SPECIAL INTEREST THREATENS TO WRECK INCOME TAX REFORM

Tax cheats thrive under the existing law, so its overhaul makes sense despite the misinformation around it

Overhauling Sri Lanka’s income tax code holds huge promise despite the misinformation perpetuated by special interest groups. The proposed new law includes measures to broaden the base, plug loopholes and, more importantly, introduce tough penalties on cheats, making a more potent tax evasion-busting weapon out of the recently installed revenue management system. Influential trade unions at the Inland Revenue Department (IRD) and some income tax consultants are lobbying to prevent the proposed law’s passage. Their voices dominate mainstream media, and the unions are threatening strike action. Initially, everybody was apprehensive, even suspicious, about the brand new income tax law and the steep learning curve that comes with it. Now, the benefits are becoming clear. “One feature of this proposed law, and it doesn’t matter where it comes from, is that it has the detail that makes it readable, understandable and workable,” says Naomal Goonewardena, a tax lawyer at Nithya Partners, a law firm.

Sri Lanka is taking a bold step to fix the income tax problem. The 2009 Presidential Taxation Commission claims the complicated tax code encourages tax dodging. Income tax at 2% of GDP is lower than that of most countries in the same stage of development. It’s even lower than the average in Sub-Saharan Africa.

The new law is expected to double the income tax-to-GDP ratio to 4% by 2020, according to the IMF. However, the ratio has the potential to be much higher, as the IRD’s revenue management system uncovers more tax cheats.

There’s an uneasy calmness in the bare office as fading daylight fills the room. Muffled sounds of chirpy goodbyes and happy feet rushing to catch the early train echo from the corridor outside into the office where a gangly, greying tax officer sits with his back to the window, looking harassed and overworked. The desk was both untidy and neat, the way only hardworking people seem to know how. The view from this 14-storey office is a drab view of downtown Colombo and after work, rush hour traffic.

“Their frustrations are understandable,” Ivan Dissanayake said softly, referring to influential trade unions within the IRD opposing the proposed new income tax code. “They don’t know anything about it,” he said, furrowing his brows. “I admit there is a communications gap there, and unfortunately, that’s creating a lot of misinformation,” Dissanayake, the deputy commissioner general, said. He leads the IRD team tasked with managing the transition once the new law comes into effect.

“One feature of this proposed law, and it doesn’t matter where it comes from, is that it has the detail that makes it readable, understandable and workable”

A couple of floors down, HAL Udayasiri sits quietly behind a desk with no computer. He is the convenor of the tax department’s many trade unions and represents different officer grades. “Whoever said Sri Lanka needs a new income tax law?” he said. “The proposed new act was drafted by the IMF for Ghana, a poor country in Africa that didn’t even have income taxes before this law was introduced,” he says.

He spoke slowly, emphasising each word: Taxpayers will be burdened with new taxes and the government will lose, not gain, revenue by the time his colleagues familiarise themselves with the new law and procedures. “I admit, the IRD is not perfect, but introducing a new law is going to be a big problem,” he said, looking down at a printed card on his desk, for inspiration perhaps, announcing a protest march against the country’s only private medical school SAITM. “We’re taking up the matter with the President. If that fails, we’ll have to take to the streets,” he said with a shrug.

Back upstairs, Dissanayake closed his weary eyes to offer them brief respite, wondering why people weren’t filing their returns online. Earlier that day, taxpayers had flooded the IRD to file last-minute returns. He had taken the initiative to visit this floor to make sure operations, and the queues, flowed smoothly. “What they say about Ghana and the draft law is not entirely true, but there’s little I can do about it right now until the document is made official,” he said.

Ghana’s income tax code, enacted in 2015, was written by the IMF’s legal experts specifically for Commonwealth countries, according to Dissanayake. It was this base document that was presented to Sri Lanka’s finance ministry to include in its tax policies. The Ministry of Finance didn’t invite public consultations for the drafting stage, which is not unusual. Bills become public documents once tabled in parliament. Thereafter, a 14-day window is open for anyone to read them and file objections in court before it’s taken up for voting. Instead, the ministry shared the raw draft unofficially with several businesses and tax consultant firms.

Gut-wrenching misgivings, sometimes panic or anger, swelled within anyone reading the draft for the first time. It wasn’t tax policy that screamed back at them: the language and structure were unlike anything they’d seen before. Tax consultants who had built decades of expertise in the existing law were shocked that all this would soon be irrelevant. They’re claiming the existing law is good. It’s the administration that’s weak.

