How does VAT work?
Value Added Tax (VAT) is a tax on the value added to goods and services at each stage of production or distribution. It is a consumption tax that is ultimately paid by the end consumer, but it is collected and remitted to the government by businesses that sell goods and services.
In a typical VAT system, businesses that sell goods or services charge VAT on their sales, and then remit the VAT amount to the government after setting off the VAT that the business paid for the goods or services that were purchased by the business to generate those sales.
For example, suppose a manufacturer buys raw materials for Rs 100 and then sells a finished product to a wholesaler for Rs 200. The value added by the manufacturer is Rs 100 (200 – 100), and the VAT charged by the manufacturer is 13% of that amount in Nepal, or Rs 13. This amount gets deposited by the manufacturer to the Revenue Department. The wholesaler then sells the product to a retailer for Rs 300, and charges VAT on that sale as well. The retailer then sells the product to a consumer for Rs 400, and charges VAT on that sale as well. At each stage of the supply chain, the VAT is charged on the value added by that business. The VAT charged by each business is then remitted to the government, and the consumer ultimately pays the VAT as part of the purchase price.
💡How does VAT/GST System differ from Sales Tax system?
The main difference between sales tax and VAT/GST (Value Added Tax / Goods and Service Tax) is that sales tax is collected only at the point of sale to the end consumer, while VAT/GST is collected at every stage of production and distribution. In a sales tax system, the tax is calculated as a percentage of the sale price, and businesses do not generally receive an input tax credit. In contrast, in a VAT/GST system, businesses are allowed to claim an input tax credit for the VAT/GST paid on the inputs used in production, and the tax is calculated on the value added at each stage of production or distribution. Additionally, compliance requirements and record-keeping obligations are generally higher in a VAT/GST system than in a sales tax system.
The identification of “end consumer” is very important in the sales tax system. End consumer is the person who ultimately uses or consumes the product or service and is not reselling it. Although in many cases, it is easy to identify the end consumer, in some cases, it may be more difficult to identify the end consumer. For example, in a business-to-business transaction where the product is purchased by one business for use in the production of another product, it may not be immediately clear who the end consumer is. In these cases, the tax authority may provide guidelines or rules to help determine who the end consumer is that takes into account the factors such as the intended use of the product, the identity of the purchaser, and whether the product is being purchased for resale. Ultimately, it is the responsibility of the seller to collect and remit the sales tax, so they must make a reasonable effort to identify the end consumer and collect the appropriate amount of tax.
We know what “Reverse Charging” in VAT is
What is the reverse charging mechanism in the VAT system? Reverse charge mechanism is a mechanism used in VAT systems that shifts the responsibility for paying the tax from the supplier to the recipient of goods or services. Reverse charging mechanism is often used to prevent tax evasion and ensure that VAT is properly collected on cross-border transactions. It is also used in cases where the supplier may not have a physical presence in the country or may not be registered for VAT in the country.
In the context of Nepal reverse VAT is envisioned in the following scenarios:
- When a person in Nepal (whether un/registered for VAT purposes) imports service from a party outside Nepal, the importer shall collect and deposit tax on the taxable value of the service.
Section 8(2) of the VAT Act, 2052
- Any person who fails to obtain the commercial purpose construction service of building, apartment, shopping complex, or other structures as prescribed that exceeds Rs 5 millions from a VAT registered party, is required to deposit the VAT on the service by the owner of such building as if it were obtained from a VAT registered party.
Section 8(3) of the VAT Act, 2052
- VAT will be levied on the royalty/auction amount of the woods at the earliest of auction, release, cutting order on national forest as well as private/community forest, which will be deposited by the buyer to the Revenue Department.
Section 12Ka of the VAT Act, 2052
- Although at face, the VAT paid to the Customs Office at the point of importing goods also does seem like a reverse charging application of VAT, it is not treated as such because the amount of the VAT doesn’t get directly paid to the Tax Revenue Office but to the Customs Revenue Office, and these Import VAT collected by the Customs gets deposited to the Tax Revenue Office at some point later.
