Here we go again, discussing the same infamous taxing provision under Income Tax Law of Nepal: the Section 89. Here’s my frustrating comment on the Section 89 of Income Tax Act of Nepal even before going into any discussions: this provision single handedly screws up otherwise very sophisticated tax law of Nepal. It’s more of a mental liability than a tax liability and has been since its introduction, shamelessly piggybacking on, arguably, a drafting mistake. So many foreign establishments, branch offices, contractors and importers in Nepal have suffered huge troubles and consequences due to Section 89.
Introduction to Section 89
Section 89 is one of its kind. It is a withholding provision under Chapter 17 of the Income Tax Act, 2058. The problem with Section 89 is that unlike in Section 87 and Section 88, it fails to affirm the source principle for the income to be taxed under it. For example the source of the employment related payment to be taxed under Section 87 is affirmed in Section 67(6)(i) of the Act. This also similarly applies to the withholding provisions under Section 88 (e.g. service fee, royalties and dividend). Section 89 does not apply to the payment made to an individual for the non business rent payment of land, house or goods & equipment installed in house.
Additionally, this also doesn’t apply on the tax exempt payments or payments under Section 87, Section 88, Section 88Ka. Section 89 applies on the following payments made by resident person: (i) Payment under deed or contract, (ii) Insurance commission, paid to non-resident insurance company, (iii) Commission on reinsurance premium received from non resident insurance company, paid to non-resident person, and (iv) Payment made to works done by Consumer Committee. These can be broadly categorized into following groups:
Insurance related payments
The withholding tax applicable under Section 89 to insurance related payments are generally justified considering that various conventions concluded by OECD member countries include a provision which stipulates that insurance companies of a State are deemed to have a permanent establishment in the other State if they collect premiums in that other State through an agent established there – other than an agent who already constitutes a permanent establishment – or insure risks situated in that territory through such an agent. Therefore, withholding on insurance related payments need not be further contemplated as it is also adopted by many countries around the world. See more on the Insurance PE here in my other blog: A Dummy’s Guide to Permanent Establishment
Consumer Committee related payments
Development activities and several projects in Nepal had been adopting the practice of employing the local population for labor, employment and other engagement in projects. This has added advantage of utilization and promotion of local skills, enthusiasm and originality to the projects and further the employment opportunities in the country. Such local populations form consumer committees who get compensated typically on a wage basis. Finance Act 2075 introduced Section 89(3Ka), after which such compensation started getting taxed at 1.5% of the payment. There may not be a requirement to further contemplate on this matter but I believe that the withholding rate could be revised to 1% of the payment so that it doesn’t exceed the 1% Social Security Tax applicable in employment as such wage receivers of consumer committees do not generally exceed the basic 1% employment tax exemption limit. Additionally, the provision has failed to specify that the Section 89(3Ka) applies only to “resident consumer committees”, although unlikely in practice, could include the payments made to non-resident consumer committees, which is not the intention of the provision. These improvements could more streamline the provision under Section 89(3Ka).
Payment under “deed or contract”
This is where much contemplation is needed. There are several issues to be discussed regarding this topic.
- When a resident person makes a payment under deed or contract to a resident person, withholding tax at the rate of 1.5% is applied on the payment, under Section 89(1).
- When a resident person makes a payment under deed or contract to a non-resident person, withholding tax at the rate of 5% is applied on the payment, under Section 89(3)(a).
Both these provisions have led to some serious practical problems. Let’s discuss them:
Payment made to resident person under Section 89(1)
The problem with this subsection concerns what really is the meaning of “deed or contract”. The definition provided by the Income Tax Act is broad and includes in its meaning the contract or deed made for: (i) the supply of goods, or (ii) the supply of labor, or (iii) construction / installation of tangible property / structure, or (iv) supply of service related to construction / installation of tangible property / structure, or (v) any other act as specified by the IRD.
The meaning of contract is really wide and most importantly includes the contract made for supply of goods, which is the most problematic meaning for this purpose. The meaning of “contract or deed” under the National Civil code could very well include the deemed or quasi contracts as well. The definition of “contract for supply of goods” should have been limited to some extent and due to the absence of which it is normal for resident persons making payment in Nepal to extend this meaning to include any supply of goods exceeding NPR 50,000 under 89(2). The withholding rate for this purpose is 1.5% and the suppliers of goods who operate in very low commission margins face cash difficulties to bear the cash cost of this withholding rate. We will discuss this in detail in sections below.
Payment made to non-resident person under Section 89(3)(a)
The problem with this subsection is an extension of the problem under Section 89(1) but with far more consequences. In the case of resident payee, the problem is really only limited to facing cash flow difficulties to suppliers of goods who operate in low commission margins. However, unlike resident payee, if the payee is non-resident for the purpose of supply of goods for the purpose of Section 89(1) a huge 5% withholding rate applies and due to the wide meaning of “contract or deed”, there is no consensus as to what really should be covered by its meaning and whether this overrules or disregards the source principle of taxation. Because payment made to foreign suppliers of goods who supply their goods into Nepal, cannot be treated as Nepal sourced payment simply by the reason of mere supply. We will discuss this in detail in sections below.
Bare Text from Law
Here is a timeline showing how the provision under Section 89 of the Income Tax Act evolved over the years with the amendment brought by several Finance Acts:
89(1): In making payment of a sum exceeding fifty thousand rupees for payment of deed or contract, a resident person shall withhold tax at the rate of one and half percent of the total amount of payment.
89(2): The amount referred to in Section 89(1) shall be fixed also by adding any other payments, if any, made by such person or his associated person under the same contract to the person or his associated person entitled to payment under that contract in the past ten days.
