IMAGE: MARK LONG
WHEN A poor country decides to tax more of the economic activity within its borders, it is usually a sign of development. So it is with Nepal. The Himalayan republic’s Inland Revenue Department has formally notified seven of the countries with which it has double-taxation treaties of a change to its domestic law. The amendment introduces what is known as an “anti-treaty-shopping” rule. The countries—Austria, China, South Korea, Norway, Pakistan, Sri Lanka and Thailand—are those whose treaties with Nepal are now subject to the new provision. It is a small but big step in the country’s economic maturation.
Double-taxation treaties exist to prevent income from being taxed twice, once in the country where it is earned and again in the recipient’s home country (see this Dolma’s case). They typically lower the rate of withholding tax—a levy on cross-border payments such as dividends or interest—that would otherwise apply. But such agreements can be exploited. “Treaty shopping” is the practice of routing investments or payments through an intermediary country, or a local entity, solely to secure a more favourable tax rate. A foreign investor might use a shell company in Nepal, or in a country that has a treaty with Nepal, to claim a lower withholding tax even though the firm’s real owners live elsewhere. The new rule seeks to stop that.
Nepal’s law will deny treaty benefits to any entity if 50% or more of its ownership is held by people or firms that are not residents of either Nepal or the treaty partner. The provision is intended to protect the integrity of the country’s tax treaties, ensuring their benefits go to genuine residents of the signatory states. The formal notifications to treaty partners are a procedural necessity, making the domestic change effective for the purposes of treaty application. It brings Nepal into line with international efforts, led by the OECD, a club of mostly rich countries, to curb treaty abuse.
The immediate hit will fall on those using Nepali entities or treaty partners as conduits. Investment funds and holding companies that lack real substance—say, no employees or operations in Nepal—will be unable to claim reduced withholding rates. Service and royalty arrangements that rely on clever structures rather than genuine economic activity will also be affected. Tax advisers who built such schemes will need new business models. Bona fide investors with actual operations in Nepal should be unaffected.
In the short term, the government can expect higher revenues. Payments that once slipped through at low treaty rates will now be taxed at Nepal’s domestic withholding rates, which can be as high as 25%. Withholding agents, such as banks and companies making cross-border payments, will have more paperwork. They must collect documentation proving residency and substance. Some taxpayers will challenge the denials, leading to a rise in disputes and requests for bilateral talks between tax authorities.
The diplomatic implications are manageable. Nepal’s move falls in line with global norms, which should please multilateral institutions and many developed countries. The seven notified partners may seek clarifications, but outright opposition is unlikely. Several have similar anti-abuse rules themselves. Competent authorities will engage in technical discussions to smooth the transition. The greater risk is a short-term chill on certain cross-border investments until the practical application of the rule becomes clear.
Companies and investors with Nepali interests should now review their structures. Those using local entities as conduits must consider restructuring. Firms with real operations should document their substance—board meetings, local staff, office leases and decision-making. Withholding agents ought to strengthen due diligence. Where big sums are at stake, seeking advance rulings from Nepali authorities or triggering bilateral talks may be prudent.
For Nepal the change represents a trade-off. It should boost revenue and fairness, but may dampen some foreign investment in the short term. The authorities must now provide clear guidance on how the rule will be applied, perhaps with examples or safe harbours. Strengthening beneficial-ownership registers and information exchange will make enforcement more effective. With careful implementation Nepal can curb abuse without harming genuine investment. That would be a sign of a tax system growing up. ■
