As the Organization for Economic Co-operation (OECD) engages countries worldwide in a global effort to address tax base erosion and profit shifting (BEPS), KPMG in Sri Lanka analyzes the Sri Lankan tax statutes introduced over the years to prevent BEPS and other tax avoidance. We also highlight instances where the lack of certain provisions may expose the country to potential base erosion.
Sri Lanka’s tax law imposes a general anti-avoidance rule1 (GAAR). The GAAR may be applied where the tax office believes a transaction that reduces (or would have the effect of reducing) the amount of tax payable by any person is artificial or fictitious or that any disposition has not in fact been executed. In such cases, the GAAR empowers the tax office to disregard the transaction or disposition2 and tax the parties involved accordingly.
In 2006, Sri Lanka introduced thin capitalization rules denying deductions for subsidiary companies for the cost (i.e., interest) of intercompany loans that exceed prescribed gearing limits (also known as debt-to-equity ratios). This prohibition was extended to holding companies as of the effective year of assessment 2007/2008.
Key features of these rules are as follows:
Sri Lanka’s transfer pricing rules, introduced in 2006, enforce the arm’s length principle in related party transactions. Transfer pricing is quite new to Sri Lanka, and practical enforcement is not yet implemented. Further, the country’s revenue authorities have not indicated their position on the OECD’S BEPS initiative.
Sir Lanka’s transfer pricing rules apply to transactions between the taxpayer and an ‘associated undertaking’, that is, where there is a degree of direct or indirect control between the parties. The transfer pricing provisions apply to all transactions regardless of value. However, thresholds have been set out for application of the documentation rules, as explained below.
Recently, a new transfer pricing regulation was issued to address ambiguities in the previous regulation and indicate how the revenue authority plans to administratively enforce the transfer pricing rules. The guideline provides that where the aggregate value of international transactions with an associated undertaking is less than 100 million Sri Lankan rupees (LKR) or where the aggregate value of other transactions with an associated undertaking is less than LKR 50 million, the documentation rules do not apply.
The revised regulation also requires directors to certify that transactions concluded with related parties are at arm’s length and should form part of the annual accounts.
Sri Lankan tax law requires payers to withhold tax on any payment made to any person outside Sri Lanka in respect of:
In order to remit certain payments via a bank, a tax clearance certificate from Internal Revenue Department is required.
The limitation on benefits (LOB) concept is not explicitly set out in the income tax law but is found in some of Sri Lanka’s tax treaties. LOB articles set out a beneficial ownership percentage designed to minimize abuse of treaty provisions and/or treaty shopping.
For example, the tax treaty between Sri Lanka and the United States contains a specific LOB article (Article 23), as does the new treaty between Sri Lanka and India (Article 28). In other treaties, the concept is embedded in articles covering interest, dividends and royalties.
At present, Sri Lankan tax statutes do not specifically address e-commerce tax issues, and the tax office has not issued any administrative rulings in this area. As a result, the supply of goods and services via digital means are not subject to tax in Sri Lanka.
The concept of permanent establishment (PE) is alien to Sri Lanka’s domestic tax law, and so the application of PE concepts is restricted to situations covered by tax treaties.
1Section 103 of the Inland Revenue Act.
2‘Disposition’ includes any trust, grant, covenant, agreement or arrangement.
3Sale of manufactured products > 50 percent of turnover in year of assessment.