Key Takeaways
- Sri Lanka’s Board of Investment is working to resolve issues caused by VAT on locally produced inputs, which hinders backward integration in industries like apparel.
- The removal of the SVAT system has created cash flow challenges and increased interest costs for exporters who can no longer benefit from VAT exemptions on local supplies.
- Competitor nations like Vietnam and Taiwan offer VAT exemptions or zero-rating for sales into export zones, providing a more favorable environment for exporters.
- Industry leaders warn that without adjustments, crucial backward integration investments may be halted, impacting competitiveness and potentially leading to offshore migration of businesses.
- The Sri Lankan government has submitted budget proposals and engaged with the Inland Revenue Department to address this anomaly, seeking potential leeway for deemed exporters.
Addressing VAT Impact on Local Production
Sri Lanka’s Board of Investment (BOI) is actively working to mitigate the adverse effects of Value Added Tax (VAT) being applied to locally produced inputs. This policy is reportedly discouraging essential backward integration within the country’s manufacturing sectors, particularly the prominent apparel industry.
Recent complaints from the Sri Lankan apparel sector highlight the repercussions of removing the Supplementary VAT (SVAT) system. This system previously allowed local producers to supply goods to exporters in a manner that was effectively VAT-exempt. Its discontinuation has led to significant cash flow needs and increased interest expenses for exporters, straining their operational finances.
International Comparison and Competitive Landscape
Industry observers point to international practices in countries like Vietnam and Taiwan, where sales to firms within free trade zones are zero-rated for VAT, mirroring the treatment of final exports. Under a zero-rating regime, no VAT is levied, and crucially, suppliers retain their entitlement to input tax credits, maintaining their financial flexibility.
In contrast to the challenges faced in Sri Lanka, imported inputs are generally VAT-free in Sri Lanka, aligning with practices in other East Asian competitor nations. However, the application of VAT on domestic inputs creates a competitive disadvantage.
Impact on Backward Integration and Industry Viability
The apparel industry in Sri Lanka has issued a stark warning: they may be compelled to halt their efforts in backward integration if current policies persist. This move is seen as a necessary step to remain competitive on the global stage.
Chairman Arjuna Herath of the BOI noted the substantial investments already made by the apparel industry in backward integration. He cited the example of a textile production zone established in Eravur as a testament to this commitment.
Government and BOI Initiatives
“We have actually submitted a budget proposal this time for the budget to avoid this anomaly,” Herath stated, indicating proactive steps being taken by the BOI.
Discussions have also been held with the Inland Revenue Department. “We have taken up with the Inland Revenue Department as well. They have recognized that, within the provisions, whether they may have some leeway to look at this within the zone for deemed exporters on a deemed exporters basis to do this.”
“So, we are actively engaged on this.”
Historical Context and Global VAT Practices
The concept of zero-rating for sales into export-oriented zones, including services, is not new. Countries like Vietnam and Taiwan, which pioneered free trade zones in the 1960s, have long implemented such measures to support their export sectors.
Taiwan’s economic journey offers a parallel narrative. In the 1950s, much like Sri Lanka, Taiwan faced monetary challenges attributed to central bank policies. High import taxes protected domestic industries but crippled export manufacturing due to the cost of inputs. Initially, tax rebates were offered, but the establishment of a free trade zone near Kaohsiung port proved instrumental in helping exporters circumvent protectionist barriers. At that time, VAT was a nascent concept, primarily confined to Europe.
Modern VAT systems originated in France, experimentally introduced in Ivory Coast in 1954 and adopted domestically in 1958. The system later spread throughout the European Economic Community, with the UK implementing it in 1972.
💡 There appears to be a limited understanding of VAT in the United States, where former President Trump notably criticized it as an unfair export subsidy.
Broader Economic Repercussions
The removal of the SVAT system has also impacted local buying offices, according to comments from Sri Lankan exporters. Beyond halting backward integration and reducing purchases from domestic suppliers, these offices might consider relocating abroad to escape the financial strain caused by the SVAT policy change, industry analysts suggest.
While some export sectors might absorb the financial shock, those with thinner profit margins, such as the apparel industry, are expected to suffer more acutely.
Producers in Sri Lanka’s tea sector have also voiced concerns, anticipating increased interest costs due to reduced selling prices. This stems from the cash flow burden exporters face when paying VAT upfront, even with potentially shortened refund periods.
Following the removal of SVAT, tea prices reportedly saw a decrease of approximately 100 rupees per kilogram. Hopes remain that prices may partially recover once VAT refunds are processed.
Unlike in sectors dealing with industrial goods, where exporters can readily switch to importing inputs and cease local procurement, tea plantations and smallholder farmers will likely retain domestic buyers. However, the tea prices may be adjusted downwards to offset the cash flow costs borne by exporters.
Sri Lanka has a history of increasing taxes in response to balance of payments crises, often triggered by central bank actions critics describe as monetary accommodation or easy monetary policy—terms often associated with inflationary interest rate cuts or money printing.
Currency crises have also historically led to hikes in income tax. This, in turn, has historically necessitated the introduction of lower tax regimes to attract foreign investors and support export-oriented businesses.
📊 Sri Lanka’s current corporate tax rate stands at 30 percent, considerably higher than the 20 percent rate common in East Asian countries and Scandinavian nations that maintain greater monetary stability.
Expert Summary
The Sri Lankan BOI is addressing the negative impact of VAT on locally produced inputs, which stifles backward integration, particularly in the apparel sector. The removal of the SVAT system has created cash flow issues for exporters, contrasting with favorable zero-rating policies in competing nations like Vietnam and Taiwan.
Industry leaders warn of potential halts in backward integration and even relocation of businesses if the issue is not resolved, prompting government action through budget proposals and engagement with tax authorities.