Contractor Tax Obligations In Afghanistan: Navigating Local Tax Laws

Afghanistan's tax system is complex and difficult to navigate, especially for contractors. The country's income tax rates are progressive and capped at 20%. While some sources indicate that U.S. contractors are exempt from Afghan taxes, others suggest that they may be required to pay taxes under certain conditions. For instance, contractors with Afghan employees are responsible for withholding taxes from their wages and making the necessary payments to the local taxing authorities. Additionally, U.S. citizens working in Afghanistan may be eligible for tax exemptions, such as the Foreign Earned Income Exclusion, but they must meet specific requirements. Understanding the intricacies of Afghanistan's tax system and navigating the challenges of contracting in the country can be daunting, and seeking expert advice is often recommended.

US defence contractors and subcontractors are exempt from Afghan taxes

On December 30, 2015, the US Department of Defense (DoD) issued a Final Rule stating that US defence contractors and subcontractors performing work in Afghanistan are exempt from Afghan taxes. This rule updates the tax provisions of the DFARS to reference the Bilateral Security Agreement signed by the US and Afghanistan in 2014, which explicitly exempts US contractors from Afghan tax obligations.

The US-Afghanistan Bilateral Security Agreement of 2014 exempts the US government, its contractors and subcontractors (other than those that are Afghan legal entities or residents) from paying any tax or similar charge assessed on activities associated with contracts performed within Afghanistan. The Agreement also exempts the acquisition, importation, exportation, reexportation, transportation, and use of supplies and services in Afghanistan, by or on behalf of the US government, from any taxes, customs, duties, fees, or similar charges in Afghanistan.

Despite this agreement, there have been instances of the Afghan Ministry of Finance (MOF) levying taxes and penalties on US contractors. A 2013 Special Inspector General for Afghanistan Reconstruction Audit found that a sample of 43 contractors had been assessed $921 million in taxes and penalties despite such prior agreements. In several instances, US contractors were required to pay taxes to the Afghan government even though they had been issued tax exemption certificates by the Afghan Ministry of Finance.

To avoid such situations, it is important for contractors to obtain a tax-exemption certificate from the Afghan MOF. Agencies are unlikely to reimburse any taxes paid to the Afghan MOF if the agency has a bilateral agreement in effect with the MOF. Contractors should also be aware that the withholding rate for unregistered businesses is 7%, compared to 2% for registered businesses.

It is worth noting that contractors are still responsible for complying with Afghan tax law as it applies to any Afghan employees. Contractors must withhold taxes from the wages of Afghan employees and make the required payments to the appropriate local taxing authority.

US citizens or resident aliens may qualify for the foreign earned income exclusion

U.S. citizens or resident aliens may qualify for the foreign earned income exclusion if they meet certain requirements. To qualify, you must have foreign earned income, your tax home must be in a foreign country, and you must be one of the following:

• A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.
• A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.
• A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.

Foreign earned income is generally income you receive for services you perform during a period in which you meet both of the following requirements:

• Your tax home is in a foreign country.
• You meet either the bona fide residence test or the physical presence test.

The foreign earned income exclusion is not automatic. Eligible taxpayers must file a U.S. income tax return each year with either a Form 2555 or Form 2555-EZ attached.

Contractors may need to pay US taxes on their worldwide income

As a contractor, you must file a US tax return and pay US taxes, regardless of where you live and where your income is sourced or paid. This means that, as a contractor, you may need to pay US taxes on your worldwide income.

However, there are some exclusions available that can reduce or eliminate your US tax liability. These must be actively claimed when filing your taxes.

Foreign Earned Income Exclusion (FEIE)

The FEIE lets US persons living abroad exclude a certain amount of foreign-earned income from taxation. The FEIE exclusion amount is adjusted from year to year based on inflation. For the 2023 tax year, the maximum exclusion was $120,000, and this increased to $126,500 for the 2024 tax year.

