• Concerns, opportunities, compliance challenges

The Government recently announced the imposition of a flat 18% Value-Added Tax (VAT) on digital services provided by non-resident companies to local consumers, effective 1 October. 

This measure, introduced through the VAT (Amendment) Act No.4 of 2025, has sparked some controversy, with many expressing apprehension regarding its potential implications and cost escalations. 

As a VAT base broadening measure, stakeholders have highlighted both positive and concerning aspects, while also raising concerns about the implementation process and overall compliance.

Pros and cons for the industry

As a result of the decision, foreign service providers are required to register for VAT in Sri Lanka and collect tax on their services. Several services are listed as likely to become liable to VAT collections once enforcement is in effect. These include e-commerce services, cloud computing, Software as a Service (SaaS), cybersecurity services, digital marketing and advertising, and fintech, among many others.

Speaking to The Sunday Morning, industry expert and former Chairman of the Federation of Information Technology Industry Sri Lanka (FITIS) Indika De Zoysa elaborated on several implications of this decision for the industry.

De Zoysa highlighted that the decision equalised VAT obligations between local and offshore platforms, as offshore suppliers were not previously liable for VAT. However, he added that this cost may be passed on to consumers in Business-to-Consumer (B2C) transactions or at the Small and Medium-sized Enterprise (SME) level, depending on the platforms’ decisions. 

While acknowledging potential benefits for some local businesses, he also noted the existing lack of certain digital services within the country.

Addressing concerns over potential deterrence of platforms, De Zoysa said: “I don’t think any platforms will be driven away. However, with the 18% cost escalation, fluctuations in market conditions, demand, and supply could be expected, and market dynamics will decide how the business impacts will manifest. However, in the global environment, many countries have adopted similar policies, particularly the Digital Services Tax (DST).” 

De Zoysa further explained that there was currently no clear definition of the action plan regarding how taxation revenue would be utilised. However, he believes incentives should be provided as needed in order to ensure business activity in the country. 

Accordingly, he stressed that policy-level clarity was needed on the types of investments that would be made as a result of this decision, and how the introduction of this VAT on digital services would be neutralised to ensure no disturbance to business activities.

Industry concerns and user impact

Commenting on the matter, Digital Trust Alliance President Lakmal Embuldeniya noted that while the industry would be influenced, the impact would also notably affect customers. He also explained that concerns currently existed over technical complexities in tax collection, adding that the process and mechanism for tax collection and execution remained unclear.

VAT registration is required for any company with a value of supply exceeding Rs. 60 million per annum in the last 12 months or Rs. 15 million in the last three months, and many e-commerce platforms are above this threshold.

Hence, Embuldeniya pointed out that a primary impact would be on the user, who would face an 18% additional cost on top of existing expenses.

“The industry will also be burdened by additional costs as many resources are obtained online, from software to certain operational applications. This is because Sri Lanka lacks human resources with the skills required for certain services in areas such as digital trust and cybersecurity, making us dependent on these external service providers. 

“Even offshore consultancy services are included in the list, and in addition to e-commerce, a significant number of cybersecurity and ICT-related services are included. These will be a burden for any mid-size to small company in the country,” he pointed out.  

However, Embuldeniya also addressed the other perspective of this decision. The industry has advocated a fair VAT taxation policy to benefit local companies, as locally registered digital service providers were subjected to VAT while non-resident platforms were not. Therefore, he noted that this would be positive for local businesses competing with offshore ones.

“The extent of the impact on digital service providers or whether platforms would be discouraged depends on how business operations have been conducted in the country. However, platforms might not be driven away unless users find alternatives. But the advantages provided might be changed,” he noted. 

A digital VAT is not a Digital Services Tax

Meanwhile, speaking to The Sunday Morning, KPMG Sri Lanka Tax and Regulatory Division Principal Suresh R.I. Perera elaborated on the tax policy and its financial implications.

According to him, the primary economic focus of the digital VAT, effective from 1 October, is broadening the VAT base, resulting in additional VAT revenue to the country and levelling the playing field for local players. 

“This move is to introduce a digital VAT and not to introduce the controversial Digital Services Tax in Sri Lanka. While both are designed to tax the digital economy, they operate on fundamentally different principles and target different aspects of digital businesses,” Perera said.  

