Sri Lanka Tax mess

UNCLAS SECTION 01 OF 03 COLOMBO 000794

SIPDIS

STATE FOR EB/MTA/MST AND SA/INS; MCC FOR D.NASSIRY AND
E.BURKE

USDOC FOR EROL YESIN

SENSITIVE, SIPDIS

E.O 12958: N/A
TAGS: ECON EFIN CE
SUBJECT: Sri Lanka Tax mess



1. (U) Summary: The cost of doing business in Sri Lanka is
set to rise, due to increased taxation and tax complexity.
International trade is also subject to high taxation in the
form of increased non-tariff fees and surcharges. However,
the impact of higher taxes is not equitable. For companies
entitled to tax holidays, the impact (and the tax liability)
is relatively low. Tax incentives offered to attract
investments have lowered potential tax revenue from a large
number of companies. End Summary.

New taxes
--------------


2. (U) The Parliament recently approved or amended several
tax laws to enforce tax proposals contained in the
Government of Sri Lanka's (GSL) 2006 budget. Key among the
new tax instruments is a cumbersome Stamp Duty (SD),which
will apply to several business instruments/transactions
including affidavits, mortgage payments, rentals, various
types of receipts, insurance policies, credit card charges
and salaries. In most cases, the tax rate is relatively
low, but would complicate business transactions by requiring
purchase and affixing of stamps to documents-the processing
of which is already burdensome in Sri Lanka. In other
instances, the duty will be withheld and sent to the Inland
Revenue Department (by the merchant directly) as in the case
of the SD on credit cards and salaries. The government will
also continue a 0.1% tax on all bank debits. Tax experts
say the stamp duty and the debit tax could result in a "tax
on tax" situation, as they are applied more than once on
money exchanging for a single transaction. For example,
since most people pay credit card bills through bank checks
or by withdrawing money from a bank, the transaction would
be taxed twice under the debit tax and stamp duty.

Thin capitalization and transfer pricing
--------------


3. (SBU) For the first time, Sri Lanka is to introduce
rules on thin capitalization (which limits a company's tax
breaks on loans made by shareholders - allowing shareholders
to keep their capital base "thin" and finance through debt
while writing off debt payments). Some tax experts are
concerned about the introduction of these advanced concepts
in Sri Lanka and suggest the country is not yet ready for
such sophisticated taxation, while others believe that they
will bring Sri Lanka's tax structure in line with global
developments. According to Premila Perera, Tax Partner at
KPMG, Sri Lanka will be one of the first developing
countries to introduce the thin capitalization concept and
has gone further than many countries by including both
related domestic and foreign debt. According to Perera, in
most countries, thin capitalization is introduced only to
cover related party foreign debt.


4. (U) The government will also introduce transfer pricing
rules using the "arm's length" principle (which uses prices
applied to sales to third parties on related party
transactions). However, Sri Lanka does not have enough data
to determine arm's length pricing, thus requiring income tax
assessors of the Inland Revenue Department to determine the
applicability of rules.

Corporate and Personal Income taxes are going up
-------------- ---


5. (U) Reversing a previous Government's decision to
gradually reduce the highest income tax rates to 20%, both
corporate and personal tax rates were increased from April
1, 2006. The highest tax band on corporate and personal tax
was increased to 35% from 30%. The government will also
continue with an additional Social Responsibility Levy (SRL)
(the procedures from which fund child protetion activities)
on income tax, which has been icreased to 1% from 0.25%.
Over the years, the goernment has begun to disallow various
business epenses when determining profits. Currently, it
does not allow companies to deduct a range of expenses such
as advertising (limited to 50%),overseas business trips and
entertainment expenses.


6. (U) The Banking community has raised concerns over

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increasing financial sector taxes. Banks pay corporate
income tax and an additional Value Added Tax (VAT) on
earnings. The overall tax rate on banks will rise to about
60% in 2006. Several bank CEO's have made public statements
complaining about the high tax environment. They claim that
high tax rates in the midst of higher capital adequacy
requirements, high levels of non-performing loans and
necessary technology upgrades does not bode will for the
industry. They assert that the high tax rates will result
in higher transaction costs over the long term.

Taxes on international trade also rising
--------------


7. (U) Meanwhile, Sri Lanka is continuing with a range of
taxes on international trade. The taxes include import
duty, an import duty surcharge, import fees, a Port and
Airports tax (PAL),SRL and VAT. Some imports are also
subject to an excise fee. VAT applies to both imports and
domestic production and services. Many of these taxes have
been increased in each successive budget over the past three
years. Other new taxes, such as a tax on foreign movies, are
also contemplated. Several US companies have complained to
the Embassy regarding the high level of taxation on imports.

