INVESTMENT CLIMATE STATEMENT 2009 - SRI LANKA

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SUBJECT: INVESTMENT CLIMATE STATEMENT 2009 - SRI LANKA



REF: 08 STATE 123907



1. Per reftel, post is pleased to present the investment climate

statement for Sri Lanka for 2009.



[Begin text:]



INVESTMENT CLIMATE STATEMENT-SRI LANKA

JANUARY 2009



Openness to Foreign Investment



Unpredictability Impedes Investment



Sri Lanka's intractable civil war, erratic policy environment, and

cumbersome bureaucracy make it an unpredictable investment

destination. However, compared to other South Asian countries, Sri

Lanka is relatively open to foreign investment. It offers a

relatively open financial system, moderately good infrastructure,

and generally capable workers. Some U.S. and other foreign

investors have realized worthwhile returns on investment in Sri

Lanka; others have tried and gone away frustrated.



Sri Lanka is a lower-middle income developing nation with a gross

domestic product of about $38 billion in 2008. This translates into

a per capita income of over $1,800.



The Sri Lankan economy is remarkable for its resilience. Although

suffering a civil war that began in 1983, GDP growth averaged around

5% in the last ten years. Even the December 2004 Indian Ocean

tsunami failed to dent GDP growth, which was over 6% in 2005-2008,

due in part to damage being offset by reconstruction. Unfortunately,

inflation remained high during this period, as in 2008, when it

averaged 14% year-on-year.



Despite the civil war and global recession, Sri Lanka's gross

domestic product (GDP) grew once again by an estimated 6% in 2008.

Growth was led by telecommunications, ports, construction,

government services, agriculture and manufacturing exports. Sri

Lanka's trade and current account deficits widened sharply, mainly

due to higher oil prices. While Sri Lanka's exposure to the global

financial crisis is liited due to controls on its capital account,

SriLanka experienced capital flight by foreign investrs who had

invested in government debt instrumens. By early December 2008,

Central Bank reserves declined to around $2 billion, or less than 2

months of imports, due to intervention in an attempt to maintain a

de facto peg against the dollar. The rupee was allowed to

depreciate marginally in late December. As a result, the rupee

depreciated overall by only about 4% in 2008 and the real effective

exchange rate of the rupee remains overvalued. The Central Bank

expects a balance of payments (BOP) deficit in 2008.



2009 will be a challenging year for the Sri Lankan economy. The

Central Bank expects the economy to grow by 5-6% in 2009, aided by

growth in agriculture, manufacturing and services, and forecasts

inflation to slow down to single digit levels. A successful halt to

the civil conflict, although not yet assured, could also help

growth. Nonetheless, the global economic downturn is likely to

impact the economy in a number of ways. Exports, services and

remittances will likely decline, exerting pressure on the currency

and reserves. The government's budget forecasts, including a

deficit of only 6.5% of GDP, are likely unrealistic in light of

global recessionary conditions. Sri Lanka will also likely face

extreme difficulty in obtaining commercial loans in 2009 to assist

in the financing of its deficit and debt service. With a continued

refusal to even consider IMF assistance in the future, it will need

to either significantly revise its forecasts for 2009, or find other

sources of funds.



Sri Lanka is a stable parliamentary democracy. In 1978, it shifted

away from a socialist orientation and opened to foreign investment.

However, changes in government have often been accompanied by

reversals in economic policy. Of the two major parties, the more

pro-business United National Party has been in opposition in recent

years. When it last held power, from 2002 to 2004, it pursued

privatization and regulatory reform welcomed by domestic and foreign

investors.



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Currently, the ruling Sri Lanka Freedom Party has a more statist

economic approach, guided by President Rajapaksa's 2005 election

manifesto Mahinda Chintana ("Mahinda's Thoughts"). Mahinda Chintana

seeks to reduce poverty by steering investment to disadvantaged

areas; developing small and medium enterprises; promoting

agriculture; and expanding the already enormous civil service. The

Rajapaksa government has halted most privatization and advocates

permanent state control of what it deems "strategic" enterprises

such as state-owned banks, airports, and electrical utilities. The

government has increased direct and indirect taxation to fund

increased government expenditure. The government has adopted import

substitution and has increased taxes on imports to protect local

industries.



Multinational companies complain that increasing government bias in

favor of local businesses is harming the local investment climate.

Though many multinational companies perform better than the local

private sector, international MNCs and SMEs feel the government is

blatantly biased towards local companies. Some investors believe,

and are concerned, that Sri Lanka is becoming a highly nationalistic

environment where the government often blames foreigners for its

economic and social ills.



The 24-year ethnic conflict between the U.S.-designated terrorist

organization Liberation Tigers of Tamil Eelam (LTTE) and the

Government of Sri Lanka has been a serious impediment to foreign

investment. A Norwegian-brokered ceasefire between the LTTE and the

government, in effect since February 23, 2002, broke down in 2006

and was formally abrogated by the government in January 2008. As a

result of major military operations, the government recently

regained control of the Eastern Province (2007) and most of the

Northern Province (2008). The government's military offensive to

regain the control of the entire national territory appears to be on

the verge of success.



Other impediments to investment in Sri Lanka are workers' declining

English language skills, inflexible labor laws, overburdened

infrastructure, and its unreliable court system. Sri Lanka boasts a

90% literacy rate in the local Sinhala and Tamil languages, but

English, which was once widely spoken, is now far less prevalent.

Sri Lanka's labor laws include many model protections, but can make

it nearly impossible for companies to lay off workers even when

market conditions fully warrant doing so. The cost of dismissing an

employee in Sri Lanka is, percentage-wise, one of the highest in the

world. Sri Lanka has not invested in infrastructure to keep pace

with its growth. Its roads are narrow and congested. Its

electricity supply is generally reliable but can fail to meet peak

demand in years of low rainfall and is priced higher than in other

Asian countries. Businesses in Sri Lanka also face high interest

rates. Sri Lanka's courts cannot be relied upon to uphold the

sanctity of contracts. The courts are not practical for resolving

disputes or obtaining remediation, because their procedures make it

possible for one side in a dispute to prolong cases indefinitely.

Aggrieved investors (especially those dealing with the government of

Sri Lanka on projects) have frequently pursued out-of-court

settlements, in hopes of speedier resolution. In late 2008, the

Supreme Court, in an interim order, halted payments to five

international and local banks involved in oil hedge contracts with

the government. One of the involved banks is American.



Trade



According to preliminary data for 2008, Sri Lanka's exports (mainly

apparel, tea, rubber, gems and jewelry) were $8.2 billion and

imports (mainly oil, textiles, food, and machinery) were $14.1

billion. Exports to the United States, Sri Lanka's second largest

market, are projected around $1.9 billion in 2008, or 24% of total

exports. For many years, the United States has been Sri Lanka's

biggest market for garments, taking about 50% of total garment

exports. India is Sri Lanka's largest supplier, with exports of

over $2.6 billion. The United States' exports to Sri Lanka are

projected at around $280 million in 2008. US exports consist

primarily of wheat as well as industrial machinery, medical

instruments, paper, specialized fabrics and textiles for use in the

garment industry, and pharmaceuticals.





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Board of Investment



The Board of Investment (BOI) (www.boi.lk),an autonomous statutory

agency, is the primary government authority responsible for

investment, with a focus on foreign investment. The BOI is

authorized to manage a number of export processing zones which

feature business-friendly regulations and improved infrastructure

for foreign investors. The BOI is intended to provide "one-stop"

service for foreign investors, with duties including approving

projects, granting incentives, and arranging services such as water,

power, waste treatment and telecommunications. It also assists in

obtaining resident visas for expatriate personnel and facilitates

import and export clearances. The Public-Private Partnership Unit,

a new division of BOI, has responsibility for coordinating all

public-private infrastructure projects.



BOI incentives are attractive and real, but the BOI is not the "one

stop shop" it aspires to be. Although it is relatively effective in

assisting investors who want to establish operations within its

industrial processing zones, it is less effective in facilitating

and service large investments outside these zones. Sri Lanka's

large, inefficient, and dated bureaucracy often works at

cross-purposes with BOI authorities and commitments. Additionally,

major investments in Sri Lanka, such as infrastructure projects,

require approval from the full cabinet, a process which is not

transparent and which can politicize even the most needed

investments. Registration of foreign company branch offices in Sri

Lanka can be cumbersome as well.



Although there are cases in which it appears that the BOI has been

used for political purposes upon occasion, generally the treatment

given to foreign investors is non-discriminatory. However, even

with incentives and BOI facilitation, foreign investors face

difficulties operating in Sri Lanka. Problems range from difficulty

clearing equipment and supplies through customs speedily to

difficulty obtaining a factory site. Legal challenges to

environmentally sensitive projects have been burdensome, even when

objections are unfounded. Slow and indecisive application of

bureaucratic requirements has also obstructed investment. In part

to avoid these delays, and to overcome land allocation problems, the

BOI encourages investors to locate their operations in

BOI-established industrial processing zones. Investors locating in

industrial zones also get access to relatively better infrastructure

facilities such as reliable power, telecommunication and water

supplies.