89(3): Notwithstanding anything contained in Section 89(1), tax shall be withheld as follows from payment made by any resident person to any non-resident person under any contract:
(a) For deed or contract, five percent,
(b) For a commission in payment of a premium to a nonresident insurance company or a premium amount received for reinsurance from a non-resident insurance company, one and half percent,
(c) Where the Department has given that resident person a notice in writing except as referred to in clause (a) or (b), at the rate specified in the notice.
89(3Ka): Tax shall be withheld at the rate of one and half percent from payment of an amount exceeding fifty lakh rupees for a work to be performed by a consumers’ committee.
89(4): Notwithstanding anything contained in Section 89(1), this Section shall not apply to the following payments:
(Ka) Any other payment except rent paid for a land or house having source in Nepal or goods and equipment installed in the house to an individual other than that operating a business,
(Kha) Payments enjoying tax exemption or payments liable to tax withholding pursuant to Section 87, 88 or 88Ka.
Explanation: For the purpose of this Section “deed or contract” means a contract or agreement concluded for the supply of any goods or labors or construction, installation or establishment of tangible property or structure and such act as specified to be a deed or contract by the Department, and such contract or agreement also includes payment for the service related to construction, installation or establishment, if such service is also covered by it.
Important Notes and Circulars from IRD
|1||Section 89||नेपाल श्रोत भएमात्र करकट्टी गरिने||आयकर निर्देशिका|
|2||बीमा प्रिमिय||जतिसुकै रकमको बीमा प्रिमियममा पनि १.५ प्रतिशत अग्रिमकर कट्टा गर्नुपर्ने||नेपाल टोबाको कम्पनीलाई २०६१।५।१ को पूर्वादेश २०६५।६।३ देखि अप्रभावकारी|
|3||म्यान पावर सप्लाई करार||म्यान पावर सप्लाई करार मानिने २०६०।८।२२ मा होटेल डे ला अन्नपूर्णलाई पूर्वादेश तथा सम्झौता गरेको भए १.५ प्रतिशत कर लाग्ने||२०५९।५।७ मा नेपाल सुरक्षा व्यवसायी संघलाई पत्र|
|4||हेलिकोप्टर, हवाइजहाज पट्टा||हेलिकोप्टर, हवाइजहाज पट्टामा नलिई ढुवानी कार्यको करार गरी हवाई सेवा उपलब्ध गराए दफा ८८(१) आकर्षित नहुने र दफा ८९ आकर्षित हुने||२०६१।१०।१८ को सार्वजनिक परिपत्र|
|5||SBH सम्झौता||Service by Hour (SBH) सम्झौता अनुसारको भुक्तानी करार हुने||२०७३।९।२८ को परिपत्र|
|6||गैरवासिन्दालाई भुक्तानी||गैरवासिन्दालाई भुक्तानीगर्दा कुल भुक्तानीको १५ प्रतिशत अग्रिमकर कट्टि गर्ने||२०६१।४।५ को सार्वजनिक परिपत्र २०६५।६।३ देखि अप्रभावकारी|
|7||सामानको प्रतिस्थापन भुक्तानी||विदेशी कम्पनीबाट मर्मत गराउदा सामानको प्रतिस्थापनमा कर नलाग्ने तर सेवाको अंशमा दफा ८९(३)(क) बमोजिम १५ प्रतिशत कर कट्टा गर्नुपर्ने||क्यान्सर अस्पतालको मर्मतसम्बन्धमा ने.रा. बैकलाई २०६४।१२।१७ को पत्र|
|8||विदेशी परामर्शदातालाई भुक्तानी||विदेशी परामर्शदातालाई एडिवि इम्प्रेट खाताबाट भुक्तानी गर्दा पनि १५ प्रतिशत लाग्ने||मेलम्चि खानेपानी समितिकासन्दर्भमा नेरावैकलाई २०६४/२/३० को पत्र|
|9||उपकरण खरीद वापत भुक्तानी||टावर र उपकरण खरीद वापत भुक्तानी गर्दा अग्रिम कर नलाग्ने तर सेवा शुल्कको हकमा १५ प्रतिशतका दरले अग्रिम कर लाग्ने||टेलिकमको सेवा विस्तारका क्रममा नेरावैकलाई २०६४/६/१० को पत्र|
|10||सामानको प्रतिस्थापन भुक्तानी||सामान प्रतिस्थापनमा कर नलाग्ने ज्यालामा १५ प्रतिशत लाग्ने||एअर मर्मतका सन्दर्भमा नेरावैकलाई २०६४।६।३० को पत्र, २०६३/६/३ देखि सेवा शुल्कको दर १० प्रतिशत भएको|
|11||एलपि ग्यास ढुवानी||गैरबासिन्दाबाट एलपि ग्यास ढुवानी गराउँदा ५ प्रतिशत कर लाग्ने||२०६९।१२।१६ को नेआनिलाई पत्र|
|12||सामान सप्लाइ||रेल्वे मर्मत सामान सप्लाइ गर्ने भारतीय कम्पनीलाई ५ प्रतिशत लाग्ने||२०७३।४।१९ रेल्वे कंलाई पत्र|
|13||नोट छपाइ||नोट छपाइमा ५ प्रतिशत लाग्ने||२०६९।४।१९ नेराबैलाई पत्र|
|14||“ठेक्का/करार” परिभाषा||भाडा दफा ८८ मा पर्ने भएकाले यो कुरामा दफा ८९ मा संशोधन आवश्यक भएको|
|15||बिभागबाट करार मानिएको||सुडानबाट नेपालमा गरिएको ढुवानीलाई करार मानिने||२०७३।५।१९ मा नेपाल प्रहरीलाई र मल ढुवानी करार मानिनेः २०७०।९।२१ मा कृ. सा. कं लाई पत्र|
Purpose of Section 89: Just a filler for tax assessments
We have observed in the timeline chart above that several finance acts have tried to bring changes to the Section 89 but always failed to correctly or perhaps clearly interpret the meaning of “deed or contract” for the same. Tax Authorities and Auditor General’s Office and have been turning their blind eye on this, because this has always been a filler criteria for tax assessments. Despite several requests for clarity regarding this provision from practicing auditors, tax practitioners, advisors and lawyers, the much needed clarity has never made its way to the text of law. Taxpayers seeking personal advice on the application have been entertained in few instances where the meaning of the “deed or contract”, as always, have been described too widely to include any and every form of contracts under the sun, and also blatantly disregarding the “source principle” of taxation.
