By Srivante Gunawardena
As 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 1 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 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.
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 three times of the equity for manufacturing entities and four 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 capitalisation 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 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.
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.
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.
(The next Part of this article will focus on the special provisions in the new Act and how these could be tweaked.)
(The writer is Chief Consultant at SG Business Management Consultancy; [email protected] or www.sgbmc.com.lk.)