Laws Affecting Investment



The principal law governing foreign investment is Law No. 4, created

in 1978 (known as the BOI Act),as amended in 1980, 1983 and 1992,

along with implementation regulations established under the Act.

The BOI Act provides for two types of investment approvals. Under

section 17 of the Act, the BOI is empowered to grant concessions

(see details below) to companies satisfying certain eligibility

criteria on minimum investment, exports and in some cases

employment. Investment approval under Section 16 of the act permits

entry for foreign investment to operate under the "normal" laws of

the country and applies to investments that do not satisfy

eligibility criteria for BOI incentives. Other laws affecting

foreign investment are the Securities and Exchange Commission Act of

1987 as amended in 1991 and 2003, and the Takeovers and Mergers Code

of 1995 revised in 2003. A new Companies Act came into effect in

2007 replacing the Companies Act of 1982. The new law aims to

improve trade and commerce as well as corporate governance in the

business sector. It features simplified regulations concerning

company formation; provisions specifying the duties of company

directors; provisions to prevent the abuse of powers by directors;

provisions to protect creditors; and a dispute board to settle

disputes among directors. Various labor laws and regulations also

affect investors. See sections below.



Foreign Equity Shares by Sector



The government allows 100% foreign investment in the following

services: banking, finance, insurance, stock-brokering,

construction of residential buildings and roads, supply of water,

mass transportation, telecommunications and information technology



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(software development and business process outsourcing),energy

production and distribution, professional services, and the

establishment of liaison offices or local branches of foreign

companies. These services are regulated and subject to approval by

various government agencies. The screening mechanism is

non-discriminatory and, for the most part, routine.



Investment in other sectors is restricted and subject to screening

and approval on a case-by-case basis when foreign equity exceeds

49%. The affected sectors are: shipping and travel agencies;

freight forwarding; fishing; timber-based industries; growing and

primary processing of tea, rubber, coconut, rice, cocoa, sugar and

spices; and the production for export of goods subject to

international quota. Foreign investment restrictions and government

regulations also apply to international air transport; coastal

shipping; lotteries; large-scale mechanized gem mining; and

sensitive industries such as military hardware, dangerous drugs and

currency.



Foreign investment is not permitted in the following businesses:

non-bank money lending; pawn-brokering; retail trade with a capital

investment of less than $1 million (with one notable exception: the

BOI permits retail and wholesale trading by reputed international

brand names and franchises with an initial investment of not less

than $150,000); coastal fishing; and the awarding of local

university degrees. Foreign degree courses can be offered in Sri

Lanka by affiliating with foreign universities. However, there is

no scheme to monitor the quality assurance or accreditation of the

foreign courses offered in Sri Lanka.



Privatization Halted



The current Government has halted most privatization. Government

treatment of foreign investors in past privatization processes has

been largely non-discriminatory. In 2003, however, the government

sold part of the retail operations of state-owned Ceylon Petroleum

Corporation to Indian Oil Corporation without a formal tender

process. In 2008, the Supreme Court cancelled a privatization of a

government owned bunkering company, done in 2002, citing it was

illegal.



Labor unions in state-owned enterprises are often opposed to

privatization and restructuring and seem particularly averse to

foreign ownership. In the past, this made the privatization of

government entities problematic for new foreign owners.



Conversion and Transfer Policies

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



In accordance with its Article VIII obligations as a member of the

International Monetary Fund

(http://www.imf.org/external/pubs/ft/aa/aa08. htm),Sri Lanka has

liberalized exchange controls on current account transactions. In

times of balance of payments difficulties the government tends to

impose controls on foreign exchange transactions. Most recently, in

October 2008, the Central Bank required importers to keep a 100%

deposit on letters of credit on a range of imports. The deposit

requirement on the import of cars is 200% of the value of the

import.



Exporters must repatriate export proceeds within 90 days to settle

export credit facilities. Other export proceeds can be retained

abroad in a local banks correspondent bank. Currently, contracts

for forward bookings of foreign exchange are permitted for a maximum

period of 180 days for the purposes of payments in trade. In

addition, with effect from November 1, 2008 banks are required to

obtain a 100% deposit of the contract value in rupees.



There are no barriers, legal or otherwise, to the expeditious

remittance of corporate profits and dividends for foreign

enterprises doing business in Sri Lanka. Remittance of business

fees (management fees, royalties and licensing fees) is also freely

permitted for companies with majority foreign investment approved

under Section 17 of the BOI Act. Repatriation of funds for debt

service and capital gains of companies exempted by the BOI from

exchange control regulations is permitted. Other foreign companies

remitting funds for debt service, business fees and capital gains



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require Central Bank approval.



The average delay period for remitting investment returns such as

dividends, return of capital, interest and principal on private

foreign debt, lease payments, royalties and management fees through

normal, legal channels is in the range of 1 to 4 weeks. All stock

market investments can be remitted without prior approval of the

Central Bank through a special bank account. Investment returns can

be remitted in any convertible currency at the legal market rate.



While controls on capital account (investment) transactions usually

prohibit foreigners from investing in Sri Lankan debt instruments,

the government allows limited access to foreigners to invest in

government rupee bonds and treasury bills. The Central Bank's

dollar denominated bond issues in the local market are also open to

foreign investors. Local companies require Central Bank approval to

invest abroad. The process of granting approval for such

investments was streamlined in 2002, resulting in a substantial

increase in approvals.



Expropriation and Compensation

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



Since economic liberalization policies began in 1978, the Sri Lankan

Government has not expropriated a foreign investment. The last

expropriation dispute was resolved in 1998.



Dispute Settlement

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



Legal System



Sri Lanka's legal system reflects diverse cultural influences.

Criminal law is fundamentally British. Basic civil law is

Roman-Dutch. Laws pertaining to marriage, divorce, and inheritance

are communal. Sri Lankan commercial law is almost entirely

statutory. The law was codified before independence in 1948 and

reflects the letter and spirit of British law of that era. Its

amendments have, by and large, kept pace with subsequent legal

changes in the U.K. Several important legislative enactments

regulate commercial matters: the Board of Investment Law, the

Intellectual Property Act, the Companies Act, the Securities and

Exchange Commission Act, the Banking Act, the Industrial Promotion

Act and Consumer Affairs Authority Act. Most of these laws were

revised recently.



Sri Lanka's court system consists of the Supreme Court, the Court of

Appeal, Provincial High Courts and the Courts of First Instance viz.

district courts (with general civil jurisdiction) and magistrate

courts (with criminal jurisdiction). The provincial high courts

have original, appellate and reversionary criminal jurisdiction.

The Court of Appeal sits as the intermediate appellate court with a

limited right of appeal to the Supreme Court. The Supreme Court

exercises final appellate jurisdiction for all criminal and civil

cases. Citizens may apply directly to the Supreme Court for

protection if they believe any government or administrative action

has violated their fundamental human rights.



All commercial matters exceeding the value of Rs 3 million

(approximately $26,500) fall within the jurisdiction of the

Commercial High Court of Colombo. There are also a number of

tribunals which exercise judicial functions, such as the Labor

Tribunals to hear cases brought by workers against their employers.

Until recently, the court system was largely free from government

interference. There are allegations that the judiciary is sometimes

subject to political influence, but this has not been evident in

commercial litigation so far. Litigation can be slow and

unproductive, though. Monetary judgments are usually made in local

currency. Procedures exist for enforcing foreign judgments.



In late 2008, acting on a fundamental human rights petition, the

Supreme Court, in an interim order, halted payments to five

international and local banks involved in oil hedge contracts with

the government. One of the banks involved is American.



Bankruptcy Laws





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The Companies Act and the Insolvency Ordinance provide for

dissolution of insolvent companies, but there is no mechanism to

facilitate the re-organization of financially-troubled companies.

Other laws make it difficult to keep a struggling company solvent.

The Termination of Employment of Workmen Act (TEA),for example,

makes it difficult to fire or lay off workers who have been employed

more than six months for any reason other than serious,

well-documented disciplinary problems. The Labor Commissioner's

approval or the affected employee's consent is required to fire

workers. The government has introduced a standard compensation

formula under the TEA to facilitate termination for other than

disciplinary reasons. Employers protest that compensation is

excessive compared to similar formulae in the Asian region, with

terms in Sri Lanka about twice as generous as the East Asian

average. (See section on "Labor" for further details.)



In the absence of proper bankruptcy laws, extra-judicial powers

granted by law to financial institutions protect the rights of

creditors. When a company cannot meet the demands of a creditor for

a sum exceeding Rs 50,000, (approximately $440) the creditor may

petition for company to be dissolved by the court. Lenders are also

able to enforce financial contracts through powers that allow them

to foreclose on loan collateral without the intervention of courts.

However, loans below Rs 5 million ($442,500) are exempt from the

application of the law. Additionally, a recent judgment ruled that

these powers would not apply with respect to collateral provided by

guarantors to a loan. These two moves have weakened creditors'

rights. Financial institutions also face other legal challenges as

defaulters obtain restraining orders on frivolous grounds due to

technical defects in the recovery laws. Also, for default cases

filed in courts, the judicial process is extremely slow.



