Stakeholders have raised concerns over tax implications pertaining to the digital industry, especially for small-scale Information and Communication Technology (ICT) businesses and Small and Medium-sized Enterprises (SMEs) of the industry, calling for well-established mechanisms.
The Government announced a reduction in the annual turnover threshold for the registration of Value-Added Tax (VAT) and Social Security Contribution Levy (SSCL) from Rs. 60 million to Rs. 36 million. This proposal, which is to be implemented with effect from 1 April 2026, has been put forward with the view of broadening the tax base.
A Rs. 25,500 million budgetary allocation has been made to develop the digital economy in 2026, and Sri Lanka’s digital economy target for 2030 is to achieve a $ 15 billion contribution to the Gross Domestic Product (GDP). For this, supporting innovation is integral.
Concerns over mechanisms
Digital Trust Alliance (DTA) President Lakmal Embuldeniya elaborated on several tax-related concerns that could impact the industry, especially small-scale ICT businesses.
He noted that the decision to reduce the VAT registration threshold would burden small-scale ICT service providers, similar to small-scale organisations across various industries, thereby impacting cash flow and making operations difficult. This is particularly due to the taxes and charges that are already required to be paid, potentially affecting even telecommunication charges, and ultimately, the end customer.
Key Budget measures impacting the ICT SME sector, according to Embuldeniya, include the VAT registration threshold reduction from Rs. 60 million to Rs. 36 million, Simplified VAT (SVAT) abolition and a refund-based VAT regime, and an 18% VAT on non-resident digital services on cloud, Software as a Service (SaaS), ads, and streaming.
In addition to this, regarding SVAT abolition, he pointed out the necessity of finalising the establishment of a proper mechanism for refunds and providing a guarantee on refunds. He added that most organisations in the ICT industry, especially those above the Rs. 50 million threshold, were reliant on cash flow, and were already impacted by financial requirements such as payroll and credits extended to customers for certain periods. This, he noted, also resulted in thin margins.
The Government previously intended to introduce an 18% VAT on digital services provided by non-resident companies to local consumers, effective 1 October 2025. This has now been delayed until April 2026.
On the proposed digital services tax, Embuldeniya pointed out the lack of an established mechanism to charge this, highlighting that an explanation of how the process would unfold was necessary.
“As solutions, we are suggesting that the reduction of the VAT threshold should be done in a phased-out manner, increasing the rate in each phase until 18% is reached as a whole. Moreover, it is necessary to consider competition as well. For instance, businesses would try to avoid taxes by purposefully staying below the threshold, finding ways to circumvent it, with implications for competition in the market,” he added.
Embuldeniya highlighted that these measures could significantly impact the achievement of digital economy targets. When small-scale businesses and entrepreneurs are being taxed, he noted that there would also be the risk of increased talent migration.
According to him, the target should be to bring businesses currently within the Rs. 36 million threshold up to Rs. 60 million. He highlighted the need for strategies to facilitate and boost innovation and entrepreneurship.
Furthermore, Embuldeniya observed that the overall Budget allocation for 2026 for the ICT sector was not very different from the previous Budget, remaining largely similar when considering the allocations.
Policy recommendations from the DTA include a national fiscal strategy dialogue on a phased VAT threshold, since gradual inclusion builds SME confidence; a digital tax infrastructure; and a national framework for secure e-invoicing and data sharing. These also include refund transparency and SME trust grants to support the adoption of secure tax compliance technology, as well as the establishment of a joint policy council to embed the ICT industry in the national fiscal strategy dialogue.
Supporting innovation
Meanwhile, digital transformation expert Asela Waidyalankara explained that for most small tech companies, cloud services, Artificial Intelligence (AI) tools, and online advertising were not optional extras but the backbone of their business. Thus, he noted that adding VAT to these tools increased costs at a time when many SMEs were already stretched. This can slow down experimentation, delay product releases, and make it harder for young companies to scale.
“There is also a compliance issue. Extending VAT to foreign digital providers sounds simple, but in practice it requires very clear rules. Who collects the VAT? Who remits it? How do SMEs reclaim it? Without clarity, SMEs end up spending time on paperwork instead of building products.
“And of course, there is the competitiveness angle. If the cost of digital inputs goes up locally, Sri Lankan startups become less competitive compared to regional players who often enjoy tax incentives or more predictable tax regimes,” he added.
Addressing industry concerns, Waidyalankara highlighted that the ICT industry was not opposing taxes. The concern however, according to him, is how these policies are introduced and whether they support growth rather than slow it unintentionally. Accordingly, if Sri Lanka is aiming for a $ 15 billion digital economy, then tax policy has to work hand in hand with innovation policy.
Recommending several practical steps, he highlighted the need to provide clear guidance first, since SMEs needed certainty on who paid, who filed, and how refunds worked.
