Uncertainty roils Sri Lanka bond markets after tax reversals

Withholding tax will have to be deducted from listed corporate bonds which are in existence, a tax official said, raising concerns over the risk of doing business in Sri Lanka, selective implementation of the law, with the possibility of some bonds being taxed twice.

The taxation changes of bonds including government debt, under a new income tax law also raised the question of indirect expropriation, according to some analysts, though uncertainty prevails.

“The 5 percent withholding tax rate is applicable at the time of payment of interest,” Thanuja Perera, consultant to Sri Lanka’s Finance Ministry told a forum organized by the Ceylon Chamber of Commerce refereeing to corporate debt.

“So payments made after this date – after April 01, 2018 – will be subject to the 5 percent withholding tax.”

Under a new income tax law interest on private corporate debt will be taxable, with a final 5 percent tax being deducted from individuals and standard taxation for companies with the withholding tax being an advance payment.

Sri Lanka made interest on bonds issued from January 2013 tax free in a blatantly interventionist move to ‘promote corporate bonds’ which was used by large investors as a tax shelter.

Selective Implementation?

A boost to the investment climate was made by the state going through tax holidays already granted under the Board of Investment concession as befits a free country.

Tax holidays themselves, where different persons engaged in the same activity is treated differently, may amount to an undermining of just rule of law, liberty advocates say.

However in reversing the tax free status of bonds already issued, Sri Lanka is going against the policy of allowing tax holidays already granted by the Board of Investment to run its course, raising questions over selective implementation of the law.

The income tax law, to which many changes were made to the original draft, in the so-called ‘committee stage’ is not available in final form yet.

There is a lot of uncertainty in corporate and gilt markets, where participants are seeking clarity.

For example in a more damaging fallout, there is the risk that some corporate bonds, issued before 2013, where withholding tax has been already paid, being taxed twice.

Sri Lanka’s Hatton National Bank issued 10 year bonds in September 2011, expiring in 2021.

At the time the prospectus informed shareholders that withholding taxes have been paid.

“In terms of Section 135 of the Inland Revenue Act No 10 of 2006 as amended by Inland Revenue (Amendment) Act No 22 of 2011 the Issuer of any corporate debt security is required to remit withholding tax at the rate that may prevail at the relevant time on the entirety of the interest which may accrue on such corporate debt to the Inland Revenue Department at the time of the issue of such corporate debt security,” the prospectus said.

“Pursuant to such a deduction and remittance being made there would be no further withholding of any tax by the Issuer on any interest being paid on such corporate debt security.”

Prospective investors were informed that there is interest rate risk (the bonds were fixed rate), re-investment risk (of coupons), default risk and liquidity risk.

The possibility of the government deducting a withholding tax at a later date was not listed as a risk.

Own Goals?

There are not many tax paid bonds in existence now as most have expired. There are more tax free bonds, but they are also expiring progressively.

Some liberty advocates and those who want to reduce investment risks of the country, and create a safer and more predictable business environment, are puzzled why bureaucrats and politicians are pushing up risks of investing in Sri Lanka by retrospective taxes, or practices which could amount to indirect expropriation in ‘own goal’ types of actions.

In 2015 Sri Lanka imposed retrospective corporate taxes to get 60 billion rupees, undermining the investment environment of the country, at a time when the country was already struggling for foreign direct investment. There were also so-called ‘revenge taxes’.

In 2011 there was an expropriation law.

It is not clear how much cash the state will get by reversing the tax status of existing corporate bonds. Whether the tax gains justify the damage done to the investment framework is not known.

Prepaid taxes

In government bonds, the income tax law has said there will be no withholding tax from April 2018. However withholding tax at 10 percent has already been paid on all bonds issued and held in portfolios of domestic and foreign investors.

Government bonds rates are now quoted net of tax. The practice of paying withholding tax ‘upfront’ was done for ease of secondary market trading, which is peculiar practice.

Officials say even in existing bonds, where taxes have already been paid there will ‘no withholding tax’ in the future. Since taxes have already been paid at 10 percent in existing bonds, the question may be academic.

Meanwhile no mention has been made on returning taxes already paid by bond holders, for the balance tenors of the bonds to make good the claim that there will be ‘no witholding tax’ in the future for bonds already issued.

Investors in government bonds ‘grossed up’ their income by 10 percent to claim the taxes already paid, when filing returns. With no credit for withholding taxes already paid, and no prospect of a return of such taxes, there is a risk that they may lose the income they had after paying a 28 percent income tax.

“We are still trying to make sense of the effect of the laws. One effect would be that in future, a higher interest rate would be demanded,” a gilt dealer said.

“However markets overall viewed the Inland Revenue Act positively. Rates came down after the law was passed.”

Theres is a risk that the biggest hit would fall on pension funds of old people, such as the Employees Provident Fund, which own most of the bonds.

Uncertainty

Taxation of pension funds has already been raised from 10 percent to 14 percent. In the past due to the 10 percent tax credit, pension funds hardly paid any taxes.

If there is no credit for taxes already paid, there is a risk that the tax would be effectively 24 percent, on the existing portfolio.

The denial of the tax credit for bonds in issue – where future taxes on the remaining duration of the bond is charged to the past – or the non-return of taxes, may amount to an extraordinary case of retrospective taxes or a novel method of expropriation unknown to other jurisdictions, liberty advocates say.

Under a new law, foreign investors in bonds may also have to pay capital gains tax and income tax. They also will not be able to claim credit for taxes already paid. It is not yet clear whether they will have to open tax files here.

The new income taxes come into effect in April 2018, giving ample time for foreign investors to decide whether to stay in the country or not. With budgets improving Sri Lanka’s interest rate are also easing, which means bond prices are rising able to absorb some shocks.

In the past Sri Lanka imposed many taxes on midnight or January 01 after a budget, without parliamentary sanction.

Imposing taxes after passing them in parliament with a future effective date is a major improvement in business climate and treatment of unarmed citizens by an armed state with coercive power, analysts say.

While governments are entitled to change taxes, people can make long term decisions only when the rules of the game do not change suddenly.

State Minister of Finance Eran Wickramaratne had said that the new income tax law will bring predictability to the tax framework in the future as few changes are envisaged.

Though many transitional provisions had been provided, in the case of corporate and government, there is still uncertainty. (Colombo/Sept12/2017 – Update II)