The new Companies Act of 2007 introduced a "solvency test" to

determine the financial health of a company. There are provisions

relating to the responsibilities of a company's directors in cases

of serious loss of capital. The solvency test is intended to

prevent companies without sufficient assets from obtaining loans and

to protect rights of creditors.



The Companies Act does not provide for the revival of struggling

companies. However, as in the past, it is expected that the courts

would take a liberal attitude towards any restructuring plans that

may be of benefit to a company.



Investment Protection



In principle, foreign investments are guaranteed protection by the

Constitution of Sri Lanka. The government has entered into 24

investment protection agreements with foreign governments (including

the United States) and is a founding member of the Multilateral

Investment Guarantee Agency (MIGA) of the World Bank. Under Article

157 of the Constitution of Sri Lanka, investment protection

agreements enjoy the force of law and no legislative, executive or

administrative action can be taken to contravene them. The

government has ratified the Convention on Settlement of Investment

Disputes, which provides the mechanism and facilities for

international arbitration through the World Bank's International

Center for the Settlement of Investment Disputes (ICSID).



The U.S.-Sri Lanka Bilateral Investment Treaty (BIT) was ratified by

both governments in 1993

(www.state.gov/documents/organization/43588.p df).



Arbitration



The Arbitration Act of 1995 gives recognition to the New York

Convention on Recognition and Enforcement of Foreign Arbitral

Awards. Arbitral awards made abroad are now enforceable in Sri

Lanka. Similarly, awards made in Sri Lanka are enforceable abroad.

A center for arbitration known as the Institute for the Development

of Commercial Law and Practice (ICLP)

(www.iclparbitrationcentre.com) has been established in Colombo for

the expeditious, economical, and private settlement of commercial

disputes. However, the ICLP appears unlikely to become involved in

disputes involving the Sri Lankan Government, which is often a party

to disputes involving foreign investors.





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Sri Lanka's first commercial mediation center was established in

2000 and became operational in mid 2001. Commercial mediation is

conducted under the Commercial Mediation Act. Interest in mediation

is still low.



The Labor Department has a process involving labor tribunals for

settling industrial disputes with workers or unions, and arbitration

is required when attempts to reconcile industrial disputes fail.

The Labor Commissioner typically becomes involved in

labor-management mediation. Other senior officials, including the

Labor Minister, and the President, have intervened in particularly

difficult cases.



The government record in handling investment disputes is

problematic. Disputes often become politicized, causing the

government to put political interests ahead of its respect for the

sanctity of contracts. For example, in 2006, the Indian Oil

Corporation's petroleum retailing subsidiary in Sri Lanka

temporarily closed its operations when the government failed to

honor its commitment to reimburse the company for fuel sold at the

government-controlled price.



Investment Disputes Involving U.S. Companies



U.S. companies have experienced problems with payment of valid

contracts; implementation of agreements with the government; and

inexplicable failure to secure contracts, despite demonstrated

superior performance, high value, and competitive bids.



A U.S. power company producing electricity in Colombo has been

unable to obtain payment since 2004 for power that it produced under

a temporary, more costly, operating mode following a fire in its

plant. The company had intended to suspend operations to conduct

repairs following the fire, but agreed to the government's request

that it keep producing power even at a higher cost. However, the

government withheld payment on the basis of a questionable Attorney

General finding that the higher than usual electricity price was

imposed on the government "under duress."



Performance Requirements and Incentives



Performance Requirements



The Board of Investment specifies certain minimum investment amounts

for both local and foreign investors to qualify for incentives.

Firms enjoying preferential incentives in the manufacturing sector

in most cases are required to export 80% of production, while those

in the service sector must earn at least 70% of income in foreign

exchange. Sri Lanka complies with WTO Trade Related Investment

Measures (TRIMS) obligations.



Sri Lanka encourages foreign investment in information technology,

electronics assembly, light engineering, automobile parts and

accessories manufacturing, industrial and information technology

parks, rubber based industries, information and communication

services, tourism and leisure related activities, agriculture and

agro processing, port-related services, regional operating

headquarters, and infrastructure projects. Foreign investors are

generally not expected to reduce their equity over time, nor are

they expected to transfer technology within a specified period of

time, except for build-own-transfer or other such projects in which

the terms are specified within pertinent contracts.



In some BOI-approved enterprises, businesses are required to

maintain certain levels of employment to enjoy incentives. In

addition, privatization agreements generally prohibit new owners

from dismissing workers, although the owners are free to offer

voluntary retirement packages to reduce their workforce. Some

foreign investors have received political pressure to hire workers

from a particular constituency or a given list, but have

successfully resisted such pressure with no apparent adverse

effects.



Foreign investors who remit at least $250,000 can qualify for a

one-year resident visa, which can be renewed. Employment of foreign

personnel is permitted when there is a demonstrated shortage of

qualified local labor. Technical and managerial personnel are in



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short supply, and this shortage is likely to continue in the near

future. In the past, foreign employees attached to BOI-approved

companies received preferential tax treatment for an initial period.

This concession was withdrawn in April 2008. BOI is planning to

appeal to the Finance Ministry to reverse this decision. Foreign

employees in the commercial sector do not experience significant

problems in obtaining work or residence permits.



Investment Incentives



The Board of Investment (www.boi.lk) has various incentives, with

such investments typically requiring prior approval by various

ministries. Please see the note at the end of this section on

proposed changes to the incentive programs listed:



Incentive Program I:



Qualifying industries:

-Non-traditional manufacturing exports and companies supplying to

exporting companies. Minimum investment of $500,000(a);

-Export oriented services. Minimum investment of $500,000;

-Manufacture of industrial tools and/or machinery. Minimum

investment of $500,000;

-Small-scale infrastructure. Minimum investment of $500,000;

-Research and development. Minimum investment of $100,000;

-Agriculture and agro processing industries. Minimum investment of

$150,000;

-Export trading houses of rural sector. Minimum investment of

$150,000



Incentives: Currently, the above industries qualify for a five-year

tax holiday. A preferential tax of 10% in the 6th and 7th years

follows the tax holiday for some industries. Some of these

industries qualify for duty-free imports (generally, during the life

of the project for export-oriented projects, and during the project

implementation period for others). Exporting companies and

export-oriented services will be exempted from exchange control

regulations. They will also qualify for free repatriation of

profits and dividends and free transferability of shares. A

two-year tax holiday is available for investments with an investment

less than $500,000. A recently introduced Economic Service Charge

(ESC) at 0.25% of income applies to BOI-approved companies with tax

holidays. The tax applies even to existing companies -- there is no

grandfather clause. ESC will apply to BOI approved manufacturing

companies from the fourth year of operation.



Incentive Program II:



Qualifying Industries:

-Information technology (IT) or information technology enabled

services. Minimum investment of $150,000. Minimum employment

levels apply;

-Information technology training institutes. Minimum number of

students applies;

-Business Process Outsourcing (BPO). Minimum investment of

$150,000. Minimum employment levels apply;

-Regional operating headquarters providing the following services to

related businesses outside Sri Lanka: administration, business

planning, sourcing raw materials, research and Development,

technical support, financial and treasury management, marketing and

sales promotion. Minimum investment of $250,000.





Incentives: Currently, IT services, IT training institutes, and BPO

firms qualify for tax holidays of 5-12 years provided they meet

minimum employment and student levels. Otherwise, a preferential

tax of 10% applies for 2 years. Regional operating headquarters

qualify for a tax holiday of 3 years. A preferential tax of 10%

will apply in the 4th and 5th years. From the 6th year onwards, a

preferential tax of 15% will apply. Capital goods for these

projects will be exempted from import duty for above investments.

An Economic Service Charge at 0.25% of income applies to

BOI-approved companies enjoying tax holidays, from the fourth year

of operation. The government proposed in late 2008 to charge this

tax from the year of commencement, with effect from April 1, 2009.



Incentives for Regional Development



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The BOI has a separate incentive program to promote regional

development, with the aim of establishing new factories or service

companies (such as hotels, hospitals, or training institutes) in the

regions outside the capital Colombo. The incentives include 10-20

year tax holidays for investments in northern and eastern provinces

and 2-10 year tax holidays for investments located in other

provinces. In addition, imports of machinery and equipment are

exempted from both customs duty and the value-added tax. Minimum

investment levels apply.



Incentives for Eastern Province Development



Investments in the three districts in the Eastern Province, Ampara,

Batticaloa, and Trincomleee, receive generous tax incentives

including 10-20 year tax holidays. Incentives are targeted at

producers of textile and apparel, food, wood, paper, rubber and

plastic products, fishing gear and fishing boats. In addition,

hotels, agriculture-based industries, and fisheries are also

entitled for these incentives. Exporting companies can import raw

material, capital goods and construction material free of import

duty under this program. Companies producing for the local market

can import capital goods and construction material without duty. In

addition, state lands will be made available at concessionary rates

for these projects.



