When freeloading life insurers decided to pay taxes

For years, Sri Lanka’s life insurance industry exploited loopholes in the tax code to avoid taxes on profits. Then, realisation dawned that it was no longer in their best interest

A group of insurance c-suites were shaken by what they were seeing. A piece of legislation still in the draft stage was proposing a new method to tax profits of life insurance businesses. The execs were now looking at projections prepared by the Insurance Association of Sri Lanka, the industry body, showing how their life insurance businesses would be impacted. The effective tax rate of the proposed new code screamed out to them: 80-100% of profits!

Who could they turn to? The SLFP-UNP government just voted in to power in August 2015 was desperate for revenue.Top bureaucrats at the Finance Ministry were under pressure  to deliver. And tax collectors at the Inland Revenue Department (IRD) didn’t seem to like them much anyway because most life insurance companies did not pay tax despite making profits.

The members of the association were angered by the seemingly unfair rules in the proposed new Inland Revenue Act. They desperately engaged members of the legislature and technocrats of the bureaucracy, but progress was slow. They even appealed to the Supreme Court. However, the strategy they ultimately adopted ensured a win-win for the industry and Inland Revenue.

“We decided the best strategy was to get the industry aligned with one common objective and accept the fact that the government needs revenue. We had to understand this first and foremost, so we could play the game to win strategically,” said Dirk Pereira, former president of the Insurance Association and chief executive of Union Assurance.

Pereira acknowledged a problem with just 3 out of 15 life insurance companies paying taxes. “We had an industry lobbying together taking the stand that we would like to pay more taxes although the existing law then allowed us to pay little or no income taxes,” he said.

According to the existing Inland Revenue Act No. 10 of 2006, life insurance companies’ taxable profits were arrived at by the I-E principle: deducting management expenses from investment income from the life fund, which is where premiums belonging to policyholders are kept. Management expenses were defined as those attributable to the business.

Life insurance companies were showing taxable losses by setting off all related expenses of the business from profits reported in the books. Under the old code, insurance companies took liberties to allow a range of expenses to minimise their income tax liability. In one instance, it was found that nearly 20 different expense items ranging from interest expenses, brokerage fees, staff welfare, rent, utilities, printing, stationery and maintenance costs were being deducted from profits reported in a life insurance company’s books to arrive at lower taxable profits.

TAXATION is the price for civilization. The reason why is easily explained: An effective tax regime is based on trust – trust that taxpayers will contribute a fair share without gaming the system and those in authority will use the money wisely on public infrastructure, law and order, and welfare. Sri Lanka’s struggle since independence to push ahead with institutional reforms, open up its economy and improve welfare is clearly manifested in how people pay taxes. In 2015, tax collections as a percentage of GDP declined to 12% – lower than levels seen in most of Sub-Saharan Africa – from over 20% in the 1970s. More worrying is that income tax contributions are too low at the equivalent of two percent of GDP, below some peers in the middle-income group: Georgia and Mongolia have 9%, Bhutan 7.7% and Samoa 5.6%. Even troubled Egypt has 6%.

There are three reasons for this. First, income tax evasion is widespread for an economy in Sri Lanka’s state of development. Second, the tax code has too many loopholes, making it easy to avoid taxes without committing a criminal offence (you hire a tax consultant for this). Third, Sri Lanka’s revenue department is not an autonomous agency. The overarching reason: lack of trust. When Sri Lanka proposed to overhaul its tax code in 2015, the move was met with defiance from both sides – tax collectors and taxpayers – mostly because they feared change, having mastered a flawed system to perfection.

FOR THE YEAR TO END-DECEMBER 2017, listed Union Assurance reported a profit of Rs3.3 billion. But, in the notes to its financial statements, the insurer said it did not pay income taxes because it did not make taxable profits but losses. Another listed company, Softlogic Life reported a Rs1.5 billion profit after adding back Rs420 million in deferred taxes based on prior tax losses. Ceylinco Insurance pays income tax on its life insurance business, but the IRD has issued tax assessments for 2010-14 disputing the company’s assessments.

The department was irked by this behaviour.

“The income tax was low compared to the numbers generated as profits. The Inland Revenue felt the industry could have paid more, and we felt it was appropriate too,” Pereira says.