Let’s list some of the lapses of the Section 89 in points below:
Fails to properly define the meaning of “contract”
What is the meaning of “deed or contract” for the purpose of Section 89?
As per the Explanation under Section 89 and also discussed above, for the purpose of this Section “deed or contract” means a contract or agreement concluded for the supply of any goods or labors or construction, installation or establishment of tangible property or structure and such act as specified to be a deed or contract by the Department, and such contract or agreement also includes payment for the service related to construction, installation or establishment, if such service is also covered by it.
स्पष्टीकरणः यस दफाको प्रयोजनको लागि “ठेक्का वा करार” भन्नाले कुनै वस्तु वा श्रमिकको आपूर्ति वा मूर्त सम्पत्ति वा संरचनाको निर्माण वा जडान वा स्थापना गर्ने सम्बन्धमा गरिएको करार वा सम्झौता तथा विभागले ठेक्का वा करार भनी तोकेको कार्यलाई सम्झनु पर्छ र त्यस्तो करार वा सम्झौताले निर्माण वा जडान वा स्थापनासँग सम्बन्धित सेवा समेतलाई समेटेको भए सो सेवा बापतको भुक्तानीलाई समेत जनाउँछ ।
So what does the Income Tax Directive have to explain regarding the meaning of contract? Well, nothing. Read this indeterminate tautological literature from the Income Tax Directive and decide for yourself.
ऐनको उपरोक्त परिभाषा ऐनको दफा ८९ को प्रयोजनका लागि अर्थात ठेक्का वा करारमा अग्रिम कर कट्टी गर्ने प्रयोजनका लागि गरिएको भए पनि सो परिभाषा करार ऐनले गरेको करारको परिभाषासँग नबाझिएको र आयकर ऐनको अन्य कुनै दफाले करारको छुट्टै परिभाषा नगरेको हुँदा आयकर ऐन र यस निर्देशिकाको प्रयोजनका लागि करारको उक्त परिभाषा नै सान्दर्भिक र आधिकारिक रहेको मान्नु पर्दछ । ऐनको उपरोक्त व्यवस्था अनुसार करारले कुनै वस्तु वा श्रमिकको आपूर्ति सम्बन्धमा भएको सम्झौता वा कुनै मूर्त सम्पत्ति वा संरचनाको निर्माण वा जडान वा स्थापना गर्ने वा सो सम्बन्धी सेवा प्रदान गर्ने सम्बन्धमा गरिएको कुनै पनि प्रकारको लिखित वा मौखिक सम्झौतालाई जनाउछ । ऐनको उपरोक्त व्यवस्थामा विभागले करार भनी तोकेको कार्य पनि करार अन्तर्गत पर्ने विभागले हालसम्म करार अन्तर्गत पर्ने भनी उपरोक्त परिभाषामा उल्लिखित कार्य बाहेक अन्य कुनै कार्यलाई तोकेको छैन । यस अवस्थामा आयकर ऐन र यस निर्देशिकाको प्रयोजनका लागि करार भन्नाले कुनै वस्तु वा श्रमिकको आपूर्ति गर्ने सम्बन्धमा भएको सम्झौता, कुनै मूर्त सम्पत्ति वा संरचनाको निर्माण वा जडान वा स्थापना गर्ने सम्बन्धमा भएको सम्झौता र कुनै मूर्त सम्पत्ति वा संरचनाको निर्माण वा जडान वा स्थापना गर्ने सिलसिलामा आवश्यक पर्ने कुनै सेवा प्रदान गर्ने सम्बन्धमा भएको सम्झौतालाई सम्झनु पर्दछ ।
The explanation in the tax directive really fails to deliver.
On the one hand the meaning of contract is too wide. Does this contract/agreement need to be a formal contract/agreement, with paper/ink or some elaborate contract negotiation process or is it intended to include all the types of contract (e.g. deemed contracts or quasi contracts)? Well, both the Act and Directive don’t seem to provide clarity in this matter.
Should this definition of contract be explicitly limited to include only the manufacturing/supplying a product based on some additional requirement and specification of customers than normal sales terms? This may include specifying the terms for regular delivery of goods, brokerage, unique requirement for quantity, unique requirement for quality, domicile and shipments etc. Because in absence of such limitation to the meaning of contract, this could include in its meaning (i) every purchase of goods from non-residents (subjected to 5% tax), and (ii) every purpose of goods from residents exceeding NPR 50,000 (subjected to 1.5%), which clearly should not be the case.