Incentives for Infrastructure Development



Companies acquiring existing companies in petroleum, power

generation, transmission, development of highways, seaports,

airports, railways, water services, public transport, agriculture

and agro processing and other infrastructure projects approved by

the BOI will qualify for tax holidays ranging from 5 to 8 years

depending on the magnitude of investment. A preferential tax of 15%

will follow after the tax holiday period. These companies will also

qualify for duty free imports of capital goods. A minimum

investment of $12.5 million is required.



Large-scale new infrastructure projects in power generation,

transmission and distribution; development of highways, seaports,

airports, public transport and water services; establishment of

industrial parks, and other infrastructure projects approved by the

BOI will qualify for tax holidays ranging from 3 to 15 years

depending on the size of the investment. A preferential tax of 15%

will follow the tax holiday. They will also qualify for duty free

imports of capital goods. A minimum investment of $12.5 million is

required.



Incentives for Other Investments



-Industrial estates. Minimum investment of $500,000 to $10 million;

tax holidays ranging from 3 to 15 years;

-Textile fabric manufacturing, processing. Minimum investment of

$500,000 to $10 million; tax holidays ranging from 5 to 15 years.



For further information on investment incentives and other

investment-related issues, potential investors are encouraged to

contact the Board of Investment directly. The BOI can be found at

www.boi.lk, or reached via e-mail at info@boi.lk. The BOI has

introduced an investor matchmaking service via the BOI website.

Information regarding this service can be found at

www.boi.lk/partnership.



Trade Agreements Enhance Market Access to South Asia and Europe



A preferential trade agreement, the Indo-Lanka Free Trade Agreement

(ILFTA) (www.doc.gov.lk) between Sri Lanka and India, is now in

effect. Under this agreement, most products manufactured in Sri

Lanka with at least 35% domestic value addition (if raw materials

are imported from India, domestic value addition required is only

25%),qualify for duty free entry to the Indian market. Tariff

concessions for Sri Lankan products include zero tariffs on 4,235

items; 50 to 100% reduction for tea and garments under quota; 25%

reduction for 553 textile items; and no reduction for 431 items on

India's "negative list." Discussions are underway to reduce the

negative lists of both countries. The two countries are also

discussing services sector liberalization, under a proposed



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Comprehensive Economic Partnership Agreement (CEPA). Other areas

potentially covered by the CEPA are investment and economic

cooperation. Because production constitutes a portion of value

addition, ILFTA and the proposed CEPA enables foreign firms

operating in Sri Lanka to gain preferential entry into the Indian

market.



Some U.S. companies currently avail themselves of the ILFTA by

adding at least 35% value in Sri Lanka and getting import duties

into India reduced from as much as 15% to as little as zero. The

American Chamber of Commerce in Sri Lanka, in a study on the ILFTA,

identified agro processing, food preparation, tea, rubber products,

coconut products, spices, furniture, ceramic and confectionary as

having growth potential in India. The study also found vehicles and

vehicle parts, aircraft parts and motorcycles to be possible

attractive sectors for U.S. manufacturers under the Indo-Lanka

Agreement.



Sri Lanka's Board of Investment promotes the following product

sectors under ILFTA: beverages, confectionary, rubber products,

plastics, coconut products, footwear, paper, textiles and garments,

artificial plants, ceramics, glassware, jewelry, iron and steel

products, aluminum extrusions, machinery and mechanical appliances,

electronics and electrical products, automobiles and spare parts,

furniture, and doors.



The 2005 Sri Lanka-Pakistan Free Trade Agreement (SLPKFTA)

(www.doc.gov.lk) provides Sri Lanka with duty-free entry into

Pakistan for 206 items. Pakistan's negative list contains 541 items

with no duty concessions. Pakistan is expected to offer duty free

entry to almost all Sri Lankan exports except those in the negative

list in 2009. Sri Lanka's Board of Investment promotes the

following product sectors under SLPKFTA: spices, coconut based

products, animal or vegetable oils, confectionary, processed food,

rubber products, ceramics, jewelry, iron and steel, copper and

aluminum articles machinery and mechanical appliances, electronics

and electrical appliances, medical instruments, and automobiles and

spare parts.



Sri Lanka and six other South Asian nations belonging to the South

Asian Association for Regional Cooperation (SAARC) agreed in 2004 to

establish a South Asian Free Trade Area (SAFTA)

(http://www.saarc-sec.org/main.php),which began operation on July

1, 2006. SAFTA offers regionalized tariff reductions for imports

from member countries. Stated goals of SAARC members under SAFTA

are to reduce duties for imports from member countries to between

zero and 5% over a period of 7-10 years.



These agreements help make Sri Lanka a gateway to South Asia for

foreign investors.



Sri Lankan exports to the European Union (EU) are also duty free

under the "GSP-Plus" incentive agreement in effect since July 2005,

Under this program, 7,200 Sri Lankan products meeting

rules-of-origin criteria can enter the EU duty free. The GSP plus

scheme for Sri Lanka was renewed in January 2009 for a period of

three years, subject to the results of an on-going investigation.

Depending on the findings of the investigation, benefits could be

withdrawn before 2011.



Right to Private Ownership and Establishment



Private entities are free to establish, acquire, and dispose of

interests in business enterprises. Private enterprises enjoy

benefits similar to those granted to public enterprises, and there

are no known limitations to access to markets, credit, or licenses.

Foreign ownership is allowed in most sectors. Private land

ownership is limited to fifty acres per person. The government owns

about 80% of the land in Sri Lanka, including the land housing most

tea, rubber, and coconut plantations. The government has leased

most of these plantations to the private sector on 50-year terms.

Although state land for industrial use is usually allotted on a

50-year lease, 99-year leases may also be approved on a case-by-case

basis, depending on the nature of the project.



While foreign investors can purchase land from private sellers, the

government has imposed a 100% tax on land transfers to foreigners.



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For this purpose, Sri Lanka has defined foreign investment to

involve as little as 25% foreign ownership - a definition that can

be particularly difficult for companies listed on the Colombo Stock

Exchange since on any particular day, their ownership

characteristics may vary. Apartments above the third floor of

condominium buildings, land for the development of large housing

schemes, hospitals and hotels with a minimum investment of $10

million, exporting companies with a minimum investment of $1

million, and large infrastructure projects with a minimum investment

of $50 million are exempted from the tax. Regulations regarding

these exceptions have been published in Gazette No 1386/18 dated

March 30, 2005.



Protection of Property Rights

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



Property Rights



Secured interests in property are recognized and enforced. The

legal system is nondiscriminatory and protects and facilitates

acquisition and disposition of property rights by foreigners,

although it has recently become subject to political influence. A

fairly reliable registration system exists for recording private

property including land, buildings and mortgages. However, there

are problems due to fraud and forged documents. The Government has

begun to address these issues under a World Bank-sponsored judicial

reforms project.



Intellectual Property Rights Protection



Sri Lanka is a party to major intellectual property agreements

including the Berne Convention for the Protection of Literary and

Artistic Works, the Paris Convention for the Protection of

Industrial Property, the Madrid Agreement for the Repression of

False or Deceptive Indication of Source on Goods, the Nairobi

Treaty, the Patent Co-operation Treaty, the Universal Copyright

Convention, and the Convention establishing the World Intellectual

Property Organization (WIPO). Sri Lanka and the United States in

1991 signed a Bilateral Agreement for the Protection of Intellectual

Property Rights. Sri Lanka, a WTO member, is also a party to the

Trade Related Intellectual Property Rights (TRIPS) agreement in the

World Trade Organization. Sri Lanka has not acceded to the WIPO

Performances and Phonograms Treaty (WPPT); the WIPO Copyright Treaty

(WCT); or the WTO Information Technology Agreement.



In November 2003, a new intellectual property law came into force

that was intended to meet both U.S.-Sri Lanka bilateral IPR

agreement and TRIPS obligations to a great extent. The law governs

copyrights and related rights, industrial designs, patents,

trademarks and service marks, trade names, layout designs of

integrated circuits, geographical indications, unfair competition,

databases, computer programs, and undisclosed information. All

trademarks, designs, industrial designs and patents must be

registered with the Director General of Intellectual Property. Sri

Lanka introduced regulations to regulate the commercial use of local

creations in 2008.



Infringement of intellectual property rights (IPR) is a punishable

offense under the law. Intellectual property rights come under both

criminal and civil jurisdiction. Recourse available to owners

includes injunctive relief, seizure and destruction of infringing

goods and plates or implements used for the making of infringing

copies, and prohibition of imports and exports. Penalties for the

first offence include a prison sentence of 6 months or a fine of up

to Rs 500,000 ($4,425),but smaller penalties are the norm.

Penalties can be doubled for a second offense. Aggrieved parties

can seek redress for any IPR violations through the courts, though

this can be a frustrating and time-consuming process.



Since the passage of the 2003 IPR law Sri Lanka has slowly begun

enforcing its provisions. The Police occasionally raid counterfeit

CD/VCD stores as well as counterfeit garment sellers. However, it

is rare for the police to act without a formal complaint and

assistance from an aggrieved party. Several offenders have been

charged or convicted by courts. However, the minimal damages and

suspended sentences imposed suggest that the court system still

fails to recognize the significance of intellectual property



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rights.