Secondly, he highlighted the need to offer transitional relief for SMEs, adding that this could be a temporary waiver, credit, or refund scheme for VAT on digital services. This is because it buys SMEs time to adjust without disrupting their operations.
Waidyalankara also pointed to the need to protect the competitiveness of digital exporters. Accordingly, digital services sold overseas should remain zero-rated with fast refunds and export-driven digital firms are where Sri Lanka can scale fastest.
He further opined that pairing the tax changes with pro-growth measures was also necessary. This includes incentives for cloud adoption, Research and Development (R&D) tax credits, easier foreign payments, and simplified compliance portals. According to him, the message should be: “Yes, contribute to taxes, but we will help you grow.”
“If implemented thoughtfully, these tax measures can coexist with a vibrant digital economy. But if we move forward without adequate safeguards for SMEs, we risk slowing innovation at a time when Sri Lanka needs to accelerate it. The goal shouldn’t just be to tax digital services; it should be to grow digital businesses,” he added.
Reliance on global providers
Meanwhile, BCS Sri Lanka Section Chair Vajeendra S. Kandegamage noted that Sri Lanka had not yet reached a stage where it could rely on local data centres to be competitive. Even though some services have been established, he noted that the country was still not receiving proper, dependable service from them, with some providers unable to even guarantee the basic 99.9% uptime.
“Recently, we saw a major Government-run cloud service go down for several days, which shows where we stand. But when we look at the global context, the situation is very different. Leading cloud providers operate multiple data centres around the world, which means minimum downtime and strong reliability. As SMEs, our clients, especially international clients, expect this level of uptime from us,” he explained.
Kandegamage noted that Sri Lanka was forced to depend on global cloud providers who offered competitive pricing and consistent service. Moreover, he noted the use of online tools and SaaS platforms for development work at very reasonable costs.
With the new taxes, however, he highlighted that even these costs would increase, resulting in the development cost rising. In order to maintain the profit margins, businesses will have no choice but to increase contract rates. However, he noted that this would become challenging when competing globally.
Kandegamage observed that since local SMEs could not stay competitive, companies would naturally start looking at other countries or move their services elsewhere, directly affecting the industry and slowing down innovation.
He added that all of this would impact the national target of reaching $ 5–15 billion in digital economy earnings. SME shutdowns, reduced competitiveness, and higher operating costs will mean fewer exports and slower growth.
“If SMEs can’t sustain themselves because they are forced to raise prices and lose clients in the global market, the entire digital economy will suffer and the long-term goals will become much harder to achieve,” he added.
Critical transformations
Meanwhile, industry expert and former Chairman of the Federation of Information Technology Industry Sri Lanka (FITIS) Indika De Zoysa noted that there would be several implications from an SME perspective, especially since most SMEs catered to the Business-to-Consumer (B2C) segment. He explained that with B2C, the price changes would be directly passed on to the customer, unlike in Business-to-Business (B2B) where there were avenues to reimburse costs.
Thus, he noted that price escalations, which would lead to demand concerns, would be challenging for SMEs.
Commenting on the digital services tax, De Zoysa observed that this would also lead to further cost escalations in the B2C segment. While this is a strategy used in many countries to protect local developers, he noted that these measures were implemented in ways that avoided double taxation. However, he pointed out that a cost escalation could not be avoided in this instance.
Regarding the implications on digital economy targets, while he noted that any tax increase would have a somewhat negative effect, ensuring that other requirements were met would help minimise this impact and allow the growth path to continue.
With a notable amount of funding allocated to the sector in the coming year, De Zoysa highlighted the need for proper execution of plans, especially investment in the education sector, digital infrastructure, and the deployment of 5G, all of which were critical transformations that needed to function smoothly.
Fixing the refund system
Commenting on the VAT threshold reduction and its general economic implications, tax expert and Verité Research Lead Economist Raj Prabu Rajakulendran noted that Sri Lanka’s VAT threshold used to be higher and required reduction. Accordingly, he opined that this was a welcome move, especially to expand the tax base.
He also addressed concerns associated with this. One is the increase in capacity/workload, which will strain the Inland Revenue Department, requiring significant resources to handle the task.
He then pointed out the issue pertaining to SMEs. “If they have not been paying, there is a need to pay their fair share of taxes. The problem comes with refunds, since the VAT is charged on the value addition. If there is an input credit, it should be credited off and a VAT refund should be provided.
“While the SVAT could be used earlier, with its abolition, certain concerns have been raised regarding the refund system, such as those about the duration and liquidity issues. This is a valid concern and liquidity issues need to be resolved by ensuring faster refunds,” he added.
Rajakulendran stressed that the solution was not changing the reduced VAT threshold, but rather involved fixing the related issues simultaneously, such as the refund system.