Tax collections remain Low
--------------


8. (U) The recent moves to increase taxes indicate that the
private sector will have to bear the brunt of the
government's fiscal profligacy. With a projected budget
deficit of 9.1% of GDP in 2006, the Sri Lankan government is
hard pressed to find funds to cover expenses. Sri Lanka's
tax collections were about 14% of GDP in 2005 and the
government hopes to increase tax collection to about 16% of
GDP in 2006. Most taxes come from indirect taxes. Direct
taxes on income contribute only about 16% of tax revenue.


9. (U) There are many reasons for low tax revenue. Tax
incentives and tax holidays offered to encourage investments
by the Board of Investment (BOI) are key reasons for low
levels of direct taxation from the corporate sector,
especially from foreign investors. For example, Dialog
Telekom, an investment by Malaysia Telecom and Sri
Lanka's largest listed company, which made a profit of Rs 7
billion (USD 70 million) in 2005 is exempted from corporate
tax due to a 15 year tax holiday. Its tax liability will be
limited to just 0.6% of profits, via the Economic Service
Charge (a minimum tax on the exempted companies) and tax on
interest income. Similarly, while there is a wave of new
high rise apartment buildings shooting up around Colombo,
none is likely to bring tax revenue due to tax holidays
(unless they are foreign owned, in which case there is a
100% tax on the land value). Many exporting companies are
also subject to various tax incentives. These tax
incentives exclude some of the most profitable companies
from taxation.


10. (U) Another reason for sluggish tax revenue is the loss
of traditional sources of revenue, such as certain import
duties, due to tariff concessions offered under bilateral
and multilateral trade agreements including the Indo-Lanka
Free trade agreement (ILFTA). Imports of inputs and
production related items by exporting companies are also
free of import duty. Government tax experts have indicated
that to compensate for tax losses arising from duty
concessions granted under bilateral trading arrangements,
taxes on imports from other countries will need to be
increased. Import levies appear to be a relatively painless
domestic political device - less controversial to a
political base than broadening the income tax base or
raising VAT.


11. (U) Weak tax administration is a vulnerability. Tax
evasion is thought to be high. Out of a workforce of
approximately 10 million, only 143,704 individuals file tax
returns. In addition, there are 194,847 private sector
workers who pay taxes under the mandatory Pay-As-you-Earn
(PAYE) tax scheme

Concerns

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--------------


12. (SBU) While increased taxation seems to conform with
the President's vision of bridging the rich-poor gap, tax
experts say the government should not add additional taxes,
but should instead focus on increasing the tax base. At a
recent KPMG tax seminar, Premila Perera noted that the new
taxes and tax concepts will increase the complexity of the
tax system, and suggested that private sector CEO's should
pay increased attention to risk management and corporate
governance in this high tax environment. The higher tax
rates could also worsen Sri Lanka's economic freedom
rankings (Heritage Foundation) used by the Millennium
Challenge Corporation (Sri Lanka already faces low rankings
in the budget deficit and inflation categories).


13. (U) Government efforts to increase taxation come at a
time when the Inland Revenue Department (IRD) has come under
close public scrutiny following the revelation of a tax
fraud. Several former senior officers of the IRD and
businessmen have been arrested following a scam in which
more than Rs 3.5 billion (USD 35 million) had been
fraudulently paid out as VAT refunds. (Note: VAT paid on
imports consumed by exporting companies is refunded, but
genuine companies experience long delays in getting the
refunds.) Speaking at the KPMG seminar, Richard Ebell, Vice
Chairman of Hayleys Ltd, one of Sri Lanka's largest
companies, expressed concern over the lack of controls in
the tax system in light of the huge fraud. He noted that
Hayleys is experiencing serious problems in collecting VAT
refunds amounting to Rs 500 million (USD 5 million). A
previous reform effort to strengthen tax collection under a
single Revenue Authority has been abolished.


14. (SBU) Srilal Ahangama, Group Finance Director of
Maharaja Organization, one of Sri Lanka's largest privately
held companies, told Econ FSN that Sri Lanka's tax system
has always been complex and businesses just accept it. He
said his company would seek to find ways to lower the tax
burden within the tax law. Nilanthi Sivapragasam, Financial
Controller of Aitken Spence Group, another large publicly
held conglomerate, said that they are not overly worried
about the 5% increase in corporate taxation, but are highly
concerned about new rules on thin capitalization and
transfer pricing. According to her these rules would have a
direct impact on groups of companies with many subsidiaries
like Aitken Spence. According to Sivapragasam, these
concepts are usually applied to monitor multi-national
company (MNC) operations. However, Sri Lanka is to apply
these rules to cover local subsidiaries. According to her
estimates, the government earnings from these moves would
not be significant. Several companies have made
representations to the government on these rules, and it is
not clear if the government will change them.
ENTWISTLE