Chapter-6 Tax Accounting and Time

22. Method of tax accounting

Rule 8(1): In maintaining accounts of tax pursuant to Section 22 of the Act, accounts shall be maintained in accordance with the accounting standards, if any, prescribed by the prevailing law.

Rule 8(2): In cases where any accounting standards are not specified pursuant to Sub-rule (1), tax accounting shall be carried out as per the accounting standards specified by the Department based on any prevailing international principle or practice.

In this context, the Act provides that accounting must be done in accordance with Nepal Accounting Standards/Nepal Financial Reporting Standards (NAS/NFRS) issued by the Institute of Chartered Accountants of Nepal (ICAN), and where such standards are not available, in accordance with International Accounting Standards/International Financial Reporting Standards (IAS/IFRS) or other prevailing principles.

(1) The matter of when any person receives any income or makes any expense shall be determined in accordance with the widely recognized accounting principle, subject to this Act.

(2) An natural person shall, while computing the income to be earned from his employment and investment, maintain accounts on the cash basis, for purposes of tax.

Provided that where, after the filing of a case in court and its determination, any natural person receives a lump-sum payment of remuneration for past income years in respect of employment, such remuneration shall be accounted for on the accrual basis in the relevant income years for tax purposes.

This provision is clarified in the following example:

Example 8.2.1: Suppose Kamal Pariyar is an employee at the Agriculture Supplies Corporation. He received the total amount of Rs. 2,40,000 due as salary and allowances at the rate of Rs. 20,000 per month from 2080 Shrawan to 2081 Ashadh only in 2081 Shrawan. In this situation, since accounting is on a cash basis, the amount must be included in income for tax purposes in the month in which it was received, namely 2081 Shrawan. Therefore, under this method, regardless of which income year the income relates to, it must be accounted for as income in the income year in which it is received.

(3) A company shall maintain accounts on the accrual basis, for purposes of tax.

For tax purposes, the term "company" has a broader meaning than "company" in the corporate sense. The entities that fall within the term "company" for tax purposes are listed in Section 2(m) of the Act. Such companies must account on the accrual basis. The provision is clarified in the following example:

Example 8.2.2: Suppose Kamal Services and Company Pvt. Ltd. entered into a contract to provide security guards to the Agriculture Supplies Corporation, and in this context, the company provided 5 security guards in 2081 Ashadh. The invoice value under the agreement for providing security guards for that month was Rs. 30,000. Since the right of the company to receive Rs. 30,000 from the Agriculture Supplies Corporation for providing security guards was created, even though the cash payment was not received from the Agriculture Supplies Corporation, the company must include the above-mentioned Rs. 30,000 in its income for income year 2080/81.

(4) Except if the Department has otherwise specified by issuing a notice in writing, any person may, for purposes of income tax, shall maintain accountxs on the cash or accrual basis, subject to sub-sections (1), (2) and (3).

An natural person must account on a cash basis for income from employment and investment, and a company must account on an accrual basis for tax purposes. In other circumstances, such as an natural person or a partnership firm with fewer than 20 partners accounting for business income, either the cash or accrual basis may be used.

(5) Any person may make an application to change the method of accounting for tax purposes, subject to sub-sections (2) and (3). If the Department thinks that it is necessary to change the method of accounting to clearly show the income of such person, the Department may give permission to change the method of accounting.

Generally, an accounting method once adopted must be used consistently. However, a person other than a company who considers that their accounting method has become difficult to compare with the accounting method used by other persons conducting similar businesses, or for any other valid reason, may apply to the Department to change the accounting method. That is, a person who has been accounting on a cash basis and wishes to account on the accrual basis, or a person who has been accounting on the accrual basis and wishes to change to the cash basis, may apply to the Department. If the Department considers it necessary to change the accounting method in order to clearly present income, it may grant approval for such change. Since the employment and investment income of an natural person must be on a cash basis except for the restrictive provision under the proviso to Section 22(2), and the accounting for a company's income must be on the accrual basis for tax purposes, applications to change these provisions cannot be submitted.

(6) If the method of accounting of any person for purposes of tax is changed pursuant to sub-section (5), in computing the income of that person in the income year when such change is made, adjustment shall be so made that no amounts out of those included, deducted or to be included or deducted are omitted or duplicated.

Where an accounting method is changed for tax purposes without obtaining the Department's approval, an adjustment must be made in the income year of the change to ensure that no amount is omitted or duplicated. This provision is clarified in the following example:

Example 8.2.3: See Example 6.2.7

Tax accounting method (Sec 22): natural person → CASH basis for employment & investment income (exception: court-awarded lump-sum back-pay = accrual in the relevant years);company → ACCRUAL basis; others (incl. partnership with fewer than 20 partners) → cash OR accrual by choice. Method once chosen must be applied consistently; a change needs Department approval, with an adjustment in the change year so no amount is omitted or duplicated.

23. Cash basis accounting

Any person shall, in maintaining accounts on the cash basis of his income earned from employment, business or investment for tax purposes, subject to this Act, do as follows:-

(a) To treat as income received and include it in his income computation only at the time when payment is received by him or made available to him.

(b) To deduct for expense only after he makes payment.