Fails to adjust the “50k” threshold to the current price
When Section 89 was introduced for the first time with the enactment of Income Tax Act, 2058 the limit for the application of TDS on contract payment was NPR 50,000. However, as of March 2022, some 20 good years have passed but there has been no revision on the threshold of the NPR 50,000 for application of TDS on contract payment. Had the threshold of NPR 50,000 been linked with the 15% interest rate which is the interest rate applicable for tax law purposes in Nepal, the amount would have reached well above NPR 800,000 providing a much needed relief in the withholding taxes applicable on the contract payment. Even when just a 10% revision rate is applied the amount would still be somewhere around NPR 350,000. This has never been considered for reform throughout the years despite Section 89 has been subjected to amendment by many Finance Acts. For similar comparison, the cash limit of expense disallowance under Section 21(2) of the Act has also not been revised since the enactment of the Income Tax Act, 2058.
Had this limit of NPR 50,000 been revised for the purpose of Section 89 to its current price then the even wider meaning of the “deed or contract” to include every supply of goods would not be such a troubling problem, at least for the contracted supplies within the country. For payment to supplies under a contract by non-residents this would still not help, because the problem lies in the source of the payment for such supplies, which we will discuss in paragraph just below.
Fails to specify the “source of payment”
Section 89 is infamous for its omission to mention “Nepal sourced payment” unlike the withholding provisions in Section 87 and Section 88. This has led to tax officers contending that Section 89 applies even when the payments are not sourced in Nepal. This is truly an absurd statement. The payment made for the mere purchase of goods into Nepal does not constitute Nepal sourced payment, and this is true as per the international practices and also true as per the Section 67 of the the Income Tax Law of Nepal.
Nepal follows a residency principle based tax system. In residency principle based tax systems, all the income of the resident person is taxed irrespective of the location of the source of income and income of non-resident person is taxed only to the extent of the income having source in Nepal. This principle has also been adopted by the Income Tax Act 2058 of Nepal.
In case of person resident in Nepal
1. If you are a person resident in Nepal then all your income from employment, business, investment or windfall gain of the year irrespective of the location of the source of the income will be treated as your assessable income.
2. The income to be included in assessable income will be calculated as per the provisions of Section 7, 8, 9 and Section 2(Ja1). Income can include both Nepal as well as foreign sourced income.
3. The tax rate as specified in the Act are applied in the taxable income assessed as above.
In case of person not resident in Nepal
1. If you are a non-resident person, employment, business, investment or windfall gain will be treated as your assessable income but only to the extent the income has a source in Nepal.
2. The rate as specified in the Act (including withholding rates) will be applied in the Nepal sourced income assessed as above.
Nepal follows a source and residency based principle. There are only a few exceptions to this general rule, some reasonable like Section 70 and Section 95Ka and some arguably, outright absurd like Section 89. Some income of non resident persons that are not sourced in Nepal may be subject to tax. The instances where this might occur in case of prevailing Income Tax Act in Nepal are discussed below.
The application of advance tax withholding mechanism under Section 95Ka doesn’t regard the source based principle for deduction of taxes. When Section 95Ka is attracted, the fact that the income is not sourced in Nepal, doesn’t provide any relief to the person who is liable to deduct the advance taxes on the gains determined.
If we observe the above provisions for advance tax deduction as provided in Section 95Ka, we can easily conclude that Section 95Ka disregards the source and residency based principle. Let’s say for example:
(1) A person supplies Wheat into Nepal. Simply by supplying goods into Nepal, it cannot be deemed to be Nepal sourced but 2.5% tax has to be withheld at the point of customs by Customs Office, disregarding the source principle of taxation to non-residents.
(2) A non-resident has an interest in equity shares of an entity in Nepal. He disposes off that share. But since the disposal of that share doesn’t fall under the definition of disposal of domestic assets, it doesn’t constitute Nepal sourced income. However, it still is taxable under the provision of Section 95A and the tax applicable is withheld by the entity whose interest is being disposed of in case of unlisted shares and by the entity involved in securities market business in case of listed shares.
Taxes under Section 95Ka on supply of some goods into Nepal and disposal of the shares held by non-residents in Nepal are simply taxed by the provision of Section 95Ka but absent of establishing any Nepal source provision under Section 67 of the Act. It is not a common practice to apply income taxes on the import of goods like in Section 95Ka not having the source principle established under Section 67 just adds another layer of problem to this taxation.
Section 70 relates to cross border transport taxation in Nepal. The provision of taxation under Section 70 has also been established under Section 67 of the law. At face some income derived under Section 70 seems quite different from typical Nepal sourced income but this is similar to the taxing principle followed in cross border transport taxation mostly all around the globe.
Section 70 defines the taxing basis, Section 67(6)(g) defines the sourcing principle and Schedule 1(2)(7) defines the tax rates. Taxation under proviso to Schedule 1(2)(7) deals with nonresident persons making service available in water transport, air transport, or telecommunication service which have no destination to another foreign country from Nepal. In this case tax is applicable in Nepal even in the incomes that are not sourced in Nepal, also some exemption is provided in income that are sourced in Nepal. This is due to internationally adopted practice in taxation of the civil aviation industry as per Chicago Convention on International Civil Aviation (International Civil Aviation Organization) and Berlin Convention on International Radiotelegraph (International Telecommunication Union) discussed in another blog here: Cross Border Transport Taxation in Nepal
Section 89 has the most problems regarding taxation of non-Nepal sourced income. Firstly, it fails to establish the source principle under Section 67. The other problem with Section 89 is that it goes against the PE taxation principle.
Two important questions need answering in this context. Question (i): What is the source of income for payment for supply of goods? Question (ii): Does the transaction of supply of goods create a taxable permanent establishment? These questions will be discussed in detail in the section below.
