Author: Matt Nissley, CPA
Article 72 of the Afghan Income Tax Law requires withholding of contractor tax on payments to contractors (note: “contractors” is a comprehensive term that includes all vendors, suppliers, consultants, etc.). The withholding amount is 7% of the gross contract price for unlicensed contractors and 2% for licensed contractors. The Income Tax Manual specifies that there is an annual threshold of AFN 500,000, and that transactions below this threshold are not subject to withholding tax.
While the essence of this law is quite simple, practically speaking it raises many questions for taxpayers. Contractor tax is often a contentious issue for taxpayers as they go through the tax clearance and tax audit process. The purpose of this post is to clarify common areas of confusion based on Quest’s technical interpretation of the tax law as well as many years of experience helping taxpayers resolve these issues with the Afghanistan Revenue Department (ARD). This post assumes that the reader is already familiar with the published guidance on this issue, so please make sure that you have read the contents of Article 72 from the Income Tax Manual as well as Taxpayer Guide 21 and Taxpayer Guide 21b as background to better understand this post.
Common Contractor Tax Scenarios
- Withholding vs. Paying Tax on Top of the Contract Price: The law is designed so that contractor tax should be withheld from the gross amount so that the financial burden of the tax falls on the contractor rather than the entity making payment. For example, if an entity is making a payment to an unlicensed contractor for goods that cost $100, the entity should withhold $7 (and remit to the ARD) and pay $93 to the contractor. However, what often happens is that the contractor will refuse to accept a withholding and will insist on receiving payment equal to the full gross price. In the example above, this means that the entity would pay $100 to the contractor and then remit an additional $7 to the ARD. This practice increases the cost of goods and services to the entity buying them, as the entity has now paid a total of $107 when the original price was set at $100. Quest recommends that entities always negotiate a gross price with contractors and clarify upfront that tax will be withheld from the gross amount as per the law.
- Contractor Tax Withholding as an Advance Payment: When an entity withholds contractor tax from a payment to a contractor and remits the tax to the ARD, this tax withholding is actually an advance payment against the contractor’s final tax liability. For unlicensed contractors, the 7% withheld represents their final tax liability (under the fixed tax system). For licensed contractors, the 2% withheld must be claimed as a credit against subsequent tax liabilities under the annual income tax system. Tax Guide 21 states that this credit should be claimed as an advance payment on the contractor’s annual income tax return. In practice, however, the ARD also allows this credit to be claimed on quarterly BRT tax returns as an offset to business receipts tax.
- Fulfilling Tax Filing Obligations: Entities are required to submit a monthly contractor tax form to the ARD along with the remittance of contractor tax withheld by the 10th of the following month. The first page of the contractor tax form requires reporting aggregate gross payments subject to contractor tax and the aggregate amount of contractor tax withheld. However, it is very important to also report the details of every individual payment subject to contractor tax on the second page of the tax form, including the contractors’ names, Taxpayer Identification Numbers (TIN), etc. After the contractor tax form has been cleared at the ARD, the entity must provide a copy of the detail sheet to the contractors from whom tax was withheld. This is the only way that the contractors can then claim a credit for the amount withheld against their subsequent tax liabilities. Quest recommends that entities proactively provide these detailed tax forms to all licensed contractors monthly, rather than only providing them upon request.
- Acceptable Licenses for 2% Withholding: The Income Tax Manual states “…For the purposes of Article 72 [contractor tax withholding], all licenses issued for the purpose of allowing commercial and economic activities by the government and official agencies to natural and legal persons are acceptable.” A common question is whether local Municipality license holders qualify for 2% withholding, and the answer is “yes” based on the quoted text above. On the other hand, note that foreign contractors who are licensed in their own country but not in Afghanistan are not eligible for the lower 2% withholding rate. Regarding valid licenses that are expired, Quest recommends withholding 7% even if 2% would normally be withheld if the license was current. In any case where an entity withholds only 2% from a payment to a licensed contractor, it is important for the entity to retain a copy of that license so that the correctness of the 2% withholding can be subsequently proved to tax auditors.
- Contractor Tax for Foreign Contractors: The general principle on contractor tax withholding with foreign contractors is that if the contractors have an income tax liability in Afghanistan for the goods or services provided, contractor tax should be withheld. In practice, a reasonable guideline to follow in line with Quest’s understanding of the law is that contractor tax should be withheld on payments to foreign contractors unless the goods or services provided were made available to the organization outside Afghanistan and the payment to the contractor was made from a bank account outside of Afghanistan.
Example 1: An organization with an HQ office in Europe and branch registered in Afghanistan hires a consultant based in Europe to provide advisory services related to a project in Afghanistan. The consultant performs all work remotely and the HQ office pays the consultant from its European bank account. Contractor tax should be withheld because the consultant is providing services directly to a project inside Afghanistan.
Example 2: A private hospital in Afghanistan imports medical supplies from India. The vendor ships the goods from India to Afghanistan, and the hospital pays the supplier from its bank account in Afghanistan. The payment is subject to contractor tax.
Example 3: A construction company with an HQ office in the U.S. and registered branch offices in multiple countries including Afghanistan purchases general liability insurance from a U.S.-based insurance company for its global operations. The cost of this insurance is allocated and pushed down to all branch office accounting records as an HQ overhead. This expense is not subject to contractor tax withholding because the insurance provider did not provide the service directly to Afghanistan and was paid from the construction company’s U.S. bank account.
