Business Tomorrow recently invited Pasan Malinda Katipearachchi, one of Sri Lanka’s pioneering international tax experts with extensive experience in IT industry employee taxation and corporate tax planning, to discuss the newly introduced 15% Service Export Tax and its implications on the IT sector.

Understanding the Service Export Tax

The newly implemented 15% Service Export Tax has stirred significant concern among IT companies operating in Sri Lanka. The industry, which has historically benefited from tax incentives to promote global competitiveness, now faces an additional tax burden. This move raises questions about corporate tax impacts, talent retention, and overall industry sustainability.

Impact on Corporate Tax in the IT Industry

BT: How does Sri Lanka's corporate tax rate for IT firms compare to other key markets like India, UAE, and Singapore?

PMK: When comparing Sri Lanka’s 15% Service Export Tax to other jurisdictions, we see stark differences:

• India: India provides a corporate tax rate of 15% for new IT companies under its special tax regime, while general corporate tax rates stand at 22% (without incentives). Additionally, various state-level incentives and deductions help IT firms remain competitive.

• UAE: The UAE has historically been a zero-tax jurisdiction, but with the introduction of 9% corporate tax in 2023, IT firms still enjoy significant tax advantages over Sri Lanka. Additionally, free zones continue to offer tax-exempt structures for tech firms.

• Singapore: Singapore maintains a 17% corporate tax rate, but IT and tech startups can benefit from partial tax exemptions and extensive grants to encourage R&D and innovation.

Sri Lanka’s shift from zero-tax to 15% for IT services creates a disadvantage in attracting foreign investors compared to these countries, where long-term stability and incentives continue to support IT sector growth.

Impact on Corporate Tax in the IT Industry

Business Tomorrow (BT): Pasan, as an expert in international tax management, how do you see the 15% Service Export Tax impacting the corporate tax obligations of IT firms?

Pasan Malinda Katipearachchi (PMK): The introduction of this tax is a fundamental shift from the previous zero-tax policy for IT and IT-enabled services (ITES) exports. IT firms in Sri Lanka primarily earn in foreign currency, contributing significantly to the country’s foreign exchange reserves. This sudden shift increases the overall effective tax rate for these businesses, leading to several consequences:

1. Reduction in Profit Margins: Many IT firms operate on competitive pricing models in the international market. The added 15% tax will squeeze profit margins, forcing companies to either absorb the cost or pass it on to clients.

2. Impact on Foreign Direct Investment (FDI): The IT sector has been a key driver of foreign investment, with global tech firms outsourcing operations to Sri Lanka due to its skilled workforce and tax incentives. A higher tax rate could deter new investments and push existing companies to consider relocating to tax-friendlier jurisdictions.

3. Competitive Disadvantage in the Global Market: Sri Lanka competes with other IT outsourcing hubs like India, Bangladesh, and the Philippines, where governments provide tax reliefs and incentives. This additional tax makes Sri Lankan IT services more expensive, potentially driving clients to other cost-effective markets.

4. Cash Flow and Business Expansion Challenges: The additional tax reduces free cash flow, limiting reinvestment opportunities in R&D, innovation, and talent acquisition. Many firms might scale down hiring or halt expansion plans, affecting overall industry growth.

Concerns Over Employee Taxation and Retention

BT: Apart from corporate taxation, how will this impact employees in the IT industry?

PMK: The IT industry heavily relies on highly skilled professionals, and retaining talent is already a challenge due to brain drain. If companies pass on the tax burden through cost-cutting measures such as lower salary increments, reduced bonuses, or fewer benefits, it could accelerate the migration of top talent to other countries. Moreover, the taxation uncertainty could discourage freelancers and startups, further impacting the sector’s growth.

BT: If brain drain accelerates, what will be the impact on foreign reserves?

PMK: The outflow of skilled professionals leads to a decline in foreign remittances as fewer IT professionals remain in the country to generate export revenue. This reduces the inflow of foreign currency, worsening Sri Lanka’s balance of payments. Additionally, losing top talent weakens the country’s ability to attract high-value contracts, ultimately leading to slower economic growth in the IT sector.

