VZCZCXRO5893
RR RUEHLMC
DE RUEHLM #0794/01 1360943
ZNR UUUUU ZZH
R 160943Z MAY 06
FM AMEMBASSY COLOMBO
TO RUEHC/SECSTATE WASHDC 3377
INFO RUCPDOC/USDOC WASHDC
RUEHNE/AMEMBASSY NEW DELHI 9628
RUEHKA/AMEMBASSY DHAKA 9190
RUEHIL/AMEMBASSY ISLAMABAD 6080
RUEHKT/AMEMBASSY KATHMANDU 4115
RUEHCG/AMCONSUL CHENNAI 6633
RUEHLMC/MILLENNIUM CHALLENGE CORP

UNCLAS SECTION 01 OF 03 COLOMBO 000794 
 
SIPDIS 
 
STATE FOR EB/MTA/MST AND SA/INS; MCC FOR D.NASSIRY AND 
E.BURKE 
 
USDOC FOR EROL YESIN 
 
SENSITIVE, SIPDIS 
 
E.O 12958: N/A 
TAGS: ECON EFIN CE
SUBJECT: Sri Lanka Tax mess 
 
 
¶1. (U) Summary:  The cost of doing business in Sri Lanka is 
set to rise, due to increased taxation and tax complexity. 
International trade is also subject to high taxation in the 
form of increased non-tariff fees and surcharges.  However, 
the impact of higher taxes is not equitable.  For companies 
entitled to tax holidays, the impact (and the tax liability) 
is relatively low.  Tax incentives offered to attract 
investments have lowered potential tax revenue from a large 
number of companies.  End Summary. 
 
New taxes 
--------- 
 
¶2. (U) The Parliament recently approved or amended several 
tax laws to enforce tax proposals contained in the 
Government of Sri Lanka's (GSL) 2006 budget.  Key among the 
new tax instruments is a cumbersome Stamp Duty (SD), which 
will apply to several business instruments/transactions 
including affidavits, mortgage payments, rentals, various 
types of receipts, insurance policies, credit card charges 
and salaries.  In most cases, the tax rate is relatively 
low, but would complicate business transactions by requiring 
purchase and affixing of stamps to documents-the processing 
of which is already burdensome in Sri Lanka.  In other 
instances, the duty will be withheld and sent to the Inland 
Revenue Department (by the merchant directly) as in the case 
of the SD on credit cards and salaries.  The government will 
also continue a 0.1% tax on all bank debits.  Tax experts 
say the stamp duty and the debit tax could result in a "tax 
on tax" situation, as they are applied more than once on 
money exchanging for a single transaction.  For example, 
since most people pay credit card bills through bank checks 
or by withdrawing money from a bank, the transaction would 
be taxed twice under the debit tax and stamp duty. 
 
Thin capitalization and transfer pricing 
---------------------------------------- 
 
¶3. (SBU)  For the first time, Sri Lanka is to introduce 
rules on thin capitalization (which limits a company's tax 
breaks on loans made by shareholders - allowing shareholders 
to keep their capital base "thin" and finance through debt 
while writing off debt payments).  Some tax experts are 
concerned about the introduction of these advanced concepts 
in Sri Lanka and suggest the country is not yet ready for 
such sophisticated taxation, while others believe that they 
will bring Sri Lanka's tax structure in line with global 
developments.  According to Premila Perera, Tax Partner at 
KPMG, Sri Lanka will be one of the first developing 
countries to introduce the thin capitalization concept and 
has gone further than many countries by including both 
related domestic and foreign debt.  According to Perera, in 
most countries, thin capitalization is introduced only to 
cover related party foreign debt. 
 
¶4. (U) The government will also introduce transfer pricing 
rules using the "arm's length" principle (which uses prices 
applied to sales to third parties on related party 
transactions).  However, Sri Lanka does not have enough data 
to determine arm's length pricing, thus requiring income tax 
assessors of the Inland Revenue Department to determine the 
applicability of rules. 
 
Corporate and Personal Income taxes are going up 
--------------------------------------------- --- 
 
¶5. (U) Reversing a previous Government's decision to 
gradually reduce the highest income tax rates to 20%, both 
corporate and personal tax rates were increased from April 
1, 2006.  The highest tax band on corporate and personal tax 
was increased to 35% from 30%.  The government will also 
continue with an additional Social Responsibility Levy (SRL) 
(the procedures from which fund child protetion activities) 
on income tax, which has been icreased to 1% from 0.25%. 
Over the years, the goernment has begun to disallow various 
business epenses when determining profits.  Currently, it 
does not allow companies to deduct a range of expenses such 
as advertising (limited to 50%), overseas business trips and 
entertainment expenses. 
 
¶6. (U) The Banking community has raised concerns over 
 
COLOMBO 00000794  002 OF 003 
 
 
increasing financial sector taxes.  Banks pay corporate 
income tax and an additional Value Added Tax (VAT) on 
earnings.  The overall tax rate on banks will rise to about 
60% in 2006.  Several bank CEO's have made public statements 
complaining about the high tax environment.  They claim that 
high tax rates in the midst of higher capital adequacy 
requirements, high levels of non-performing loans and 
necessary technology upgrades does not bode will for the 
industry.  They assert that the high tax rates will result 
in higher transaction costs over the long term. 
 
