Traditional Value-Added Tax (VAT) frameworks are unable to capture tax from cross-border digital services that are prevalent with the rapid growth of the digital economy. This has allowed large multinational technology companies to provide digital services to Sri Lankan consumers without paying VAT. 

This is while local providers domiciled in Sri Lanka are still subject to Sri Lankan tax codes, resulting in an uneven playing field. To address this, Sri Lanka introduced a digital VAT regime through the VAT (Amendment) Act No.4 of 2025 that specifically targets services provided by non-resident suppliers to Sri Lankan consumers. They must register, collect, and remit VAT if their supplies to Sri Lankan consumers exceed Rs. 60 million within the preceding 12 months. 

Is this a tax on the digital economy/digital tax? 

This is not a tax on the digital economy, nor is it a digital tax. 

A digital tax targets specific businesses that provide goods or services through digital means. It also generally targets the revenues of the digital service provider. 

A VAT is a consumption tax; it is borne by the consumer of goods and services, not the service provider. The service provider only acts as a collecting agent. 

For example, Company ‘A’ provides transportation services exceeding Rs. 60 million per year. Then Company ‘A’ adds 18% VAT onto its invoices. It registers, collects, and remits this 18% VAT to the Inland Revenue Department (IRD). 

A VAT is not industry specific. It is payable on a variety of goods and services, from imported milk powder to financial services. The recent amendment extended the coverage to digital services provided by non-resident suppliers, ensuring neutrality and fairness by broadening the tax base and levelling the playing field across industries and among local and foreign businesses. 

Is it fair to tax these digital services? 

Yes, subjecting foreign digital services to VAT is a fair practice. 

1. It broadens the tax base by including digital services in addition to other goods and services already subject to VAT. 
2. The VAT rate applied is the same rate that is applied for consumption of other goods and services; it is not a different rate so there is no discrimination. 
3. It levels the playing field across industries by making any good or service subject to VAT. It also levels the playing field among local and foreign providers of digital services. 

Previously all local digital service providers had to register and pay VAT if their revenues exceeded the threshold. Foreign digital service providers did not have to, creating an unfair advantage. From October, foreign digital service providers will also be subject to the same VAT rate as local digital service providers (e.g. PickMe vs. Uber). 

Adversely affected segments

There are some segments of the population, such as students, charity organisations, etc., who may be adversely affected by the increase in costs of digital services due to the imposition of VAT. The increase in costs may be too difficult to bear, negatively impacting outcomes that are good for society, like education. 

In such instances, it is possible to consider concessions for services provided to these affected groups (e.g. exemptions on student subscriptions or services used exclusively for educational purposes). 

Why VAT instead of DST? 

Governments prefer taxes like VAT over Digital Service Taxes (DST) because VAT is paid where the customers are located. This means multinational companies pay some taxes in the countries where their users are located and not just in the countries where the company is located, which is fairer. It also helps avoid the same profits being taxed twice – once where the company is based and again where its customers are. 

To keep things fair and simple, the Organisation for Economic Co-operation and Development (OECD) suggests that taxes should be low-cost and hard to avoid. Services should be taxed in the country where they are actually used. For sales to regular customers, tax should be paid where the buyer lives. For sales to businesses, it should be where the business is based. 

To treat everyone equally, both local and foreign digital companies should follow the same tax rules, with clear limits on who needs to register and when. 

SL not first to impose VAT

Sri Lanka is not the first country in the world to charge VAT on digital services. Over 120 countries have implemented similar VAT/Goods and Services Tax (GST) rules including the UK, the European Union, and India. 

Who must pay VAT? 

It is not only foreign digital service providers who must pay VAT. 

The recent gazette notification outlines the process for foreign digital service providers to register, collect, and remit VAT. There are multiple other goods and services, including local digital services, that have already been subject to pay VAT. The recent changes only extend VAT coverage to include foreign digital service providers. 

Entities liable to pay the tax

Any digital service provider who is located in a foreign country and provides a service through an electronic platform to Sri Lankan consumers and where the revenues from those services exceed Rs. 60 million within the last 12 months are liable to register, collect, and remit 18% VAT to the IRD. 

These services can be Business-to-Consumer (B2C) or Business-to-Business (B2B). It includes services such as, but not limited to, cloud storage, e-commerce, streaming services, and social media. 

Consumers to pay more 

It does mean that consumers will have to pay more for any foreign digital services that they obtain. It will be collected and remitted to the IRD. 

Administrative challenges 

According to current IRD rules, the Nonresident Digital Service Provider (NDSP) is responsible for registering, collecting, and remitting the VAT. As the service provider is not located in Sri Lanka, enforcement can be an administrative challenge. 

Countries like India and the Philippines adopt a ‘reverse charge mechanism’ for B2B transactions. Essentially, the local business purchasing the digital service (such as hotels in the case of using Booking.com) would be collecting the VAT and paying it on behalf of the NDSP. The advantage is that this shifts the burden of responsibility to an entity located and domiciled in Sri Lanka, under IRD jurisdiction, making it easier to ensure compliance. 

For NDSPs that provide only B2C services, the mechanism is more straightforward. NDSPs register and obtain a Taxpayer Identification Number (TIN), register for VAT, collect and pay, and file returns with the IRD. The 18% increase in prices will be borne by the local customer. 

Enforcement, especially for large, globalised platforms (such as Netflix or Spotify), which operate in many countries with varying tax systems, should not be difficult. However, monitoring the value of supply generated in Sri Lanka will require third-party data from the NDSP or other institutions, which might be challenging to obtain. 

However, compliance among smaller NDSPs will be a challenge. Even within Sri Lanka, smaller companies are less VAT-compliant than larger companies; in 2024, VAT compliance among large taxpayers was 89% while VAT compliance among other entities was only 55%. So this will be challenging to navigate. 

According to the IRD’s rules, non-compliance will lead to penalties and eventually service restrictions or blacklisting. However, there are no provisions for forcibly registering NDSPs, so registrations will have to be voluntary. 

Enforcing service restrictions for non-compliance will also be challenging as it is outside the jurisdiction of the IRD and will require legal and technical coordination with agencies like the Telecommunications Regulatory Commission of Sri Lanka. Moreover, with access to services like Virtual Private Networks (VPN), users can bypass these restrictions and still access these digital services, complicating the matter further. 

Facilitating compliance  

According to the rules laid out, NDSPs must register, collect, pay, and file VAT returns with the IRD. As NDSPs are likely to be in multiple different countries, it is essential that the IRD can effectively facilitate online registrations and return submissions. The IRD should support NDSPs to keep the cost of compliance low, towards encouraging voluntary compliance and revenue generation. 

As highlighted previously, the IRD must also provide clear guidance, clarity, and accurate information to NDSPs. The IRD must proactively address the challenges that will arise in the implementation of this digital VAT and provide clear interpretations to aid future compliance. 

(Arutha is a Colombo-based policy think tank focused on economic research and communication with a special interest in public debt and taxation)