Applicability of Capital Gains Tax in Offshore Share Transactions
The applicability of capital gains tax under Section 95A in offshore share transactions under the Income Tax Act (ITA) of Nepal has sparked considerable debate and analysis within legal and financial circles. The intricacies surrounding the application of these provisions have generated significant interest prompting a thorough examination in this article. Our objective is to meticulously scrutinise the nuances inherent in these regulatory measures, providing an in-depth exploration of their implications. This exploration will encompass an examination of the legal principles guiding these provisions, while also delving into the historical practices that have shaped their application. Furthermore, an analysis of the current practices in light of these provisions will be undertaken to offer a holistic understanding of their impact on offshore share transactions within the Nepali legal framework.
1. Understanding Capital Gains Tax under Section 95A
1.1. Provision of Section 95A
Section 95A of the ITA mandates tax payments on gains from the disposal of interest in a resident entity by a person. The tax rate varies based on the nature of the entity whose interest is disposed of and the nature of the person disposing of the interest. The tax rate ranges from 5% to 25% of the gain. The obligation for withholding tax on such gains lies on the stock exchange, i.e. Nepal Stock Exchange, in the present context, if the interests of listed companies are being disposed of. For unlisted companies, the withholding obligation remains with the relevant company. Notably, capital gains tax under Section 95A applies solely to the disposal of interest in a resident entity. The ITA clearly defines the term ‘resident entity’ and ‘interest in the entity’, providing detailed explanations as follows.
1.2. Clarification on Residency
It is crucial to understand that Section 95A is applicable exclusively when the disposal of interest occurs in a resident entity. A resident entity includes, among others, a foreign permanent establishment of a non-resident person situated in Nepal and a company incorporated under the laws of Nepal or one with management effectively located in Nepal during any income year. The Income Tax Directives, issued by the Inland Revenue Department (which is responsible for drafting and implementing tax policies and laws), further provides clarity on the application of Section 95A through illustrative examples. These examples include scenarios such as the disposal of shares by a natural person in a company listed on the stock exchange and the other related to the disposal of shares by a company in a company not listed on the stock exchange. Notably, there is an absence of example demonstrating the application of capital gains for a foreign individual or company selling shares in another foreign company that holds shares in Nepali listed or unlisted companies.
1.3. Interest in Entity
The term ‘interest in the entity’ is explicitly defined as the contingent right to receive income or capital of any entity. The Income Tax Directives elaborate on this definition, contextualizing it across various entities. In case of a company, interest in the entity means the right of the shareholder to receive consideration for the investment and also the contingent right in the event of liquidation. However, it is noteworthy that the explanation and the example provided in the Income Tax Directives do not encompass scenarios of the indirect ownership or the ultimate beneficiary, leaving a gap in the coverage of these specific aspects.
1.4. Implications for Offshore Transactions
Considering the provisions outlined above, in the context of offshore transactions where shares of a foreign company, which in turn holds shares in Nepal, are disposed of, capital gains tax should not be payable in Nepal. This exclusion arises due to the specific drafting language of Section 95A, which exclusively capture transactions where the shares of the Nepali company are directly sold. As such, the scope of this section does not extend to situations involving the indirect sale of shares in Nepali companies through a foreign entity.
2. Principles of ITA
The taxation framework under the ITA relies on the residence rule and the source of income rule. According to these principles, a non-resident person is only liable to pay taxes in Nepal solely on income sourced in Nepal. However, not all the income has source in Nepal as only those explicitly outlined in Section 67 of the ITA are deemed to have a source in Nepal. While Section 67 of the ITA comprehensively delineates various sources of income in Nepal, encompassing dividends, interest, royalties, and rents, it notably omits explicit coverage of offshore transactions related to the transfer of shares. Section 67 specifies that profits or losses arising from the disposal of property or liabilities are considered to have a source in Nepal only if the property is situated within Nepal. Despite this, the explanatory notes accompanying the section narrow the definition of ‘property situated in Nepal’ to specific categories of property, excluding shares in foreign entities holding shares in Nepali entities.
3. Past Precedent and Practice
In the renowned case of Dwarikanath Dhungel v. Large Taxpayer Office, the Supreme Court of Nepal has held that Section 95A of the ITA is applicable in offshore share transactions. As discussed above the capital gains tax on the disposal of shares lies with the shareholder disposing of the shares, and Nepal Stock Exchange or relevant Nepali company to withhold and deposit the capital gains tax. However, the Supreme Court in the said case does not explicitly mandate the offshore shareholder or other person to pay capital gains tax under this section and it also has not required the Nepali company to deposit the capital gains tax with the Tax Office.
Despite the absence of explicit provisions in the ITA, tax authorities have endeavoured to assert taxation on non-residents for gains derived from the disposal of shares in offshore entities that hold shares in Nepali entities. Additionally, they have assigned Nepali entities with responsibility of withholding capital gains tax in such transactions. This highlights a disparity between the legal provisions articulated in the ITA and the actual practice followed by tax administration, introducing a notable incongruity between the statutory framework and the practical implementation of tax regulations.
Conclusion
The applicability of capital gains tax under Section 95A of ITA in offshore share transactions gives rise to several issues. Although legal provisions and the Income Tax Directives issued by the Inland Revenue Department provide some guidance, ambiguities persist. Addressing these ambiguities is imperative for providing additional clarification and ensuring consistent application of tax laws, thereby promoting fairness and transparency in the taxation of offshore transactions involving Nepali entities. Establishing clear guidelines for application of Section 95A and maintaining consistency in its implementation will foster a more conducive environment for investment and business activities in Nepal.