The system of including amounts in income only after cash is received, and recording expenses only after cash has been paid, is called the cash-basis accounting method. However, even where accounting is on a cash basis, expenses under Section 15 (Cost of Goods Sold) must be recorded on the accrual basis. The provisions on cash-basis accounting are clarified in the following example:

Example 8.3.1: Suppose Mohan Kasaju & Sons is a sole proprietorship. That firm accounts for its income and expenses on a Cash Basis for income tax purposes. The position of the firm's transactions in income year 2080/81 is as follows:

a. Cash received in 2080/81 from credit sales made in 2079/80: Rs. 50,000.

b. Total sales of 2080/81 were Rs. 10,00,000, of which Rs. 9,00,000 was received in cash.

c. Employee salary expense of Rs. 2,00,000 for 2080/81, of which Rs. 1,80,000 was paid; Rs. 20,000 was paid only on date 2081.4.14.

d. Cost of sales of Rs. 6,00,000 already paid.

e. In 2080/81, advance payment of Rs. 1,00,000 for rent for 2081/82 was made.

f. The rent of Rs. 90,000 for 2080/81 was paid in cash in income year 2079/80.

g. Of the total interest expense for 2080/81 of Rs. 60,000, Rs. 10,000 was paid only on date 2081.4.20.

Based on the above, the income of that firm for income year 2080/81 must be computed on a cash basis as follows:

In this way, where the firm accounts on a cash basis for income tax purposes, Rs. 9,50,000 must be included in income (Inclusion) and Rs. 9,30,000 may be claimed as a deduction (Deduction).

Cash basis (Sec 23): include income only when payment is actually received or made available; deduct an expense only when it is actually paid. Exception: stock-in-trade expenses under Sec 15 are recorded on the accrual basis even under cash accounting

24. Accrual basis accounting

(1) Any person shall, in maintaining accounts on the accrual basis of his income earned from business or investment, subject to this Act, for purposes of tax, include any payment in computation of his income, considering that such payment has been received immediately when the right to receive such payment is created.

Example 8.4.1: Suppose Mohan Kasaju & Sons mentioned in Example 8.3.1 above accounted for its income and expenses on an Accrual basis for income tax purposes. In that case, the transactions mentioned in that example must be included in income and claimed as deductions as follows:

In this way, where the firm accounts on an accrual basis for income tax purposes, Rs. 10,00,000 must be included in income (Inclusion) and Rs. 9,50,000 may be claimed as a deduction (Deduction).

(2) For the purposes of making deduction in computing income earned by any person as mentioned in sub-section (1), the following expenses shall be deemed to have been borne:-

(a) If any payment involving such expenses has been made in lieu of a payment made by any other person, the expenses shall be deemed to have been borne in the following circumstances:-

(1) The person has the liability to make that payment,

(2) The value of such liability can be ascertained in a realistic manner, and

(3) Payment has been received from another person, or

For an expense to be deducted on an accrual basis, the following three conditions must be met:

First condition: The party to be paid must be identified. An expense arrangement with an unidentified party is a probable obligation (provision), and a provision expense is not deductible. Suppose Shailesh purchased a computer from City Computer Pvt. Ltd. for Rs. 1,00,000 on credit. Since the ownership of that computer was transferred from City Computer to Shailesh, Shailesh's obligation to pay Rs. 1 lakh to City Computer Pvt. Ltd. was created.

Second condition: For an expense to be deducted on an accrual basis, the value of that obligation must be ascertained in a realistic manner. Even if there is an obligation to pay, if the amount is uncertain, the estimated loss is recorded as a provision expense in the financial statements, and provision expenses are not deductible. In the above example, since Shailesh purchased goods worth Rs. 1 lakh from City Computer Pvt. Ltd. and a bill has been issued, the value of that obligation is Rs. 1 lakh, which is determinable.

Third condition: For an expense to be deducted on an accrual basis, the amount must be in respect of goods or services received from the party to be paid. Where goods or services have not been received, even if the paying party is identified or the amount is identified, such an amount is not an expense but a prepayment. The other person, City Computer Pvt. Ltd. in the above example, has provided payment (goods) to Shailesh. Since all three conditions mentioned above are met for this purchase transaction, Shailesh must record this purchase transaction as an expense on the accrual basis. The provisions on payment accounting are further clarified in the following example:

Example 8.4.2: Suppose Bikash Nepal Trading Pvt. Ltd. sold goods worth Rs. 50,000 to Swarnima Pvt. Ltd. on the condition of payment one month later. In this situation, since Swarnima Pvt. Ltd. received goods worth Rs. 50,000 from Bikash Nepal Trading Pvt. Ltd. and has an obligation to pay one month later, and such an obligation can be ascertained in a realistic manner, Swarnima Pvt. Ltd. may claim that expense as a deduction on the accrual basis at the same time.

(b) In all other circumstances except that mentioned in clause (a), an expense shall be deemed to have been borne at the time when payment is made.

