Taxation of Composite Contracts in Nepal
OFFSHORE SUPPLY AND SECTION 89
Nepal’s tax system is conceptually aligned with global practice in recognising two core principles of taxation: the residency principle and the source principle. Under these principles, a resident is taxed on worldwide income, while a non-resident is taxed only on income that has a source in Nepal. This territorial limitation is enshrined in Sections 6 and 67 of the Income Tax Act of Nepal, 2002 (2058) (ITA).
However, the actual application of the law has not always followed this principle. The operation of Section 89, which imposes withholding tax obligations on payments made under deeds or contracts, has been interpreted in a way that expands Nepal’s taxing jurisdiction beyond what the law itself appears to permit.
This conflict is especially visible in the treatment of composite contracts involving both offshore and onshore activities. Since most large infrastructure and EPC contracts are structured as composite contracts, the way they are taxed directly influences project costs and can determine whether foreign contractors are willing to invest and operate in Nepal.
Composite Contract Structure
In a typical composite contract:
Offshore supply: The foreign contractor (incorporated and managed outside Nepal) manufactures and supplies equipment from abroad. The entire activity (production, assembly, testing and shipment) occurs outside Nepal. Offshore supply is invoiced directly from the foreign company to the Nepali customer.
Onshore supply:
The same foreign contractor establishes a branch office in Nepal (Nepal branch) to carry out the onshore part of the contract. The branch is responsible for installation, commissioning, construction and training activities within Nepal. Onshore services are invoiced locally.
The structure is common in large turnkey infrastructure projects (power stations, transmission networks, industrial plants) because it allows technical equipment to be manufactured in specialised facilities abroad, while the installation and project execution are handled through the Nepal branch.
Original Tax Practice: Offshore Supply
In the past, tax authorities in Nepal insisted on withholding tax (WHT) on offshore supply under Section 89(3) of the ITA. This provision requires a resident payer to deduct 5% WHT when making payments under a deed or contract to a non-resident.
In practice, this meant that:
• even where the offshore supply was entirely performed abroad, and
• even where the foreign contractor had no operations in Nepal in respect of that supply,
the tax authorities still required the payer to deduct 5% WHT at the time of payment. The justification provided was that the statutory wording of Section 89 was broad enough to cover any payment under a contract, regardless of the income’s source.
This approach was inconsistent with the charging provisions of the ITA, which restrict tax to income sourced in Nepal.
Change in Approach: Public Circular and Attribution to Nepal Branch
In recent years, the tax authorities have advanced a new position through a public circular, which may be summarised as follows:
1. A composite contract must be treated as a whole.
2. Since the foreign contractor delivers part of the contract through its Nepal branch, the branch becomes the taxable presence in Nepal.
3. Consequently, both offshore and onshore supply segments are considered part of the business income of the Nepal branch.
4. The entire contract amount is therefore subject to:
• Withholding tax at the customer level, and
• Corporate income tax in Nepal at the branch level.
In other words, what was previously taxed through withholding on offshore supply has now been expanded into a doctrine of full attribution of composite contract income to the Nepal branch.
The Legal Conflict
This change raises a fundamental question: Can offshore supply, conducted entirely outside Nepal, be taxed in Nepal simply because it forms part of a composite contract that also includes onshore activities?
1. Source Principle vs Circular
• Section 6 of the ITA: Non-residents are taxable only on Nepal-sourced income.
• Section 67 of the ITA: Defines Nepal-sourced income, among other things, as arising from activities conducted in Nepal.
• Offshore manufacture and supply do not fall under the scope of Section 6 and 67 of the ITA.
2. Withholding Provision Vs. Charging Provision
• Section 89 is a withholding mechanism; it does not create a new head of income.
• By treating all contract payments as subject to Section 89, the tax authorities effectively override the source rule.
• This raises a doctrinal issue: a withholding provision cannot expand the scope of chargeability.
3. Branch Attribution Issue
• A Nepal branch is a resident under Section 2(ao) of the ITA.
• As a resident, it is taxed on worldwide income.
• But attributing offshore activities of the head office abroad to the branch stretches the meaning of ‘worldwide income’ beyond recognition, since the branch itself never carried out those activities.
Comparative Perspective
Globally, the treatment of composite contracts has been clarified through international guidance and precedents. The OECD Model Commentary provides that only profits attributable to a permanent establishment in the host country can be taxed there. Activities carried out wholly abroad remain outside the host country’s taxing rights. This principle suggests that Nepal’s current practice, taxing offshore supply by attributing it to the Nepal branch, departs from widely accepted international norms.
Implications for Foreign Contractors
1. Contractual Uncertainty: Even clear contractual segregation between offshore and onshore components will not prevent full attribution by the tax authorities.
2. Increased Tax Burden: Offshore supply income, which should remain outside Nepal’s tax net, is now brought within both WHT and corporate tax.
3. Risk of Double Taxation: The same income may be taxed in Nepal and again in the contractor’s home jurisdiction, with limited scope for relief where no tax treaty exists. In addition, even where a treaty is in place, its application in Nepal is often inconsistent, which is a separate topic for discussion.
4. Investor Confidence: The unpredictability of tax outcomes creates a deterrent for foreign contractors considering long-term projects in Nepal.
Options for Foreign Contractors
1. Advance Ruling and Judicial Recourse: Contractors may seek clarification before tax liability is finalised. However, in light of the public circular, the tax authority is highly likely either to adhere strictly to the circular or to delay issuing a ruling. In either case, the matter may need to be challenged judicially, a process that could take three–four years for final resolution.
2. Tax Refund: In principle, refunds are available where excess WHT has been withheld. In practice, however, refunds are administratively difficult for non-residents and rarely granted. They may be possible if the issue is resolved through the courts, but even then, the process remains highly burdensome.
3. Treaty Relief: Where a tax treaty exists, double taxation can potentially be resolved through the Mutual Agreement Procedure.
Conclusion
The evolution of Nepal’s practice on composite contracts reflects a shift from narrow enforcement of Section 89 withholding on offshore supply to a broader doctrine that treats the entire contract as taxable income of the Nepal branch. While this approach simplifies administration for the tax authorities, it risks overreach by disregarding the source principle embedded in Nepali tax law.
The legal position remains that only Nepal-sourced income should be taxable in Nepal. Offshore supply, manufactured and delivered abroad, does not meet this criterion. Until clarified by courts or legislation, foreign contractors will continue to face uncertainty, not over whether tax will be imposed, but over whether the current approach of taxing offshore supply will ultimately withstand judicial scrutiny, and how relief (if any) may be obtained.
Only through consistent alignment between the source principle and the enforcement of Section 89 can Nepal strike the balance between securing tax revenues and maintaining a predictable environment for cross-border investment.
