Income tax is levied in the income of a person. If there is no income tax in that income, return to the investor will be higher. For example, if Rs.1000 of investments earn Rs.100 in a year before income tax of 25%; profit before tax is Rs.100 (10% of investment), income tax is Rs.25 (25% of income) and ultimate return to the investor is Rs.75 (7.5% of investment). This is why, income tax is major cost for the return to the investor (tax to net-return ratio is 1:3 in above example). Taking the dividend tax or repatriation tax, actual return will be lower than above too. Considering income tax is one of the major cost for the return to the investors, States allow the tax concession to attract huge amount of investments- especially for the infrastructure and industrial investments. Tax concessions, in contrast, cannot attract the foreign investments even there is full exemption to foreign investors.
We have not analyzed the impact of taxation in foreign investment. ‘How much direct investment will flow into Nepal, if it allows full tax exemption’ has a readymade answer of enough or more than we desire. The reality in substance is different than this.
There are more than twenty factors that affect the foreign investment in any country, directly or indirectly. Taxation is one average factor out of them, but not major amongst them. The reason is, excluding very few example, investor has tax obligation. Tax exemption in source or tax concession in source, normally, do not reduce their ultimate tax burden.
In the existing Nepal’s tax regime, there are many instances of tax concession and many of them are designed to attract foreign direct investments. Investments in the sector of manufacturing industries (except negative externalities), hydro-electricity or alternative electricity, tourism, information technology, petroleum extraction etc. are designed to attract huge amount of foreign investments.
Let’s discuss the impact with real case of tax concession in Nepal tax. There is full tax concession for the first 10 years from the date of generation of electricity, if this date falls upto 2080 Chaitra-end. Only 50% of applicable tax is levied for next 5-years. Concession in tax would be, of course, high rate of return with early pay-back. Assuming local tax rate of foreign investor is 30% in their own country. In the tax view point, this policy has four deficiencies.
Firstly, the investor will not receive any tax benefit, even Nepal allows full tax concession. In case the Hydel Company earns, say, Rs.1000 Crores. Based on tax concession, no tax is levied here and profit after tax is Rs.1000 Crores. But, investor is foreigner, and will have to pay domestic tax at 30% on their own country, resulting ‘effective profit after tax’ to the investor is equivalent to Rs.700 Crores. How much would be after tax profit, if Nepal tax rate is 20% in Hydel? This would be Rs.200 Crores in Nepal and equivalent of Rs.100 Crores in their own country and ultimately after tax income would be Rs.700 Crores. Levying tax in Nepal or concession has not affected it’s after tax income. In fact, tax concession to foreign investor, except few exception as below, is meaning-less concession. It shifts the tax from Nepal treasury to foreign country treasury.
Secondly, equity portion in any Hydel project is a small proportion comparing to debt financing and spontaneous financing. There is no tax concession for the return to the debt (interest, commission or other charges). Nepal tax do not recognize the spontaneous financing as a source of financing and may have even tax administration burden to the investor. Had tax would be an attraction, the exact benefit is allowed to a part of gross investment which employed as equity.
Thirdly, there are few extra-ordinary anti-avoidance measure employed in earlier year of business. Depreciation is one major example. There is compulsory depreciation including compulsory acceleration for tax in the beginning of the business. Major portion of capital investment base will compulsorily depreciate during the period of tax concession. After concession period, there would be unattractive depreciation base causes the high tax. In the manufacturing or infrastructure business, method for repair allowance is demotivating rewards for investors. We know the new machine or installation requires low repair cost and old equipment or installation requires high repair cost. Sometimes, repair cost in old equipment or machinery would be so high (beyond economic repair, BER), to the owner and motivates to replace it. There is high limit of repair in the new equipment and this limit falls when it becomes old. Again after concessional period, real repair cost will be disallowed, results high tax.
Above cases are similar for any type of tax concession which were intended for foreign investments like manufacturing, infrastructure, service-sector, information technology, tourism or other. Attracting foreign investor, tax concession is not a good tool. Minor activity of central bank, for example, would be very influencing factor to the foreign investor than periodic tax concession or no tax forever.
Fourthly, foreign investors have expertise of investment in the country having vulnerable public administration including tax administration. No foreign investors relies the tax administration, where the country adopts withholding tax practices in normal business transactions (except for employment). Withholding tax procedures always creates ambiguities and judge is always the taxation authority who are complaints also. Internationally, tax concession is strictly interpreted in favor of taxation authority. To obtain the concession, each and every provision of tax conditions must be fulfilled by tax payer. In case, assessing officer rejects the tax concession showing minor deviations, there would no remedy to the taxpayer/investor. There would be appeal mechanism; however, ultimately assessing officer is judge there. Eventually such practices demotivate experienced foreign investor in the tax matters.
