At a Glance
- Sri Lanka’s Board of Investment (BOI) is addressing the negative impact of Value Added Tax (VAT) on locally produced inputs, which is hindering backward integration in key industries like apparel.
- The removal of the Secondary VAT (SVAT) system has created cash flow challenges and increased interest costs for exporters, as they can no longer sell to exporters under a VAT-exempt arrangement.
- Competitor nations like Vietnam and Taiwan effectively zero-rate sales into export firms, allowing for VAT exemption and input credit for suppliers, a practice Sri Lanka aims to emulate.
- The apparel industry warns that this VAT anomaly could force a halt to backward integration efforts and potentially lead to the relocation of buying offices abroad, impacting local sourcing.
- The Sri Lankan government is actively seeking budget proposals and engaging with the Inland Revenue Department to find a solution for deemed exporters and mitigate these negative impacts.
BOI Tackles VAT Impact on Export Sector
Sri Lanka’s Board of Investment (BOI) is actively working to resolve the adverse effects of Value Added Tax (VAT) on domestically produced inputs. This tax application is significantly discouraging backward integration efforts within Sri Lanka’s export industries.
The apparel sector has voiced significant concerns, highlighting how the removal of the Secondary VAT (SVAT) system has disrupted their operations. Previously, SVAT allowed local producers to supply goods to exporters with a VAT-exempt status. Its absence now imposes considerable cash flow burdens and necessitates higher interest expenses for these exporters.
International Comparisons: VAT Practices
In comparable export-oriented economies, such as Vietnam and Taiwan, domestic sales to firms within free trade zones are treated as zero-rated, mirroring the treatment of final exports. This practice, akin to Sri Lanka’s treatment of final exports, means no VAT is charged, and crucially, suppliers are eligible for input tax credits.
💡 Unlike the situation with locally sourced inputs, imported inputs in Sri Lanka, much like in other competitive East Asian nations, remain VAT-free. This creates a disparity that penalizes local suppliers.
Threat to Backward Integration
Industry leaders in the apparel sector have issued a stark warning: without a resolution to this VAT anomaly, they may be compelled to abandon their strategies of backward integration. This move is seen as essential for maintaining global competitiveness.
The apparel industry has made substantial investments in developing local supply chains through backward integration. An example is the dedicated zone established in Eravur, specifically designed for textile production, demonstrating a commitment to deepening local capabilities.
Government Engagement and Proposed Solutions
“We have actually submitted a budget proposal this time for the budget to avoid this anomaly,” stated Chairman Arjuna Herath, underscoring the proactive steps being taken. The BOI has also engaged directly 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, Herath added, signaling a concerted effort to find a practical solution.
Historical Context of Free Trade Zones and VAT
The concept of zero-rating domestic sales into export zones is not new. Nations like Vietnam and Taiwan, with Taiwan pioneering free trade zones in the early 1960s, have long utilized this approach, extending zero-rating not only to final exports but also to services provided within these zones.
Interestingly, Taiwan faced its own economic challenges in the 1950s, stemming from monetary instability and protectionist import taxes that hampered export manufacturing. Initially, tax rebates were used to combat protectionism.
The establishment of a free trade zone near Kaohsiung port was a strategic move to help exporters circumvent these protectionist barriers. At that time, VAT was largely absent outside of Europe, so it did not present an immediate issue for emerging European export powerhouses.
Modern VAT systems originated in France, with initial trials in Ivory Coast in 1954 before its adoption in France in 1958. VAT later spread throughout the European Economic Community, with the UK adopting it in 1972.
💡 There appears to be a limited understanding of VAT mechanisms in some regions, such as the US, where former President Trump criticized it as an unfair export subsidy.
Broader Economic Implications
Exporters in Sri Lanka have reported that the reversal of the SVAT system has also negatively affected local buying offices. This includes halting purchases from suppliers located outside of designated zones.
Analysts suggest that, similar to the potential halt in backward integration and local sourcing, buying offices might also face pressure to relocate overseas due to the removal of SVAT. This could diminish local linkages and opportunities.
While some export sectors might absorb the financial impact, industries operating on thinner profit margins, such as apparel, are likely to experience more severe consequences from the current VAT regime.
Impact on Tea Producers
Sri Lanka’s tea producers have also indicated that they will incur additional interest costs due to reduced selling prices. This stems from the cash flow burden exporters face when paying VAT upfront, even with reduced refund periods.
Following the removal of SVAT, tea prices reportedly decreased by approximately 100 rupees per kilogram. While there is an expectation of some price recovery once VAT refunds are processed, the immediate impact has been significant.
📍 Unlike manufacturers of industrial goods, who can easily switch to importing inputs and cease local purchases, tea plantations and smallholders remain tied to the local market. However, prices may adjust downwards to account for the increased cash flow costs borne by exporters.
Economic Cycles and Tax Policies
Sri Lanka has a history of increasing taxes in response to balance of payments crises. These crises are often triggered by central bank actions, such as engaging in ‘monetary accommodation’ or implementing ‘easy monetary policy’—terms critics often associate with inflationary interest rate cuts or money printing.
Currency crises have also led to escalations in income tax. This, in turn, has often created a need for lower tax regimes to attract foreign investors and support export-oriented businesses.
📊 Sri Lanka’s current corporate tax rate stands at 30 percent, which is considerably higher than the 20 percent often seen in East Asian and Scandinavian countries that maintain greater monetary stability.
Expert Summary
The Sri Lankan BOI is actively addressing critical VAT issues impacting the export sector’s backward integration capabilities. The removal of SVAT has created financial strain for exporters, particularly in the apparel and tea industries.
With international benchmarks favoring zero-rating for domestic sales into export zones, Sri Lanka is exploring solutions to revise its VAT policy to support local production and maintain export competitiveness.