TWEAKING THE NEW INLAND REVENUE ACT

I write this article, the political situation of the country is still unravelling and given the inextricable link the policy framework has with political institutions, the exact fate of the implementation of the new Inland Revenue (IR) Act, remains to be seen.

However, as per the status quo, the new IR Act has been effective since 1st April 2018, and despite the significant changes brought to the tax system, in the Sri Lankan spirit of things, it is only now that we are witnessing a scurry to comply with the Act.

The new IR Act drew much flak in the Bill stage, more for the promoters of the Act rather than any demerits of the Act itself. This article, however, will not dwell on the IMF connection, the condition precedent to the Extended Fund Facility granted to the GOSL, or the verbatim reproduction of the Income Tax Act of Ghana. Instead, the focus is on the pros and cons of the Act and how the Act could be tweaked to better serve its objectives.

The Pros

The new Act has cleared the clutter in the old Act with its many amendments. It has drastically reduced the number of exemptions, deductions, disallowed expenses, reliefs and qualifying payments, and thereby streamlined the tax computations. It has also streamlined the tax review and appeals process. At the same time, it incorporates some constructive tax concessions to attract foreign direct investment and relocate in Sri Lanka the headquarters of an international network of institutions, which compliments well with the objective to make Sri Lanka a regional trade/financial hub.

The Cons

Simplification and Clarity

The Act is a vast improvement on the older one, in terms of simplification and clarity. However, more could be done in both aspects, which is important, if, the government intends to achieve its objective to broaden the tax base and encourage more people to pay tax. In this regard, it is commendable that the Inland Revenue Department (IRD) has published a draft guide to the Act. But, again, more could be done to make it simpler for the taxpayer.

One suggestion is to segregate the tax regulations according to the source of income. Most taxpayers derive income from one source and find it confusing to manoeuvre through the inapplicable regulations. Further, both the guide and Act, at times, lack clarity on the applicability of certain provisions to a source of income. For example, it is not clear whether some of the deductions apply to business income or investment income or both. Another pertinent suggestion is to publish this guide in all three languages.

Capital Gains Tax (CGT)

The CGT has been reintroduced under the new Act with the overarching objective of increasing tax revenue. It drew criticism over its perceived impact on the sale/realisation of individual properties. However, the Commissioner General of Inland Revenue (CGIR), subsequently issued a gazette specifying that only the gains from the realisation of ‘investment assets’ shall be subject to CGT. Nevertheless, there are still some confusing points regarding the CGT, which especially relate to a business.

Under the old Act, if a business derived a gain from the realisation of a capital asset, such gain was treated as a business income and liable for tax accordingly (either at the individual or corporate rate). However, under the new the CGT, provided the capital asset is classified as an investment asset, any gain from the realisation is liable for tax at a universal rate of 10%. Further, the market value of the asset as at 30.09.2017 is considered as the cost of the asset. Therefore, it is very likely that a business would pay less tax under the new CGT. This would prompt a business to reclassify its capital assets as investment assets.

Although, an investment asset is defined as a capital asset (and a capital asset excludes trading stock and depreciable assets), the CGT provisions make several references to trading stock and depreciable assets without affording much clarity on when such assets qualify as capital assets and/or is liable for CGT.

Further, a business is imposed with a procedural burden of having to pay CGT and file a return within one month of the gain from the realisation of an investment asset. This could be easily made to coincide with the quarterly payment of income tax.

Interest Expense and Financial Cost

The Act allows for the deduction of interest expense, and financial cost attributable to financial instruments. However, the latter is only applicable to entities (excludes individuals) and is subject to what is referred to as the ‘thin capitalization rule’. According to this rule, the financial cost attributable to financial instruments cannot exceed 3 times of the equity for manufacturing entities and 4 times for other entities.

The Act describes interest expense as interest incurred under a debt obligation and the definition of ‘financial instrument’ includes a debt obligation. This suggests that the interest expense of an entity is subject to the thin capitalization rule applicable to financial cost. However, under the old Act, there was no restriction on the deductibility of interest expense. This limit on the interest expense would be unfavourable to a highly geared business.