As stated above, although a provision expense is treated as an expense in the financial statements, it is not treated as an expense for tax purposes. However, where actual payment is made in the income year, such expense is allowed as a deduction. Such expenses are treated as borne on the basis of actual payments. This provision is clarified in the following example:

Example 8.4.3: Suppose by the end of income year 2080/81, Red Nepal and Company Pvt. Ltd. had an employee gratuity liability of Rs. 5,00,000 that had been created based on the employee service condition regulations. In preparing the financial statements in accordance with Nepal Accounting Standards, the company must record that amount as an expense and account for it as a liability. However, since the employees had not yet retired and the liability amount could change by the time they retire in the future, such gratuity liability cannot be treated as a liability whose value can be ascertained in a realistic manner for income tax purposes, and even though the expense was claimed in the financial accounts, it is not treated as deductible for income tax purposes. If the company had paid such liability to an approved retirement fund in such a way that it cannot be used by the company and on an identified basis for employees, that is, in such a way that the value of the liability can be ascertained in a realistic manner, it may claim the deduction at the time of payment for income tax purposes. Otherwise, the gratuity liability may be treated as an expense only at the time it is actually paid to the employee upon retirement.

(3) Notwithstanding anything contained in sub-section (1), the Department may recognize the accounting specified by the Nepal Rastra Bank with respect to banking business, subject to the Nepal Rastra Bank Act, 2058 (2002) and prevailing laws relating to banking.

Provided that a cooperative organization may keep accounting of interest income on cash basis.

Under Section 24(1) of the Act, accounting must be maintained on an accrual basis. However, Section 24(3) provides that in the case of banking business, the Department may recognise the accounting method prescribed by Nepal Rastra Bank, subject to the Nepal Rastra Bank Act, 2058 and prevailing laws relating to banking. Similarly, cooperative institutions may also account for interest income on the cash basis. This means that a banking business is not obligated to strictly follow the general accrual basis rule for interest income if Nepal Rastra Bank prescribes a different accounting treatment - for example, where a loan has become non-performing, Nepal Rastra Bank may direct that interest not yet received should not be recognised as income. In such cases, the banking entity may follow the NRB-prescribed treatment for income tax purposes.

(4) Where, in computing on the accrual basis the income earned by any person from a business or investment, any payment receivable by that person is included or any payment to be borne by that person is deducted, and a difference occurs in the amount received or paid by that person because of, inter alia, difference in the exchange rate, the difference shall be adjusted in receiving or making payment.

Nepal Accounting Standards require that foreign currency receivables or payables be restated at the exchange rate prevailing on the last day of the income year, and any resulting gain or loss must be recorded in the profit and loss account for that income year. Although that NAS provision is applicable or mandatory for financial purposes, for income tax purposes, foreign currency receivables or payables cannot be included as income or deducted as expense based on a restatement at the exchange rate prevailing on the last day of the income year. For income tax purposes, the foreign exchange gain or loss must be computed using the exchange rate on the date of actual receipt or payment, and such gain or loss due to change in exchange rate must be included in income or deducted as expense in the income year of actual receipt or payment. The following examples further clarify this provision:

Example 8.5.1: See Section 28

Example 8.5.2: See Section 28

Example 8.5.3: See Section 28

Accrual basis (Sec 24): include income when the RIGHT to receive arises (not when received); deduct an expense only when ALL 3 are met = (1) the payee is identified + (2) the liability value is realistically ascertainable + (3) the goods/services have been received. A mere provision (uncertain amount or unidentified payee, e.g. unfunded gratuity) is NOT deductible until actually paid.

Banking business may follow NRB-prescribed accounting (24(3)); cooperatives may keep interest income on cash basis; exchange-rate differences are adjusted on receipt/payment (24(4))

25. Reverse of amounts including bad debt

(1) When maintaining accounts of the amounts received and expenses borne in the computation of the income earned by any person from any employment, business or investment, the person shall make proper adjustments at the time of reimbursement, recovery, relinquishment of claim, writing off or remission in any of the following circumstances:-

(a) Where that person pays back such amount, or recovers the expense, as the case may be,

This provision is clarified in the following example:

Example 8.6.1: Suppose Ganesh General Stores Pvt. Ltd. purchased goods worth Rs. 5,00,000 from Nepal Trading Company Ltd. on date 2081.03.20. Accordingly, Ganesh General Stores Pvt. Ltd. claimed Rs. 5,00,000 as an expense deduction in income year 2080/81, and Nepal Trading Company Ltd. included that amount in income for the sale. On date 2081.04.10, Ganesh General Stores Pvt. Ltd. claimed that goods worth Rs. 40,000 out of the purchased goods had expired and become unusable. Based on confirmation of this fact, Ganesh General Stores Pvt. Ltd. returned those goods to Nepal Trading Company Ltd. on date 2081.5.20. In this situation, Nepal Trading Company Ltd. must adjust by claiming a deduction on date 2081.5.20, while Ganesh General Stores Pvt. Ltd. must adjust by including the amount of the returned goods in income on the same date.

