The Government introduced a bill on 21 February proposing amendments to the Inland Revenue Act No.24 of 2017, incorporating tax proposals announced by President Anura Kumara Dissanayake in Parliament.
A key amendment outlined in the bill, one proposed by the International Monetary Fund (IMF) as well, was the removal of tax exemptions on foreign service income and foreign source income, which sparked significant controversy both within and outside of Parliament.
The Sunday Morning Business spoke with several economists, industry experts, and tax experts regarding the economic implications of the tax as well as the rationale behind it.
Evolution of tax exemptions
According to the proposal, starting 1 April, foreign service and foreign source income exemptions will be replaced with a 15% tax rate for both companies and individuals.
Companies will be taxed at 15% on profits from services rendered in or outside Sri Lanka for use outside the country, where payment is received in foreign currency and remitted through a Sri Lankan bank, as well as on profits from foreign sources earned and remitted similarly. Individuals will also be taxed at a maximum of 15% on these same categories of income.
Speaking to The Sunday Morning Business, KPMG Sri Lanka Tax and Regulatory Division Principal Suresh R.I. Perera addressed concerns about capital flight and the notion that higher taxes alone would drive service providers to relocate to tax-friendly jurisdictions, stating that this was unlikely.
“It also depends on the country’s tax framework. I personally do not believe that tax per se results in a brain drain or people moving out of the country. People often move in search of better environments or opportunities, and tax is unlikely to be the sole contributor,” he said.
Reflecting on the evolution of tax exemptions on foreign currency earnings in Sri Lanka, Perera explained that initially, professionals who had worked abroad and brought their earnings back to the country had enjoyed tax exemptions.
Over time, this benefit expanded to include sectors such as construction contractors, and eventually, it extended to all services rendered to persons outside Sri Lanka, whether performed within or outside the country.
Perera noted that when the Inland Revenue Act was introduced in 2018, most of the previous exemptions for income tax under Section 13 of the old act had been removed for a brief period. He highlighted that the same exemptions were reintroduced later, but with a condition that the services rendered had to be utilised outside Sri Lanka.
Disparity between merchandise and service export taxes
In 2024, the total merchandise exports amounted to $ 12,772 million, while services amounted to $ 3,714 million.
In this context, Perera remarked that the disparity between goods and services exporter taxes was questioned by many, as exporters of goods always paid taxes. He pointed out that while merchandise exporters had previously paid a 14% tax rate, the new changes had increased their rate to 30%.
This rise in tax rates was highlighted when Sri Lanka was grappling with a financial crisis, which was also reflected in the IMF report recommending the elimination of the exemption for service exporters.
Nonetheless, Perera noted that the IMF report did not specify a particular tax percentage but only recommended eliminating exemptions, adding that the expectation of many was that it would be at the rate of 30% as well. However, with negotiations, the rate has been brought down to 15% for service exports, whether performed inside or outside the country.
“This decision therefore stems from the crisis, where the need to pay a fair share of taxation was raised, especially given that merchandise exporters paid 30% while service exporters were exempted. Some might still raise questions as to whether there is parity between merchandise exports and service exports given the difference in rates,” he noted.
He also stated that there was a view that a majority of the export proceeds were being retained outside the country. In practice, he pointed out that if merchandise exporters refrained from bringing in the money, this could be traced as they passed through Customs, but tracing service exports was relatively more challenging.
Perera highlighted the need for an effective system in order to monitor tax proceedings as the influx of money into Sri Lanka was crucial. Commenting on tax evasion, he acknowledged the challenges and emphasised the need for an effective system to ensure that foreign earnings were remitted to the country.
He further explained that foreign currency earnings were crucial for Sri Lanka, especially as the country sought to recover from its financial crisis.
“We need to increase the flow of foreign currency into the Sri Lankan economy. The situation where exporters who bring in dollars stand to benefit when it comes to taxation when compared to rupee earners can be considered justifiable due to this reason. It is important to incentivise and encourage them by using tax as a tool,” he said.
However, Perera highlighted that the key issue was the disparity between merchandise exporters and service exporters. “You cannot justify treating exporters of merchandise, who also bring in foreign currency, and exporters of services in two different ways. That is where the problem lies,” he added.