Meaning of “contract” and “source of income” for Section 89
Definition under Income Tax Act
Following the discussion made above in “Section 89 Purpose” above, the definition of contract under Section 89 is too wide to reach an agreeable meaning to it. This definition was introduced by Finance Act 2064 and has not seen any changes to it since. Although the definition was provided by Finance Act 2064, Section 89(3) didn’t provide any explicit tax rate so a default withholding rate of 1.5% under Section 89(1) was applicable for the short duration until a significant change was brought by Finance Act 2065. Later, Finance Act 2065 provided 10% withholding rate on service contracts and 5% on other contracts. Finance Act 2065 later reduced this particularly huge withholding rate to 5% applicable on contract payment (service or otherwise), although the definition of contract did not observe any meaningful explanation to the definition of “contract or deed”. The disagreement between the tax authorities and tax practitioners and taxpayers regarding this has only worsened since then. Since the recent past few years, the annual report from the Office of Auditor General’s has also put light on this issue and thus increasing and widening the disagreement between tax authorities and tax practitioners. The latest amendment brought by Finance Act 2078 providing an exception to the certain purchases made by police and army forces of Nepal only strengthened the view of tax authorities regarding the meaning of “contract or deed” and what it constitutes and so taxpayers have started receiving adverse tax assessments in this context since.
But does the Income Tax Act really include the payment for purchase of goods as Nepal sourced payment?
Answer: No. As per Section 67(6)(l) of Income Tax Act 2058, payment for goods is considered to have source in Nepal when the payment relates to the disposal of assets situated in Nepal. These are the assets situated in Nepal:
1. Land and Building situated in Nepal (irrespective of whether it is owned by resident or non-resident person)
2. All assets owned by resident person other than Land and Building situated in foreign country
Okay, let’s marinate our brain in the meaning of this. This means that when a payment is made in respect of disposal of goods (e.g. trading stock but not foreign land/building) owned by a resident person then that payment is considered to be Nepal sourced. But, if the payment is made in respect of disposal of goods (e.g. trading stock but not land/building situated in Nepal) owned by a non-resident person it is not considered to be Nepal sourced. But does the liability that is created against the payment of an asset-not-situated in Nepal create a domestic liability? No, domestic liability is created against the payment for domestic assets only. Meaning, if we acquire goods from a non-resident person, liability that is created against it is not a domestic liability, because domestic liability is created against the payment for domestic assets only.
Another argument from tax authorities has been that since Section 89 doesn’t limit its application to “Nepal sourced payments” unlike in Section 87 and 88, the source principle doesn’t apply to Section 89. What could be the reason behind it? We will discuss this in the context of commentary and insight provided by Symmetrica’s Model Tax Law, from where our Income Tax Law has been derived, in paragraph just below. Peter Harris and Income Tax Act of Nepal
Definition under Symmetrica’s Model Tax Law
The Income Tax Act under The Commonwealth of Symmetrica is a model tax law, on which the Income Tax Act, 2058 of Nepal has been modeled after. This model tax law provides the withholding on contract payments as below under Section 212.
Regarding withholding Taxes
Link to model law: The Commonwealth of Symmetrica Income Tax Act
Relevant Sections: Section 210 to 213 under Subdivision A: Withholding Obligations of Division II: Income Tax Payable by Withholding.
Major Observation from model law:
The withholding for service fee or payment under contract under Section 212(1) applies only to the income sourced in the state.
Regarding application of withholding Taxes
Link to commentary on model law: The Commonwealth of Symmetrica Income Tax Act Commentary
Relevant paras: Para 322 to 331 under Division II: Income Tax Payable by Withholding
Major observations from the commentary to the model law:
- This Division requires withholding of tax from certain payments that have a domestic source. (para 322)
- The obligation to withhold does not apply to all types of payments. It applies comprehensively to payments for services. (para 323)
- Many countries do impose a general withholding tax at a low rate on all contract payments. However, inevitably there is a dispute as to the rate of this withholding tax and how it applies in the context of non-resident payees. For example, this power may be used with respect to insurance premiums paid by residents to non-resident insurers. (para 326)
Although the provisions and commentaries in the model tax law of Commonwealth of Symmetrica is only a persuasive logic, it gives us the opportunity to learn about the intention of the law. Yes, non-residents can be subjected to withholding rates but the payment should be sourced in Nepal, as discussed in the model law commentary para 322 and 326. The present interpretations followed by the tax authorities in Nepal have failed to concur with this commentary by the model tax law on which it is based. Yes, of course there is localization of laws regarding the taxation principle, but can the local law be so divergent as to completely disregard the “source based taxation principle” altogether?
Definition under Income Tax Directives
Income Tax Directive has provided some illustrative examples for the purpose of Section 89 in Example #16.2.49, #16.2.50 and #16.2.51.
