Implementation of Double Taxation Avoidance Agreements in Nepal

Double Taxation Avoidance Agreements (DTAAs) are designed to prevent the same income from being taxed in both the source country and the residence country. By allocating taxing rights between contracting states, DTAAs promote certainty, reduce fiscal barriers to cross-border trade and investment, and serve as a cornerstone of international tax cooperation. 

Nepal has signed DTAAs with 11 countries with the same objective.

Despite entering into DTAAs, the practical implementation of DTAAs in Nepal has remained legally contested and administratively inconsistent. While treaties are intended to override conflicting domestic law under Nepal’s Treaty Act 1990, tax authorities generally apply domestic provision restrictions even where the treaty does not provide for such limitations.

Nepal’s DTAA Framework and Treaty Law

Nepal’s power to enter into DTAAs originally existed under the Income Tax Act 1974 (ITA 1974). Pursuant to that authority, Nepal has entered into a majority of its existing DTAAs. The domestic legal status of these treaties is governed by Nepal Treaty Act 1990 (Treaty Act). The spirit of the said Act, as reflected in judicial interpretation, is that treaty obligations should prevail, and where any change in domestic law is required for the implementation of a treaty, such change should be duly carried out.

This principle also mirrors international treaty law under the Vienna Convention on the Law of Treaties, which requires that treaties be performed in good faith and prohibit states from invoking internal law as justification for failure to perform treaty obligations. While Nepal has signed the Vienna Convention but has not formally ratified it, these principles are widely recognised as forming part of customary international law.

In theory, therefore, Nepal’s DTAA obligations should prevail over inconsistent provisions of domestic tax law.

Section 73(5) of (Nepal) Income Tax Act and Limitation of Treaty Benefits

The Income Tax Act 2002 (ITA 2002) introduced a major structural change to Nepal’s international tax regime. Section 73(5) provides that tax exemptions under any DTAA shall apply in Nepal only if at least 50% of the ownership of the foreign entity is beneficially held by residents of the treaty partner country.

This provision operates as a statutory limitation of benefits rule introduced unilaterally into domestic law. The difficulty is that all of Nepal’s DTAAs were signed before 2002 and do not contain such ownership conditions. Among Nepal’s treaties, only the Nepal-India DTAA explicitly includes a limitation of benefits clause.

As a result, Section 73(5) has created a fundamental legal conflict. From a treaty law perspective, Nepal cannot unilaterally impose new eligibility conditions on treaty benefits without renegotiating the treaty with the counterpart state. However, in practice, tax authorities in Nepal routinely apply Section 73(5) as a screening test before granting any treaty relief.

Judicial Approach to DTAA Interpretation

The courts of Nepal have considered DTAA related disputes in only a limited number of cases. However, the approach of the court has generally favoured domestic tax administration over treaty.

In Dwarika Nath Dhungel v. Large Taxpayer Office, the Supreme Court upheld the validity of Section 73(5) as a mechanism to prevent treaty shopping. However, the court did not examine whether domestic law could override treaty obligations already undertaken by Nepal, nor did it assess the retrospective application of Section 73(5) to treaties signed before 2002.

In Pro Biotech Industries Pvt Ltd v. Large Taxpayer Office and Due Soft Overseas Nepal Pvt Ltd v. Department of Revenue Investigation, the dispute revolved around whether withholding tax was applicable on payments made to Indian entities for sales commission and service fees in the absence of a permanent establishment in Nepal. The Supreme Court held that since the Nepal-India DTAA did not specifically exempt such income, Nepal was entitled to levy withholding tax.

These decisions illustrate that the domestic tax provisions are being applied as the primary reference point, even in treaty cases.

Conflict with Treaty 

One of the most significant areas of DTAA dispute in Nepal concerns capital gains arising from the sale of shares in Nepali companies by foreign investors. Several of Nepal’s treaties, allocate taxing rights over such gains exclusively to the residence state of the seller. The treaty does not impose any beneficial ownership requirement (except Nepal-India treaty) for claiming this relief. However, the tax authorities would still apply Section 73(5) of the ITA 2002. From a legal standpoint, this approach conflicts directly with DTAA, Treaty Act, and international treaty law. The treaty bases taxing right on the residence of the entity, not the nationality or residence of its investors.

Further, the implementation problem is not limited to capital gains. It is equally visible in cross-border service payments. A recurring asymmetry exists in how service fees are taxed for example between Nepal and India. When an Indian resident makes payment to a Nepali resident for services, withholding tax is generally not applied in India. However, when a Nepali entity makes payment to an Indian resident for similar services, Nepal’s tax authorities routinely impose withholding tax. The Revenue Tribunal in Nepal has affirmed this practice on the basis that the Indian recipient can claim foreign tax credit in India. This approach, however, misunderstands the function of tax treaties.

The purpose of a DTAA is not merely to enable credit mechanisms but to allocate taxing rights in the first place. If a treaty provides that certain service income is taxable only in the residence state in the absence of a permanent establishment, the source state should refrain from taxing that income. 

Administrative Practice and IRD Notice

The institutional position of the tax authorities on DTAA implementation became clearer through a public notice issued by the Inland Revenue Department dated November 12, 2025. The notice stated that Nepal has notified those DTAA counterpart countries with which Nepal had signed DTAAs prior to 2002 about the application of Section 73(5).

This notice confirms that the tax administration intends to apply domestic ownership restrictions irrespective of when the treaties were signed, i.e., before or after the enactment of the Income Tax Act 2002. The implication is that treaty benefits will be filtered through Section 73(5) as a matter of administrative policy, even where the treaty itself does not contain any such limitation.

Way Forward

The present approach to DTAA implementation in Nepal has two primary consequences:

First, it creates legal uncertainty for foreign investors. Treaty protections form a central part of investment structuring. When such protections are denied through administrative interpretation or domestic law, Nepal’s investment climate is directly affected. Accordingly, the supremacy of treaties, particularly DTAAs, should be reaffirmed through Parliament, especially in the context where judicial decisions on DTAAs have not been fully consistent with treaty principles.

Second, the retrospective application of Section 73(5) to treaties signed before 2002 undermines legal predictability and investor reliance. This raises serious concerns relating to fairness and legitimate expectation. Therefore, where Nepal seeks to introduce ownership-based eligibility conditions, such conditions should be implemented through bilateral treaty amendments, not through unilateral domestic legislation.