Transfer Pricing

Transfer pricing regulations stipulate that any income/loss from transactions entered into with associated enterprises shall be ascertained having regard to the arm’s length price. Transfer pricing regulations existed under the old Act as well. However, the procedure under the new Act seems to unnecessarily protract the enforcement of the transfer pricing regulations. According to the Act, where it appears to the Transfer Pricing Officer (TPO) or Assistant Commissioner (as the case may be) that arm’s length pricing has not been followed, such officer may initiate a transfer pricing audit. The officer shall carry out an inquiry into the matter, determine the arm’s length price and refer it to a Technical Review Committee. This committee shall review the determined arm’s length price and either make an interim or final order thereon. The taxpayer who is not satisfied with this order may appeal to a Dispute Resolution Panel, which shall issue a final order. Thereafter, the TPO/Assistant Commissioner shall issue an assessment according to the final order. The taxpayer has a further opportunity to appeal against the assessment according to the normal objections and appeals process under the Act.

Instead of this lengthy procedure, the implementation of the transfer pricing regulations could be absorbed into the normal assessment, and objections and appeals process under the Act. Accordingly, after an inquiry, TPO/Assistant Commissioner could issue an assessment and if aggrieved, the taxpayer has recourse to the objections and appeals process under the Act. There could be a sub-division or officers specialised in the subject of transfer pricing within the objections and appeals process.

Tax Payment

The new Act has introduced a significant change to the tax payment process. A taxpayer must file a statement of the estimated tax payable for the ensuing year of assessment and pay tax according to such estimate. This is a stark difference from the earlier practice of paying tax in arrears i.e. on the actual taxable income. However, the taxpayer must still file a return of income within eight months after the end of the year of assessment.

The IRD has provided instructions on how to prepare the estimate of the tax payable. Accordingly, it could be prepared by either adding 5% to the tax paid in the previous year or by estimating the income sources.

It is doubtful whether there is an advantage to the IRD from the payment of tax based on the above estimate. More than any advantage it seems to increase the process burden of both the taxpayer and the IRD. Firstly, at the end of the year of assessment, there would always be a refund or underpayment. Secondly, the Act allows the taxpayer an opportunity to file a revised estimate. Thirdly, as per the instructions of the IRD, even taxpayers with only income from employment (PAYE) must file a nil estimate.

Assessments

The assessments have also undergone some changes; however, it is the possibility to further amend an assessment that protracts the process. Under the old Act, an amended/additional assessment could only be further amended in the limited circumstance where the court annulled the assessment.

Under the new Act, an Assistant Commissioner, could amend the original assessment within thirty months thereof and further amend the original assessment up to a period of four years. Thus, the Assistant Commissioner has the opportunity to amend the original assessment twice. The authorities may want to consider limiting the circumstances where an amended assessment could be further amended to avoid a protraction of the process.

Partnerships

The approach to taxation of partnerships has been changed under the new Act. In the old Act, the partnership was liable to pay tax and the partners received a tax credit for the tax paid by the partnership. However, in the new Act, except in the case of a gain from the realisation of an investment asset, the partnership is not liable to pay tax. Instead, it is the partners who are liable to pay tax. The partnership is required to withhold tax at the rate of 8% from each partner’s share of the partnership income. The share of partnership income is treated as business income of the partner and liable for tax at the individual tax rate. The partner receives a tax credit for the withholding tax.

However, there is a lack of clarity in the new Act regarding how the partnership income and/or each partner’s share of the partnership income should be calculated. In the old Act, it was clearly specified that the partnership income should be calculated according to the Act (i.e. taxable income).

Concessionary Corporate Tax Rates

The new Act provides a concessionary tax rate of 14% for small and medium enterprises (SMEs) and defines a SME as having an annual gross revenue of less than Rs. 500 Mn.