“We have one of the best laws in the world. If the IRD is inefficient or incompetent, that’s not because thelaw is bad,” a tax consultant said,  not wanting to be named. “I have no faith in the IRD’s ability to understand a new and entirely different set of rules,” another said, predicting a nightmarish transition for everybody. “It will take us years to recover from this. Revenue will suffer,” he said. President Sirisena has heard the special-interests cacophony. Some tax consultants have built lucrative practices and have the ear of policymakers who often consult them about tax policy. He has promised to give tax consultants and IRD unions a hearing.

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 Presidential tax commission appointed in 2009 couldn’t ignore problems with the tax code. “The importance of the simplification of the tax system to improve voluntary compliance is a running theme throughout our report,” it said.

Its mandate was to study Sri Lanka’s tax system and find solutions to arrest declining tax revenue. The commission included Prof WD Lakshman as its chairman and Saman Kelegama, both economists; Rajan Asirwatham, chairman of the Faculty of Taxation of CA Sri Lanka, the country’s accounting body, and a director at several listed firms; Nihal Fonseka, then CEO of DFCC Bank; BRL Fernando, former chairman of listed CIC; and RPL Weerasinghe, former Director General of the Inland Revenue Department.

The commission discovered several problems with the tax code. It was frequently amended and retrospective taxes added. The IRD was not clear on how each of the law’s provisions applied, leading to arbitrary rulings. Computing and filing tax returns were complicated. “Tax compliance is difficult,” the commission said.

Sri Lanka used to collect as much as 20% of GDP in taxes, but over the past decade-and-a-half, things have gone horribly wrong, with the total tax-to-GDP ratio declining to 12% in 2015 with income tax at 2%. As a result, the government struggled to raise enough revenue to pay for public infrastructure and social services. Debt mounted instead, and the poor were burdened with consumption taxes.

Rather than paying the most taxes, rich people and corporates enjoy unintended subsidies by exploiting tax concessions and loopholes that are not available to those earning less. Many businesses and wealthy people don’t feel compelled to pay taxes on profits or income because the government is corrupt and nobody else pays taxes anyway.

It didn’t help that the tax department has a tendency to unduly focus on existing taxpayers “ignoring the vast numbers who do not submit returns”, the tax commission report says. The harassment leads to taxpayer reluctance to pay taxes and avoid the IRD, hiring tax consultants to exploit loopholes in the law. This is called tax avoidance and is not illegal. But it’s not allowed either.

Companies making a turnover below Rs250 million or profit below Rs5 million are taxed at 14%, but once they cross these thresholds, they are liable to be taxed up to 28%. So, when they near this threshold, they float a subsidiary instead. This is one example of tax avoidance. Intergroup payments for goods and services have also been found to be under-priced to minimise tax liabilities, says IRD Assistant Commissioner Gamini Waleboda who spoke to Echelon in 2016. He declined to talk about the proposed new tax code.

Their mastery of the tax code gives tax consultants advantage over underpaid, demoralised officers at the tax department, many of whom had been recruited without a background in business or finance. They use “legal provisions to their advantage, even lodging frivolous appeals with a view to delay the payment of taxes due,” the tax commission report said.

Interest expenses on borrowings are tax-deductible anywhere in the world, but there is room for tax avoidance within a group. A company borrowing from a bank can transfer the funds to another business in the group under a lower tax threshold to enjoy the benefits of tax arbitrage. The existing tax code specifies how much of this is permissible. “But, companies keep pushing the limit, hoping we’ll miss it,” Waleboda claims. The proposed new tax law will allow the IRD to fine companies filing returns incorrectly.

The existing tax code prohibits these practices but it’s not easy to capture when IRD officers have only audited final accounts to go by. “Making a call on this is not always easy,” Waleboda says. “The law is complicated, and interpretations can vary.” Tax dodgers not only gamble on the incompetence of tax officers, but also get inside help.

“Companies couldn’t deal with complexities around computing and filing tax returns,” the tax commission says

Waleboda admits there are IRD officers who can be bought. According to the tax commission, the IRD has paid insufficient attention to pursuing tax avoiders, “or even colluding with them”. It found that tax disputes were sometimes settled through private  negotiations without formal assessments being issued. Tax files were also moved around without proper oversight.

The proposed new income tax code was drafted with these challenges in mind.

The existing tax code defines tax avoidance schemes as transactions that are ‘fictitious’ and ‘artificial’. Proving intercompany fund transfers and sales on these terms is difficult, especially when savvy tax consultants are at hand to argue the case on behalf of their clients.

However, the proposed new law defines tax avoidance in broader terms to include transactions that appear to have no commercial benefit to a company other than to minimise taxes.