Withholding tax on normal business transaction will create the ambiguity for tax obligation. For example, purchase of equipment from foreign country, there is income of exporter in own country and tax on importing country will not levied to the exporter. But, country employing withholding tax on normal business transaction seeks withholding tax in import. Taking example of Nepal, non-resident do not require to pay tax if they have not business income in Nepal as per Nepal tax law. In case a Hydel Company imports electro-mechanical equipment, 5% withholding tax requires to withheld as per another Section of tax law. Exporting party, of course, do not pay the Nepal tax as per international practice or showing Nepal tax law. But, importing party obliges for withheld the tax; this means 5% of import cost will be paid by the Hydel Company as gross-up procedure. The tax concession during business period has paid in advance during constructor period here. Similar cases will be occurred for interest during construction too. Foreign investor will recover interest delay with grace-period during construction because of reason of cash-flow to the developer. Tax on that interest will be levied at the point of accounting of interest during construction. Here, debt-financer realizes the short-fall of cash-flow during construction, but taxation authority having tax concession facility fails to realize same. In most of the case of withholding tax procedure, this will either be grossed up burden to the developer or early financing requires to them.
Then, question may arise, why tax-heaven are attractive to the foreign investors or black-money owner? The reason is not the tax or tax-heaven, but the loose corporate environment and tight information policy. If an investor registers a company in Nepal, practically winding up is extremely difficult; if a labor works for 240 days, many practical difficulties requires to remove him/her; if a company earns profit and wants to repatriate dividend, transferring bank seeks tax-paid -certificate during tax concession period etc. are more decisive factor for foreign investor than tax concession. In the tax-heaven countries they have- most easy process for registering a company or liquidation - within one or few days; nolabor restrictions, easy and fast administrative procedure, fast judicial process; restriction-less money transfer/wiretransfer etc.
Tax concession to the foreign investor may be sometimes beneficial to the real investor in case there is double tax avoidance agreement either with exemption method of elimination of double tax or with tax sparing provision.
In the exemption method of elimination of double taxation, domestic investor having foreign income is exempt for local tax; so, tax benefits from the Source State fall in the pocket of investor.
In the credit method of elimination of double taxation, tax sparing method within the credit method will bring back the tax concession to the pocket of investor. In tax sparing method, resident country levies the tax in foreign source income assuming, the deemed payment of tax to the extent of concession allowed in the source country. Nepal has entered into tax treaties with 10-StatesAustria, China, India, Korea, Mauritius, Norway, Pakistan, Qatar, Sri Lanka and Thailand. There is good condition of Tax Sparing Provision in all those ten tax treaties, except obstacles with Austria and Norway. Under Tax Sparing Provision, the tax concession in the source country deemed to be as tax paid for the purpose of tax calculation in resident country of the investors. For example, if a Chinese investor invests equity capital in hydro-electricity project in Nepal, there is tax concession for first 10 years. In the absence of tax concession, there is tax of 20% of profit. Chinese investors receive full income due to tax concession, and Chinese taxation authority allows Nepal tax credit of 20% based on Tax Sparing Provision under Para 3 of Article 23 of tax treaty of Nepal and China. Similar benefit will receive by the investors from other treaty-countries except investors from Austria and Norway.
In the case of investors from Austria, there is Tax Sparing Provision in the tax treaty, but Austria exempts Nepal income for Austrian tax as exempt method of double taxation, but it uses exemption with progression. Due to exemption method, out tax concession is benefit to the Austrian investors in Nepal. But exemption with progression of Austrian tax, it increases the tax burden to the investors and intended benefit will be lower than Nepal allows as concession.
In the case of investors from Norway, there was Tax Sparing Provision for the first 10 years which lapsed the benefit period now. Any tax concession from Nepal tax to the Norwegian investors in Nepal, now obtains tax concession here, but requires to pay whole tax in Norway. This will shift the tax concession from Nepal treasury to the Norwegian treasury.
Apart from above cases, all the foreign equity investors will not obtain any tax benefit from concession in Nepal. In all cases, debt-investors will not obtain any tax concession.
Some of the tax concessions are for public-consumption only. For example, we can discuss the tax concession in information technology. Nepal tax law allows few tax concessions in specified IT-business having operated in specified places of business-parks. Unfortunately, we have no such technical parks, where any tax concession may be waived for the information business-holder. Second example is establishment of manufacturing industry in the Special Economic Zone (SEZ). We planned to establish SEZ since last 30 years, but have none. Third example would be tax concession on sale of or export of intellectual property, where its registration law is extremely weak to obtain own right.
What can we do for attracting foreign investments? Even income tax is one of the major cost for the return to the investor, this is not major factor for investing in any project or in any country. Person having income pays tax, if and only if there is good business environment. For taxation, minor harassment may demotivate the investor. We should concentrate to resolve those minor tax factors which may cause the investor heavy administrative burden. Repatriation of income is another crucial factor for investors. Consider, there is tax concession and banker, as instructed by a circular of tax administration, does not allow the repatriation of income without tax paid documents. This is minor administrative burden, but all the investing environment has collapsed easily.
(This article is reproduced from the June 2016, Vol. 18, No. 4 edition of journal published by The Institute of Chartered Accountants of Nepal.)