Counterfeit goods continue to be widely available in Sri Lanka.

Local agents of well-known U.S. and other international companies

representing recording, software, movie, clothing and consumer

product industries continue to complain that lack of IPR protection

is damaging their businesses. Piracy of sound recordings and

software is widespread, making it difficult for the legitimate

industries to protect their market and realize their potential in

Sri Lanka. Software companies complain of the lack of IPR

enforcement within government institutions and even some larger

corporations, including several banks. An IPR working group of

adversely affected industries, led by the American Chamber of

Commerce of Sri Lanka, is working to pursue more aggressive

enforcement and enhance public awareness.



Patents, Copyrights and Trademarks



Patents are valid for 20 years from the date of application but must

be renewed annually. Patents are granted for inventions, with the

following exceptions: discoveries, scientific theories and

mathematical methods, plant or animal varieties (other than micro

biological processes) and essential biological processes for the

production of plants and animals (other than non-biological and

microbiological processes),business rules and methods, methods of

treatment by surgery or therapy, and diagnostic methods practiced on

a human or animal body. The law also permits compulsory licensing

and parallel imports of pharmaceutical products. Compulsory

licensing will allow the government to grant licenses to manufacture

certain patented drugs, overruling patent licenses in a national

emergency. The parallel imports will allow the import of a branded

drug from an alternative source.



Copyrights are not registered. A work is protected automatically by

operation of law. Original literary, artistic, and scientific works

including computer programs and databases are protected under the

new law. There are enforcement limitations applying to copyrights,

including software.



Sri Lanka recognizes both trademarks and service marks. The

exclusive right to a mark is acquired by registration. A mark may

consist of words, slogans, designs, etc. Protection also is

available to well known marks not registered in Sri Lanka.

Registered trademarks are valid for ten years and renewable. The

law also recognizes both certification marks and collective marks.



Transparency of Regulatory System

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



The Board of Investment strives to inform potential investors about

laws and regulations that may affect operations in Sri Lanka. Laws

are in place pertaining to tax, labor and labor standards, exchange

controls, customs, environmental norms, and building and

construction standards. However, some of the laws and regulations

are difficult to access.



Foreign and domestic investors often complain that the regulatory

system is unpredictable due to outdated regulations, rigid

administrative procedures, and excessive leeway for bureaucratic

discretion. Effective enforcement mechanisms are sometimes lacking,

and coordination problems between the BOI and relevant line agencies

frequently emerge. Lethargy and indifference on the part of mid-

and lower-level public servants compound transparency problems.

Lack of sufficient technical capacity within the government to

review financial proposals for private infrastructure projects also

creates problems during tendering. An example of weakness in

regulations occurred in mid-2006, when police and government

agencies closed two satellite television broadcasting stations for

not possessing required licenses. The two stations remained closed

for over five months, before various government agencies

reauthorized their operations.



In 2005-2007, the Government awarded several key infrastructure

projects to Chinese companies outside the tender process. They

included a 300 megawatt coal power project, a fuel bunkering

project, and a large port construction project in the Southern

district of Hambantota. In addition, the Government has promised



COLOMBO 00000067 013 OF 023





oil exploration rights to India and China outside the tender

process. Similarly, in 2008, the government-owned Ceylon Petroleum

Corporation signed an agreement with the government of Iran to

finance the expansion of the country's oil refinery. The government

had previously signed a Memorandum of Understanding with an American

company to negotiate an agreement for the same project.



Although many foreign investors, including U.S. firms, have had

positive experiences in Sri Lanka, some have encountered significant

problems with government practices and regulations. Some

multinational firms have experienced extensive unexplained delays in

trying to reach agreement on investment projects. Others have had

contracts arbitrarily canceled without compensation, even though the

Sri Lankan Cabinet had approved those contracts.



Proposed laws and regulations are generally made available for

public comment. However, occasionally they are published without

public discussion.



Efficient Capital Markets and Portfolio Investment

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



Availability of Financial Resources



Retained profits finance about 70% of private investment, with short

term borrowing financing a further 20% of investment. The stock

market and corporate securities market have not been significantly

used to raise capital. Foreign direct investment (FDI) finances

about 4% of overall investment. Foreign investors are allowed to

access credit on the local market. They are also free to raise

foreign currency loans.



The state consumes over 50% of the country's domestic financial

resources and has a virtual monopoly on the management and use of

long-term savings in the country. This inhibits the free flow of

financial resources to product and factor markets. For 2009, the

government's net borrowing from the local market is forecast to be

Rs 183 billion ($1.6 billion). Due to high inflation and increased

government borrowing, interest rates were high in 2007 and 2008.



Credit Instruments



Commercial banks are the principal source of bank finance. Bank

loans are the most widely used credit instrument for the private

sector. Financial institutions also raise syndicated bank loans to

fund large-scale investment projects undertaken by the private

sector.



The domestic debt market in Sri Lanka is still at a nascent stage.

The first credit rating agency in Sri Lanka was Fitch Rating Lanka

(www.fitchratings.lk),which opened an office in Colombo in 1999.

Fitch Ratings Lanka is a joint venture between Fitch Ratings Inc,

International Finance Corporation, (IFC),Central Bank of Sri Lanka,

and several leading local financial institutions. Credit ratings

are now mandatory for all deposit-taking institutions and for all

varieties of debt instruments and have helped numerous Sri Lankan

companies raise funds through debt markets.



Sri Lanka received its first sovereign credit ratings in December

2005, with a "BB-minus" from Fitch Ratings and a "B-Plus" from

Standard and Poor's (S&P). Current ratings are B-Plus (Fitch) and B

(S&P). Both agencies have assigned a stable rating outlook for Sri

Lanka. These sub-investment grade ratings reflect declining foreign

reserves, high fiscal deficits, the high level of government

indebtedness, and weak revenue mobilization, together with political

and security concerns.



Accounting Standards



There is an active and fairly competent accounting profession, based

on the British model. The source of accounting standards is the

Institute of Chartered Accountants of Sri Lanka (ICASL),and

standards are constantly updated to reflect current international

accounting and audit standards adopted by the International

Accounting Standards Board (IASB). In addition, Sri Lanka is

following the worldwide move to adopt International Financial

Reporting Standards (IFRS) for financial reporting purposes set by



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the IASB. The proposed full convergence is expected to be in 2011

for financial periods on or after January 1, 2012. A significant

change is expected with full convergence.



Due to the lack of an adequate enforcement mechanism problems with

the quality and reliability of financial statements still exist.



Sri Lankan accounting standards are applicable for all banks, stock

exchange listed companies and all other large and medium-sized

companies in Sri Lanka. Accounts of such business enterprises are

required to be audited by professionally qualified auditors holding

ICASL membership. ICASL has published accounting standards for

small companies as well. The Accounting Standards and Monitoring

Board (ASMB) is responsible for monitoring compliance with Sri

Lankan accounting and auditing standards. British professional

accounting bodies are quite active in Sri Lanka. The Chartered

Institute of Management Accountants (CIMA),a leading professional

accounting body based in the UK and spread over the Commonwealth,

has its largest overseas presence in Sri Lanka. CIMA UK suspended

the Sri Lanka divisional council over a governance issue in December

2008. However, CIMA programs and operations in Sri Lanka, including

member services, continue undisrupted.



Securities and Exchange Commission.



The Securities and Exchange Commission (SEC) regulates the

securities market in Sri Lanka. The SEC law was revised in 2003,

enhancing the SEC's coverage and investigative powers. The SEC now

covers stock exchanges, unit trusts, stock brokers, listed public

companies, margin traders, underwriters, investment managers, credit

rating agencies and securities depositories.



Foreign investors can purchase up to 100% of equity in Sri Lankan

companies in numerous permitted sectors. In order to facilitate

portfolio investments, country funds and regional funds may obtain

Ministry of Finance approval to invest in Sri Lanka's stock market.

These funds make transactions through share investment external

Rupee accounts maintained in commercial banks.



Colombo Stock Exchange



The Colombo Stock Exchange (CSE) has fully automated trading,

clearing and settlement systems. The CSE maintains a rolling

settlement period of 3 days. Twenty one local and foreign joint

venture brokers currently operate at the CSE. Foreign stockbrokers

are permitted to hold up to 100% equity in stock brokerage firms

operating at the CSE. The SEC has a settlement guarantee fund with

an initial capital of Rs 100 million ($88,500),which aims to

guarantee the settlement of trades between clearing members of the

exchange.



There are 235 companies listed on the stock exchange with the top

ten positions by market capitalization held by telecommunication

companies, banks, conglomerates and food and beverage companies.

The CSE, after being one of the best performing markets in the

region in 2005-6, suffered in 2007-2008 due to increased

conflict-related violence and the global financial crisis. The

market indices lost 41% in 2008 on top of a 7% drop in 2007.