The special interest lobby claims that any company receiving tax concessions could be construed as avoiding taxes under the new law. “Every transaction that is viewed as deriving a tax benefit will be questioned by the IRD. The courts will be inundated with disputes,” one tax consultant said, and a few agree.

However, Goonewardena believes the tax avoidance section in the new law is clear. “It deals with tax avoidance schemes that tax consultants designed for their clients. These schemes are not so prevalent in Sri Lanka, but they are a problem in more mature markets. So, the new law moves in the right direction,” a tax lawyer at Nithya Partners says.

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hile tax avoidance is a serious issue, tax evasion is an even bigger problem. According to the tax commission, the income tax code seems to encourage it. In 2007/8, nearly 62% of companies registered with the IRD to pay taxes were non-compliant, the tax commission discovered. One reason for this may be that many small companies had gone bust and didn’t file for bankruptcy. The complex tax code is another reason. “Companies couldn’t deal with complexities around computing and filing tax returns,” the tax commission says. “In an environment of weak enforcement, this leads to a high degree of tax evasion.”

Tax collection data suggests that tax evasion is rampant. Sri Lanka’s income tax-to-GDP ratio, at two percent, is much lower than that of some peers in the middle-income group: Georgia and Mongolia have 9%, Bhutan 7.7%, Samoa 5.6% and even troubled Egypt has 6%, according to the IMF.

Traders in Pettah, Colombo, have been caught maintaining separate books to cheat taxes. Business owners charge personal expenses to the company, dodging taxes at both business and personal levels. Property and vehicles are bought under relatives’ names. “Professionals are the other big income tax evaders. Doctors and lawyers, in particular, were adept at evading taxes,” says RPL Weerasinghe, a former IRD commissioner general. Around 7% of the working population pays taxes, including pay-as-you-earn taxes deducted by employers.

However, opponents of the proposed new tax code argue that the existing law is not the problem. “We already have the laws, and breaking them is illegal. The problem is that we have an administration that can’t implement the law or catch the cheats,” a tax consultant argued.

However, the existing law lets off tax evaders with a slap-on-the-wrist penalty of paying one to two years’ taxes and a fine of Rs50,000. Other countries have weighty fines and jail sentences. In the UK, tax evaders are publicly named and shamed, if caught. Sri Lanka’s proposed new tax code will increase the fine to Rs10 million and introduce a two-year jail term.

The new tax code comes at a good time, when the tax office has completed installing a revenue management system called RAMIS to detect tax cheats. This system links the IRD’s database with those of over 20 other government institutions including the land and motor vehicle registries, and Customs. If a professional fails to disclose his income and buys a vehicle in a relative’s name, the super database can make the match. Improved detection and tough penalties in the new law will make it a potent deterrent.

ho cares where it came from if it’s a good thing,” SR Attygalle, deputy secretary to the Ministry of Finance, says about importing Ghana’s income tax code. Attygalle is chairman of the steering committee implementing the proposed new tax code comprising senior officials from the ministry, the IRD and the Attorney General’s office. “People fear change, and many have enjoyed loopholes in the law for far too long, so they make up stories,” he says. People are getting over their initial apprehensions and appreciating the simplicity and direction of the new law.

Currently, there are nine sources of tax, and each is treated differently. The proposed new code classifies these into four areas: income from employment, business, investment and others, so no more mining forward and backwards between different sections to understand the implications of a particular transaction. “We may end up paying more taxes, but the new act is great for planning investments and strategy. There’s a certainty,” another accountant said. Taxpayers will have better control over their tax filing and reduce dependence on tax consultants. “Taxpayers could do a lot more
work on their own,” lawyer Naomal Goonewardena says. Companies are already excited about this prospect. “The language is simple, so you don’t need to have a command of taxation principles to understand it,” the financial controller of a listed firm said.

Businesses file different income statements related to various activities with their returns. This is done so tax officers can make sure expenses related to activities exempted from tax, or taxed at a lower rate, are not charged to normal activities, which could bring down the tax liability. For example, if export income is tax exempt, a company may be tempted to deduct export-related costs from its local trading business. The proposed new rules are so clear that companies won’t have to prepare multiple income statements, which will reduce compliance costs and fees paid to tax consultants.