Government perspective
Meanwhile, responding in Parliament to requests from the Opposition regarding the withdrawal of service exporter taxes, Deputy Minister of Economic Development Prof. Anil Jayantha Fernando explained that the 15% tax on digital service exports followed careful consideration of the sector and had been applied fairly.
He detailed the tax structure, stating that individuals exporting digital services received a special advantage. The first Rs. 150,000 is exempt from taxes, while the next Rs. 83,000 is taxed at 6% and the remaining amount at 15%.
To receive this benefit, individuals must prove their income derived from service exports when filing tax returns, hence the bank submission requirement. Prof. Fernando highlighted that while tax evasion under this system was a separate concern, the tax itself was not unfair.
Meanwhile, speaking to The Sunday Morning Business, Deputy Minister of Finance and Planning Harshana Suriyapperuma addressed concerns regarding the 15% tax, noting that this measure was a reduction from a previously agreed 30% tax.
“It is a misconception that the Government has imposed taxes on freelancers, which is completely incorrect and a misrepresentation. If you follow the media and read the news, the previous Government had agreed to impose a 30% tax. In fact, the incumbent Government has reduced that tax by 50%, bringing it down to 15%,” he said.
The Deputy Minister also pointed out that the 15% tax rate on export services, including IT, was significantly lower than the maximum 36% tax on regular employment income. He explained that this reduction was part of the Government’s strategy to provide relief to the public while preparing the economy for growth.
Marginal impact expected
According to the tax, individuals are taxed starting from 6% and companies are taxed at a flat rate of 15%. On the other hand, individuals earning rupees are taxed progressively at rates of 6%, 18%, 24%, 30%, and 36%.
Commenting on the tax rates, economist and Frontier Research Head of Macroeconomic Advisory Chayu Damsinghe told The Sunday Morning Business that while there had been discourse regarding how the tax for service exporters was high, this was not very accurate for two reasons.
One of these reasons is that it is not a tax on revenue but on profits. For firms, it is a tax on profits after deducting cost, while even for individual freelancers, it is counted as business income and cost can be deducted.
Additionally, Damsinghe highlighted that apart from certain specific instances, the majority of countries had not implemented a 0% tax regime. Therefore, he noted that questions could be raised as to whether the number was truly high, given that it still remained at a concessionary rate.
“On the other hand, in terms of how it impacts revenue, as far as I understand, both the Government and the IMF are not expecting this to account for a significant portion of revenue, but it is instead meant for maintaining the tax system. Therefore, in this context, I do not think that it would have a substantial impact on competition of service exporters or revenue,” Damsinghe said.
However, despite the impact not being materially significant, he noted that this principle introduced both negative and positive aspects, the positive being a fairer and more equitable system, while the negative constituted the symbolic impact of the notion that the Government was not providing tax exemptions to service exporters.
Commenting on the emerging discourse surrounding capital flight, he pointed out that fears of such consequences may be overestimated, as this argument could be made regarding any taxable sector, highlighting the economic crisis which came about the last time tax holidays were at the forefront of policy.
“There will certainly always be individuals and firms that might move to different jurisdictions in hopes of better opportunities, which is not malicious as they are rational business decisions. However, the tax regime is usually not the sole factor that affects a business and Sri Lanka offers several benefits to these industries, especially digital services, as the higher end of labour in the country is more cost-effective,” he explained.
He noted that any company with tax as the primary decision maker was already able to move to other jurisdictions, adding that this particular tax would not necessarily make a significant impact on such a decision, considering the other benefits that could be enjoyed in Sri Lanka.
“This is not to say that there are no impacts; however, the impacts are not significant to the point that the dynamics in the industry would be completely changed. The changes will be marginal,” he said.
Addressing tax evasion concerns, Damsinghe explained that certain steps were being taken in response to the problems of tax compliance across the board, with the Inland Revenue Department (IRD) introducing several compliance and tax administration benchmarks such as technology installations at the department and improvements in online tax payment systems.
He therefore noted that data indicated improvements with regard to tax administration and more steps were expected to be taken to ensure the continuation and improvement of tax compliance.
Govt. revenue vs. foreign exchange earnings
Meanwhile, University of Peradeniya (UOP) Professor in Economics Ananda Jayawickreme stated that this move was unfavourable to many service exporters, particularly individual freelancers. A large number of freelancers are currently active, encompassing youth, seasoned academics, and ICT startups, covering a wide range of activities.