(b) Where the accounts of the amount received have been maintained on the accrual basis and the person subsequently relinquishes his right to receive that amount, or where that amount is a debt claim of that person and he writes off the debt as a bad debt, or

Where any person who has accounted on the accrual basis for income tax purposes has computed a receivable and subsequently relinquishes the right to receive such amount, that is, abandons the debt claim, that person may claim an expense deduction accordingly. This provision is clarified in the following example:

Example 8.6.2: Suppose Himal Public Services Pvt. Ltd. has been selling goods on credit to customers. That company has a receivable of Rs. 60,000 recorded as income on the accrual basis from sales in income year 2080/81. Among the outstanding receivables, Rs. 10,000 was outstanding from Chipalu Company. A dispute arose regarding this transaction, and in the context of resolving the dispute, by court order, Himal Public Services Pvt. Ltd. relinquished Rs. 2,000 on date 2081.2.5 on the condition that Chipalu Company would pay the remaining Rs. 8,000. The Rs. 2,000 relinquished may be claimed as a deduction by that company on the date of relinquishment. The amount that Chipalu Company no longer needs to pay is included in income.

(c) Where the accounts of the expense incurred have been maintained on the accrual basis and the person subsequently relinquishes his liability to incur such expense, or where that expense is a debt claim, the person to whom the debt is to be repaid remits the debt.

Where any person who has accounted on the accrual basis for income tax purposes has computed a payable (liability or loan) and subsequently the liability no longer exists or the person entitled to receive payment relinquishes their right, an adjustment must be made to income accordingly. This provision is clarified in the following example:

Example 8.6.3: Suppose Shubhalaxmi Commercial Bank Ltd. forgave Rs. 40,000 out of Rs. 1,00,000 in outstanding interest from Diva Industries Pvt. Ltd. while recovering its old loan on date 2081.02.01. In this situation, since that company had previously claimed the interest expense as a deduction on an accrual basis, Diva Industries Pvt. Ltd. must include the forgiven interest of Rs. 40,000 in income at the time of forgiveness.

(2) Any person may relinquish the right to receive any amount or write off the debt claim of that person as a bad debt only in the following circumstances:-

(a) In the case of a debt claim of any financial institution or bank, the debt claim is converted into a bad debt as per the specified criteria, and

Rule 9: For purposes of Clause (a) of Sub-section (2) of Section 25 and Sub-clause (1) of Clause (c) of Sub-section (3) of Section 40 of the Act, the standards determined by the Nepal Rastra Bank shall apply in respect of a debt of a bank or financial institution becoming unrecoverable or its conversion into a bad debt.

Banks and financial institutions may write off debt claims subject to the above criteria. However, banks and financial institutions that have claimed risk reserve expenses under Section 59(1A) of the Act may not claim expense deductions for loan write-offs under this section. However, where the amount in the risk reserve fund is reduced to the extent of the written-off loan and included in income upon such write-off, such loan write-off is not deemed to have occurred under this section. Accordingly, when writing off a loan, the amount from the loan loss provision equivalent to the written-off loan must also be included as income in the profit and loss account. The accounting provisions in this regard are clarified in the following examples:

Example 8.6.4: Suppose the loan position of New Bank Ltd. at the end of income year 2064/65 is as follows:

The bank wrote off loans within the criteria specified by Nepal Rastra Bank and has not claimed risk reserve expenses under Section 59(1a) of the Act. In this situation, the bank may claim the written-off loan of Rs. 6 crores as an expense deduction under this section. The accounting for the above loan write-off is as follows:

At the time of loan write-off: Rs. 6,00,00,000

Dr. Loan Write-off (Profit & Loss Account): Rs. 6,00,00,000

Cr. Loans and Advances: Rs. 6,00,00,000

Adjusting to loan loss provision:

Dr. Loan Loss Provision (Profit & Loss Account): Rs. 6,00,00,000

Cr. Loan Loss Provision (Balance Sheet): Rs. 6,00,00,000

Example 8.6.5: Suppose New Bank Ltd. has been claiming risk reserve expenses under Section 59(1a) of the Act. The position of the bank's total loan outstanding, loan loss provision and written-off loan at the end of income year 2064/65 is as follows:

Under Section 59(1A), loan loss provision is allowed only up to 5% of year-end outstanding loans.

Year-end loans = Rs. 99 crore

Maximum allowable provision: 0.05×99,00,00,000=4,95,00,000

Therefore:

So, Rs. 15 lakhs is disallowed for tax purposes.

Why Only Rs. 2.35 Crore is Allowed?

The bank charged:

Thus, tax deduction = Rs. 2.35 crore, not Rs. 2.50 crore.

What Happened to the Rs. 1 Crore Loan Write-off?

Normally, when a loan is written off, a bank may want to claim a bad debt deduction under Section 25.

However, the bank has already been claiming deductions through the loan loss provision account.

To prevent double deduction, the bank transferred Rs. 1.10 crore from the provision account to income.

Since the provision reversal (Rs. 1.10 crore) exceeds the write-off (Rs. 1 crore), the tax system treats the write-off as already absorbed by the provision.

Therefore: No separate bad debt deduction is allowed under Section 25(2)(a).

(b) If, after having followed all proper measures to receive payment in circumstances other than those referred to in clause (a), that person is reasonably satisfied that the right or debt claim cannot be realized or recovered.

For persons other than banks and financial institutions to write off a debt claim, they must have made attempts to recover the debt, such as police action and court proceedings as appropriate, based on the debtor's financial condition and efforts to recover. Only after such efforts have failed may such an uncollectible amount be written off.