The major purpose of the reverse charge mechanism in VAT systems is to shift the responsibility for paying VAT from the supplier to the recipient of goods or services. This is used mostly in specific circumstances, such as cross-border transactions with suppliers, where it can be difficult for the supplier to comply with the VAT collection and remittance requirements. The other goal of the reverse charge mechanism is to prevent tax evasion and ensure that VAT is properly collected on certain significant and sensitive transactions (e.g. the one implemented in the real estate development in Nepal). By requiring the recipient of the goods or services to report and pay the VAT to the government instead of the supplier, the government can better track and enforce VAT compliance. Lastly, reverse charging can also provide some administrative benefits and the problem of demand driven by pricing difference on obtaining service from VAT registered or unregistered suppliers.
Provisions from VAT Law on “Withholding VAT”
The unique, one of a kind provision that we have in VAT Law of Nepal – the “Withholding VAT”. Let’s call it “Withholding VAT” in this post as this is the best name that closely resembles how it actually works.
Firstly let’s look into the relevant provisions from the law covering the “Withholding VAT”.
मूल्य अभिवृद्धि कर ऐन, २०५२
मूल्य अभिवृद्धि कर नियमावली, २०५३
मूल्य अभिवृद्धि कर निर्देशिका, २०६९ (दोस्रो संशोधन, २०७६)
But “Withholding VAT” is not the same as “Reverse Charging”
💡Who does this provision apply to?
This “Withholding VAT” is applicable in transactions of supply for VATable goods and services to Nepal government entities or public institutions wholly or partly owned by Nepal government. Such public entities are required to withhold VAT as prescribed when making the payment to the supplier of such goods or services.
💡How is the amount to be withheld towards VAT determined?
When such public institutions are making payment to the supplier of such goods or services, save for this provision, the entire amount of payment would constitute the amount of VAT applicable on the transaction. But since the introduction of this provision such public entities are required to withhold 30% of the total VAT included in the total payment in making the payment.
💡Does this apply to all kinds of supplies to the public institutions?
Rule 6Ga of the VAT Rules provides that this provision of withholding VAT applies in the case of payments made as per an agreement or the contract. Does this mean that it doesn’t apply to smaller or one off transactions that do not have a formal written agreement or contract in place? Yes, it doesn’t. It has been clarified in multiple occasions by IRD in its notices and newsletters:
ठेक्का वा करार अन्तर्गतको मूल्य अभिवृभि कर भुक्तानी सम्बन्धी सूचना
कर बुलेटिन, बर्ष ७, अंक ९ (Page 5)
💡How does this amount get deposited to the Revenue Department?
The public institution withholding this payment is required to deposit the amount to the respective revenue office disclosing the details of the supplier. The internal clarification sent by Ministry of Finance to Financial Comptroller General Office regarding the procedure to deposit the withholding VAT is in the link: ५० प्रतिशत मु.अ.कर दाखिला सम्बन्धमा
💡What is the timeline for depositing this amount?
Neither the VAT Act nor the VAT Rules prescribes the timeline or the due date for the public institution to deposit this special “withholding VAT”. Statutorily, the supplier of the goods or service is required to deposit their output VAT within 25th of the following month. Even so, the responsibility of the supplier to deposit their VAT liability within the 25th of the following month doesn’t have any bearing on when the receipt of the goods or service should actually make the payment. Naturally, it is purely based on the contractual terms and commercial negotiations. So the public institutions generally deposit the amount of such withholding VAT only when they are actually releasing the payment to such suppliers. Having said that, suppliers of the goods or service can legitimately expect the amount of the VAT withheld by the public institution to be deposited in their account at the same time around which they receive their payment for supplies as per the terms of contract. Rule 6Ga(2) of the VAT Rules also requires the public institution to notify the concerned contractor or supplier that the tax amount under the concerned revenue heading has been deposited.
💡How will the withholding VAT deposited by the public institution be claimed by the supplier/contractor?