“These are individual earnings and labour income. The impact on the economy could be severe if experts migrate, discouraging such services. This could also lead to reduced competitiveness in the market, with freelance services being procured from other countries,” he said.
Furthermore, he questioned whether the Government’s priority was revenue generation or foreign exchange earnings. He added that the Government could explore various other revenue generation methods, particularly by addressing inefficiencies in the tax system, correcting systemic issues, and addressing tax evasion, while reducing expenditure.
“The Budget does not appear to accommodate expenditure management mechanisms, placing a central focus on revenue. At present, the primary requirement is foreign exchange earnings and the Government should focus on that market. If taxation is necessary, lower initial tax rates subject to gradual increases are more viable,” Prof. Jayawickreme explained.
He further noted that starting with a tax rate of 15% could lead to significant complications. According to him, taxation at multiple points, heavy taxation, and tax on taxes could be burdensome and intolerable for many, especially in a developing economy in need of significant investment and where personal incomes remain limited.
Prof. Jayawickreme also expressed the need to retain experts within the country, incentivising foreign exchange generation. “Resistance to IMF proposals from the Government remains limited. Foreign exchange earnings are substantial. While a considerable amount of tax revenue can be collected from a 15% rate, increased focus should be given to foreign exchange earnings,” he shared.
Commenting on tax compliance, he revealed that in Sri Lanka, higher tax rates created incentives for tax avoidance. Therefore, the Government needs to be cautious about imposing taxes and it should not be the automatic solution for all revenue concerns.
Impact on ICT industry
Arguments against taxing exporter services frequently refer to the potential impact on the ICT industry. According to Export Development Board (EDB) data, up to December 2024, ICT/Business Process Management (BPM) services were valued at $ 1,454.46 million, representing a growth of 29.81% from 2023.
Commenting on this proposal, Federation of Information Technology Industry Sri Lanka (FITIS) Chairman Indika De Zoysa stated that while taxation was justified, as all should pay their fair share, it was important to explore what benefits taxpayers would receive.
He remarked that ICT service exporters had benefited from a tax-free period for a considerable time and the exemption had been removed due to the country’s fiscal situation, along with the 15% tax cap.
“However, it is important to recognise that the majority of services export technology companies and even individual freelancers are highly movable and have options to open accounts in other countries. Therefore, as an industry association, we have discussed these concerns with the Ministry of Digital Economy,” he said.
De Zoysa added that the ICT industry was resilient, having endured multiple past crises. In that context, the industry is examining the benefits corporations and individuals can receive as a result of taxation.
“We are assessing how taxation can impact aspects such as obtaining loans and purchasing vehicles, and what concessions and benefits would be available to these taxable segments, both directly and indirectly. Discussions are focused on how value can be added to those within the tax net. This will likely prevent capital flight and relocation,” he said.
Managing taxes and thin margins
The Sunday Morning Business also spoke with several freelancers earning foreign currency, who expressed their concerns over the withdrawal of the exemption.
A freelancer, who wished to remain anonymous, noted that the 15% tax on foreign income was a significant blow: “Many of us turned to freelancing not just as a career choice but as a necessity, especially during tough economic times. We contribute valuable foreign exchange to the economy and this tax reduces our already limited margins. Unlike traditional employees, freelancers do not have job security, fixed incomes, or benefits such as health insurance and retirement funds.
“Our earnings are not always consistent and a 15% tax on top of the other costs we bear makes freelancing less viable. Additionally, this tax could discourage the growth of the digital economy in Sri Lanka, where many talented professionals are working with international clients. Instead of encouraging us to bring in foreign income, this tax feels more like a penalty for looking beyond local opportunities.”
Another freelancer added: “Freelancers like me often operate with thin margins. Many of us have to cover our own health insurance, retirement savings, and business expenses, unlike traditional employees. A 15% tax on foreign income does not only cut into profits, it can also make the difference between a sustainable freelance career and struggling to make ends meet.
“Furthermore, this tax might discourage new freelancers from entering the market, stifling innovation and growth in a sector where Sri Lanka has a lot of untapped potential. Instead of taxing us further, the Government could explore ways to support freelancers, such as reducing costs associated with receiving international payments or offering incentives for skill development and business growth.”