The concept of Foreign Permanent Establishments (FPE) is relatively new in Nepalese context. Though Income Tax Act 2058 introduced it more than 6 years back, the provision is yet to be properly explained and implemented. Here we try to explain what FPE means, concept underlying it and its responsibilities under the IT law.
The existence of a “Permanent Establishment” (PE) in a country as per Tax law is analogous to the concept of branch under Company law.
As per Sec 2 (ka da) of IT Act, Permanent Establishment means a place from where a person fully or partially conducts his business. The term also includes place of fully or partially conducting business through agents (other than independent agents), place where main equipment or machinery is kept or installed or used, places where a person has provided any technical, professional, or consultancy service through his employees or otherwise for more than 90 days (at once or severally) in a 12 months period and a place where a person is engaged in a construction, assembly, or establishment project for 90 days or more, and the place of supervision of such project.
If the permanent establishment is of a foreign entity, it becomes ‘Foreign Permanent Establishment’ (Sec. 2 (Bha) of IT Act). Such FPE is treated as an entity for income tax purpose. So, all the provisions applicable to entity as per Income Tax Act apply to FPE. The income earned through such FPE in Nepal is taxed as an entity and the income that it repatriates to its controlling foreign person is taxed as if it is dividend distributed.
PE- International Concept
As per international tax law concept, all countries assert jurisdiction to tax persons where the source of income, profits or gains or the location of assets fall in their territory. Called “source concept”, it gives first right to tax an income in the country where its source is located. When an overseas resident has substantive presence in a country, he meets the threshold of having a permanent establishment (PE). If the person is carrying on business through such PE, than tax may be due in the country where PE is established, on “source concept” as well as in the country of his residence on “resident concept”. So, the provision of PE is widely accepted around the globe and is incorporated in OECD and UN Model conventions. These conventions are internationally accepted models for conducting bilateral Double Tax Avoidance Treaties and are also authoritative text for interpreting PE.
Interpreting FPE with Examples
As we have defined FPE as PE of a foreign entity, to establish a FPE, the point first is to determine whether PE exists on not.
The basic definition of PE given in IT Act simply means “a place from where a person fully or partially conducts his business”. This gives three basic conditions to decide the existence of PE.
- • Existence of place of business
- • This place of business must be fixed and
- • Carrying of business through this fixed place.
Though the term ‘fixed’ is not clearly mentioned in this definition, we use it here because the intention of law is not to term an isolated transaction of short term nature as PE, hence the criteria of 90 days for specified transactions. Besides, in OECD & UN Model conventions, fixed place of business is the most basic condition used for determining the existence of PE. The mere fact that an enterprise has certain amount of space at its disposal which is used for business activities is sufficient to constitute a place of business. No formal right to use that place is therefore required.
- Suppose an employee of a company who for a long period of time, is allowed to use an office in the headquarters of another company (e.g. a newly acquired subsidiary) in order to ensure that the latter company complies with its obligations under contracts concluded with the former company. In such case the employee is carrying out business of the former company and the space at his disposal in the latter company will constitute PE. (See Commentary to Article 5 OECD Model Treaty).
- Beta Bank of Nepal did a technical service agreement (TSA) with Alpha Bank whereby Alpha Bank provided three managerial level staff to Beta for a whole year to provide technical assistance. In return, Beta Bank reimburses all the salary and other cost of staffs and a separate fee to Alpha Bank. In such a case, Alpha Bank is said to have FPE in Nepal.
- Suppose a Malaysian company wins a contract to undertake construction of a bridge in Nepal. A construction team of the company works in Nepal for 175 days to construct the bridge and returns to Malaysia. Though the Malaysian company does not have any separate legal status here, it is regarded as having FPE in Nepal because it was involving in construction project for more than 90 days.
FPE- Liabilities as per IT Act
Once we conclude that FPE exists, many provisions of the IT Act is attracted, as the FPE is regarded as entity. FPE are regarded as “Residents” for Nepal and so are required to comply with the provisions applicable to resident persons, like deducting TDS when it makes payment attracting Sec. 87, 88 & 89.
The FPE should file its tax return under self assessment basis by including all income of the FPE and deducting all relevant expenses. Any expenses of the foreign person in its respective country that is exclusively incurred for the purpose of such FPE can be claimed as expense. The profit is taxed as if it were an entity.
The Profit after tax so derived, is taxed at 5% when it is repatriated to the nonresident foreign person. This is a form of dividend tax and ensures that domestic companies are not at disadvantaged position compared to FPE.
Such tax paid by FPE here could again be taxed in the country of residence of the foreign person. In that case, the foreign resident claims tax credit for the tax that is paid in Nepal by his FPE as per the law of the country of his residence. So, in example “1” above, from Beta Bank perspective it is sufficient if it makes TDS on service fee it pays to Alpha Bank and on employee remuneration. However, if FPE of Alpha Bank does not submit its tax return here, it is avoiding tax in Nepal because higher tax rate applies as an entity and additional tax on repatriation. This avoided tax indirectly goes to the country of residence of Alpha Bank, instead of Nepal who has the first right to tax the income on “Source concept” basis.