Under Rule 6Ga(3) of the VAT Rules and Section 25Ga1(1) of VAT Act, the contractor/supplier can adjust such amount with the net VAT payable by them. Practically, the amount of the VAT withheld and deposited by the public institutions will be accounted for in the VAT ledger of such supplier maintained by Revenue Department (can be viewed in the Audit Trail Report “ATR” of the supplier). Since this amount is already accounted for as the amount of VAT deposited by the supplier, the supplier would then be required to deposit only the balance amount of the liability.
💡The infamous “timing issue” and reconciliations required in withholding VAT system.
As discussed earlier above, since there is no specific requirement of timing or due date on which the public institution should deposit the taxes, oftentimes, the suppliers come across the issue where they have outstanding VAT payables but the amount of the VAT withheld by the public institution has not been deposited yet. In such cases, the supplier will have to take the burn and deposit the VAT liabilities at their due dates and wait for the public institutions to have the amount deposited and accounted for – at a later point when they will be credited for the amount deposited by the public institutions. This issue and the subsequent clarifications from IRD has been presented by Onlinekhabar in news as well: सरकारी भुक्तानीमा अग्रिम कर कट्टी झण्झटिलो
💡Accounting for withholding VAT transaction
Let’s take an example of transaction for the supply of an equipment by a supplier to a public institution registered in VAT for Rs. 100
|In the books of public institutions||In the books of supplier/contractor|
|Asset||Dr 100||Account Receivables||Dr 107.6|
|VAT Receivable||Dr 13||Withholding VAT||Dr 3.9|
|Withholding IT||Cr (1.5)||Withholding IT||Dr 1.5|
|Withholding VAT||Cr (3.9)||VAT Payable||Cr (13)|
|Account Payables||Cr (107.6)||Sales||Cr (100)|
Need for this provision
Not in any corner of the world you will see VAT arising under the same transaction being deposited partly by the buyer and partly by the seller. This VAT withholding provision is a strange addition in the Indirect Tax Law but this rings to the problem of a mismanaged public expenditure system.
In Nepal, mismanagement of funds by contractors involved in public works projects is a pervasive issue. Contractors often engage in expense cooking, profit manipulations, and overspending to inflate project costs and divert public funds for their own benefit. These unethical practices can lead to substandard project quality and even project failures, resulting in a waste of taxpayer money and negative impacts on public safety and well-being. One the one hand mismanagement of funds by contractors in public works projects in Nepal is a serious issue that undermines public trust in government and can have significant negative impacts on society, while on the other, most contracts report losses in the public contract, resulting in ineffective VAT collections, more often than not, requiring to refund their input taxes, which in itself is not an issue, but an overall report of economic losses of the private sectors reported in the public expenditure is an indication of ineffective public spending capacity – which is a burning issue in Nepal.
This provision intends to force the private sectors who are suppliers and contractors to correctly report their accounting and reporting with a force of inertia of paying VAT to the government, albeit by a mechanism of withholding VAT in advance – however strange that may be.
The Problem with Refunds
The provision for withholding VAT was introduced in VAT Rule 6Ga through Finance Act, 2076 but for a period of one year until Finance Act, 2077 came with introduction of Section 25Ga1 in VAT Act, there was time when there was no any specific provision for the refund of the withholding VAT.
Section 25Ga1(2) of the VAT Act, provides that the amount of the excess VAT withheld, that remains unsettled for the consecutive four months can be applied for refund by the contractor/supplier and the decision to determine the refund (if appropriate) will be made within 60 days of the application made.
The period of one year until 25Ga1 was introduced in VAT Act by Finance Act, 2077 was a transient period where an absence of particular provision for applying for the refund of withholding VAT was felt. Unlike in Income Tax Act, 2058 which under Section 113 allows for refund of any tax paid in excess of a person’s tax liability – there aren’t any such specific provisions in the VAT Act, 2052. So during that transient year, there were few contractors and suppliers who were not able to claim the refund due to this absence of refund mechanism and there were discussions among many such contractors/suppliers to apply the Archimedian legal remedies to obtain an order of Mandamus through Courts for resolving this problem. But now that the specific refund mechanism has been introduced through the Act, let’s hope this refund mechanism gets streamlined and common understanding among all the stakeholders – taxpayers, public institutions and revenue department alike.