However, because the tax code was ambiguous, the department took liberties on giving its own interpretation leading to several disputes clogging the Tax Appeals Commission.

The IRD tried to plug this gap when the SLFP-UNP government presented its first budget in 2015 by defining management expenses, and this was included in the new Inland Revenue Act draft. According to the proposed definition, these were salaries and other expenses assigned to the unit managing the investment portfolio and capital allowances in respect of depreciable assets exclusively owned and used by the unit. It left out a big ticket expense: acquisition costs like to insurance agents and advertising costs.

“We did our calculations and realised that profits will be taxed at 80-100% if this became law,” Pereira says. “We could have taken the stand that we will fight this for the private sector, but that would have been a mistake.”

TAXATION HAS been a tough problem ever since civilization began. History is replete with examples where either excessive taxation or dismal collections have ruined prosperous cities or left them in the gutter. Ineffective tax regimes were certainly not a direct cause of ruin, but an important manifestation of the trust deficit among fellow citizens, trading partners and foreign peoples.

At the height of their glory, the Muslim caliphates perpetuated pro-market economies. Other religions were tolerated, with Buddhist monks from the Far East and Christians in the West teaching in their universities. Marketplaces were inspected regularly to ensure quality of goods.

The efficiency and complexity of their public water and sanitation systems impress even today. Roads and trading routes were kept safe. People lived in prosperity and peace. Justice was known to be administered fairly without favour. Holding all this together was effective taxation. Taxation is effective when rates are fair and people are willing to pay income tax rather than consumption tax, which tends to hurt the poor the most.

“Taxation is the price we pay for civilization, for our social, civil and political institutions, for the security of life and property, and without which, we must resort to the law of force”, wrote a committee appointed by the Governor of Vermont, USA, in a report to the legislature in 1852, echoing the ancient wisdom valid even today, where in rich countries income tax collections to GDP are high: Denmark has 29%, New Zealand 18%, Belgium 16% and Sweden 15%. In Sri Lanka, less than 20% of total tax revenue is generated from income tax; the rest comes from consumption tax that hurts poor people the most. The government intends to increase the income tax share to 40%, widely believed to be a fairer and more desirable level.

The new Inland Revenue Act is expected to plug loopholes. But, expanding the tax net will mostly be possible with the Revenue Administration Management Information System (RAMIS) linking the Inland Revenue with 23 other agencies. RAMIS is expected to tilt the income tax evasion game in the IRD’s favour.

RAMIS will monitor the movement of individual tax files. In the past, poor oversight meant files could move from person to person, allowing taxpayers to game the system with inside help. Tax officials will no longer need to manually reference data from other agencies to catch tax dodgers. The system is programmed to make the connections and flag potential tax evaders. However, expecting results overnight will be too optimistic. “It could take us 10 years before we see a more tax-compliant nation,” an assistant commissioner working closely with the RAMIS project said.

PEREIRA UNDERSTANDS Inland Revenue’s gripe. “They kept complaining that the private sector had complicated things to such an extent to avoid paying taxes. The private sector needs to strategically take a step back and simplify businesses so that they can generate profits and pay a fair tax. I believe the insurance industry set the right example,” he said.

Three years later, after several frustrating rounds of negotiations – with some members even losing heart along the way – the association got what it wanted, reaching an agreement with the Inland Revenue and the Treasury outside Supreme Court.

“We suggested a mechanism to plug the existing loophole so that every life insurance company will pay the 28% tax on profits, just like any normal business would, and we got the Inland Revenue to agree,” Pereira said.

It’s not clear how much revenue this will generate, but it could be substantial. For instance, Union Assurance would have had to pay 28% on its Rs3 billion profit for 2017 had the new code been effective then, rather than reporting tax losses by deducting various expenses and not paying taxes at all like it did that year. The new tax code (Inland Revenue Act No. 24 of 2017) is here to stay with effect from 1st April 2018. While many in the private sector and Inland Revenue have their reservations and doubts, Pereira says the new tax code is simpler as a result of the hard bargaining.

“To an extent, we got the simplicity and certainty we wanted. We can generate profits to distribute to shareholders and retain to grow the business, and the government will get more revenue. It’s a win-win, because we decided to begin by saying we want to pay more taxes,” Pereira said.

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