Report: Large Tax Office Vs Rastra Banijya Bank - Taxation of Concessional and Interest Free Employee Loans

LEGAL-TAX ANALYSIS REPORT

Taxation of Concessional and Interest-Free Employee Loans

Based on Supreme Court of Nepal Judgment

Case No. 074-RB-0302

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Supreme Court Judgment Date: 2079.11.08 B.S.

Taxpayer: Rastriya Banijya Bank Limited | Assessment Year: FY 2061/062 B.S.

Judges: Hon. Justice Prakashman Singh Raut | Hon. Justice Sushmalata Mathema

Prepared for: Employer / Payroll Compliance Reference

Prepared by: Roshan Poudel | Chartered Accountant | Tax Consultant

A. Executive Summary

This report presents a detailed legal and technical analysis of the Supreme Court of Nepal's judgment concerning the income tax treatment of loans extended by an employer (Rastriya Banijya Bank Limited) to its employees at concessional or no-interest rates. The case consolidates two appeals

• 074-RB-0302 filed by the Large Taxpayer Office (LTO), Lalitpur against the Revenue Tribunal's decision, and

• 074-RB-0309 filed by Rastriya Banijya Bank Limited pertaining to the income tax assessment for Financial Year (FY) 2061/062 B.S.

The core tax controversy was whether the interest foregone by the bank on loans advanced to its employees constitutes taxable income and, if so, in whose hands such income is to be recognized:

• the employer's (as forgone income) or

• the employee's (as a taxable employment benefit/perquisite).

The Supreme Court concluded that:

• There is no provision in the Income Tax Act, 2058 (Income tax Act 2058) that permits the tax authority to compute an average interest rate and add notional/imputed interest income from employee loans to the employer's (bank's) taxable income.

• The tax authority's method of imputing interest at average lending rate of 7.31% and including it in the bank's income was found to be legally flawed and without statutory basis.

• The employee loan arrangement in the case was not purely interest-free. It involved an insurance linked structure, further weakening the tax authority's position.

• The Supreme Court overturned the Revenue Tribunal's decision on employee loans (which had reversed the LTO's addition) and directed that the imputed interest addition to the bank's income should not stand.

B. Background of the Case

C. Facts and Issues Involved

C.1 Specific Facts - Employee Loan Issue

The specific facts concerning the employee loan heading, which is the subject of this analysis, are as follows:

• RBB's Schedule 13 (Annex-13) of the income return showed loans and advances extended to employees totaling Rs. 1,80,40,63,563 (opening balance Rs. 1,68,26,69,378; closing balance Rs. 1,92,74,57,739; average = Rs. 1,80,40,63,463).

• The loans were characterized as 'interest-free' by the tax authority. However, RBB disputed this characterization, explaining the structure of the arrangement (see below).

• The tax auditor, in Note 4 of the Tax Audit Report, computed an average interest rate of 7.31% based on the lending rate of the bank and determined imputed interest income of Rs. 13,19,50,146 (= Rs. 1,80,40,63,463 x 7.31%).

• The LTO included this amount of Rs. 13,19,50,146 in RBB's taxable income under Section 7 of Income tax Act 2058.

C.2 Structure of the Employee Loan Arrangement

RBB argued that the loans were not simply 'interest-free.' The actual arrangement operated as follows:

Example – Concessional Loan with Insurance Linked Recovery Structure

Scenario

An employee receives a staff housing loan of NPR 5,000,000 from a bank.

How the Arrangement Works

1. Insurance Requirement

The employee must purchase an endowment life insurance policy of NPR 5,000,000 assigned to the bank.

Effectively:

Bank secures the loan through insurance.

Employee bears the insurance cost.

2. Premium Deduction

Annual premium of NPR 400,000 is deducted from salary.

Over 10 years:

Thus, employee contributes NPR 4 million from personal income.

3. Endowment Maturity

At maturity, insurance proceeds amount to NPR 6,500,000.

The maturity proceeds are first adjusted against the loan balance:

4. Bonus Sharing

Surplus NPR 1,500,000 is shared:

The bank effectively earns NPR 375,000 despite stating the loan is “interest-free”.