उदाहरण १६.२.४९: मानौं, ABC & Co.ले CBS International बाट राशन ठेक्का बापतरु.५१,०००।-प्राप्त गरेका रहेछन् । यस्तो भुक्तानी रु.५०,०००/-भन्दा बढी भएकोले पूरै भुक्तानी रकममा कर कट्टा गर्नु पर्दछ । अर्थात, CBS Internationalले कुल ठेक्का रकम रु.५१,०००।- भुक्तानी दिदा १.५ प्रतिशतका दरले हुने रु.७६५।-कर कट्टा गरी बाँकी हुन आउने रु.५०,२३५१- ABC & Co. लाई भुक्तानी दिनु पर्दछ ।
उदाहरण १६.२.५०: मानौं, Zenithहोटल प्रा. लि. ले आफ्नो होटललाई वर्ष दिनभरि आवश्यक पर्ने कुखुराको मासु Haris Fresh Houseबाट खरिद गर्ने गरी सम्झौता गरेका रहेछन् । निज होटलले मासु खरिद गरेबापत दश दिनमा रकम रु.५५,०००/- भुक्तानी दिएका रहेछन् ।यसरी विगत दश दिनमा भुक्तानी गरेको रकम रु.५५,०००/- मा १.५ प्रतिशतका दरले हुने रु.८२५१- भुक्तानीमा कर कट्टा गरी भुक्तानी दिनु पर्दछ ।
उदाहरण १६.२.५१: मानौं, नेपाल जीवन बीमा कम्पनी लि. ले जापानी जीवन बीमा कम्पनीसँग Reinsuranceकरार गरेको रहेछ । आर्थिक वर्ष २०७६/७७ मा जापानी जीवन बीमा कम्पनीलाई रु.१०,००,०००/- Reinsurance Premium भुक्तान गरेको रहेछ भने जापानी जीवन बीमा कम्पनी गैर बासिन्दा बीमा कम्पनी भएको कारण यस्तो भुक्तानी रकममा १.५ प्रतिशतका दरले हुन आउने रकम रु.१५,०००/- भुक्तानीमा कर कट्टा गरी बाँकी रकम रु. ९,८५,०००/- भुक्तानी दिनु पर्दछ ।
Regarding the meaning of contract, the examples #16.2.49 and #16.2.50 discusses contracts with some elaborate contract negotiation process rather than just being a deemed or quasi contract, but since the examples are only for illustrative purposes, it is not wise to draw any conclusion from this. Regarding the source of income for payment under supplies received from non-resident, there aren’t any examples in the directive that resolves this issue, so the directive is not helpful in any of the issues.
Link to Income Tax Directive
Definition under Permanent Establishment Directive
Permanent Establishment Directive 2077 issued by IRD warrants a separate discussion: Debunking IRD’s PE Directive 2077. Although the directive completely fails to affirm that the business profits are taxable only to the extent it can be allocated to the permanent establishment, it has in example 4.2.7 illustrated that the mere purchase of goods doesn’t create a taxable presence of foreign entities in Nepal. This illustration, when viewed in context of the application of withholding taxes on supplies, may help to conclude that the mere contract for supplies of goods should not be subjected to withholding taxes under Section 89(3) of Income Tax Act.
Link to IRD’s PE Directive 2077
But what about the purchase of services from a person who doesn’t have a taxable presence in Nepal? Should not it be exempted from any taxes in Nepal as provided in the Article 7: Business Profits of the Double Tax Avoidance Agreements that Nepal has entered with? This we will discuss in the section right below.
Article 7 benefit under DTAA? A horse laugh !!
In the Supreme Court’s decision in the Duosoft Nepal Pvt Ltd vs Department of Revenue Investigation and Revenue Tribunal Tribunal’s decision on Taragaun Regency Hotel Limited v/s Inland Revenue Department, the benefits under Article 7 of DTAA were denied. So the answer to the question above in the previous Section is, Yes the benefit should have been available but the Court’s view in this matter has been unfavorable to the taxpayer in previous decisions.
More discussion on this topic in my other blogs:
(1) DTAA benefit in Nepal?
(2) Disbursement, Reimbursement and Transfer Pricing of Costs
Commentaries from Model DTAAs
DTAAs do not govern the local taxation principles but Article 7: Taxation of Business Profits. However, despite the local laws, Article 7 of the DTAA provides relief in relation to the local tax laws of one state that intend to tax business profits of an enterprise in another state which does not have taxable presence in the former state. So alleviates the chances of taxation of profits derived by a supplier of goods into Nepal that doesn’t have taxable presence in Nepal. Since mere supply of goods into another state doesn’t create any form of taxable establishment in that state, Article 7 should potentially prevent the adverse interpretations under Section 89 of the Income Tax Act, 2058. But the state of DTAA benefit and the authorities’ and court’s view on this matter is not favorable to the taxpayers as discussed in section just above.
Article 7 of DTAA allocates taxing rights with respect to the business profits of an enterprise of a Contracting State to the extent that these profits are not subject to different rules under other Articles of the Convention. It incorporates the basic principle that unless an enterprise of a Contracting State has a permanent establishment situated in the other State, the business profits of that enterprise may not be taxed by that other State unless these profits fall into special categories of income for which other Articles of the Convention give taxing rights to that other State.
OAG’s Understanding of “Contract” under Section 89
The Office of Auditor General’s recent interest in application of Section 89 has fired up the debate and interest in Section 89 even further.
Here is a snip of the not so definitive view of OAG in its recent 2077 Annual Report.
ठेक्का वा करार – आयकर ऐन, २०५८ को दफा ८९(३) मा गैर बासिन्दालाई हुने ठेक्का वा करारको भुक्तानीमा ५ प्रतिशत कर कट्टा गर्ने व्यवस्था छ । ठेक्का वा करारलाई आयकर निर्देशिका, २०६६ (तेस्रो संशोधन २०७७) ले समेत व्याख्या गरेको छ । विमान उत्पादकबाट हवाईजहाज खरिद, नेपाल आयल निगमद्वारा इन्धन खरिद, अन्य संस्थाहरूबाट मल, नून, विद्युतीय उपकरण, सवारीसाधन, भारी उपकरणलगायत खरिद गर्दा कुनै न कुनै प्रकारको ठेक्का वा करार हुने गर्दछ। सो ठेक्का वा करारको आधारमा भुक्तानीमा कर कट्टी गर्ने वा नगर्नेमा फरक फरक अभ्यास देखिन्छ । तसर्थ भुक्तानीमा कर कट्टी हुने ठेक्का वा करारसम्बन्धी व्यवस्थालाई स्पष्ट गर्नुपर्दछ ।
There are not any countries that apply withholding taxes on supplies from non-residents. Because that is essentially a form of customs duties and is also against the general general taxation principles and transfer pricing principles. Section 89 has no comparatives in other tax jurisdictions, as it should be.
