US embassy cable - 04COLOMBO1858

UNCLAS SECTION 01 OF 04 COLOMBO 001858 
 
SIPDIS 
 
SENSITIVE 
 
MANILA FOR USADB; DEPT PLEASE PASS TO MCC:SGROFF 
 
E.O 12958: N/A 
TAGS: ECON, EFIN, ETRD, CE, ECONOMICS 
SUBJECT: NEW TAX SQUEEZE PRIOR TO UNVEILING SRI 
LANKAN BUDGET 
 
1.  (SBU) Summary: The Government of Sri Lanka has 
introduced a series of politically motivated taxes 
just prior to its presentation of the 2005 budget. 
Most of the taxes attempt to satisfy the Marxist 
elements in the current government, who want to be 
seen as protectors of the national heritage, rural 
farmers and local businessmen.  The Finance Ministry 
says the measures are needed to protect the fast- 
depleting foreign reserves and protect industries 
from dumping.  Some of the taxes have come into 
effect with retroactive charges to 2002.  These 
taxes are indicative of the cash flow problem faced 
by the GSL.  The timing of the tax announcement, 
just prior to the new budget, may be an attempt to 
make the new budget appear less of a burden and more 
generous.    End Summary. 
 
2.  (U) Below is a list of recent tax measures 
followed by detailed information on each tax: 
 
-- 100% tax on sale of land and property to foreign 
nationals (including companies with over 25 percent 
foreign equity) 
-- Repeal of 2002-tax amnesty 
-- Hike in duty on motor vehicle imports 
-- New duty on non-essential imports 
-- A tax on Government securities transaction with 
retroactive effect to 2002 
-- Economic Service Charge on turnover of companies 
 
Tax on property 
--------------- 
 
3.  (SBU) The first tax to be introduced by this 
Government was a 100 percent transfer tax on 
property sales to foreign nationals and companies. 
This tax was mooted by the Janatha Vimukthi Peramuna 
(JVP), a key element of the current ruling 
coalition, following extensive press coverage of 
property purchases by foreigners, after the 
abolition of a 100 percent transfer tax in 2002. 
 
4.  (U) In particular, significant negative 
publicity was focused on real estate purchases 
inside the historic Dutch fort in Galle, and along 
the southern coastal belt, both JVP strongholds. 
Foreign land ownership was a hot issue in the April 
2004 election campaign, with the UPFA promising to 
stop foreign land purchases if elected.  The new 
law, however, goes beyond the previous property tax 
as it also covers local companies with more than 25 
percent foreign equity.  It also requires a 
government assessment of land value for land sold to 
foreigners.  For these reasons it has been heavily 
criticized by the business community. 
 
5.  (SBU) According to a partner at a leading law 
firm, his firm is recommending against land 
purchases by foreign clients as a result of the tax 
and uncertainties surrounding implementation of the 
value assessment requirement.  A Finance Ministry 
official told EconFSN that the Ministry is seeking 
to amend that requirement and also to give power to 
the Finance Minister to exempt companies from the 
tax on a case-by-case basis. Contacts at the Colombo 
Stock Exchange indicate they have not heard many 
complaints from listed companies with over 25% 
foreign holding, but that most firms could 
circumvent the tax by creating a new, wholly-Sri 
Lankan-owned corporation for property holdings. 
 
Repeal of Tax Amnesty 
--------------------- 
 
6.  (U) The Government has also moved to repeal 
(parts of) a controversial tax amnesty granted by 
the previous government.  The amnesty was declared 
in 2003, allowing people to declare undisclosed 
assets and income, and also obtain waivers from a 
range of unpaid taxes.  The purpose of the amnesty, 
according to the previous Finance Minister, was to 
widen the tax net.  The amnesty attracted 58,000 
applications, all of which would be added to the tax 
rolls. 
 
7.  (SBU) The President and the new government 
criticized the amnesty, saying that it paved the way 
for corrupt supporters of the previous Government 
and tax dodgers to escape from their tax 
liabilities.  In addition, the Government has said 
that tax collections have decreased due to the 
amnesty.  The main criticism has been the coverage 
of indirect taxes (Goods and Services Tax (GST - a 
precursor to the Value Added Tax implemented in 
2002), excise tax, import and export duties) 
enabling large-scale tax evasion. 
 
8.  (U) According to the new legislation, taxpayers 
will still be able to qualify for amnesty on income 
tax, but not on other indirect taxes.  Finance 
Ministry officials argue that these indirect taxes 
have already been recovered by businesses from 
consumers (such as GST on consumer products) and 
should be rightly paid back to the Government.  The 
business community, especially the powerful Ceylon 
Chamber of Commerce, has expressed reservations on 
the repeal of the tax amnesty, saying it has 
compromised the credibility of the government in the 
investor community. 
 