Impact on Transfer Pricing Perspective

BT: From a transfer pricing perspective, how does the 15% Service Export Tax impact multinational IT firms operating in Sri Lanka?

PMK: Transfer pricing is a crucial aspect for multinational IT companies, as they engage in inter-company transactions across different jurisdictions. The new tax creates several implications:

1. Increased Compliance Requirements: Companies will need to ensure their transfer pricing policies are aligned with the new tax structure. This may involve reassessing inter-company pricing models to comply with Sri Lankan tax regulations while maintaining competitiveness.

2. Risk of Double Taxation: With Sri Lanka imposing a 15% tax, companies with operations in low-tax jurisdictions like UAE or Singapore may face double taxation risks, depending on tax treaties and relief mechanisms.

3. Shift in Operational Models: Firms may reconsider service delivery models, possibly relocating shared service centers or restructuring operations to optimize tax efficiency.

4. Impact on Cost Structures: The added tax burden may necessitate pricing adjustments in intra-group service transactions, impacting overall business profitability.

Potential Solutions and Industry Response

BT: What measures can IT firms take to mitigate the impact of this tax?

PMK: IT firms should explore multiple strategies, including:

1. Structuring Operations More Efficiently: Companies could consider optimizing their corporate structures and invoicing strategies to minimize taxable income under the new rules.

2. Lobbying for Policy Revisions: IT industry leaders and professional bodies should actively engage with policymakers to advocate for tax incentives or a tiered taxation model that protects small and medium-sized firms.

3. Exploring Alternative Markets: Expanding into regional tax-friendly jurisdictions or setting up subsidiaries in global IT hubs can help mitigate the additional tax burden.

4. Investment in High-Value Services: Instead of competing solely on cost, companies should shift towards high-margin services such as AI development, blockchain, and cybersecurity, where price elasticity is lower.

Cons for the Country as a Whole

BT: What are the broader negative implications of the 15% Service Export Tax on Sri Lanka as a whole?

PMK: Beyond the IT sector, this tax policy could have serious consequences for the overall economy:

1. Decline in Foreign Exchange Reserves: As IT companies struggle with higher taxation, their ability to attract and retain foreign clients diminishes, leading to a reduction in foreign exchange inflows.

2. Slower Economic Growth: The IT sector has been a significant contributor to GDP growth. With reduced competitiveness, the sector's expansion may stagnate, affecting overall economic performance.

3. Capital Flight and Business Relocation: Companies may consider shifting operations to tax-friendlier countries, leading to job losses and a shrinking tax base for the government.

4. Reduced Investor Confidence: Policy instability discourages foreign direct investment (FDI), making Sri Lanka less attractive compared to regional competitors like India, UAE, and Singapore.

5. Impact on Other Export-Oriented Sectors: The tax sets a precedent that could be extended to other industries, raising concerns for businesses in BPO, software development, and consulting services.

Final Thoughts

BT: Given the challenges and potential solutions, what is your overall assessment of the Service Export Tax’s impact on the IT industry?

PMK: While the government aims to increase tax revenue, this policy risks undermining one of Sri Lanka’s fastest-growing sectors. If not carefully managed, it could lead to capital flight, talent loss, and stagnation in IT sector growth. A balanced approach—where tax policies support economic expansion rather than hinder it—is crucial for maintaining Sri Lanka’s position as a global IT outsourcing hub.

Conclusion

The 15% Service Export Tax presents significant challenges for Sri Lanka’s IT sector, impacting corporate profitability, international competitiveness, and talent retention. As discussions with policymakers continue, it remains to be seen how the industry adapts and whether adjustments will be made to ensure sustainable growth.

This discussion was conducted by Business Tomorrow (Pvt) Ltd with Pasan Malinda Katipearachchi, a recognized expert in international tax solutions for the IT industry.