Let’s take an example from India. In India TDS is to be deducted at the rate of 2% on payments made to the supplier of taxable goods and/or services, where the total value of such supply, under an individual contract, exceeds Rs. 250,000. However, such deduction is not required when the location of supplier and place of supply is different from the State of the registration of the recipient. So this essentially only applies to the suppliers and purchasers of goods within the same state and that the threshold for its application is also pretty higher than that prevalent in Nepal. This withholding provision doesn’t apply to suppliers non-resident to the state of the purchaser.
List of problems caused by Section 89
Here are some of the problems caused by adverse interpretation of Section 89.
Increase in contract costs
The application of Section 89(3) to supplies under contract received from non-residents leads to cost inefficiency. Nepal has only entered into DTAA agreement with only 11 countries: India, Austria, China, South Korea, Mauritius, Norway, Pakistan, Qatar, Thailand, Sri Lanka and Bangladesh. Taxes applied in Nepal thus may not be available for relief in other countries than those above, so this effectively increases the contract cost and leads to overall business inefficiency, the cost of which may be more than the benefit derived from charging the taxes under Section 89(3). Also, considering that Section 89 taxes disregards the supremacy of the DTAAs and the previous decisions from the Courts and Authorities in Nepal have not been so keen to implement the benefit under DTAA (as discussed above), the taxes levied under 89(3) could be dishonored for credit by the countries, even those who we have negotiated DTAA with. So Section 89(3) taxes is a concern for taxpayers in all countries who have a contract arrangement in Nepal.
Establishment of entity/establishment in Nepal
A Permanent Establishment (PE) is a construct for tax purposes. Depending on the activities of a foreign enterprise in Nepal it could trigger one/few of the several forms of PE: Fixed Place PE, Project PE, Service PE, Agency PE and Insurance PE. Under Section 154 of Companies Act 2063 of Nepal where any foreign enterprise carries on any transaction for a period of one month or more through an office established in Nepal or used therefor or appoints any person for regular contact or avails its service, such company shall be deemed to have done a transaction or established an office in Nepal. The criteria for triggering Branch Office under Companies Act and Permanent Establishment under Income Tax Act are quite different as PEs like Agency PE or Service PE do not necessitate the actual physical presence of the company in Nepal.
So why is this concept relevant for the purpose of Section 89? The reason is that when a foreign enterprise secures the contract for both supply of goods and services of Nepal, to be relieved from the 5% withholding taxes under Section 89(3) the foreign company may opt to establish a branch office / subsidiary in Nepal instead of just a PE for tax purposes. The consequence of having a PE in Nepal is that the operation of foreign enterprise in Nepal will be viewed as a distinct entity and the transfer pricing rules should be applied to reasonably determine the revenues and expenses attributable to the unit in Nepal. Profits derived by PE in Nepal will be subject to taxation as an entity in Nepal. A PE also gives rise to income or value-added tax liability in Nepal. The foreign entity might have to do a cost analysis for tax efficiency to determine how to set up the establishment in Nepal.
What is the practical approach followed by composite contractors working in Nepal?
In practice, the contract for supplies and services are split and services are routed through the permanent establishment / branch in Nepal and supplies are routed through the offshore company itself. However, the tax authorities may inquire on the profitability arising under the supply of goods and look into the transfer pricing on goods/supplies. (i.e. lower quote and low profitability under service portion and higher quote and higher profitability on the supply of goods). In this scenario, there are risks that the supply of goods will be treated as income of the permanent establishment in Nepal. Regarding the contract of supplies of goods, where the payments are being made by the public authorities in Nepal, in practice, do not withhold the 5% taxes under Section 89(1) but some may, which is a very indecisive portion until negotiated before contracting. However, like we discussed above, payment for supplies of goods should not attract any withholding taxes, as profits on supplies are typically not attributable to the establishment in Nepal under normal taxation principle and transfer pricing principle and source of income principle. Also they should not be subject to taxation under Section 89(3) in Nepal as per Double Taxation Avoidance Agreement with the other country, if any. But having said that, to adopt this in Nepal is a huge challenge and given the views taken by the authorities, tribunals and courts, should be carefully negotiated in the contract to avoid future tax burdens.
Another problem that arises when actually trying to adopt Section 89(3) in its letter, although preferable, composite contracts (both supply of goods and services) when routed through permanent establishment in Nepal, might create additional issues relating to scope of activities of a branch/establishment in Nepal. Firstly, there are as of now only a few consortiums/projects who have adopted the approach for composite contract and the concerned authorities have raised the issue that branches of foreign companies established in Nepal cannot do trading activities in Nepal (i.e. supplies). Under foreign investment laws, companies with foreign investment (including Nepal Branch of foreign companies) are not allowed conduct trading activities in Nepal. So this is actually a double edged sword. The dissonance and tone deafness of the authorities in Nepal has led to this inescapable situation for foreign contractors in Nepal.
