Fueling Nepal's IT Sector: The Impact of Tax Arrangements and Future Potential

With the potential to become a major driver of economic growth, the Information technology (IT) industry in Nepal is still in its early stages of development Despite being a booming industry that is yet to be remarkable in the business sectors of Nepal, the IT industry has been creating thousands of new job opportunities and has been making a significant impact in the overall economy of the country. 

In the same manner, the IT industry is one of the prominent sectors of businesses that attract foreign investment in Nepal. As a technology-driven industry, the IT industry is the most fast-paced business in Nepal, which has helped to improve the transfer of technology and has been making Nepal competitive in the global economy. 

In the current times, Nepal has successfully entered the global market and has been establishing itself as an alternative offshore outsourcing location to other  South Asian countries such as India, Pakistan, etc. The significantly low labor cost in comparison to other countries, the ideal time zone, and the adaptability of the workers seeking better opportunities in Nepal are a few of the major reasons why Nepal has been gaining popularity as the offshore outsourcing venue for foreign IT entities. Consolidating business in Nepal, many foreign companies have been building a niche market for their products globally. 

Impact of Tax Arrangements in the IT Sector

Even though larger South Asian economies like India and China have made remarkable contributions to their economy through export sales of IT services, Nepal is also emerging as a better alternative for outsourcing services. In order to emerge as a remarkable venue for providing IT services, collective efforts to promote the IT sector will be required from the private sector and government in Nepal.  

Talking about this, the government has been taking important steps over the last two years by incentivizing tax arrangements for IT companies/ persons who have earned foreign currency by exporting IT services from Nepal. 

And yes! Tax arrangements can have a significant impact on the development of the IT sector in Nepal. In fact, it is a major attraction for any business sector. In general, tax arrangements can have a positive or negative impact on the IT sector, depending on the specific details of the arrangements.

For example, if the government imposes a new tax on outsourcing IT services, companies may find it more expensive to outsource their IT requirements. This could result in employment losses in the IT sector, as companies would move their operations to countries with lower taxes. On the other hand, governments offering tax breaks for research and development (R&D) expenses, could incentivize companies to invest in IT infrastructure and R&D. This could result in job creation and economic growth in the IT sector. Likewise, as relevant to the present scenario, tax breaks for IT export sales can make it more profitable for businesses to sell their IT products and services overseas. This can help to boost the IT sector's contribution to the economy.

Tax Arrangement in the Past and Present

As opposed to the tax arrangements that have been brought from the last two fiscal years (F/Y), F/Y 2079/80 and F/Y 2080/81 for the IT sector, the tax arrangement previously for the export sales of IT services was the same as that for the domestic sales. Meaning, the IT entities were liable for 25% corporate tax on income generated from revenue, either domestic sales or export sales. 

However, the government took a massive leap by introducing a major tax exemption of 99% on the export sale revenue of IT services for the F/Y 2079/80. In the Finance Act, 2079, a special provision was brought in section 22 that provided:

“Person or entity who has earned foreign currency by exporting IT services, including business process outsourcing, software programming, cloud computing, etc., will be liable for 1% income tax in relation to such income earned in foreign currency for the F/Y 2079/80”

In the same manner, continuing to take the leap, the government for the upcoming F/Y 2080/81 has proposed another such impressive provision, actually even better. Amending section 11 subsection 3e(c) in  the Income Tax Act, 2058, the government has proposed the following  through the Financial Bill, 2080:

“Person or entity who has earned foreign currency by exporting IT services, including business process outsourcing, software programming, cloud computing, etc., to be provided 50% income tax exemption up to F/Y 2084/85 in relation to such income earned in foreign currency.” 

Analyzing the Tax Arrangements 

The potential benefits of the export sales and the influx of foreign currency in Nepal, have also majorly contributed to the introduction of this incentivizing tax arrangement over the past two years. This incentive, primarily brought to encourage citizens and entities who were earning from exporting their services abroad, can also increase the government’s foreign currency reserve to a certain extent, as a roundabout outcome. 

According to the Nepal Rastra Bank’s (NRB) annual report on ‘Current Macroeconomic and Financial Situation of Nepal’ (Based on Five Months’ Data Ending Mid-December, 2021/22) the gross foreign exchange reserves decreased by 13.2% to Rs.1214.03 billion in mid-December 2021 from Rs.1399.03 billion in mid-July 2021. Even the remittance inflows decreased by 6.8 % against an increase of 11.0 % in the previous fiscal year. Thus, it cannot be overlooked that the tax incentive was also brought as a recourse to the major foreign currency crunch that the government was facing. In a time when even less would have been significant, this incentive seems crucial to bring in at least some amount of foreign currency to balance the declining foreign exchange reserve of the country.