Substance of the Arrangement

Although the loan is formally described as concessional, or interest-free, economically:

• employee bears insurance cost of NPR 4 million,

• bank obtains indirect economic return,

• bank risk is substantially mitigated through assigned policy,

• arrangement operates partly as employee welfare scheme, secured financing structure &indirect return mechanism.

Therefore, the transaction is not a pure zero-cost loan in substance.

C.3 Issues Before the Court

The core legal issues on the employee loan heading were:

• Whether imputed/notional interest on loans extended to employees can be included in the employer's (bank's) taxable income under Income tax Act 2058.

• Whether Income tax Act 2058 contains any specific provision permitting computation of an average interest rate and inclusion of notional interest in the bank's income.

• Whether the employee loan arrangement (with insurance, premium deduction, and bonus sharing) constitutes a 'concessional loan' in the traditional sense.

• Whether the tax authority's use of the average lending rate of 7.31% has any statutory basis.

• Whether the correct forum for taxing the benefit is the employee's employment income rather than the employer's income.

D. NRB Regulatory Framework

• Nepal Rastra Bank Act, 2058 and Banking and Financial Institution Act, 2073 govern the accounting policies of banks, including recognition of interest income.

• NRB Directive on Cash-Basis Accounting: Under NRB directives, banks are required to recognize interest income on a cash basis - i.e., only when actually received in cash. This means that forgone interest on employee loans cannot be recognized as notional income in the bank's books.

• NRB Unified Directives contain specific provisions on employee loan policies including ceilings on loan amounts and terms.

The court specifically noted that Section 24(3) of Income tax Act 2058 provides that in the context of banking businesses, Nepal Rastra Bank's prescribed accounting treatment may be recognized for tax purposes. This is the legal basis for the bank's argument that notional interest cannot be included as income.

E. Court's Analysis and Interpretation

E.1 On the Employee Loan Issue

The Supreme Court examined the employee loan heading in detail in Paragraph 26 of the judgment.

"उक्त ऐनको कुनै पनि दफामा औसत ब्याजदर निकाली सो दरमा कर्मचारी सापटी रकमको औसत मौज्दातमा ब्याज आम्दानी गणना गरी बैंकको करयोग्य आयमा समावेश गर्ने व्यवस्था नैं छैन।"

Translation: 'There is no provision in any section of the Act [Income tax Act 2058] to compute an average interest rate and include notional interest income computed on the average balance of employee loans in the bank's taxable income.'

This is the single most important judicial observation in the case on the employee loan issue. The Supreme Court explicitly held that the method adopted by the LTO computing average interest at 7.31% and including it in the bank's income has no statutory basis under Income tax Act 2058.

E.2 On the Nature of the Loan Arrangement

"कर्मचारीलाई दिएको ऋण निव्याजी होइन... बोनस रकममध्ये ७५ प्रतिशत कर्मचारीलाई र २५ प्रतिशत बैंकको आम्दानीमा हुने व्यवस्था रहेको छ।"

Translation: 'The loans given to employees are not [purely] interest-free... Out of the bonus amount, 75% goes to the employee and 25% is credited as bank income.'

The court acknowledged RBB's argument that the loan arrangement was not a simple interest-free loan. The insurance linked structure (life insurance = loan amount, premium deducted from salary, endowment applied to loan, 25% bonus to bank income) created an implicit cost to the employee and an implicit return to the bank making the classification as 'purely interest-free' inaccurate.

E.3 On the Tax Authority's Methodology

The court found multiple infirmities in the LTO's approach:

• No statutory basis for averaging: Income tax Act 2058 does not prescribe an 'average lending rate' method for computing taxable benefits from concessional loans.

• Wrong taxpayer: Even if a benefit exists, the benefit accrues to the employee, not to the bank. Including the amount in the bank's income confuses the legal incidence of tax.

• Cash basis conflict: NRB directives require interest recognition on cash basis. Imputing notional interest conflicts with this mandatory accounting policy.