Reverse of amounts (Sec 25): adjust income/expense when a previously-claimed amount is repaid, recovered, relinquished, written off or remitted. Bad-debt write-off allowed only if (a) a bank/FI loan is classified bad per NRB criteria (Rule 9), or (b) for others, reasonable recovery efforts (incl. legal action) have failed. A bank that already claims the Sec 59(1A) risk-reserve cannot also deduct the loan write-off.

26. Method of deriving average of amounts includible and deductible under long-term contract

(1) For the purposes of computing the income earned by any person from any employment, business or investment in any income year, the estimated amounts includible and deductible according to the sum of sequential increase as per the percentage of completion of the contract under the long-term contract of that person shall be deemed to have been received or spent.

Explanation: For the purposes of this Section, "long-term contract" means any contract of the following nature:-

(a) A contract with a validity period of more than twelve months, and

(b) A contract with a deferred consideration other than made for a contract which is concluded for production, installation or construction or for the discharge of relevant services for each of such works or a contract not containing such elements.

Rule 12(1): In cases where the income derived by any person from investment, employment or business at any time is not computed likewise in a normal income year at any time, the amounts to be included in computing the income at that time or at the time preceding it shall be the amounts to be included as per the sum of gradual increase.

Rule 12(2): In cases where the income derived by any person from business or investment at any specific time is not computed likewise in a normal income year at any time, the amounts allowed to be deducted in computing the income at that time or at the time preceding it shall be the amounts to be deducted as per the sum of gradual increase.

Rule 12(5): The provisions of the long-term contract mentioned in Section 26 of the Act shall apply to the following contract: (a) a contract related with production, construction or installment or a contract on the fulfillment of the services related thereto, at the time of commencement of the Act; and (b) in cases other than those mentioned in clause (a), a contract as per such time and condition as specified by the Department.

A long-term contract means a contract for production, installation, or construction of any goods or property, or for providing services necessary for such work, where the contract tenure period exceeds twelve months, and a contract with deferred return. The contract tenure period means the period from commencing the work required to be done under the contract to completing such work, including any warranty or guarantee period. For a contract to be a long-term contract, at the time the contract is made, it must have been accepted by the parties that completing the contract will take more than 12 months.

If a contract was estimated to have a tenure period exceeding 12 months at the time of entering the contract, but the contract was completed in less than 12 months, the contract tenure period must still be considered to be more than 12 months, and such contract still falls under long-term contracts. Conversely, if a contract was estimated to have a tenure period of less than 12 months at the time of entering the contract, but completing the contract took more than 12 months due to circumstantial reasons, the contract does not fall under long-term contracts.

Example 20.1.1: New Nepal Construction Company Pvt. Ltd. entered into a contract with the Department of Roads in income year 2075/76 to construct a road for Rs. 11 crores to be completed within 4 years. Since both parties entering into the road construction contract agreed at the time of entering the contract that completing the contract would take more than 12 months, i.e., four years, and entered the contract accordingly, the said road construction contract is a long-term contract. If the condition was mentioned in the above contract that if the road constructed and handed over by Nepal Construction Company suffered any damage within one year of handing over, Nepal Construction Company would have to repair it, then the warranty period must also be included in the contract tenure period, and in this situation, the contract tenure period of the above contract would be 5 years.

Example 20.1.2: New Nepal Construction Company Pvt. Ltd. entered into a contract with the Department of Roads in income year 2078/79 to construct a road for Rs. 5 crores to be completed within 16 months. However, while working, the company completed the road construction work and handed over the constructed road to the Department of Roads within 10 months. Although the said road construction contract was completed in less than 12 months, since both parties entering the contract agreed at the time of entering the contract that completing the contract would take more than 12 months, i.e., 16 months, and entered the contract accordingly, the said contract is still a long-term contract.

Example 20.1.3: New Nepal Construction Company Pvt. Ltd. entered into a contract with the Department of Roads in income year 2078/79 to construct a road for Rs. 3 crores to be completed within 10 months. However, while working, before the company had completed the road construction work, a flood came and some of the already constructed road was damaged. Since the damaged road had to be reconstructed, Nepal Construction Company took 14 months to complete the contract. Although the said road construction contract took more than 12 months to complete, since both parties entering the contract agreed at the time of entering the contract that completing the contract would take less than 12 months, i.e., 10 months, and entered the contract accordingly, and since the contract tenure period increased due to circumstantial reasons, the said contract does not fall under long-term contracts.

However, if someone, with malicious intent or with the objective of keeping their contract within or outside the scope of long-term contracts, determines the contract period to be more or less than 12 months at the time of initially entering the contract, and then gradually reduces or increases the contract period, the tax officer may characterize such contract as a long-term contract or another type of contract and determine the income and tax liability of the contract accordingly.

According to the provision of Section 26 of the Income Tax Act, whether a contract is a long-term contract is determined not only by the contract tenure period but also by the type of contract. According to the provisions of the Income Tax Act, a contract can be a long-term contract for income tax purposes only if it relates to the production, installation, or construction of any goods or property, or relates to providing services necessary for production, installation, or construction works, or is a contract with deferred return. Contracts other than these do not fall within the definition of long-term contracts. The types of contracts falling under long-term contracts according to the provisions of the Income Tax Act are explained below.