Recently, investors have also been discouraged by Supreme Court

decisions negatively impacting businesses. One ruling, citing bias

by government officials in favor of eventual contract winner,

reversed the 2002 privatization of a bunkering unit to a large

conglomerate listed in the stock exchange. A similar case is

pending against another listed conglomerate. In yet another case,

the Supreme Court temporarily stopped payments due to local and

foreign banks for oil hedging contracts. Other issues include lack

of liquidity and limited market size.



Improvements are also needed in corporate governance,

accountability, and public disclosure. The Accounting and Auditing

Standards Monitoring Board, the Ceylon Chamber of Commerce, the

Colombo Stock Exchange, and professional accounting bodies are

taking initiatives in these areas.



Acquisition of companies through mergers and acquisitions is

governed by the Takeovers and Mergers Code of 1995 made under the

Securities and Exchange Commission of Sri Lanka Act. This law



COLOMBO 00000067 015 OF 023





applies only to companies listed on the Colombo Stock Exchange. It

is modeled on the lines of the London City Code on Takeovers and

Mergers. Acquisition of more than a 30% stake of a listed company

requires the buyer to make an offer to all other shareholders. The

articles of association of a few listed companies restrict foreign

equity to certain levels.



Banking System



Sri Lanka has a fairly well diversified banking system. There are

23 commercial banks - eleven local and twelve foreign. In addition,

there are 14 local specialized banks. Citibank NA is the only U.S.

bank operating in Sri Lanka. In late 2008, the Central Bank

dissolved the board of directors of a private local bank and

appointed the state owned Bank of Ceylon to carry on the business of

the bank. This was done to ensure stability in the overall

financial sector following a scandal at a finance company connected

to the bank. Sri Lanka experienced its first bank failure in

December 2002 when the Central Bank took action to revoke the

license of a small licensed specialized bank as it approached

insolvency. There was no fallout for other banks from this

incident. Two other small troubled banks were restructured under

Central Bank guidance.



The Central Bank is responsible for supervision of all banking

institutions. It has driven improvements in banking regulations,

provisioning, and public disclosure of banking sector performance.

Since 2004, credit ratings have been mandatory for all banks

operating in Sri Lanka. In 2006, the Central Bank introduced higher

capital requirements for commercial banks to further stabilize the

banking system, promote consolidation, and facilitate entry of

larger banks. Notable progress in 2008 includes mandatory

provisioning on performing loans and acceptance of the Basel II

standardized approach framework. In addition, the Central Bank

issued corporate governance rules for banks. The new rules are

aimed at promoting the safety and soundness of the banking system.

Nevertheless, the Central Bank still suffers from lack of autonomous

authority, especially with regard to the large state owned banks.



Sri Lanka has enacted laws to deal with money laundering and

terrorist financing. The Bank Supervision Department of the Central

Bank supervises and examines financial institutions for compliance

with anti-money laundering and terrorist financing regulations. A

Financial Intelligence Unit (FIU) was created in 2006. The

Financial Intelligence Unit has issued instructions to banks,

finance and insurance companies, and the securities industry

regarding anti-money laundering and terrorist financing regulations

and, in 2008, extended it rules on "know your customer" and

"customer due diligence" to insurance companies and the securities

industry.



State-Owned Banks



Total assets of commercial banks stood at Rs 2,100 billion ($18.5

billion) as of December 31, 2007. The two state-owned commercial

banks, Bank of Ceylon and People's Bank, with assets of Rs 437

billion ($3.8 billion) and Rs 381 billion ($3.4 billion)

respectively, still dominate banking, accounting for about 40% of

all assets.



The two state banks are inefficient and have accumulated extensive

bad debt. However, as these banks are implicitly guaranteed by the

state, their problems have not harmed the credibility of the rest of

the banking system. Progress has been made in restructuring the two

banks -- their nonperforming loan ratios declined from 18% in 2003

to 4-6% in 2007, while provisioning and profitability have improved.

Nonetheless, both these banks have significant exposure to the

state and state owned companies, which are treated as performing

loans. If state and state owned enterprises are excluded, the non

performing loan ratios on the balance portfolio were over 10%.



Private Commercial Banks and Foreign Banks



Private commercial banks and foreign banks operating in Sri Lanka

generally follow more prudent credit policies and, as a group, are

in better financial shape. Foreign banks tend to make provisions in

line with international best practices, as most foreign bank



COLOMBO 00000067 016 OF 023





branches are subject to host country supervision in addition to that

of the Central Bank of Sri Lanka.



Non-performing loans increased while provisioning declined in 2008.

Non-performing loans to total loans ratio is estimated to have

increased from 4.9% in 2007 to over 7% in 2008. There are concerns

regarding credit exposure to housing and consumer sectors, impact of

high interest rates and the impact of prevailing economic conditions

on the banking system.



Capital Adequacy



Sri Lanka adopted capital adequacy standards set by the Basel

Committee on banking regulations and supervisory practices in 1993.

The minimum capital adequacy ratio required by the Central Bank is

5% for core capital (Tier I) and 10% for risk weighted assets (Tier

I and Tier II). The Central Bank adopted Pillar 1 of Basel II

capital adequacy standard for all banks in 2008.



Risk-based capital adequacy in the banking sector was 11.9% in 2006.

The Bank of Ceylon's capital adequacy ratio is well within Central

Bank requirements. People's Bank currently does not meet capital

adequacy requirements, but it has a Ministry of Finance guarantee

for funds required to meet its obligations. The government has

commenced a recapitalization program at the People's Bank to enable

the bank to meet its minimum capital requirements.



Political Violence

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



Since early January 2008 when a largely defunct cease-fire agreement

between the government and LTTE was officially abandoned, fighting

between the Sri Lankan military, paramilitary groups and the

Liberation Tigers of Tamil Eelam (LTTE) has increased. Bomb attacks

in densely populated areas have killed dozens of civilians,

including in some areas frequented by foreign tourists. In October

2008, an LTTE attack using light aircraft damaged the main power

plant in Colombo. A U.S. company owned power plant situated

adjacent to the plant that was attacked was unharmed. In 2007, the

LTTE conducted several air attacks -- one against a military base

that adjoins the international airport north of Colombo, another on

oil storage facilities outside Colombo. There have been a series

of other incidents throughout the country targeting armed forces

personnel, politicians and civilians in 2007-2008.



While the government has controlled the eastern part of the country

since July 2007, effective securit in much of the Eastern Province

is not yet assued.



In 1997, the United States designated the LTE as a Foreign

Terrorist Organization (FTO). I 2007, the United States froze the

assets of, and blocked transactions with, the Tamils Rehabilitation

Organisation (TRO),a U.S.-registered non-profit group, on the

grounds that it provided support for the LTTE.



During two and half decades of war, foreign tourists and foreign

business representatives have not been LTTE targets, but they have

been injured in attacks on other targets. In 2001, the LTTE

attacked Colombo's international airport and destroyed commercial

and military aircraft. Sri Lankan Airlines, lost several commercial

aircraft in the attack. Prior to 2001 the LTTE attacked several

foreign-flagged commercial ships in the waters off the north and

east of the country. The LTTE has also in the past bombed Colombo's

financial and business districts, causing numerous casualties and

extensive damage to property.



Currently, Sri Lanka is included in the Lloyds Joint War Risk

Committee's war, strikes, terrorism and related perils areas list.

Insurers have imposed war risk premiums on ships and aircraft using

Sri Lankan ports and airports.



Corruption

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



Sri Lanka has generally adequate laws and regulations to combat

corruption, but enforcement is weak and inconsistent. U.S. firms

identify corruption as a constraint on foreign investment, but, by



COLOMBO 00000067 017 OF 023





and large, it is not a major threat to operating in Sri Lanka - at

least once a contract has been won. Corruption appears to have the

greatest effect on investors in large projects and on those pursuing

government procurement contracts.



There is a consensus that corruption is rampant in Sri Lanka. In

Transparency International's Corruption Perception Index for 2008

Sri Lanka ranks 92nd with a score of 3.2 out of a possible 10

points. The World Bank Control of Corruption Index which ranges

from -2.5 to +2.5 has shown an improvement to -0.13 in 2006 and 2007

from -0.26 in 2005. In a 2006 USAID Democracy and Governance

assessment, anecdotal evidence from the private sector indicated

that the percentage of a public sector contract paid in bribes

nearly tripled. According to Transparency International, corruption

is perceived as most pervasive in political appointments to

government institutions and in government procurement awards, as

well as in high frequency/low value transactions. The police force

and the judiciary are perceived to be the most corrupt public

institutions. Corruption is also a persistent problem in customs

clearance and enables wide smuggling of certain consumer items, to

the detriment of legitimate manufacturers and importers.



In 2008, the Supreme Court, examining public interest litigations

against the sale of two government properties, faulted a former

President and the Secretary to the Treasury for wrongdoing. Both

were fined. The Supreme Court also removed the Secretary to the

Treasury from his position and ruled that he cannot hold any public

office in the future. The Supreme Court also reversed the sales.



