A new Income Tax code for Sri Lanka

By P. Guruge

The payment of income tax has been in operation in Sri Lanka since 1932, without interruption. The initial legislation was the Income Tax Ordinance (Chapter 188) No. 2 of 1932, which was approved on February 9, 1932.

The Income Tax Department (ITD) was in charge of the administration of income tax, which was the only tax imposed under the Ordinance. By 1953-54, there were about 70,000 people registered to pay income tax. In 1959, Nicholas Kaldor (a UK tax expert) made some proposals (a Comprehensive Reform of Direct Taxation in Ceylon Sessional paper, IV of 1960). As a result, Gift Tax and Wealth Tax were introduced in 1959-60.

First Inland Revenue Act. A new tax code was introduced on April 1, 1963, titled Inland Revenue Act, No. 4 of 1963, to consolidate the law relating to the imposition of Income Tax, Wealth Tax and Gifts Tax. There are 12 amendments to this Act. The Income Tax Ordinance became inoperative from April 1, 1963.

Even with all these changes and very progressive tax rates, revenue from income tax during this period did not exceed 22% (average) of total tax revenue.

Second Inland Revenue Act. The second Inland Revenue Act was introduced, on April 1, 1979 as the Inland Revenue Act, No. 28 of 1979. This Act contained 19 amendments, when it was replaced with a new Act.

Third Inland Revenue Act. The Third Inland Revenue Act was introduced on April 1, 2000 as the Inland Revenue Act No. 38 of 2000. There were only six amendments to this Act.

Fourth Inland Revenue Act. The current Inland Revenue Act was introduced on April 1, 2006 as the Inland Revenue Act, No. 10 of 2006. There were eight amendments up to now and one more is pending, on the ‘2016 - Budget Proposals’.

Why a new tax code

Under the Income Tax Ordinance, until the Kaldor proposals were introduced, the tax system was simple and it was properly administered, to collect revenue. But with the expansion of the number of taxes, administrative concentration was distracted from revenue collection. Income tax was used as a means of distribution of income and wealth among the poor and needy and as a tool to drive economic development needs.

As a result, over the years the primary purpose of collecting revenue was neglected and now we face the recurring problem of inadequate revenue from taxation, including income tax, along with more poor and needy people and limping economic development. The most important reason to create a new income tax code is to generate adequate income tax revenue. There were certain expectations pronounced by the relevant political authority, that we should collect 40% out of the tax revenue from income tax, which is 20% now. That means increasing income tax revenue by 100%.

Strategy

The Taxation Commission Report – 1990 (Sessional paper No. 01-1991) states that ‘all over the world income taxation is implemented as a progressive tax based on the ability to pay’. Any proposal to abolish such tax or reduce the importance of such tax should be considered as a regressive step. Any ad-hoc changes in tax laws will create an uncertainty and may lead to the loss of tax payer confidence.

(Unfortunately, we still have not seen the Report of the Taxation Commission appointed in 2009, although the Report was submitted to the authorities in October, 2010)

Progressive tax

In the new tax code, provisions may be included to set up a progressive income tax system for people which may not be changed in the medium term. However, the tax rates proposed in ‘Budget-2016’ (and not implemented), may not produce progressive income tax.

In any case currently, there is a progressive tax structure, with special lower rates and higher rates for specific activities and sources of income. It may be appropriate to combine these special rates with the main tax rate structure, to achieve the progressivity, simplicity and clarity.

Since the current rate structure begins from 4% and goes up to 8%, 12%, 16%, 20%, and 24% (maximum) it may be appropriate to consider the basic rate of 12% and the progressive rates of 18%, 24%, and 30% (maximum). It may also be necessary to consider appropriate tax slabs (revenue). The ‘slabs’ in the current rate structure discourage the earning of higher income, since an person may reach the highest rate of tax at a fairly low level of taxable income (above Rs. 3,000,000). The following may be an acceptable rate structure for individuals.

Taxable Income (Rs) Rate

On the first Rs. 1,000,000 12%

On the next Rs. 2,000,000 18%

On the next Rs. 4,000,000 24%

On the balance 30%

An additional surcharge of 25% on the gross income tax may be imposed on liquor, tobacco, casinos and any lottery, betting or other gaming activities. All withholding taxes may be fixed at the basic rate which is 12%. The partnerships may also be taxed at 12%. If any sector to be considered for a preferential rate such rate may be fixed at 18% (maximum).

Tax free allowance

The next question is the quantum of the tax free allowance applicable to resident people. Many countries use a per capita income multiple (maximum up to five times) as the tax free allowance. But certain countries do not follow such a measurement. It may be appropriate to consider an amount not exceeding Rs. 1,000,000 as the tax-free allowance. It may be necessary to abolish the current practice of allowing tax-free allowance to non-resident Sri Lanka citizens. The tax-free allowance should be limited to resident individuals and charitable institutions.

Taxation of companies

The taxable income of any company may be taxed at 30%, subject to the 25% surcharge on liquor, tobacco, casinos and any lottery, betting or other gaming activities. Since, many private companies appoint closely connected directors not providing any service and pay salaries below the taxable limit and avoid the payment of income tax, there should be a minimum tax payable by every company.

Calculation of taxable income

This is an area where a lot of simplification is needed. Even in the last Budget Speech (2016), there were certain proposals to this effect.

To be continued next week