Laws · Analysis

Overstated tax losses: the false-return penalty is tied to tax shortfall, so a loss-making return may attract none

Possible loopholeMedium confidenceEnacted ActReform recommendation

Section 120 of the Income Tax Act 2058 charges a fee for false or misleading statements equal to 50 or 100 per cent of the resulting tax shortfall. If a taxpayer reports a loss and the loss is reduced on audit but no tax becomes payable for that year, there is no shortfall to calculate the fee from. The Auditor General reported that tax audits in 2080/81 cut reported losses by Rs 59.74 billion, that no fee or interest applies to loss-making taxpayers, and suggested a fixed percentage of the overstated loss or a fee once the taxpayer returns to profit.

Laws and sections involved

आयकर ऐन, २०५८ · Income Tax Act, 2002 s.120; s.20 (loss carry-forward); ss.118–119 (interest)
Our paraphrase: a person who makes a false or misleading statement to the Department is charged a fee of 50 per cent of the resulting tax shortfall if by mistake, or 100 per cent if knowingly or negligently (s.120); unrelieved business losses may be carried forward and deducted for seven years (twelve for certain infrastructure, power and petroleum projects) (s.20(1)).
Law Commission consolidated text to the Financial Act 2083 (2083/03/30); footnotes on the s.120 page record amendments by the Financial Acts 2081 and 2083 (which words they changed was not confirmed); the text read still ties the fee to the tax shortfall. s.120 on PDF pp.141–142; s.20 on PDF pp.41–42. Official text

The apparent issue

The penalty for false statements is calculated only from a tax shortfall. A taxpayer who overstates a loss may face no penalty in the year of the false return, because no tax was due either way. The texts read do not say whether, when an overstated loss is later carried forward and used, the resulting shortfall in a later year attracts the s.120 fee.

Evidence

The Auditor General noted that s.120(क) charges 50 per cent of the tax shortfall for a mistaken false return and 100 per cent for a knowing one, plus interest under ss.118–119, but that there is no legal provision for any interest or fee for loss-making taxpayers. According to the Inland Revenue Department's annual report, amended assessments of 4,450 taxpayers audited in 2080/81 adjusted Rs 59.74 billion of losses, with a larger cumulative amount over four years. Office of the Auditor General Ministry of Finance chapter, para 79, printed p.130 (PDF p.160)
The Auditor General said that because a profit-return filer pays fees and interest while a loss-return filer does not, loss-reporting taxpayers may understate income and inflate expenses, and recommended reviewing the law, for example by charging a fixed percentage of the loss as a fee or requiring the fee once the taxpayer returns to profit. Office of the Auditor General Para 79, printed p.130 (PDF p.160)
The following year's report noted that most of the losses adjusted through tax audit relate to government-owned enterprises. Office of the Auditor General Ministry of Finance chapter, para 70, printed p.132 (PDF p.164)
Sections 20 and 120 were read in the Law Commission consolidated text (see laws). Nepal Law Commission s.20 PDF pp.41–42; s.120 PDF pp.141–142

Possible readings

Reading 1 (the Auditor General's view): as drafted, s.120 creates no cost for overstating a loss, which is an incentive to overstate; the law should add a penalty measured on the overstated loss.
Reading 2: an overstated loss is only valuable when it is carried forward under s.20 and set off against later profits; at that point the false statement produces a tax shortfall, and s.120 can apply to that later shortfall, so the gap is one of timing and enforcement rather than a true loophole.
Reading 3: where losses are corrected by audit before they are used, the audit itself removes the benefit; a separate penalty would mainly deter, and could fall heavily on loss-making public enterprises whose losses are not tax-motivated.

Why it matters in practice

If Reading 1 is right, the tax system may encourage loss overstatement and audit effort produces no penalty revenue. If Reading 2 is right, the law already works but depends on tracking corrected losses across years. Any new penalty would need to avoid penalising honest errors and public enterprises disproportionately.

Hypothetical example

Hypothetical: two companies each understate income by Rs 1 crore. Company A had reported a Rs 50 lakh profit; on audit it owes extra tax and a s.120 fee of up to 100 per cent of the shortfall. Company B had reported a Rs 2 crore loss; on audit its loss falls to Rs 1 crore, no tax becomes due, and on one reading no fee applies.

Possible improvements and trade-offs

Amend s.120 to charge a fee equal to a fixed percentage of the overstated loss (one option the Auditor General suggested).
Simple and deterrent; the rate must be set so it does not exceed the tax value of the loss, and honest errors need protection.
Charge the fee when the overstated loss would have been used — that is, when the taxpayer returns to profit (the Auditor General's other suggestion), and state this expressly.
Ties the penalty to real revenue effect; requires tracking corrected losses over up to twelve years.
No change to the Act; rely on audit corrections and on applying s.120 to later-year shortfalls, issuing guidance to that effect.
No legislative cost; leaves the deterrence gap the Auditor General describes.

Questions for legal review

Where an overstated loss is carried forward and used in a later year, does s.120 apply to the later-year shortfall, and from which year does the limitation for assessment run?
Could a penalty measured on a loss (rather than on tax) be challenged as disproportionate?
What did the Financial Acts 2081 and 2083 change in or around s.120?

Research status

Researched: 2026-10-12
Confidence: Medium confidence — s.120 was read and its wording ties the fee to a tax shortfall, which the Auditor General states creates no fee for loss-making taxpayers. Confidence is not high because the carry-forward route (Reading 2) may already bring later shortfalls within s.120, and the 2081 and 2083 amendments recorded on the s.120 page were not examined in detail.
Review: Not yet reviewed by a qualified lawyer.

Still unresolved

The Inland Revenue Department's practice on applying s.120 to later-year shortfalls from overstated losses is not known.
The texts of the Financial Acts 2081 and 2083 amending s.120 were not read.
How much of the Rs 59.74 billion of adjusted losses relates to private versus government-owned taxpayers is not stated in the pages read.