E.4 On the Revenue Tribunal's Decision

The Revenue Tribunal had originally reversed the LTO's addition on the employee loan heading, finding it incorrect. The Supreme Court overturned the Revenue Tribunal's decision but arrived at the same outcome for different reasons. The Supreme Court's reversal of the Revenue Tribunal was on the basis that the Revenue Tribunal's analysis was incomplete, but the final direction was consistent with the bank's position - the imputed interest addition to the bank's income should not stand.

NOTE ON FINAL ORDER: The Supreme Court's final order (Para 28) directed that the imputed interest amount of Rs. 13,19,50,146 is not to be included in the bank's taxable income. However, the court did not hold that this benefit is entirely tax-exempt - it merely held that the wrong taxpayer (the bank) was being assessed.

F. Technical Tax Analysis

F.1 Analysis of LTO's Position vs. Bank's Position

F.2 The Unresolved Question – Employee Level Taxation

While the court settled the question at the employer level, the following question remains open and critical for compliance:

OPEN QUESTION: Does the interest benefit (the saving on market-rate interest due to a concessional or interest-free employer loan) constitute a taxable perquisite in the hands of the employee under Section 7(2) of Income tax Act 2058?

The answer, based on a reading of Income tax Act 2058 and general principles, should be YES - subject to the following analysis:

• Section 8(1) of Income tax Act 2058 includes 'any amount received from employment' in employment income.

• Section 8(2) clarifies that employment income includes cash, kind, benefit, and facility received from the employer.

• A loan at below-market interest rate constitutes a 'facility' or 'benefit' received from the employer.

• The quantifiable benefit is the difference between interest that would have been payable at the market rate and the actual interest paid (if any).

• This benefit should be included in the employee's taxable employment income and subjected to TDS at applicable rates.

The court's silence on employee-level taxation does not mean exemption. It simply means the case before the court was about the employer's assessment, not the employee's.

G. Conclusion and Professional Recommendation

G.1 Conclusion

The Supreme Court of Nepal's judgment in 074-RB-0302 establishes a clear precedent that the tax authority cannot include notional/imputed interest on employer loans to employees in the employer's taxable income when there is no express statutory provision permitting such imputation. The court's finding is grounded in strict interpretation of Income tax Act 2058 and reinforced by the NRB cash-basis accounting mandate applicable to banks.

The judgment does not, however, resolve the question of whether the interest benefit constitutes a taxable employment perquisite in the employee's hands. This question, while outside the scope of the present case, is of significant practical importance for employers and payroll compliance teams.

G.2 Recommendations for Immediate Implementation

Based on this judgment and applicable provisions of Income tax Act 2058, the following actions are recommended:

For Banking and Financial Institutions

• Document employee loan arrangements in detail - insurance linkage, bonus sharing, premium deduction to rebut any characterization as 'purely interest-free.'

• File objections / appeals in pending assessments where the LTO has added imputed interest to the bank's income, citing this Supreme Court judgment.

• Separately review TDS compliance for concessional loan benefits at the employee level under Section 87 of Income tax Act 2058.

• Engage with the Inland Revenue Department for prospective clarification on the applicable rate for perquisite valuation.

For Non-Banking Employers

• Review all existing employee loan policies and assess whether loans are provided at below-market rates.

• Compute the monthly perquisite value (market rate minus actual rate) for each employee with a concessional loan.

• Include the perquisite value in gross employment income for TDS computation from the current fiscal year.

• Document the rate used (preferably NRB base rate) and maintain consistency across fiscal years.

• Amend the employment contract / loan agreement to clearly specify the interest rate and its rationale.

For Payroll and TDS Teams

• Update payroll software to include a 'concessional loan perquisite' field in the monthly TDS computation module.

• Maintain a monthly loan-balance register for each employee with an outstanding employer loan.

• Compute monthly TDS adjustments based on the differential between market rate and actual rate.

• Include the annual perquisite value in the salary certificate (Form 16) issued to each employee.

This report is prepared for advisory purposes based on the judgment text provided. It does not constitute legal advice. Employers should consult their legal and tax advisors for specific situations.
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