. Let’s assume the person makes a minimum SSF contribution and also additional contribution to be able to pay the least annual taxes as possible. How will is Income to SSF/Savings & Taxes & Cash Pay Ratio be? In the below graph: