Facts of the Case
In the case of Duo Soft Overseas Private Limited vs. Department of Revenue Investigation (“DRI”), D. N. 8841 decided on September 8, 2012 (2069/05/23 B.S.), the Supreme Court of Nepal, presided over by Justices Damodar Prasad Sharma and Bharat Raj Upreti, ruled on the taxation of income generated by an Indian company. Duo Soft Overseas Private Limited, a Nepalese company, had purchased an e-book from an Indian company, MADS. DRI imposed a withholding tax obligation on Duo Soft, arguing that the payment constituted a taxable service. Duo Soft contested this decision, asserting that under the India-Nepal Double Taxation Avoidance Agreement (“DTAA”), such income should be taxable only in India.
Decision of the Supreme Court
The Supreme Court ruled against Duo Soft, holding that the payment for the e-book constituted a taxable service under Nepal’s Income Tax Act, 2002. It held that since the payment was made to a foreign entity, Nepalese tax law required Duo Soft to withhold taxes before remitting the amount.
Notably, the Court did not analyze Article 22 of the DTAA, instead making its decision solely based on domestic tax law. This approach imposed a tax burden on Duo Soft despite its argument that the DTAA should provide relief from such withholding obligations.
Analysis of the Decision
The ruling raises significant concerns about the misapplication of tax treaty provisions and the failure to consider DTAA obligations. Article 22 of DTAA explicitly states that income not covered by other provisions of the treaty shall be taxable only in the state of residence of the taxpayer. The purpose of this article is to provide clarity on income that does not fall under any specific category such as business profits (Article 7) or royalties and fees for technical services (Article 12).
In this case, the payment made by Duo Soft to MADS was not for business profits, as MADS did not have a permanent establishment (PE) in Nepal, nor did it qualify as a royalty or technical service fee. Therefore, the transaction should have been classified under Article 22 (Other Income), making it taxable only in India. By disregarding this key provision, the Supreme Court of Nepal effectively ignored DTAA obligations and opted for a unilateral approach based on domestic law. The Court did not even analyze the DTAA argument put forth by Duo Soft, despite the clear applicability of Article 22.
In our experience, the Supreme Court of Nepal typically gives preference to the DTAA when analyzing permanent establishment cases. However, in this instance, it was inconsistent in its approach, failing to uphold the principles of international tax treaties and allowing domestic law to override treaty obligations.
Way Forward
The case of Duo Soft underscores the complexities of unilateral tax enforcement in cross-border transactions. Taxpayers facing double taxation due to unilateral tax enforcement may seek relief through the Mutual Agreement Procedure (“MAP”) available in double taxation agreements. This mechanism allows tax authorities of both contracting states to negotiate and resolve disputes where taxation is not in line with treaty provisions.
For example, in the India-Nepal DTAA, MAP under Article 25 provides a route for taxpayers to present their case if they believe taxation in either country violates treaty provisions. If a company operating across both jurisdictions is taxed on the same income despite DTAA protections, it can approach its home country’s tax authority to engage with the counterpart in the other country. If successful, this can lead to tax adjustments that prevent double taxation.
However, MAP is not widely used due to its lengthy resolution process, uncertainty in outcomes, and the discretion tax authorities hold in resolving disputes. Given these challenges, the Foreign Tax Credit (FTC) mechanism remains the most practical and immediate solution.
Companies impacted by unilateral taxation should actively pursue Foreign Tax Credit (FTC) in India to offset taxes paid in Nepal. For example, if an Indian company earns INR 10 lakh from Nepal and is subjected to a 15% tax (INR 1.5 lakh) in Nepal, the same income may also be taxed in India. However, under the FTC mechanism, the company can claim credit for the INR 1.5 lakh paid in Nepal against its Indian tax liability, provided it meets documentation and compliance requirements and within ceiling provided by the respective tax laws. This prevents double taxation and ensures the company does not suffer excessive tax burdens.
Niti Partners can assist businesses in navigating tax laws. For expert guidance, reach out at [email protected].