The same concessionary rate is afforded to companies engaged in specific industries with the objective of promoting those industries, which include the agri-business, export and tourism industries. These industries enjoyed similar concessionary rates under the old Act and it is disheartening to see some of the highest earning corporates in the country consistently pay tax at concessionary rates. Not only is the government losing substantial tax revenue, but it also stifles the growth of SMEs in these industries. Therefore, the authorities should reconsider the blanket concessionary rate and apply the same qualification criteria as for SMEs or something similar. It should also be noted that the export definition includes ‘specified undertaking’ and the scope of specified undertaking has been widened to include several new lines of business relating export and import, where some of the highest earning corporates operate.

Life Insurance Business

Tax reform relating to the life insurance business has been a long time coming. More for the powerful lobbyists than the objective to develop the life insurance industry, one of the most profitable businesses has paid little or no tax in the past. Under the old Act, it was only the investment income of the life insurance fund that was treated as business income and all expenses relating the life insurance business were set off against such income, resulting in a taxable loss more often than not.

The new Act makes amends for this by treating as the income of the life insurance business the aggregate of; the surplus distributed to the shareholders from the life insurance fund, and the investment income of the shareholders fund less expenses. However, authorities may have gone slightly overboard by treating the surplus distributed to the participating policyholders (bonus) also as a part of the income of the life insurance business. This portion of the surplus of the life insurance fund is initially liable for tax at a concessionary rate of 14%. Since this could have a detrimental effect on the industry and policyholders as well, the authorities could consider an alternative where the tax paid on the surplus distributed to policyholders is treated as a tax paid by the policyholder and granted a tax credit in respect thereof. Such an alternative will help to promote the life insurance business given that the new Act does not afford any concessions to the life insurance business.

However, what is of more concern to the authorities is the deferred tax asset conundrum. The Act allows for the deduction of unrelieved losses in the previous six years without any restrictions and this has resulted in some insurers recognising massive deferred tax assets. This virtually ensures that such insurers will not be liable to pay tax for at least another six years. It is hard to believe that this outcome was intended given the long overdue objective to tax the life insurance business.

Petroleum Operations and Renewable Energy/Recycling & Waste Management

Petroleum operations are afforded a special status in the new Act as in the old one. These provisions are likely to have found their way in due to the Anglo-Saxon/Western influence in drafting of the law.

The authorities should consider elevating to a similar status any investments made in renewable energy projects, and recycling and waste management projects given the wind of change in favour of renewable energy over fossil fuels and the national priorities. The Act only provides a temporary concession to institutions that supply electricity using renewable resources by taxing them at the rate of 14% for the next three years.

Housing Concessions

Under the old Act the capital repayment on a loan obtained for the construction or purchase of a house was designated as a qualifying payment. However, the new Act does not afford any concessions of the sort to prospective homeowners. Considering that even developed countries provide tax concessions to encourage home ownership, authorities may want to restore similar concessions as a matter of policy.

Temporary Concessions

The new Act provides a temporary concession for headquarters relocating to Sri Lanka, by taxing such institutions at zero percent for the next three years. The relocation of head offices to Sri Lanka accords with the objective to make the country a regional trade/financial hub. Therefore, the authorities may want to consider an extension of this concession into the medium term. However, threshold requirements should be specified as in the case for enhanced capital allowances (investment incentives).

As a temporary concession, an additional deduction of 100% of the research and development expenses is allowed for the next three years. Again, this concession is something that could be extended beyond a temporary concession to promote research and development in the country. Alternatively, authorities could allow for any losses resulting from the deduction of R&D expenses to be carried forward beyond the normal period of six years.

The information technology industry is granted a temporary concession of an additional deduction of 35% of the total amounts paid to employees, provided certain conditions are met by such companies. However, more constructive concessions could be afforded to the IT industry to last well into the medium term given the objective to make Sri Lanka an ICT hub. For instance, enhanced capital allowances could be provided for the hardware, software programs and licenses used by companies that provide offshore services.

Final Remarks As highlighted in Part I & II of this article, irrespective of the controversies surrounding the enactment of the law, this is a vast improvement on its predecessor, and it is reasonable to assume that despite the political rhetoric, the framework/systems introduced by the Act would not be changed at least in the short to medium term. However, as discussed in this two Part article, there are several points in the Act that deserve the attention of the authorities and if these could be addressed, the Act would sit well with all the stakeholders.