In January 2007, a parliamentary commission found evidence of

serious and widespread waste, fraud, and abuse in the management of

Sri Lanka's numerous government enterprises. Privatization of a

handful of government enterprises between 2001 and 2004 also appears

to have been done in a corrupt manner. The mismanagement and

corruption reviewed by the Commission have cost Sri Lanka an

estimated USD 1.3 billion. However, the government has taken little

concrete action to date to address the commission's findings, and it

later replaced the Commission's chairman and some of its members;

one new appointee is the President's brother. Following the

commission's report, several other large scale corruption incidents

and frauds materialized, including at the government's tax office.



Sri Lanka ratified the UN Anti-corruption Convention in 2004. Sri

Lanka has signed but not ratified the UN Convention against

Transnational Organized Crime. Sri Lanka became a signatory to the

OECD-ADB Anti-Corruption Regional Plan in May 2006.



Bribery Commission Not Effective



The Bribery Commission is the main body responsible for

investigating allegations of bribery and corruption. The function

of the Commission, under Act No 19 of 1994, is to investigate

allegations brought to its attention and to institute proceedings

against responsible individuals in the appropriate court. The law

states that a public official's offer or acceptance of a bribe

constitutes a criminal offense and carries a maximum sentence of

seven years imprisonment and a fine at the discretion of the courts.

A bribe by a local company to a foreign official is not covered by

the Bribery Act.



Although highly publicized, efforts to investigate bribery and

corruption by the Bribery Commission and Presidential Commissions

have failed, damaging public confidence in such processes. In

February 2008, the President removed the Bribery Commission's

Director General, the sole individual able to serve indictments.



Several other government entities try to address corruption, the

most important being the Auditor General's Department. However,

there is a confusion of mandates and these institutions frequently

interpret their mandates narrowly, inhibiting their effectiveness.



Bilateral Investment Agreements

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



The Government of Sri Lanka has signed investment protection

agreements with the United States (which came into force in May

1993) and with the following other countries:



COLOMBO 00000067 018 OF 023







1. Belgium

2. People's Republic of China

3. Denmark

4. Egypt

5. Finland

6. France

7. Germany

8. Indonesia

9. India

10. Iran

11. Italy

12. Japan

13. Korea

14. Luxembourg

15. Malaysia

16. Netherlands

17. Norway

18. Romania

19. Singapore

20. Sweden

21. Switzerland

22. Thailand

23. United Kingdom



Taxation



A bilateral treaty between Sri Lanka and the United States to avoid

double taxation was ratified and entered into force on June 12,

2004.



Foreign investors not qualifying for Board of Investment incentives

such as tax and exchange control exemptions or concessions are

liable to pay taxes on corporate profits, dividends, and remittances

of profits. They are also liable to pay a Value Added Tax on goods

and services. The government has also imposed a tax of 0.1% on

debits to any current or savings account maintained at any bank in

Sri Lanka. Debits made to accounts of government and international

organizations are excluded. Accounts maintained at Foreign Currency

Banking Units, accounts maintained for stock exchange transactions

(SIERA),and resident and non-resident foreign currency accounts are

exempted from the tax.



An Economic Service Charge (ESC) at 0.25% of income applies to

BOI-approved companies enjoying tax holidays, from the fourth year

of operation. The government proposed in late 2008 to charge ESC

from the first year of operation with effect from April 1, 2009.



The Embassy encourages prospective U.S. investors to contact an

international auditing firm operating in Sri Lanka to assess their

tax liability.



OPIC and Other Investment Insurance Programs



The United States and Sri Lanka concluded in 1966 (and renewed in

1993) an agreement that allows the Overseas Private Investment

Corporation (OPIC) to provide investment insurance guarantees for

U.S. investors. OPIC currently provides coverage to banking and

power sector investments in Sri Lanka. Sri Lanka's membership in

the Multilateral Investment Guarantee Agency (MIGA) offers the

opportunity for insurance against non-commercial risks.



The U.S. Embassy and other U.S. Government institutions spend over

$13 million annually in Sri Lanka. This amount can potentially be

utilized by OPIC to honor an inconvertibility claim; however, no

such claims have been made to date in Sri Lanka. The Embassy

purchases local currency at the financial rate.



Labor

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



Labor Force



Sri Lanka's labor force is literate (particularly in local

languages) and trainable, although weak in certain technical skills

and the English language. The average worker has eight years of

schooling. Two-thirds of the labor force is male.



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The unemployment rate has declined in recent years to around 6%.

The rate of unemployment among women and high school and college

graduates, however, has been proportionally higher than the rate for

less-educated workers. Youth and entry-level unemployment and

underemployment remain a problem. A significant proportion of

unemployed people seek "white collar" jobs. However, most sectors

seeking employees offer manual or semi-skilled jobs or require

technical or professional skills such as management, marketing,

information technology, accountancy and finance, and English

language proficiency. The construction, plantation and apparel

industries report a shortage of workers. Some investors have faced

problems in finding sufficient employees with the requisite skills.





The government has initiated educational reforms it hopes will lead

to better preparation of students and better matches between

graduates and jobs. More computer, accounting and business skills

training programs and English language programs are becoming

available. But the demand for these skills still outpaces supply.





Migrant Workers Abroad



There are an estimated 1.5 million Sri Lankan workers abroad.

Remittances from migrant workers, at around $2.7 billion, are one of

Sri Lanka's largest sources of foreign exchange. The majority of

this labor force is unskilled (housemaids and factory laborers) and

located primarily in the Middle East, but Sri Lanka is also losing

many of its technically and professionally qualified workers to more

lucrative jobs abroad. Remittances from migrant workers will likely

decline in 2009. At least one labor importing country, South Korea,

temporarily stopped importing labor from Sri Lanka starting in early

2009.



Wages and Holidays



Labor is available at relatively low cost, though it is priced

higher than in some other South Asian countries. Productivity lags

behind other countries in Asia. Child labor is prohibited and is

virtually nonexistent in the organized sector, although child labor

occurs in informal sectors. The minimum legal age for employment is

set at 14. Most permanent full-time workers are covered by laws

pertaining to maximum hours of work, minimum wage, leave, the right

of association, and safety and health standards.



Many believe that Sri Lanka's labor laws and its numerous official

holidays dampen productivity. The full moon day of each month

(sacred in the Buddhist faith),if it falls on a weekday, is a paid

holiday. There are eight other public holidays. The public sector

and banks enjoy additional holidays. These statutory holidays are

in addition to 21 days of annual/casual leave and approximately 21

days of sick leave (the number of days for sick leave is at the

discretion of the management). Further, female employees are

entitled to 84 days fully paid maternity leave for the first two

pregnancies. Female workers are permitted 60 hours of overtime

work per month.



The Government continues to interfere with private sector wage

setting. In October 2005 the Government, through an act of

Parliament, took steps to mandate a wage increase (of approximately

Rs 1,000 ($8.85) per month) to private sector workers. The private

sector is concerned about such interference in wage setting, which

could damage competitiveness in certain sectors.



Termination Laws



The Termination of Employment of Workmen Act (TEA) makes it

difficult to fire or lay off workers who have been employed more

than six months for any reason other than serious, well-documented

disciplinary problems. Disputes over dismissals can be brought to a

labor tribunal administered by the Ministry of Justice. The labor

tribunals have large backlogs of unresolved cases. Certain labor

disputes founded upon fundamental rights (allegations of

termination/transfers based upon discrimination, etc.) can be

brought directly to the Supreme Court. Recent amendments to the

Industrial Disputes Act (IDA) include labor dispute resolution rules



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to expedite the dispute process.



The government has introduced a standard compensation formula under

the TEA to facilitate termination. The compensation formula takes

into account the number of years of service and offers 2.5 months

salary as compensation for 1 year of service, 12.5 months salary for

5 years of service; 38 months for 20 years and up to a maximum of 48

months salary for 34 years service. According to the World Bank's

Doing Business 2009 report, Sri Lanka's firing cost is among the

highest in the world. For example, Sri Lanka's firing cost for 20

years of service, at 38 months, compares with Pakistan and Nepal's

22.5 months, India's 19.6 months, Malaysia's 18.5 months, China's

13.2 months and Bangladesh's 11.7 months. The Labor Commissioner's

approval or the affected employee's consent is required to fire

workers. The Labor Commissioner's approval is often subject to

delays of around 6-7 months. Employers complain that the package is

excessive, especially compared to international norms. They have

also pointed out that higher compensation could adversely affect

companies requiring restructuring, and discourage investment.



Trade Unions



About 20% of the 7 million-strong work force is unionized, but union

membership is declining. There are more than 1,900 registered trade

unions (many of which have 50 or fewer members),and 19 federations.

About 15% of labor in the industry and service sector is unionized.

Most of the major trade unions are affiliated with political

parties, creating a highly politicized labor environment. Several

trade unions with affiliations to major political parties have

formed themselves into an organized group, the National Association

for Trade Union Research and Education (NATURE),to promote

education and training among trade unionists.



All workers, other than police, armed forces, prison service, and

those in essential services, have the right to strike. By law,

workers may lodge complaints to protect their rights with the

commissioner of labor, a labor tribunal, or the Supreme Court. The

president retains the power to designate any industry as an

essential service.