A production-related contract is one in which one party to the contract, i.e., a producer of some goods, is required to produce one or more tangible goods for the other party to the contract. In other words, if one person enters into a contract with another person to produce and hand over some goods or property to that person, such contract is considered a production-related contract. If a contract made to produce and hand over goods this way takes more than twelve months to complete, such contract is considered a long-term contract for income tax purposes.

Example 20.2.1: Pashupati Pvt. Ltd. entered into a contract on Shrawan 1, 2079 to produce and supply penstock pipes and turbines for a hydropower company. The company entered into the contract to produce and hand over the said goods by the end of Ashadh 2081. Since the said contract for producing penstock pipes and turbines is a production-related contract and the contract tenure period exceeds twelve months, the said contract falls under long-term contracts.

An installation-related contract (Installation) means a contract in which one party to the contract, i.e., the installer, is required to install one or more tangible goods provided by themselves at the location specified by the other party to the contract, for the benefit of the other party.

Example 20.2.2: Pashupati Pvt. Ltd. entered into a contract on Shrawan 1, 2079 to install (Install) penstock pipes and turbines imported from abroad by another company operating a hydropower project at the location where that company operates the project. The contract was made for the company to complete the installation of the said goods by the end of Mangsir 2080. Since the said contract for installing penstock pipes and turbines is an installation-related contract and the contract tenure period exceeds twelve months, the said contract falls under long-term contracts.

A construction (Construction) related contract means a contract in which one party to the contract (commonly known in everyday language as a construction entrepreneur) is to construct one or more tangible goods at the location specified by that person for the benefit of the other party to the contract. Construction-related contracts generally include contracts for the construction of physical structures.

Example 20.2.3: Pashupati Pvt. Ltd. entered into a contract on Shrawan 1, 2079 to construct a tunnel at the location where another company operating a hydropower project operates the project. The contract was made for the company to complete the tunnel construction by the end of Mangsir 2081. Since the said contract for constructing a tunnel is a construction-related contract and the contract tenure period exceeds twelve months, the said contract falls under long-term contracts.

Example 20.2.4: Pashupati Pvt. Ltd. entered into a contract on Shrawan 1, 2078 to construct a tunnel and a motor road to reach the project site at the location where another company operating a hydropower project operates the project. The contract was made for the company to complete the construction of the said tunnel and motor road by the end of Poush 2081. Since the said contract for constructing the tunnel is a construction-related contract, and since both the tunnel and motor road construction works are interrelated and interdependent with the hydropower project, and since the contract tenure period exceeds twelve months, both contracts fall under a single long-term contract.

Example 20.2.5: Pashupati Pvt. Ltd. entered into a contract on Shrawan 1, 2078 to construct a tunnel at the location where another company operating a hydropower project operates the project. The said agreement also included the work of preparing the design of the hydropower project by the company. The contract was made for the company to complete the design preparation and tunnel construction work by the end of Poush 2081. Since the said contract for constructing the tunnel is a construction-related contract, both the tunnel construction and design preparation works are interrelated and interdependent with the hydropower project, and the design preparation work, although a service-related work, is directly related to the tunnel construction work, and since the contract tenure period exceeds twelve months, both contracts fall under a single long-term contract.

Example 20.2.6: A company operating a hydropower project published a notice proposing to construct a tunnel at the location where it operates the project and a motor road to reach the project site. Pashupati Pvt. Ltd. entered into a contract on Shrawan 1, 2079 to complete both works mentioned in the notice for a lump sum of Rs. 10 crores. Even though the tunnel construction and motor road construction are separate works, since a single proposal was submitted for both works, there was a single agreement rather than separate agreements for both works, a single price was set for both works, the situation was not such that the price and cost of each work could be separated, and the situation was not such that a contract could be made for only one of the two works and the proposal for the other work rejected, both works must be treated as work under a single contract even though there are more than one work under the above contract.

Example 20.2.7: A company operating a hydropower project published a notice with separate cost estimates for each work, treating them as separate works, proposing to construct a tunnel at the location where it operates the project and a motor road to reach the project site. Pashupati Pvt. Ltd. obtained both works from the said notice and entered into contracts for both works on Shrawan 1, 2079. Even though the tunnel construction and motor road construction are interrelated works, the customer and contractor are the same persons, and a single contract was entered into for both works, since separate proposals were submitted for both works, separate prices were set for both works, the situation was such that the price and cost of each work could be separated, and the situation was such that a contract could be made for only one of the two works and the proposal for the other work rejected, even though the above works were done under a single contract, both works must be treated as work under separate contracts.

Example 20.2.8: Pashupati Consult Pvt. Ltd. entered into a contract on Shrawan 1, 2079 to prepare a detailed design for the project operated by another company operating a hydropower project. The contract was made for the company to complete the design preparation work by the end of Poush 2080. Although the design preparation work is a service-providing work, since it is work related to the construction of the hydropower project and the contract tenure period for doing such work exceeds twelve months, the said service contract falls under long-term contracts.