Splitting of Contracts
Many companies have in the past splitted the composite contract into separate supplies of goods and services so that the foreign entity will take on the supplies for goods directly imported by the customer and the local permanent establishment for providing services. However, recently IRD has been treating both the supply and the service as a composite contract and has been taxing for the whole contract. However, there is no consistency in treatment of these contracts by IRD or other authorities in Nepal. There are instances where the taxpayers have sought for appeal against such a decision of IRD and applied for review at the Revenue Tribunal for the review of application of withholding taxes on the entire contract, both goods and services. The case concerned taxing the entire contract as a composite contract.
Regarding these recent developments and interpretations from IRD, this may be viewed as contradicting the general taxation principles and transfer pricing principles. Potential taxpayers who might have to face such complications can obtain advance ruling from IRD which is issued within 45 days of filing the application. Advance ruling prevails over the public circulars issued on the particular applicant. If the applicant for the personal ruling is not satisfied with the ruling or the ruling is not provided within the specified period, they can also apply for administrative review on the same at IRD. This can further be appealed at the Revenue Tribunal and at the Supreme Court. This is quite a lengthy legal process and the success is not guaranteed given the past experiences of the Authorities, Tribunals and Courts.
Some Recent Personal Rulings issued by IRD
Some multinational companies have applied for the personal rulings regarding the withholding taxes of Section 89. The rulings provided by the IRD regarding these are inconsistent and lacks in taxing principle, like we discussed above.
Since these are personal rulings, they cannot be publicly accessible. If you want to access the contents you can request them separately to firstname.lastname@example.org or if you already have the password you can enter them below in the password field and access these documents:
(1) Some Personal Rulings issued by IRD regarding Section 89
(2) A sample of project agreement between foreign EPC Contractor and Public Authority in Nepal
What can IRD do and stop worrying about Section 89?
The problem caused by Section 89 is larger than large but the solution to this is quite simpler than expected. A simple few amendments under Section 89 is quite enough to address all the problems we discussed above:
८९(१): बासिन्दा व्यक्तिले ठेक्का वा करार बापत २०५८ सालबाट राष्ट्र बैंकको होलसेल मुल्य समायोजित पचास हजार रुपैयाँभन्दा बढीको नेपालमा श्रोत भएको रकम भुक्तानी दिँदा भुक्तानीको कुल रकममा १.५ प्रतिशतका दरले कर कट्टी गर्नु पर्नेछ ।
८९(२): उपदफा (१) मा उल्लिखित रकम यकीन गर्न एउटै करार अन्तर्गत त्यस्तो व्यक्ति वा निजको सम्बद्ध व्यक्तिबाट सोही करार अन्तर्गत भुक्तानी पाउने व्यक्ति वा कानिजको सम्बद्ध व्यक्तिलाई विगतको दश दिनमा दिइएका अन्य कुनै भुक्तानीहरु भए सो समेत जोडी यकीन गर्नु पर्नेछ ।
८९(३): उपदफा (१) मा जुनसुकै कुरा लेखिएको भए तापनि कुनै बासिन्दा व्यक्तिले कुनै ठेक्का वा करार अन्तर्गत कुनै गैर बासिन्दा व्यक्तिलाई दिने नेपालमा श्रोत भएको भुक्तानीबाट देहाय बमोजिम कर कट्टी गर्नु पर्नेछ :
(क) ठेक्का वा करारमा पाँच प्रतिशत,
(ख) गैर बासिन्दा बीमा कम्पनीलाई प्रिमियम भुक्तानी गर्दा वा गैर बासिन्दा बीमा कम्पनीबाट पुनर्बीमा बापत प्राप्त हुने प्रिमियम रकमबाट दिइने कमिशनमा एक दशमलव पाँच प्रतिशत,
(ग) खण्ड (क) वा (ख) मा लेखिएदेखि बाहेक विभागले त्यस्तो बासिन्दा व्यक्तिलाई लिखित सूचना दिएकोमा सो सूचनामा उल्लिखित दरमा ।
तर नेपाली सेना, नेपाल प्रहरी तथा सशस्त्र प्रहरीले आफ्नो प्रयोजनका लागि खरिद गर्ने हातहतियार, गोलीगठ्ठा तथा सञ्चार उपकरणको खरिद बापतको भुक्तानीमा यो उपदफा लागू हुनेछैन ।
८९(४): उपदफा (१) मा जुनसुकै कुरा लेखिएको भए तापनि देहायका भुक्तानीका हकमा. यो दफा लागू हुने छैन
(क) कुनै व्यवसाय सञ्चालनका सिलसिलामा गरिएको भक्तानी बाहेकका प्राकृतिक व्यक्तिहरुले गरेको भुक्तानी, वा
(ख) कर छुट दिईएका भुक्तानी वा दफा ८७ वा ८८ बमोजिम कर कट्टी गर्नु पर्ने भक्तानी ।
स्पष्टीकरणः यस दफाको प्रयोजनको लागि “ठेक्का वा करार” भन्नाले कुनै वस्तु वा सेवाको
श्रमिकको आपूर्ति वा मूर्त सम्पत्ति वा संरचनाको निर्माण वा जडान वा स्थापना गर्ने सम्बन्धमा गरिएको करार वा सम्झौता तथा विभागले ठेक्का वा करार भनी तोकेको कार्यलाई सम्झनु पर्छ र त्यस्तो करार वा सम्झौताले निर्माण वा जडान वा स्थापनासँग सम्बन्धित सेवा समेतलाई समेटेको भए सो सेवा बापतको भुक्तानीलाई समेत जनाउँछ ।
Thank you for reading this long read !!