To claim the FEIE, you must pass one of two residency tests:

• Physical Presence Test: You must be physically present outside of the US for 330 days out of any 365-day period.
• Bona Fide Residence Test: You must reside in a foreign country for at least an entire calendar year without intending to return to the US.

Foreign Tax Credit (FTC)

If you pay taxes to a foreign government, you may be able to claim a dollar-for-dollar credit to offset your US tax bill and remove the risk of double taxation. This is known as the Foreign Tax Credit.

Foreign Housing Exclusion (or Deduction)

As a contractor employed overseas, you can use the Foreign Housing Exclusion to exclude certain foreign housing-related expenses from your US tax bill. This applies regardless of whether you rent or own a home. If you are self-employed, you will use the Foreign Housing Deduction rather than the Foreign Housing Exclusion.

The Afghan income tax rate is progressive and capped at 20%

Afghanistan's income tax rates are progressive and capped at 20%. This means that the more you earn, the higher your tax rate will be, up to a maximum of 20%. The progressive tax system aims to tax individuals based on their ability to pay, resulting in a more equitable distribution of the tax burden.

For individuals, the income tax rates in Afghanistan are as follows:

• 0% for income up to AFN 12,500 per month
• 10% for income between AFN 12,501 and AFN 100,000 per month
• 20% for income above AFN 100,001 per month

It's important to note that these rates are for residents of Afghanistan. Non-residents are taxed only on income sourced from within the country. To be considered a resident, an individual must meet at least one of the following criteria:

• Have their principal home in Afghanistan at any time during the tax year.
• Be present in Afghanistan for a period or periods totalling 183 days or more in the tax year.
• Be an employee or official of the Afghan government posted abroad during the tax year.

The progressive tax structure in Afghanistan also applies to corporate income tax. All companies, regardless of their legal form, are subject to a corporate tax rate of 20% on their net taxable income. Net taxable income is calculated by deducting all ordinary and necessary business expenses from gross income.

In addition to income tax, there are other taxes and contributions that individuals and businesses may have to pay. These include social security contributions, withholding tax, business receipt tax (replaced by VAT in 2020), and various customs duties and fees.

Understanding the tax system in Afghanistan is crucial for contractors, especially when it comes to complying with tax laws and optimizing their earnings. It's recommended that contractors seek specialized advice or consult with umbrella companies that can provide guidance and support in navigating the country's tax regulations.

US contractors may need to pay Afghan taxes on their employees' wages

US contractors and subcontractors working in Afghanistan are not subject to Afghan taxes. However, US contractors are responsible for complying with Afghan tax law as it applies to any Afghan employees, and therefore must withhold taxes from the wages of these employees and make the required payments to the appropriate local taxing authority.

The US-Afghanistan tax situation is complex. While US contractors are not subject to Afghan taxes, they are still required to file US tax returns each year. This is the case for US citizens or green card holders, who are legally required to file a US tax return annually, regardless of whether they already pay taxes in their country of residence.

US contractors and their employees may be able to claim the Foreign Earned Income Exclusion (FEIE) if they are physically present in a foreign country for more than 330 days in a consecutive 12-month period or become bona fide residents of Afghanistan. The Bipartisan Budget Act of 2018 changed the requirements, allowing these individuals to claim FEIE even if their abode is still in the US.

The FEIE is not automatic and must be claimed on a US income tax return. Eligible taxpayers can choose to exclude their foreign-earned income from gross income, up to a certain dollar amount. For the 2018 tax year, this limit was $103,900. It is important to note that taxpayers who choose the FEIE cannot take advantage of any other exclusion, deduction, or credit related to the excluded income.

US contractors working in Afghanistan should be aware of the potential for tax disputes with the Afghan government. In the past, Afghan officials have disregarded exemption provisions, requiring contractors to make tax payments. While a Bilateral Security Agreement signed in 2014 provided more explicit exemptions, contractors should still expect some pushback from Afghan officials, especially for work performed before the agreement took effect.

Frequently asked questions