Rule 10, Contract with Deferred Return: If a party to a contract does not show the items specified by the Department regarding estimated profit and estimated loss within each six-month period after the contract commences, such contract shall be a contract with deferred return.

This means that if a person performing a contract does not submit a statement containing a notice in the manner specified by the Department regarding the estimated profit or estimated loss of the work done under the contract, such contract takes the form of a contract with deferred return and falls under long-term contracts. In this situation, such person must calculate the income for their contract on the basis of the percentage of completion in accordance with Section 26 of the Act.

(2) A contract with deferred consideration, a contract to be included according to the sum of sequential increase, a contract to be deducted according to the sum of sequential increase, an excluded contract and a contract of completion percentage shall be as prescribed.

Rule 12(3): In determining the completion percentage of the contract mentioned in Sub-section (2) of Section 26 of the Act at any specific time, it shall be determined as follows: (a) in respect of a contract related with production, construction or installment or a contract on the fulfillment of the services related thereto, by comparing the amount to be deducted as per the sum of gradual increase at that time with the amount to be deducted as per the sum of gradual increase at the time when the contract expires; or (b) in cases other than those mentioned in clause (a), as specified by the Department subject to that clause.

The percentage of completion of any long-term contract is the ratio of actual direct expenses up to any income year of any contract to the estimated total direct expenses of that contract. Rule 12(3) of the Income Tax Rules, 2059 provides that when determining the percentage of completion, it shall be determined by comparing the amount to be deducted according to the total of cumulative inclusions at that time with the amount to be deducted according to the total of cumulative inclusions at the time the contract is completed. The income of any long-term contract at any time means the amount resulting from multiplying the percentage of completion of that contract at that time by the total amount (contract value) to be received for that contract.

Example 20.8.1: New Nepal Construction Company Pvt. Ltd. entered into a contract with the Department of Roads in income year 2076/77 to construct a road for Rs. 13 crores to be completed within 4 years. The total estimated direct cost amount of that contract was Rs. 10 crores. If the company deducted Rs. 2 crores in direct expenses in income year 2076/77, then the percentage of completion of that contract for that income year is: Direct Cost Deduction Amount for Income Year 2076/77 (Rs. 2,00,00,000) / Total Estimated Direct Cost Amount of Contract (Rs. 10,00,00,000) x 100% = 20%.

Example 20.8.2: New Nepal Construction Company Pvt. Ltd. obtained a road construction contract from the Department of Roads in income year 2076/77 for Rs. 11 crores to be completed within 4 years. The total estimated cost amount of that contract was Rs. 10 crores. If the company claimed expense deductions of Rs. 5 crores in income years 2076/77 and 2077/78, then the percentage of completion of that contract for 2077/78 is: Cost Deduction Amount up to 2077/78 (Rs. 5,00,00,000) / Total Estimated Amount of Contract (Rs. 10,00,00,000) x 100% = 50%.

Example 20.13.1: Assume that New Nepal Construction Company Pvt. Ltd. obtained a contract in Income Year 2078/79 to construct a shopping mall for NPR 2 billion. The construction work was required to be completed within a period of three years.

The initial estimated cost of the contract was NPR 1.80 billion. In the second year, the owner of the shopping mall issued a Variation Order of NPR 35 million. In the third year, an additional NPR 5 million was added to that Variation Order, increasing the total Variation Order to NPR 40 million.

Due to the Variation Order, the estimated cost increased by NPR 25 million in the second year, and by an additional NPR 5 million in the third year, making the total increase in estimated cost NPR 30 million.

The construction costs incurred by the company were:

• NPR 900 million in Income Year 2078/79,

• NPR 414 million in Income Year 2079/80, and

• NPR 516 million in Income Year 2080/81.

Accordingly, New Nepal Construction Company Pvt. Ltd. must compute its deductible expenses and include income for tax purposes from Income Year 2078/79 to Income Year 2080/81 as shown below, and calculate taxable income.

Answer: Year Wise computation in Lakh

Section 20(4): Subject to sub-sections (1) and (2), if any person incurs a loss in the income year when a long-term contract obtained through international competition in their business is completed or otherwise disposed of, or if there is a loss that cannot be carried forward to subsequent years under clause (b) of sub-section (1) and that loss is related to long-term contracts, the Department may, upon giving written notice, permit the following: (a) to carry it back to past income years, and (b) to treat only so much of the unclaimed loss as the amount by which the amounts to be included on the income side exceed the amounts to be included on the expense side when calculating the income of the business related to that long-term contract in those years.

Example 20.14.2: Assume that, in the examples referred to in 20.13.1, due to an increase in market prices in the second year, the estimated cost of the contract increased and was expected to reach NPR 2.10 billion. In that year, the Shopping Mall owner refused to compensate the contractor for the increased cost.

However, at the end of the third year, an agreement was reached between New Nepal Construction Company Pvt. Ltd. and the Shopping Mall owner, under which the owner agreed to make a total payment of NPR 2.11 billion, including the variation amount.

