Lease tax Still remain uncertain

As Nepal continues to practice federalism, issue of how allocation of powers to various layers of governance structure (federal, state and local) is exercised is surfacing. One such issue that remains unsettled is the power of taxation on rental income. This issue has also been highlighted by high level committee formed by the Ministry of Finance in its Study and Recommendation Report on Provincial and Local Taxation 2019 (2076).The Constitution of Nepal 2015 (the “Constitution”) has provided taxation powers the basis of exclusive list or concurrent list. The matters covered under exclusive list can be exercised only by the structure to which it is allocated. The Constitution has allocated matters related to income tax to the federal government and rental tax on the local bodies. The Income Tax Act 2002 (which is a federal legislation) (the “Income Tax Act”) required withholding at the rate of 10% for payment of rent. The local bodies (various municipalities) also issued legislation imposing taxes on the rental income in the form of local Finance Act (the “Local Finance Act”) with rate of different withholding taxes based on the local bodies. The lessees were required to comply with deduction of withholding taxes both under the Income Tax and the Local Finance Act. The liability of the lessors on the rental income was under both the Income Tax Act and the Local Finance Act.

Gazette Notice

The Ministry of Finance published a notice dated March 25, 2019 (the “Gazette Notice”) clarifying that lessees are subject to withholding tax under the Income Tax only where the lessors are corporate entity.  In case the lessor is a natural person, provision of only the Local Finance Act is applicable. The local bodies have not provided any clarification and under the Local Finance Act, the rental tax is applicable to both lessors i.e. individual or corporate.

Decision of Biratnagar High Court

Biratnagar High Court (the “High Court”) recently on July 08, 2019 (2076/03/23) held that collection of the income tax on the rental income of the corporate entities under the Income Tax Act did not result in taxation power of Biratnagar Metropolitan Office (which is a local body) (the “Metropolitan Office”) being infringed. Metropolitan Office had filed a writ application against Inland Revenue Office Biratnagar (the “IRO”). IRO has been collecting tax on rental income from taxpayers within its jurisdiction.

Submission of Metropolitan Office

Metropolitan Office submitted that only Metropolitan Office has power to collect tax on rental income under the Constitution and collection of taxes on rental income of corporates by IRO is in breach of the provisions of the Constitution and Inter-Government Fiscal  Arrangement Act, 2017(2074). (the “Inter-governmental Fiscal Act”)

Submission of IRO

The IRO submitted that the right of collection of tax on rental income of corporate entities rest with the federal government under the Income Tax Act and the collection of tax on rental income of corporate entities was undertaken for determining corporate income tax of the entities.

High Court’s Judgment

The High Court dismissed the writ application of the Metropolitan Office and decided in favor of the IRO as follows:

1. The Court evaluated the provisions of the Constitution and the Inter Government Finance Management Act, and determined that only the local government has right to collect tax on rental income of natural person.
2. The Court also stated the Constitution and the Inter Government Fiscal Act vests right to collect tax on business income with the Federal Government. The Court observing the circumstance and the petition of the petitioner concluded that IRO had been collecting rental taxation of the corporate entities for the purpose of determining income tax of corporate entities and not house rent tax falling under jurisdiction of Metropolitan Office.

While the wordings of the decision of the High Court does not specifically state, it appears that the decision has sought to clarify that income earned by the corporate entity is in the nature of business income and therefore subject of income tax and that only the Federal Government has right to collect tax on such income. The High Court however did not deal with the important aspect of the issue i.e. whether tax on rental income of a corporate entity is business income in nature and can only be collected by the Federal Government under the Income Tax Act.

Implications of Judgment

It is understood that the Metropolitan Office has challenged the decision of the High Court before the Supreme Court. However, till the issue is finally decided by the Supreme Court, the duality of the existing practice of collection of tax on rental income of corporate entity both by the federal government and local bodies is likely to continue. This will mean that the where the lessors are corporate entity the lessor and lessee will need to structure the rental payment provision in the lease agreement with appropriate tax and legal advice.

**DISCLAIMER: This document is prepared for general understanding and should not be taken for any legal purpose without consulting legal professionals. ** The copyright of the document is vested with PLA.