Duty on motor vehicle imports 
----------------------------- 
 
9.  (U) The government has also begun to increase 
taxes on imported items.  The first in line were 
motor vehicles.  The excise duty on gasoline-powered 
cars was increased from 25 percent to 30-60 percent, 
based on engine capacity.  Smaller vehicles will be 
assessed a lower duty and bigger vehicles at a 
higher duty (at the lower duty range -- cars under 
1000 cc -- the market consists mostly of the Indian 
made "Maruti" and the locally produced "Micron"). 
 
10.  (U) Excise duty on diesel cars have been 
increased from 60 percent to 115 percent.  The 
excise duty on gasoline powered vans has been 
increased from about 15 percent to 30% and diesel 
powered from about 48 percent to 84 percent. 
 
11.  (U) In addition to increased duty, importers of 
motor vehicles are now required to pay up front when 
opening letters of credit.  The Central Bank said 
these steps should help to reduce vehicle imports, 
curb high credit growth to the private sector, 
reduce the burden on the fuel bill and reduce road 
congestion.  The increased duty on motor vehicles 
has come under sharp criticism by vehicle importers, 
who say they are unable to pay higher prices for 
imports already made.  At least one importer has 
obtained an order restraining the government from 
implementing the new tax. 
 
Import duty on non-essentials 
----------------------------- 
 
12.  (U) The Government has also introduced a tariff 
on a range of "non-essential" imports including 
fruits, vegetables, processed and unprocessed food, 
shoes, bags, rubber and plastic products, textile 
products (other than fabric), consumer items such as 
toiletries and perfumes, ceramic ware, glass ware, 
pens and electrical goods.  The tax is three tiered: 
10, 15 and 20 percent, with most of the items also 
carrying a specific (piece rate) duty.  The higher 
of the two rates will be charged.  Some of the 
specific duties would amount to a 100 percent tax as 
in the case of ballpoint pens, which are charged a 
duty of 10 rupees (about 9 US cents) per item.  The 
tariff, ostensibly imposed for Sri Lanka's Export 
Development Board, will be in addition to normal 
import duty and the 10 percent duty surcharge 
currently in effect.  The tax will send Sri Lanka's 
import duty structure sharply upwards. 
 
13.  (SBU) The Finance Ministry in a press release 
said that this measure intends to "discourage the 
importation of nonessentials in view of the foreign 
exchange crises faced by the government due to the 
escalation of world oil prices".  However, the real 
reason appears to be a politically motivated move to 
protect the local industry as indicated previously 
in the July 2004 Economic Policy Framework (EPF), 
which declared that SME's must be offered protection 
from being displaced by unfair import competition. 
The Finance Ministry Statement also said that the 
government has been informed of severe competition 
faced by the farmers and local industries due to 
dumping.  Further, the statement indicated that the 
Customs Department finds it difficult to ascertain 
the true value of imports.  Although the release 
said the income would be used for export 
development, it is most likely that proceeds will go 
to the treasury. 
 
14. (SBU) The Department of Commerce has not yet 
carried out a study of the impact of these measures 
on Sri Lanka's WTO obligations.  Since Sri Lanka's 
bound duty on agriculture is around 50 percent (for 
import tariff) and 10 percent (for other charges), 
and most non-agricultural products (except for 
textiles) are not bound, they hope these measures 
will not cause serious problems for Sri Lanka at the 
WTO. 
 
Taxes with retroactive effect 
----------------------------- 
 
15.  (U) Two other taxes have been introduced with 
retroactive effect.  They include taxation of 
trading profits and interest income of secondary 
market transaction of securities, treasury bills and 
other government bonds with retroactive effect, from 
April 2002.  Financial institutions have complained 
about this move, especially as profits attributable 
to the past years have been already paid to 
shareholders. 
 
Economic Service Charge (ESC) 
----------------------------- 
 
16.  (U) The Government has also taken steps to 
implement a 1 percent ESC proposed by the last 
government.  ESC can be set off against income tax 
payable during the year.  While the ESC was proposed 
on either a turnover or asset basis, the current 
government has implemented the tax on the basis of 
turnover. 
 
Comment 
------- 
 
17.  (SBU) The current state of the GSL's fiscal 
situation is troubled.  Retroactive taxes appear 
indicative of how low cash reserves have fallen. 
Oil prices, a general lack of business confidence 
and a surge in intermediate goods imports have put 
pressure on the rupee, and the Central Bank has 
intervened heavily to smooth its depreciation 
(approximately 7 percent since January 1).  While 
few expect these taxes to be major revenue earners, 
the Government hopes that they will help slow the 
outflow of foreign reserves. 
 
18.  (SBU) By imposing these measures through 
gazette notification, rather than the budget 
process, however, some believe the GSL is setting 
itself up to unveil a budget that is filled with 
benefits (higher public sector salaries, possibly 
increased agricultural subsidies), but that does not 
impose serious revenue or belt-tightening 
initiatives.  These taxes are also indicative, 
though, of the current GSL's general leanings toward 
import-substitution and protectionist policies, as 
promised in its Economic Policy Framework. End 
comment.