In the same manner, nevertheless remotely, the still-prevalent practice of illegal remittance of foreign currency from the foreign marketplace through illegal channels like hundi cannot be overlooked. Thus, this incentive is also an additional step taken to systemize and formalize the revenue collection of an industry that can easily attract export sales and foreign investment in comparison to other sectors of business.

Now, analyzing the two provisions, the incentivizing provision that was first introduced by the Finance Act, 2079 for F/Y 2079/80 that exempted 99% of the income tax on export sales of IT services provided by persons and entities from Nepal, was only for the F/Y 2079/80. The tax arrangement was a special provision brought by the Finance Act, 2079. However, the Finance Bill, 2080 has brought the arrangement to provide a 50% tax exemption on the export sales of IT services provided by persons and entities overseas until F/Y 2084/85. This provision has been brought as an amendment to the existing provisions of the Income Tax Act, of 2058. 

Now, if we are to analyze which is a better provision, the former or the latter for the IT business, the answer is quite evident, right? 

The former provision brought for F/Y 2079/80, despite having an enormous 99% tax amnesty for income earned through export sales, was merely a special provision brought for the same fiscal year. But if we look at the provision brought for the upcoming FY 2080/81, even though the tax exemption has been deducted to the closest half, the 50% tax exemption on export sales will keep prevailing until F/Y 2084/85. That is a whopping 5 years of tax amnesty! That means for the next five years, companies or persons exporting IT services abroad can have a 50% tax exemption on their export sales revenue.

Foreseeable Outcome

Now let's take a while to predict what kind of impact this incentive might have on the IT businesses:

Promotion of the IT Sector

Firstly, ever since the deliberation of the budget that remarked the removal of the minimum cap of foreign investment in IT sectors and the proposal to provide a foreign exchange facility of up to 10% for foreign currency earned for the establishment of contact offices in a third country, purchase of software or program and installment of equipment, for IT industries exporting service abroad, it was clear that government was of the intention to promote IT sector like never before. So, it is evident that an additional tax exemption of 50% will create a friendlier environment for IT sectors to boom. 

The Influx of Foreign Currency 

In the same manner, after bringing in a 50% tax exemption for the export sales until F/Y 2084/2085, it is evident that more native and foreign investors will be willing to invest in IT sectors. Especially foreign investors and foreign IT businesses will be willing to invest, as the tax regime for export sales will be comparatively flexible given the massive 50% tax exemption.

In the same manner, it is evident that more people engaged in IT services will be willing to export their services and this can create a huge influx of foreign currency in the country. And not just for a single year but for an estimated 5 years as per the provision. It can be predicted that for the next five years, the government will see a significant influx of foreign currency in its forex reserve.

Booming Investment Climate

Likewise,  we cannot deny how this can improve the overall investment climate in Nepal. This provision acts as a catalyst, especially for foreign investors who are willing to plan a long-term and significant investment in the IT sector in the country. This doesn’t just mean an influx of foreign currency, but also the transfer of technology, exchange of skills and business culture, and overall development of IT infrastructure, which is coming around as a basic tool for human development in the present age. 

A Pool of Skilled Human Resources

Last but not least, the creation of a pool of skilled human resources is another outcome that can be projected with the introduction of the said incentivizing provision. And further what can be predicted out of this skilled pool of  human resources are innovation, creativity, and a framework for the infrastructural development of the country using the tools of IT. 

Conclusion

Evidently, the government of Nepal has taken a number of steps to promote the IT sector in recent years. These include removing the minimum cap on foreign investment in IT sectors, providing a foreign exchange facility for IT businesses exporting services abroad, and offering tax exemptions on export sales. The most recent tax exemption, which provides for a 50% exemption on export sales until F/Y 2084/85, is likely to have a significant impact on the IT sector. It will encourage more people to export their IT services, which will lead to an influx of foreign currency into the country.  The tax exemption will also make Nepal a more attractive destination for IT outsourcing, and it will also encourage more people to start their own IT businesses. The tax exemption is seemingly a win-win for both the government and the IT sector, making a  great example of how government policy can be used to promote economic development.