Accordingly, the digital VAT is a consumption tax (like traditional VAT) applied to a broad range of digital goods and services, typically paid by the consumer. It is an extension of the traditional VAT (or Goods and Services Tax – GST, in some countries) and a consumption-based tax.

It taxes the consumption of digital services, which means that VAT is typically added to the price of the service and collected from the consumer by the service provider, who then remits it to the tax authorities.

Moreover, Perera noted that the primary goal was to ensure that VAT was paid in the country where the digital service was consumed (the destination principle), regardless of where the provider was located. Accordingly, this aims to create a level playing field between domestic and foreign digital service providers and capture VAT revenue from the growing digital economy. 

Elaborating on the Digital Services Tax in order to clarify the distinction, Perera noted that the DST was a revenue-based tax on specific digital activities of large multinational companies, designed to capture tax from their operations in a particular market.

It is often seen as an ‘interim’ measure while international consensus is being sought on taxing the digital economy (like the Organisation for Economic Co-operation and Development’s [OECD] Pillar One and Pillar Two solutions). It is also a tax on the revenue generated from specific digital activities, rather than a tax on consumption. 

Moreover, companies are usually liable for DST if their global and/or in-country revenues from specific digital services exceed certain thresholds. DSTs typically have a narrower scope than digital VAT. 

“DSTs were introduced by countries that felt that traditional corporate income tax rules did not adequately capture the value created by digital companies in their markets, especially those with significant user bases but limited physical presence. 

“The aim is to ensure these large digital companies contribute a ‘fair share’ of tax in jurisdictions where they derive significant value. It primarily targets large multinational tech companies, often with specific revenue thresholds,” Perera added.

Compliance and execution concerns

Addressing challenges that could impact the effectiveness of this policy, Perera noted that one of the primary obstacles was the Inland Revenue Department’s (IRD) ability to ensure that all liable non-resident persons providing services via electronic platforms to Sri Lankan consumers actually registered for VAT. This is because, unlike traditional businesses with a physical presence, these digital service providers operate across borders, making enforcement difficult. 

He also added that the current system heavily relied on the voluntary aspect of registration by these liable persons, which could lead to significant revenue leakage if compliance was not widespread. Hence, he highlighted that without a strong mechanism to identify and compel registration, many digital transactions might remain untaxed.

According to Perera, another challenge lies in the ability to carry out effective audits on the records of liable persons where those records are maintained outside Sri Lanka.

“Tax authorities typically rely on direct access to financial records for accurate assessment and verification. However, with non-resident digital service providers, these records are often held in different jurisdictions, potentially under different accounting standards and legal frameworks. This geographical and legal disconnect makes it incredibly difficult for the IRD to conduct thorough audits, verify reported income, and identify potential under-declarations or evasions.”

Perera also explained limitations of the current approach. According to him, one significant limitation is the dependence on VAT payments being made directly by non-resident persons. He noted that while this simplified the process for consumers, it placed the burden of compliance and payment on entities outside the direct control of the Sri Lankan tax system.

Suggesting a more effective alternative, especially for Business-to-Business (B2B) transactions, he highlighted the introduction of a reverse charge mechanism. Under a reverse charge, the recipient of the service (the Sri Lankan business) is responsible for accounting for and paying the VAT, rather than the non-resident provider. 

He added that this mechanism was widely used internationally for cross-border services because it shifted the tax liability to a party within the local tax jurisdiction, where a high collection could be expected due to easier enforcement and existing tax frameworks for businesses. 

“Without such a mechanism for B2B transactions, the IRD misses out on a potentially large and more easily collectible source of VAT revenue. For B2C transactions, the method included in the gazette is the only option where the non-resident service provider would have to collect the VAT and remit to the Sri Lankan VAT office. 

“This dual method – i.e. B2B via reverse charge mechanism and B2C via direct collection and payment by non-resident – is prevalent in the Indian GST system,” Perera added.

Based on tax net fairness

Moreover, Frontier Research Head of Macroeconomic Advisory Chayu Damsinghe opined that the tax was less on a revenue basis and more on the basis of overall tax net fairness. Similar to other stakeholders, he also highlighted that enforcement and administration would likely be a challenge.

“While there may be individual cases where it can affect costs, I am not currently expecting a significant sector-wise impact. Broadly, I don’t think the macroeconomic impact of this measure will be significant, one way or the other. However, it can affect sentiment both positively, such as through shared burdens and no tax leaks, and negatively, through the perception of adversely impacting digital services.”