Unions represented workers in many large private firms, but workers

in small-scale agriculture and small businesses usually did not

belong to unions. Public sector employees were unionized at very

high rates. Labor in export processing zone enterprises tends to be

represented by non-union worker councils.



Unions have complained that the Board of Investment and some

employers, especially in the BOI-run export processing zones,

prohibit union access and do not register unions on a timely basis.

Employers allege that the JVP, a Marxist political party opposed to

private enterprise, could provoke labor to strike under the pretense

of trade union activity. Due to the JVP's violent past, employers

are generally not in favor of it or its trade union arm, the

Inter-Company Trade Union.



In BOI enterprises, including those in the export processing zones,

worker councils composed of employees generally engage in labor and

management negotiations. These worker councils have functioned well

in some companies in providing for worker welfare. The BOI has

requested that companies recognize trade unions and accept the right

to collective bargaining. According to the BOI, where both a

recognized trade union with bargaining power and a non-union worker

council exist in an enterprise, the trade union will represent the

employees in collective bargaining.



The International Labor Organization's (ILO) Freedom of Association

Committee has observed that Sri Lankan trade unions and employee

councils can co-exist, but advises that there should not be any

discrimination against those employees choosing to join a union.

The right of employee councils to engage in collective bargaining

has been held as valid by the ILO. The ILO has, however, noted

weaknesses in rules governing operation of employee councils and low

prevalence of collective bargaining agreements and requested that

the Government address these issues.



In response to these observations, the BOI revised its labor manual

in March 2004, requesting that companies located in export



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processing zones allow union access to zones and provide official

time off to union members to attend meetings. Along with this

revision, the BOI also issued new guidelines for the formation and

operation of employee councils, giving powers to employee councils

to negotiate binding collective agreements.



In 2008, the American Federation of Labor and Congress of Industrial

Organizations (AFL-CIO) submitted a petition to the United States

Trade Representative seeking suspension of Generalized System of

Preferences (GSP) benefits for Sri Lanka due to labor rights

violations in some factories in the export processing zones.

AFL-CIO submitted a similar petition in 2002, which was rejected.

USTR did not act on the 2008 petition by year's end. A Sri Lanka

trade union made a similar case with the European Union (EU) when

Sri Lanka applied for benefits under the special incentive

arrangements of the GSP. After an audit, the EU, in January 2004,

granted significant benefits to Sri Lanka under EU GSP+ in

recognition of the country's efforts to implement core labor

standards. The EU, however, urged improvements in freedom of

association.



Key public sector entities such as the Ceylon Electricity Board and

the Sri Lanka Ports Authority also have large unions which have

protested anticipated moves towards privatization or restructuring.

In July 2006, the Supreme Court broke a port slowdown which had

disrupted shipping through the Colombo Port for over a week.

However, in response to a challenge lodged by several unions, the

ILO Freedom of Association Committee noted that the port "go-slow"

action did not disrupt an essential service, i.e. one whose

disruption would endanger life, personal safety or health of the

whole or part of the population.



Collective Bargaining



Collective bargaining is not yet popular. Employers' Federation of

Ceylon, the apex employers association in Sri Lanka assists its

member companies to negotiate with unions and sign collective

bargaining agreements. While about half of the 500 members of the

Employers' Federation of Ceylon is unionized, currently 135 of these

companies (including a number of foreign-owned firms) are bound by

collective agreements. As of September 2007, there were only three

collective bargaining agreements signed in companies located in

export processing zones.



Labor-Management Relations



Formerly confrontational labor-management relations have improved in

the last few years as employers have worked harder to motivate and

care for workers. Work stoppages and strikes in the private sector

are on the decline. While labor-management relations vary from

organization to organization, managers who emphasize communication

with workers and offer training opportunities generally experience

fewer difficulties. U.S. investors in Sri Lanka (including U.S.

garment buyers) generally promote good labor management relations

and labor conditions that exceed local standards.



ILO conventions



Sri Lanka is a member of the International Labor Organization (ILO)

and has ratified 31 international labor conventions. The labor laws

of Sri Lanka are laid out in almost 50 different statutes. The

Ministry of Labor has published a Labor Code, consolidating

important labor legislation. Sri Lanka has ratified all eight of

the core labor conventions included in the 1998 ILO Declaration on

Fundamental Principles and Rights at Work. ILO Convention 138 on

minimum age for admission to employment and Convention 182 on worst

forms of child labor were ratified during 2000-2001. Sri Lanka

ratified ILO convention 105 on Forced Labor in 2003. The ILO and

the Employers' Federation of Ceylon are working to improve awareness

of core labor standards. The ILO also promotes its Decent Work

Agenda program in Sri Lanka.



Foreign Trade Zones/Free Ports

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



Sri Lanka has 12 free trade zones, also called export-processing

zones, administered by the BOI. The oldest, the Katunayake and



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Biyagama Zones, located north of Colombo near the Bandaranaike

International Airport, are fully occupied. The third zone is

located at Koggala on the southern coast. Several mini

export-processing zones are located in provinces. There are nearly

200 foreign export processing enterprises operating in these zones.

There are also two industrial parks that have both export-oriented

and non-export oriented factories. They are located in Pallekelle,

near Kandy in central Sri Lanka, and in Seethawaka in Avissawela

about 60 kilometers from Colombo. In addition, a large private

apparel company opened Sri Lanka's first privately run fabric park

in 2007. The company invites local and foreign companies to set up

fabric and apparel factories in this eco-friendly park.



In the past, firms preferred to locate their factories near Colombo

harbor or airport to reduce transport time and cost. However,

excessive concentration of industries around Colombo has caused

heavy traffic, higher real estate prices, environmental pollution,

and scarcity of labor. The BOI and the government now encourage

export-oriented factories to set up in industrial zones farther from

Colombo. However, Sri Lanka's poor roads make these outlying zones

less appealing.



Foreign Direct Investment Statistics

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



Investment Trends



From 1998-2001, foreign direct investment (FDI) flows to Sri Lanka

averaged only about $150 million per year (excluding privatization

receipts). The 2002 ceasefire improved investor confidence, pushing

annual Foreign Direct Investment (FDI) averages to about $200

million. In 2006, FDI increased to about $450 million and in 2007

to about $550 million centered on telecommunications, business

process outsourcing, and hotel and restaurant services.



U.S. Investments



Total cumulative U.S. investment in Sri Lanka is estimated to be in

the range of $200 million. Major U.S. investors include: Energizer

Battery, Mast Industries, Smart Shirts (a subsidiary of Kellwood

Industries),Chevron, Citibank, Caterpillar, 3M, Coca Cola, Tandon

Corporation, Paxar Corporation, Pepsi Co, Sportif, Worldquest, Fitch

IBCR, AES Corporation, American International Group (AIG),American

Premium Water, Virtusa, Avery Denison, North Sails, Amsafe Bridport,

RR Donnelly (through Office Tiger and Revlon (through its Indian

subsidiary). Several Sri Lankan-Americans have started IT and BPO

companies in Sri Lanka serving the US market. In addition, IBM,

Lanier, NCR, GTE, Motorola, Procter & Gamble, Liz Claiborne, Tommy

Hilfiger, J.C. Penney, Sun Microsystems, Microsoft, Bates Strategic

Alliance, McCann-Erickson, Pricewaterhouse Coopers, Ernst and Young,

and KPMG all have branches, affiliated offices or local

distributors/representatives. Kentucky Fried Chicken, Pizza Hut,

Federal Express, UPS, and McDonald's are represented in Sri Lanka

through franchises. Numerous other American brands and products are

represented by local agents.



Non-U.S. Investments



Leading sources of foreign direct investment in Sri Lanka are

Malaysia, the United Kingdom, the United States, Singapore, India,

China, the UAE, and Korea. Major non-U.S. investors include:

Unilever, Nestle, British American Tobacco Company, Mitsui, Pacific

Dunlop/Ansell, Prima, FDK, Telekom Malaysia Bhd, S.P. Tao, HSBC and

the Indian Oil Corporation. In 2008/9, India's Bharathi Airtel

invested in mobile cellular services. Leading U.S. and foreign

investors that have acquired significant stakes in privatized

companies include Chevron, Hanjung Steel of Korea, Mitsubishi

Corporation and C. Itoh (A.K.A. Itochu) of Japan, Emirates Airlines

of United Arab Emirates, Shell Oil of the UK, and the Indian Oil

Corporation.



Web Resources

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



Board of Investment of Sri Lanka: www.boi.lk



International Monetary Fund (IMF) Sri Lanka country information:



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www.imf.org/external/country/LKA/index.htm





Article VIII obligations of the International Monetary Fund:

www.imf.org/external/pubs/ft/aa/aa08.htm



U.S.-Sri Lanka Bilateral Investment Treaty:

www.state.gov/documents/organization/43588.pd f



Institute for the Development of Commercial Law and Practice:

www.iclparbitrationcentre.com



Indo-Lanka Free Trade Agreement: www.doc.gov.lk



South Asian Free Trade Area: www.saarc-sec.org/main.php



Fitch Ratings Lanka: www.fitchratings.lk



Development Assistance Database: www.dad.tafren.gov.lk





BLAKE