Accordingly, for Income Years 2078/79 to 2080/81, the amounts deductible, the income to be included, and the loss adjustments to be made by New Nepal Construction Company Pvt. Ltd. shall be as follows:

Year-wise Computation (Amounts in NPR Crore)

Since long-term contract income is based on estimated costs, losses may arise in later years after initial taxable income. For global contracts where carry-forward alone may not allow adjustment, Section 20(4) permits carry-backward upon Department approval.

Rule 11: The following contract shall be an excluded contract: (a) any contract created because of having an interest in any entity or having obtained membership of a retirement fund; or (b) any contract of investment insurance.

According to the above provision of the Rules, a contract naturally created due to acquiring interest (ownership) in any entity or obtaining membership in a retirement fund by contributing to it, and a contract for investment insurance, i.e., life insurance, accident insurance entered into for a minimum of five years, and similar insurance contracts, constitute excluded contracts. Even if the return of an excluded contract is deferred, the Act provides that such contracts are not long-term contracts.

Example 20.4.1: Devesh Dhakal entered into an agreement with a certain insurance company and took out a life insurance policy for a period of 15 years. He is to receive a lump sum payment of Rs. 1,50,000/- after the period specified in the insurance agreement. Even though the tenure period of such a contract for receiving payment after 15 years exceeds 12 months, such an investment insurance contract does not fall under long-term contracts.

According to the provisions of the Income Tax Act and Rules, even if a contract falls under long-term contracts, there is also a provision that the long-term contract provisions do not apply to such contracts in special circumstances. The Income Tax Rules provide that the long-term contract provisions do not apply to persons who are not required to file estimated tax returns in any income year. The following provision is in Sub-rule (4) of Rule 12 of the Rules in this regard:

Rule 12(4): The provision of long-term contract made in Section 26 of the Act shall not apply to a person who is not required to file an estimated tax return in any income year pursuant to Section 95 of the Act.

The long-term contract provisions under Section 26 apply only to persons required to file an estimated tax return under Section 95.

Under Section 95(1), only persons required to pay tax by installments must file an estimated tax return.

• Under Section 94(2), a person is not required to pay installments if the total installment tax payable is less than Rs. 7,500.

Natural persons covered by Section 4(4) generally have tax payable below Rs. 7,500; therefore:

• they are not required to pay installments,

• they are not required to file estimated tax returns, and

Section 26 (long-term contract provisions) does not apply to them.

Further, under Section 95(6) and Rule 33, the Department may specify any person or class of persons as not required to file an estimated tax return.

Whenever the contract price increases due to variations, reimbursements, claims, incentives, bonuses, or additional work, the revised amount becomes part of the total contract income, and future income recognition is calculated based on the revised contract value.

Example 20.13.3: New Nepal Construction Company Pvt. Ltd. obtained a road construction contract from the Department of Roads in income year 2076/77 for Rs. 11 crores to be completed within 4 years, and the total estimated cost amount of that contract was Rs. 10 crores. However, due to a significant increase in the cost of construction materials needed to complete the contract, the construction cost was expected to reach Rs. 12 crores in income year 2078/79. New Nepal Construction Company claimed reimbursement of the additional cost of Rs. 2 crores from the Department of Roads under the terms of the contract, and the Department of Roads agreed to reimburse the claimed amount. In this situation, the amount to be included in income according to the total of cumulative inclusions for that contract at the time the contract is completed is the total cost including the additional Rs. 2 crores due to the cost increase of that contract, i.e., Rs. 13 crores. Therefore, for income years 2076/77 and 2077/78 of the said contract, the total income of the contract is Rs. 11 crores, and for subsequent years the total cost is Rs. 13 crores, and the income of the contract must be determined accordingly.

If a person engaged in a long-term contract receives any amount that is not related to the performance of the work under that contract due to being engaged in that contract, such amount must be included in the income of the income year in which that income is received. Such income must not be taken as part of the income to be received for the contract, but must be included entirely in the income of the year it is received as incidental income in the form of other income.

Example 20.14.1: New Nepal Construction Company Pvt. Ltd. entered into a contract with the Department of Roads in income year 2076/77 to construct a road for Rs. 11 crores to be completed within 4 years. The total estimated cost amount of that contract was Rs. 10 crores. The company incurred expenses of Rs. 2 crores in income year 2076/77, Rs. 3 crores in income year 2077/78, and Rs. 3 crores in income year 2078/79 for that contract. Among such expenses, Rs. 2 lakhs in income year 2076/77, Rs. 5 lakhs in income year 2077/78, and Rs. 10 lakhs in income year 2078/79 were not deductible for income tax purposes. In this situation, the expenses to be deducted according to the total of cumulative inclusions for income tax purposes for those income years for that contract are as follows:

Long-term contract (Sec 26): a contract with tenure over 12 months for production, installation, construction or related services, or a deferred-return contract (Rule 10).

Intent at the contract date governs, not the actual duration.

Income & expense recognised on Percentage of Completion (POC) = cumulative direct cost to date ÷ total estimated direct cost; income this year = POC × total contract value - income already recognised in prior years.

Contracts negotiated as one package are combined; an optional additional asset is treated as a separate contract.

On completion, an unrelieved loss may be carried back to set off prior-year contract income for a refund (Sec 26(2)).