Tax Rules for Construction Companies & Contractors in Nepal

Construction contracts sit at an unusually complicated intersection of Nepali tax law: withholding tax on the contract payment itself, VAT that can apply differently to materials and labour within the same job, and income recognition rules that do not simply follow when cash changes hands. Add multi-year projects and retention money held back until a defect-liability period ends, and it becomes easy for both contractors and the businesses hiring them to get the timing or the rate wrong. This guide walks through each piece.

TDS Rate on Contract Payments

Payments made under a construction or supply contract to a resident person are subject to withholding tax at 1.5% under Section 89 of the Income Tax Act, wherever the contract payment exceeds NPR 50,000 within the relevant threshold-testing window (aggregated over a short moving period rather than assessed strictly payment-by-payment, so splitting a bill into smaller instalments to dodge the threshold does not avoid the deduction). The party making the payment — the client or main contractor, depending on who sits where in the payment chain — is responsible for withholding this 1.5% and depositing it with the IRD, then issuing a withholding certificate so the contractor can claim the credit against their eventual tax liability.

This 1.5% is generally an advance (adjustable) tax rather than a final tax: it is credited against the contractor's actual annual tax liability once their income is assessed under normal rules, rather than being treated as the full and final tax on that contract.

VAT on Construction Materials vs Labour

VAT treatment on a construction job is not uniform across the whole invoice — it depends on the nature of each component being billed:

Materials. Cement, steel, bricks, sand, fittings, and other construction materials supplied by a VAT-registered supplier attract the standard 13% VAT rate, added to the invoice in the normal way. A contractor who is VAT-registered and purchases these materials can generally claim input VAT credit against their own output VAT, provided the purchase is properly invoiced.

Labour and services. Where a contractor bills purely for labour or construction services, VAT applies if the contractor is VAT-registered, at the standard 13% rate on the service value. Where the contractor is not VAT-registered (operating instead on a PAN bill), the transaction sits outside the VAT system, but the 1.5% contract TDS described above still applies to the payment.

In practice, most substantial construction contracts combine both materials and labour under a single agreed price, and the contractor's invoice should still separate or at least support the underlying VAT treatment of each component for the client's own input-credit purposes.

Percentage-of-Completion Income Recognition

For construction contracts that span more than one accounting period, income is generally recognised in proportion to the work completed during each period — commonly referred to as the percentage-of-completion method — rather than being recognised entirely in the period the project finally finishes or the period cash is received. This matters because it means a contractor's taxable income in any given fiscal year can differ meaningfully from the cash they have actually collected in that year, particularly on long-running infrastructure or building contracts where billing milestones and cash receipt lag behind physical progress.

Businesses running multi-year contracts should maintain a clear, documented basis for measuring completion percentage (physical progress certified by a supervising engineer, cost-incurred-to-date against total estimated cost, or an equivalent method) since this becomes the basis the tax office will expect to see if income recognition is questioned.

Retention Money Tax Timing

Construction contracts routinely hold back a percentage of each milestone payment as retention money, released only after a defect-liability period confirms the work meets specification. The tax treatment of retention follows the point at which the amount becomes due and payable under the contract, not necessarily the later point at which it is actually released in cash — income recognised under the percentage-of-completion method already reflects the full contract value for work completed, including the retained portion, and the retention held back is treated as a receivable rather than income not yet earned. Contractors should track retention separately in their accounts to avoid understating declared income in the year work was performed, and to avoid double-counting it again as income when it is eventually released.

FAQ

When is contract income taxed — on billing or on collection?

Neither strictly billing nor strictly cash collection is the controlling test for a multi-period construction contract — income is generally recognised based on the percentage of work actually completed during each accounting period, which may run ahead of or behind both the billing schedule and the cash actually received. A contractor could have completed 60% of a project's physical work while having billed only 50% and collected only 40% in cash, and tax law expects income recognition to follow the completion percentage rather than either of the other two figures. For contracts that do not span multiple accounting periods, the distinction matters less since completion and the accounting period-end are closer together.

Does the client or the contractor pay the 1.5% TDS?

The client (or the party making the payment) withholds the 1.5% from what would otherwise be paid to the contractor and deposits it with the IRD — so economically the contractor bears the deduction, receiving 98.5% of the invoiced amount in cash, while the client carries the compliance responsibility of withholding, depositing, and issuing the certificate correctly.

Is a subcontractor treated differently from the main contractor?

A subcontractor is generally subject to the same 1.5% contract TDS on payments received from the main contractor, since the main contractor is itself a withholding agent for that payment. This means on a layered project, TDS can be withheld at each stage of the payment chain — client to main contractor, and main contractor to subcontractor — with each recipient claiming their own withholding certificate as a credit.