With the opening up of the economy in 1977 and the shift to a more export-oriented development strategy, Sri Lanka sought to attract Foreign Direct Investments (FDIs) by offering attractive tax incentives as the country emerged from a decade of looking inward for economic development.
Concessions for investors were first given under the Greater Colombo Economic Commission Law No.4 of 1978 and subsequently under the Board of Investment (BOI) Act of 1992. Tax incentives were also offered under the Inland Revenue Act. The enactment of the Strategic Development Projects (SDP) Act No.14 of 2008 permitted the minister in charge of investment the discretion to grant incentives to projects deemed to be of strategic importance with only subsequent ratification by the Cabinet and Parliament.
However, providing concessions for investors has failed to bear any fruit in the last three decades as Sri Lanka’s FDI inflow remains limited to about $ 1 billion per year.
The lack of clear criteria as to what constitutes a ‘Strategic Development Project’ in the SDP Act and the discretion given to the minister to decide what constitutes such a project has led to generous tax holidays and incentives granted to projects that were not remotely strategic.
Furthermore, tax concessions under the act have been awarded to projects that are not fully foreign-funded, violating one of its core objectives, which is to attract foreign investment.
Independent think-tank Advocata Institute, in its report issued last year on reforming tax incentives in Sri Lanka, noted that the operation of multiple tax jurisdictions had led to an overlap of tax incentives, obscuring the process of monitoring the overall benefits and costs of tax incentives provided.
“Lack of transparency and well-defined criteria as well as poor evaluation of projects has led to the granting of tax incentives without proper justification, leading to large revenue losses,” the report said.
Moreover, it said that transparency, availability, and accessibility of information regarding companies that had received tax incentives, especially under the BOI Act, were limited.
In light of this, the International Monetary Fund (IMF) diagnostic report has highlighted the need for a more transparent data-sharing protocol.
Losses from tax concessions
According to the tax expenditure statement released by the Finance Ministry, exemptions provided by the BOI had caused the loss of Rs. 23.94 billion in corporate taxes to the Government in 2022 when compared to higher corporate tax rates approved by Parliament under an IMF programme.
According to the statement, the total taxable income in 2022 stood at Rs. 168 billion, with Rs. 77 billion in manufacturing, Rs. 50 billion in apparel, and Rs. 22.7 billion in the power sector.
Tax expenditure was Rs. 8,551 million in manufacturing, Rs. 5,422 million in the power sector, Rs. 5,264 million in apparel, and Rs. 2,071 million in knowledge services.
Change of institution, not function
Speaking to The Sunday Morning, Softlogic Stockbrokers Co-Head of Research Raynal Wickremeratne said that the removal of the BOI under the Economic Transformation Bill could be viewed as a change of institution rather than a change of function, as the function itself would be reassigned or redesignated.
“The change in institutions is almost similar to a Cabinet reshuffle, which involves getting new names and new institutions while the same function will continue to happen,” he explained.
Govt. should weigh cost vs. benefits
Wickremeratne noted that providing concessions to investors was a heavily debated matter which differed from economy to economy.
He said that in terms of FDI, Sri Lanka’s extremely low reserve position two years ago and the country’s foreign debt crisis showed the importance of investments to boost the economy, even for local industries, by creating more jobs.
Wickremeratne further stated that attempting to attract larger FDIs would provide a significant boost and an injection into the economy. “If you are attracting something of that scale and size, which will also see massive job creation, it is up to the Government to decide how much it is willing to spend in order to enable such a project in the country, considering all the benefits,” he added.
He noted that some local corporations were still reeling from the economic shocks and were therefore not in a position to make any major investments.
As an example, Wickremeratne pointed out that when it came to Port City Colombo, for which Sri Lanka required major investments, investors naturally compared it with similar special zones in other countries prior to investing.
Therefore, he added that Sri Lanka had to be competitive with other countries in order to attract investments and provide a reason for investors to choose the country, which could be in the form of tax breaks or other concessions.
A Vietnam-style investment law
Meanwhile, speaking to The Sunday Morning, BOI Chairman Dinesh Weerakkody stated that the only tax concession the BOI now offered to investors was the duty-free import of raw materials for manufacturing purposes.
He shared that the BOI had suggested concessions to be implemented for investors to the Government committee which was responsible for making the final decision, although this was yet to be finalised. However, he added that tax holidays granted for enhanced capital allowances were still available under the Inland Revenue Act.
With the new amendments included in the Inland Revenue Act in 2022, Sri Lanka has moved away from granting tax holidays, concessionary Corporate Income Tax (CIT), or reduced CIT and retained only the Enhanced Capital Allowance (ECA) that will be available for investments of more than $ 3 million on depreciable fixed assets. (ECA for investments less than $ 3 million will be applicable only up to 2024.)