Example 4: An international NGO is registered in Afghanistan with an HQ office in Japan. The HQ office contracts with a Japanese supplier to provide emergency food supplies for the project in Afghanistan and pays the supplier from the HQ bank account. If the contract specifies that the goods should be delivered to the HQ office (from which point the HQ office ships the goods to Afghanistan), contractor tax withholding is not required because the supplier did not make the goods available inside Afghanistan. In this case the supplier had no control over the final destination of the goods and cannot be subject to Afghan tax simply because the HQ office chose to ship the goods to Afghanistan. However, if the contract specifies that the supplier must deliver the goods directly to the project in Afghanistan, contractor tax withholding is required. - Payments to Tax-Exempt Contractors: If an entity procures goods or services from a contractor that is tax-exempt in Afghanistan, the payment is not subject to contractor tax provided that the tax-exempt contractor can provide proof of its exemption (proof which the entity making payment should retain for documentation purposes).
Example 1: An NGO procures services from a private business that has a Tax Exemption Confirmation from the ARD on this service contract under an international bilateral agreement. The NGO does not have to withhold contractor tax to the service provider, though it should make sure to retain a copy of the service provider’s Tax Exemption Confirmation.
Example 2: A local NGO contracts with another local NGO for project management training. As long as a) project management training is part of the tax-exempt mandate of the NGO providing the service, and b) the NGO providing the service has an up-to-date NGO tax exemption letter from the ARD, contractor tax withholding is not required upon payment for services provided. - Applying the AFN 500,000 Threshold: The annual threshold of AFN 500,000 mentioned in the Income Tax Manual applies to payments to a single contractor. For example, suppose that one year an entity makes payments of AFN 400,000 to Company A for computers and payments of AFN 450,000 to Company B for computers. Contractor tax withholding is not required because payments to single contractor did not exceed AFN 500,000 in a year. The fact that the goods purchased from Company A and Company B are in the same category and together exceed AFN 500,000 makes no difference.
- Crossing the Annual Threshold: If an entity makes numerous small payments to a contractor during the year and eventually crosses the AFN 500,000 annual threshold when all annual payments are considered in the aggregate, it is only the payment that crosses the threshold and subsequent payments that year that are subject to contractor tax. Previous payments made below the threshold amount are not subject to contractor tax. This is based on Taxpayer Guide 21b which states “Any single transaction between a payer and a payee which puts the payee – the person paid – over the AFN 500,000 per year threshold – either based on one transaction or many in the aggregate – that transaction triggers withholding payments due for that amount, then monthly from that point on.”
- Written Contracts: The Income Tax Law and related published guidance makes no distinction between written and verbal contracts for purposes of contractor tax withholding. However, based on internal ARD practice and regulations, tax auditors often take the position that all written contracts are subject to contractor withholding tax even if the aggregate value of annual payments to a single contractor under written contract are less than the threshold of AFN 500,000. Quest therefore recommends withholding contractor tax on all written contracts regardless of the amount. At the same time, taxpayers who did not withhold contractor tax on payments against written contracts below the annual threshold have reasonable grounds to stand on based on the published law and guidance.
- Goods vs. Services: There is no distinction between the purchase of goods and the purchase of services for application of contractor withholding tax.
- Tracking Expenses by Vendor: It is important for entities to track expenses by vendor in their accounting system. Some entities have faced a blanket contractor tax assessment on a percentage of total expenses reported on the annual income tax return, and the only way to prove that enough contractor tax was withheld on total expenses is to create a schedule of expenses by vendor (contractor) that reconciles to the annual tax return. If the entity can show that it withheld contractor tax on all payments exceeding the annual threshold to a single contractor during the year, there should be no additional assessment of contractor tax.
- Contractor Tax on Accrued Expenses: Suppose an entity receives goods or services in the month of June and receives an invoice in the same month for the full amount due. However, since the invoice terms specify that payment can be made within 45 days, the entity ends up making payment in the month of August. The entity is an accrual-basis taxpayer and therefore records the expense in the month of June in its accounting system. Is contractor tax due for the month of June or for the month of August? The answer to this common question is that contractor tax must be withheld at the time of payment (in this case, August) and remitted to the ARD by the 10th of the following month. All withholding taxes are essentially done on a cash-basis, even if an entity uses the accrual-basis of accounting for its accounting records. Likewise, if an accrual-basis entity prepays a contractor for six months of work, contractor tax must be withheld in full from the prepayment amount and remitted to the ARD upfront even if the expense is spread out evenly over six months in the entity’s accounting records.
- Reimbursable Expenses: A common question is whether contractor tax withholding is required on reimbursement expenses. For example, suppose that an entity contracts with an audit firm for an annual financial statement audit. The engagement letter specifies a fixed price for the audit and states that the auditors will bill the entity for actual out-of-pocket costs required to carry out the audit on a reimbursement basis (such as travel and accommodation costs for auditing one of the entity’s offices in another region). While contractor tax should clearly be withheld on payment of the fixed fee to the auditors, what about payment of the reimbursable expenses? The guiding principle is that if the receipt of reimbursement constitutes earned income to the party receiving reimbursement, such payment is indeed subject to contractor tax. In the example above, the auditors’ regional travel costs are part of their “cost of services provided” and likewise (based on the “matching principle” accounting concept) the reimbursement received should indeed be included in the auditors’ earned income; therefore, contractor tax withholding applies.
Conclusion
Dealing with contractor tax withholding can certainly be challenging, but this guide will help you deal with the most frequently encountered scenarios. If you have faced a challenge with contractor tax withholding that is not covered in this guide, please do let us know by leaving a comment below or emailing us at [email protected].