The special interest lobby doesn’t appreciate the simplicity. The language is too simple to explain something as complex as taxation. Also, settled principles in taxation-related case law will be redundant, they argue. “We’ll all have to go to courts to establish a body of new precedents. This new law is going to be a disaster,” a tax consultant said. However, the use of simple language and principle-based drafting is expected to reduce the incidence of disputes and time wasted over them. For example the existing act allows companies to deduct costs related to repairs, but not expenses incurred on improvements. “We’ve wasted hours haggling over this with the IRD,” the financial controller said. In accounting, an improvement is treated as a cost that enhances the value of an asset, and is therefore not deductible. The proposed new act clearly makes this distinction. “Now, it’s not vague at all,” he said.

Despite these benefits, everyone feels daunted by the transition. Most people are genuinely concerned that implementation will be rushed, but it won’t be. Once the new income tax code is enacted in parliament, implementation will take place in phases over an 18-month period, according to the IMF.

The fund is preparing clear interpretation guidelines for officers and taxpayers, explaining how each of the provisions apply. According to the tax commission, there are no guidelines on how each provision of the existing tax code applies and interpretations differ from tax officer to tax officer, leading to ad-hoc rulings and uncertainty.

Each step of the transition into the new tax law has been plotted by the IMF in detail, with clear timelines and responsibilities assigned. The fund estimates the IRD will require $4.6 million over the next two years to spend on a smooth transition, which includes campaigns to familiarise IRD staff and taxpayers about the new law, and recruiting a permanent IT specialist to maintain the revenue management database, RAMIS, that detects tax cheats in the system.

The law is far from perfect and includes unfair taxes. For example, interest income from fixed deposits will be taxed twice, 10% withheld by the bank and 28% when the income is recorded in a company’s books. Dividends will be taxed at every stage it’s transferred. The proposed law also vests the IRD with draconian powers. Tax officers may no longer be required to give reasons for rejecting assessments, and the Finance Minister may increase income tax rates without parliament approval. These must be dealt with.

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wo years ago, Prime Minister Ranil Wickremesinghe, announcing the government’s medium-term policy, said income tax’s share of total taxes must be raised to 40%—this is widely regarded as a comfortable level for equitable growth. This means the income tax-to-GDP ratio must reach at least six per cent – assuming no taxes and rates are changed.

Their mastery of the tax code gives tax consultants advantage over underpaid, demoralised officers at the tax department

According to the IMF, the income tax-to-GDP ratio, which was at 2% in 2015, can double to 4% by 2020 with the new law’s passage. The remaining 2%, and much more, can come by roping in tax evaders with RAMIS.

The proposed bill is expected to broaden the tax base in two ways. First, sweeping exemptions and concessions have been removed. Export services, previously exempt, will be taxed at 14%. Tourism-related businesses will pay 28% on profits, previously taxed at 14%. It will also capture new sources of income by updating laws to reflect trends in global trade and finance.

Foreign lenders earning interest income here will be taxed for the first time. Cross-border lending has grown over the last few years and will increase as the economy develops. Also, fees paid to banks guaranteeing these loans and swap agreements to hedge currency losses will be treated as taxable interest income. This is because they reduce borrowing costs and amount to income in principle.

Second, a capital gains tax will be introduced with the new law, exempting listed stocks and primary households. Only when the new law is presented to parliament will it be known for certain what will be taxed at the proposed rate of 10%. This new tax is not expected to generate a lot of revenue. However, it’s establishing the principle of fairness, which is important.

The capital gains tax will not apply to institutional investors and fund management firms in the business of trading in shares. Their gains will be taxed at 28%, because stocks for such firms will be classified as business assets and subject to normal business profit taxes.

Currently, foreign funds can book profits in the stock exchange and repatriate the money without paying any taxes here. “This is crazy,” one tax consultant said. “Who will want to invest in Sri Lanka’s stock exchange after this?” he asked. However, Goonewardena points out that such taxes are common elsewhere.

Savvy tax consultants excel at playing the system and helping clients avoid taxes. Tax cheats including politicians brazenly evade taxes with immunity and sometimes get inside help from the IRD. The Rs3.5 billion VAT fraud involving a senior IRD staff in 2007 is ample proof of this, where businessmen were fraudulently paid VAT refunds. It’s regarded the largest VAT scam in the world. The new tax code, together with RAMIS, promises to end all this.

As income tax revenue increases, there’s no guarantee the government will allocate resources more efficiently or contain spending. But the opportunity is there. The poor won’t be over-burdened with consumption taxes. Firms will be forced to be more productive to absorb higher tax costs and deliver decent shareholder returns. Small firms can avoid the small business trap because they will be forced to scale their businesses when they can no longer hide under exemptions or low tax thresholds—this will create more jobs.

Reforms are difficult but necessary to propel Sri Lanka to the next stage of development and realise sustainable, equitable growth for everybody. The income tax code overhaul is an important step in that direction.