With the Economic Transformation Bill attempting to replace the BOI, Weerakkody revealed that they were suggesting that Sri Lanka formulate some of the concessions which would be provided for investors into an investment law, similar to Vietnam, in order to ensure continuity.
Vietnam’s Law on Investment (LOI) includes provisions for the introduction of a ‘negative list’ for foreign investment, increase in ownership thresholds for treatment as a national investor, a ‘national security’ provision, new investment incentives, and additional measures to streamline investment procedures.
Treasury considering gradual removal of concessions
Speaking before the Committee on Ways and Means earlier this month, Ministry of Finance Department of Fiscal Policy Tax Adviser Thanuja Perera said that the authorities were expecting to recover at least Rs. 200 billion in 2024 from the removal of exemptions for Value-Added Tax (VAT). She said that the overall revenue loss to the Government due to tax exemptions provided for VAT was 1.2% of the Gross Domestic Product (GDP).
Exemptions provided by the Inland Revenue Department (IRD) have been separated into two categories: BOI exemptions and non-BOI exemptions. The ministry’s tax expenditure statement revealed that an overall VAT exemption of Rs. 554 billion had been provided in the year 2022/’23 while the non-BOI exemptions had amounted to Rs. 447 billion.
Perera said that since most of the exemptions had now been removed by the Government, the exemptions given to BOI and non-BOI companies would be discontinued in the future. She added that most of the VAT exemptions had been given to the IT sector through the non-BOI category.
Accordingly, VAT exemptions given to agriculture, apparel, knowledge services, manufacturing, infrastructure, and tourism have been removed from 1 January. However, exemptions given to the pharmaceutical and electricity sectors remain in place.
Regarding the VAT exemption recovery calculations, an IRD official revealed that the actual recovery amount would be below the amount of revenue loss, as the calculations had been made based on assumptions.
For example, he said that if a VAT-liable individual was conducting a business, their tax expenditure would be calculated by applying the standard rate and if the person was liable for it, they would claim an input. However, the official added that the IRD had no method of measuring the input claimed, since such an individual could purchase from either a VAT-registered or VAT-unregistered supplier.
New framework to provide concessions
Speaking to the media on Monday (10), State Minister of Finance Shehan Semasinghe said that the Government hoped to repeal the BOI Act while different parties were still discussing the Economic Transformation Bill that had been introduced. He said that the country’s current investment climate was unsuitable even for a local investor as it still operated under an outdated legal framework.
According to the proposed Economic Transformation Bill, the Economic Commission can present recommendations to the minister in charge to provide concessions to incoming investors. In the past, Sri Lanka used the SDP Act to provide concessions to investors without any proper explanation as to why such a concession had been given to a particular investor.
Semasinghe noted that the SDP Act had been inactive for the past year, adding that it had not been used by the Government to bring in investments. “The IMF has shown us that such legislation, which is not within a certain framework, will enable room for corruption and impact the Government’s tax revenue,” he said.
Therefore, he added that the Government had agreed with the IMF to introduce a rules-based system from early next year, which would be transparent and provide a definite methodology for providing concessions to investors.
IMF suggests rules-based criteria for concessions
The IMF staff report released following the completion of the second review of the Extended Fund Facility (EFF) on Wednesday (12) said that ad hoc and non-transparent tax exemptions had been a major factor behind low tax revenues.
It said that the Finance Ministry estimated a total tax expenditure of 4.1% of GDP in 2022, equivalent to more than half of 2022’s tax revenue (7.3% of GDP) and nearly half the envisaged revenue gains under the programme during 2023-’25.
“While some VAT and CIT exemptions were removed recently, tax incentives under SDP and BOI projects remain sizeable and imply a higher tax burden on non-exempt parties,” the IMF said.
Therefore, the IMF has advised Sri Lankan authorities to refrain from providing new tax exemptions and incentives and from approving new projects under the SDP Act. It has added that authorities should submit to Parliament by end-February 2025 amendments to the SDP Act introducing transparent, rules-based eligibility criteria for granting time-bound incentives.
No tax concessions hereafter
In its Letter of Intent to the IMF, Sri Lanka said that the SDP, BOI, and Colombo Port City Economic Commission Acts had granted a wide range of tax exemptions to some investors with no specific or transparent criteria or process.
“In order to minimise revenue losses and curb corruption risks, we are no longer providing any tax exemptions or incentives, and we are also no longer approving new projects under the SDP Act as of December 2023,” the letter reads.
The Government further said that by end-February 2025, with IMF technical assistance, it would submit to Parliament amendments to the SDP Act that would introduce transparent, rules-based eligibility criteria in order to increase the effectiveness of granted tax incentives and to limit the duration for which incentives can be granted.
“We have evaluated all existing SDP, BOI, and other contracts and published a report detailing the exemptions that have been provided and the value of all tax regulatory and other exemptions. Should we consider new tax proposals to attract investments, we will consult with IMF staff prior to their implementation,” the letter states.