With the announcement of plans to remove tax concessions previously granted to service exports by the Government, significant changes are expected to be triggered across various sectors. This landmark policy shift is directed at bolstering national revenue and fostering a more balanced economic environment.
There are several advantages to removing these concessions, despite the immediate challenges. In the long-term, taxing service exports will provide a substantial boost to State finances. The increased revenue can be redirected towards crucial public sectors such as infrastructure, healthcare, and education, driving overall national development.
The policy change will also create equal opportunity for all businesses. Companies which primarily cater to the local market have perceived these concessions as an unfair advantage and their removal will promote fair competition. Without the temptation of tax breaks, service-oriented businesses may increase their focus on domestic markets. This shift could boost innovation and investment within the country, enhancing economic resilience and reducing dependency on foreign markets.
However, the removal of these concessions is likely to lead to increased operational costs for companies in fields such as Information Technology, financial services, and consultancy, which form the foundation of Sri Lanka’s economy. Service exports in these fields benefit from the tax concessions and their removal will result in an adjustment in pricing strategy, potentially making their services less competitive internationally.
Staying competitive and profitable
Cyber Security Advisor Asela Waidyalankara, expressing his opinion on the matter, said it would impact profitability simply because these components had not been calculated.
“To remain competitive in global markets, it must be taken into consideration that the world is going through an economic slowdown as well and has become very price sensitive. In order to stay competitive, of course, we have to offer good products and services, including as an outsourcing destination for services. But when cost components like this come up, the concern will be about how we are able to compete. I think that is the primary concern.”
He added that forecasting had to also be considered, as these measures were implemented with very little notice and consultation, which affected clients with long-term contracts with Business Processing Outsourcing (BPO) and Knowledge Processing Outsourcing (KPO) providers. “Over the course of several months, cost calculations change and profitability shrinks, which becomes a challenge to operate,” he noted.
Waidyalankara said that start-ups and smaller firms, which had thrived due to these tax incentives, may find themselves under financial pressure, which could slow down the growth of new ventures and innovations.
“Larger companies, while more resilient, might re-evaluate their expansion and investment plans within the country. The economic crisis is acknowledged, yet IT is seen as a key sector that could facilitate a quicker recovery. Therefore, it is important to support these sectors and maintain certain incentives to allow for growth and potentially become the country’s leading exporter.
“Simply, it’s costing, forecasting, calculation. That’s perhaps where I would see retaining talent as a knock-on effect could perhaps be a measure because, when profitability shrinks, margins shrink. Sometimes staff retention can be difficult, especially for startups to become attractive and more viable. For investors, you have to be seen as a policy climate that should be encouraging the growth of the sector. Things like this can perhaps be seen as very regressive for an investor and may therefore defer an investment decision,” said Waidyalankara.
Given that the currency has fluctuated significantly in the last 18 months, causing difficulties, particularly for those with inflows pegged to dollar income, this volatility makes forecasting challenging, especially when the dollar becomes unstable and then decreases in value.
In this context, the introduction of various items, such as new taxation measures, along with necessary regulatory and tax alignments, increases costs and reduces profitability. Consequently, companies may reconsider using Sri Lanka as a base of operations, leading to potential talent loss as some organisations move out due to these challenges.
In the short term, the elimination of tax concessions on service exports is expected to significantly increase Government revenue. Service exports constitute a substantial segment of Sri Lanka’s economy and the taxation of these services could generate billions of rupees annually. This revenue boost is crucial for a country seeking to stabilise its economy and fund public welfare programmes.
Export revenue over taxes
Speaking on behalf of the National Chamber of Exporters of Sri Lanka, its President Jayantha Karunaratne said that the chamber was actively lobbying to address the severe debt of around $ 100 billion that needed to be paid. It is advocating for increasing export revenue rather than burdening the domestic population with additional taxes.
According to the chamber, the focus should be on developing a plan to encourage more exports and generate income from external markets, rather than relying on internal sources.
The increase in revenue must be balanced against potential reductions in service export volumes. Businesses may scale back their export activities in response to the higher tax burden, which could moderate the anticipated revenue gains. The overall fiscal impact will depend on the Government’s ability to support affected sectors during the transition.
The Board of Investment (BOI) projects, which often receive various tax incentives to attract foreign investment, will experience mixed outcomes from this policy change. While the focus of the tax removal is on service exports, the broader investment climate could be influenced.
Existing BOI projects, especially those heavily reliant on service exports, will need to re-adjust their financial models. The Government might need to consider introducing alternative incentives or support mechanisms to ensure these projects remain viable and continue contributing to economic growth.
Concessions and exemptions
Concessions for investors were initially granted under the Greater Colombo Economic Commission Law No.4 of 1978, and later under the Board of Investment (BOI) Act of 1992. Additionally, tax incentives were provided through the Inland Revenue Act.
The Strategic Development Projects (SDP) Act No.14 of 2008 allowed the minister responsible for investment to grant incentives to strategically important projects, subject only to later approval by the Cabinet and Parliament.
Board of Investment (BOI) Chairman Dinesh Weerakkody stated: “Currently, the only tax concession the BOI offers to investors is the duty-free import of raw materials for manufacturing. We have proposed additional concessions to the Government committee responsible for the final decision, though these are yet to be finalised. Nonetheless, tax holidays for enhanced capital allowances remain available under the Inland Revenue Act.”
The exemptions administered by the Inland Revenue Department (IRD) are categorised into BOI and non-BOI exemptions. According to the Ministry of Technology’s tax expenditure statement for the fiscal year 2022/’23, a total Value-Added Tax (VAT) exemption of Rs. 554 billion has been granted, with non-BOI exemptions amounting to Rs. 447 billion.
Due to recent Government measures, most of these exemptions are being phased out. Both BOI and non-BOI exemptions are expected to cease in the future. A significant portion of the VAT exemptions, particularly those under the non-BOI category, have been allocated to the IT sector.
The removal of tax concessions may lead to a period of reassessment by foreign investors. FDI inflows, particularly in the service sector, might see short-term fluctuations as investors re-evaluate the profitability of new ventures in Sri Lanka. However, if the Government can effectively utilise the increased revenue to improve infrastructure and public services, it could enhance the country’s attractiveness for investment in the long run.
“Foreign Direct Investments (FDIs) are attracted to Sri Lanka due to various benefits. If these advantages are compromised, potential investors may reassess the feasibility of their decisions. The cost implications are also critical; if costs rise, businesses may reconsider their operations or consider relocating.
“Evaluating each FDI case individually, it’s challenging to predict outcomes definitively. Therefore, any alteration in the current conditions could prompt investors to reconsider their strategies,” added Karunaratne.
Exodus likely
The service export sector is currently experiencing growth. However, the removal of tax concessions will likely impact this growth negatively. This industry is highly mobile and can relocate at any time. Implementing new taxes on this sector could indirectly push it out of Sri Lanka, resulting in a negative effect.
It’s not advisable to introduce new taxes on the service sector; instead, alternative methods of generating additional income, possibly from individuals who have benefited rather than from companies or exports, should be considered.
Introducing such taxes will likely have a negative impact, potentially causing a gradual exodus from Sri Lanka. However, while it presents immediate challenges for businesses and may influence foreign investment dynamics, the long-term benefits of increased Government revenue and a more equitable tax environment are substantial.
The success of this policy will depend on the Government’s ability to manage the transition effectively and ensure that the additional revenue is invested in ways that foster sustainable economic growth and development.
The Export Development Board (EDB) and the Ministry of Technology were not available for comment.