Taxes on international trade also rising 
---------------------------------------- 
 
¶7. (U) Meanwhile, Sri Lanka is continuing with a range of 
taxes on international trade.  The taxes include import 
duty, an import duty surcharge, import fees, a Port and 
Airports tax (PAL), SRL and VAT.  Some imports are also 
subject to an excise fee.  VAT applies to both imports and 
domestic production and services.  Many of these taxes have 
been increased in each successive budget over the past three 
years. Other new taxes, such as a tax on foreign movies, are 
also contemplated. Several US companies have complained to 
the Embassy regarding the high level of taxation on imports. 
 
Tax collections remain Low 
---------------------------- 
 
¶8. (U) The recent moves to increase taxes indicate that the 
private sector will have to bear the brunt of the 
government's fiscal profligacy.  With a projected budget 
deficit of 9.1% of GDP in 2006, the Sri Lankan government is 
hard pressed to find funds to cover expenses.  Sri Lanka's 
tax collections were about 14% of GDP in 2005 and the 
government hopes to increase tax collection to about 16% of 
GDP in 2006.  Most taxes come from indirect taxes.  Direct 
taxes on income contribute only about 16% of tax revenue. 
 
¶9. (U) There are many reasons for low tax revenue.  Tax 
incentives and tax holidays offered to encourage investments 
by the Board of Investment (BOI) are key reasons for low 
levels of direct taxation from the corporate sector, 
especially from foreign investors.  For example, Dialog 
Telekom, an investment by Malaysia Telecom and       Sri 
Lanka's largest listed company, which made a profit of  Rs 7 
billion (USD 70 million) in 2005 is exempted from corporate 
tax due to a 15 year tax holiday.  Its tax liability will be 
limited to just 0.6% of profits, via the Economic Service 
Charge (a minimum tax on the exempted companies) and tax on 
interest income.  Similarly, while there is a wave of new 
high rise apartment buildings shooting up around Colombo, 
none is likely to bring tax revenue due to tax holidays 
(unless they are foreign owned, in which case there is a 
100% tax on the land value).  Many exporting companies are 
also subject to various tax incentives.  These tax 
incentives exclude some of the most profitable companies 
from taxation. 
 
¶10. (U) Another reason for sluggish tax revenue is the loss 
of traditional sources of revenue, such as certain import 
duties, due to tariff concessions offered under bilateral 
and multilateral trade agreements including the Indo-Lanka 
Free trade agreement (ILFTA).  Imports of inputs and 
production related items by exporting companies are also 
free of import duty.  Government tax experts have indicated 
that to compensate for tax losses arising from duty 
concessions granted under bilateral trading arrangements, 
taxes on imports from other countries will need to be 
increased. Import levies appear to be a relatively painless 
domestic political device - less controversial to a 
political base than broadening the income tax base or 
raising VAT. 
 
¶11. (U) Weak tax administration is a vulnerability.  Tax 
evasion is thought to be high.  Out of a workforce of 
approximately 10 million, only 143,704 individuals file tax 
returns.  In addition, there are 194,847 private sector 
workers who pay taxes under the mandatory Pay-As-you-Earn 
(PAYE) tax scheme 
 
Concerns 
 
COLOMBO 00000794  003 OF 003 
 
 
-------- 
 
¶12. (SBU)  While increased taxation seems to conform with 
the President's vision of bridging the rich-poor gap, tax 
experts say the government should not add additional taxes, 
but should instead focus on increasing the tax base.  At a 
recent KPMG tax seminar, Premila Perera noted that the new 
taxes and tax concepts will increase the complexity of the 
tax system, and suggested that private sector CEO's should 
pay increased attention to risk management and corporate 
governance in this high tax environment.  The higher tax 
rates could also worsen Sri Lanka's economic freedom 
rankings (Heritage Foundation) used by the Millennium 
Challenge Corporation (Sri Lanka already faces low rankings 
in the budget deficit and inflation categories). 
 
¶13. (U) Government efforts to increase taxation come at a 
time when the Inland Revenue Department (IRD) has come under 
close public scrutiny following the revelation of a tax 
fraud.  Several former senior officers of the IRD and 
businessmen have been arrested following a scam in which 
more than Rs 3.5 billion (USD 35 million) had been 
fraudulently paid out as VAT refunds. (Note: VAT paid on 
imports consumed by exporting companies is refunded, but 
genuine companies experience long delays in getting the 
refunds.)  Speaking at the KPMG seminar, Richard Ebell, Vice 
Chairman of Hayleys Ltd, one of Sri Lanka's largest 
companies, expressed concern over the lack of controls in 
the tax system in light of the huge fraud.  He noted that 
Hayleys is experiencing serious problems in collecting VAT 
refunds amounting to Rs 500 million (USD 5 million).  A 
previous reform effort to strengthen tax collection under a 
single Revenue Authority has been abolished. 
 
¶14. (SBU) Srilal Ahangama, Group Finance Director of 
Maharaja Organization, one of Sri Lanka's largest privately 
held companies, told Econ FSN that Sri Lanka's tax system 
has always been complex and businesses just accept it.  He 
said his company would seek to find ways to lower the tax 
burden within the tax law.  Nilanthi Sivapragasam, Financial 
Controller of Aitken Spence Group, another large publicly 
held conglomerate, said that they are not overly worried 
about the 5% increase in corporate taxation, but are highly 
concerned about new rules on thin capitalization and 
transfer pricing.  According to her these rules would have a 
direct impact on groups of companies with many subsidiaries 
like Aitken Spence.  According to Sivapragasam, these 
concepts are usually applied to monitor multi-national 
company (MNC) operations. However, Sri Lanka is to apply 
these rules to cover local subsidiaries.  According to her 
estimates, the government earnings from these moves would 
not be significant.  Several companies have made 
representations to the government on these rules, and it is 
not clear if the government will change them. 
ENTWISTLE