Key Takeaways
- 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 export industries.
- The removal of the SVAT system has created unexpected cashflow demands and increased interest costs for exporters, particularly in the apparel sector.
- Competing nations like Vietnam and Taiwan employ zero-rated sales for inputs into export firms, a system that Sri Lankan exporters are advocating for.
- Budget proposals and discussions with the Inland Revenue Department are underway to resolve this anomaly, with potential for leeway for deemed exporters.
- The issue affects not only apparel but also other sectors like tea producers, who face cashflow challenges and potential price reductions.
BOI Addresses VAT Impact on Local Inputs
Sri Lanka’s Board of Investment (BOI) is actively working to mitigate the adverse effects of Value Added Tax (VAT) applied to locally manufactured inputs. This tax policy is recognized as a significant disincentive for businesses pursuing backward integration within the country’s export industries.
The apparel sector, a key contributor to Sri Lanka’s exports, has voiced strong concerns. The discontinuation of the Supplementary VAT (SVAT) system, which previously allowed local producers to supply exporters in a VAT-exempt manner, has led to increased working capital requirements and interest expenses for these businesses.
International Parallels in VAT Regimes
Countries such as Vietnam and Taiwan have implemented a more favourable VAT structure for exporters. In these nations, sales directed to export firms, including those within free trade zones, are treated as zero-rated, mirroring the treatment of final export sales.
💡 Under a zero-rated VAT system, no VAT is charged on the transaction, and importantly, suppliers remain eligible to claim input tax credits, thereby preventing a cascade of tax liabilities.
In contrast, while imported inputs in Sri Lanka are VAT-exempt, aligning with practices in other East Asian competitors, the tax on local inputs presents a unique challenge.
Impact on Backward Integration and Competitiveness
The apparel industry has warned that without a resolution, they may be compelled to halt investments in backward integration. Such a move could critically undermine their ability to compete effectively on the global stage.
Recognizing the importance of local value addition, the apparel sector has already made substantial investments in backward integration. As an example, Mr. Herath noted the establishment of a zone in Eravur dedicated to textile production.
“We have actually submitted a budget proposal this time for the budget to avoid this anomaly,” stated Chairman Arjuna Herath. This proactive measure underscores the urgency of the situation.
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 confirmed, indicating ongoing efforts to find a practical solution.
Historical Context of Free Trade Zones and VAT
The concept of zero-rating sales into free trade zones, encompassing not just final exports but also intermediate goods and services, is a practice seen in countries like Vietnam and Taiwan. Taiwan, a pioneer in developing free trade zones since the early 1960s, utilized these zones to foster export growth.
💡 Taiwan’s journey, similar to Sri Lanka’s, involved navigating monetary challenges in the mid-20th century. Protectionist import taxes in Taiwan initially hampered export manufacturing by increasing the cost of necessary inputs.
After implementing tax rebates to counter protectionism, Taiwan established a free trade zone near Kaohsiung Port. At a time when VAT was an emerging concept outside Europe, this initiative helped exporters overcome trade barriers.
Modern VAT systems originated in Europe, with France pioneering the tax in its colonies before adopting it domestically in 1958. The VAT model later spread across the European Economic Community, with the UK implementing it in 1972.
The understanding of VAT’s intricacies, particularly its role in export competitiveness, appears less developed in some regions, such as the United States, where former President Trump voiced criticism of it as an unfair export subsidy.
Broader Economic Ramifications of SVAT Removal
The repercussions of removing the SVAT system extend beyond direct manufacturing. Sri Lankan exporters have reported that local buying offices are also experiencing significant negative impacts.
Analysts suggest that the challenges posed by the SVAT removal could lead to the relocation of buying offices abroad, similar to how backward integration factories and external local suppliers might be abandoned.
While some export sectors with healthier profit margins might absorb these additional costs, industries operating on thin margins, such as apparel, are likely to be disproportionately affected.
Impact on Other Export Sectors
The concerns are not limited to the apparel industry. Sri Lanka’s tea producers have also indicated that they will face increased interest costs due to cashflow disruptions. This arises from the obligation to pay VAT upfront, even with reduced refund periods.
Following the removal of SVAT, tea prices reportedly decreased by approximately 100 rupees per kilogram. While a price recovery is anticipated once VAT refunds are processed, the immediate cashflow strain is undeniable.
⚡ Unlike manufacturers of industrial goods, who can more readily switch to imported inputs if local sourcing becomes problematic, tea plantations and smallholders largely remain tied to the local market. However, prices may adjust to reflect the increased cashflow costs borne by exporters.
Sri Lanka’s Tax Environment and Investor Competitiveness
Sri Lanka has a history of adjusting its tax regime, often in response to balance of payments crises. These crises have frequently been linked to central bank policies, described by critics as ‘monetary accommodation’ or ‘eased monetary policy,’ often interpreted as inflationary interest rate cuts or money printing.
Currency crises have also led to increases in income tax. This, in turn, creates a need for competitive tax rates for foreign investors and export-oriented businesses to maintain attractiveness.
Currently, Sri Lanka’s corporate tax rate stands at 30 percent. This is considerably higher than the 20 percent rate found in East Asian and Scandinavian countries that benefit from greater monetary stability, potentially impacting Sri Lanka’s investment appeal.
Conclusion
The Sri Lankan government, through the Board of Investment, is actively addressing a critical issue affecting its export sector: the VAT imposition on local inputs. The removal of the SVAT system has created significant financial burdens, particularly for the apparel industry, jeopardizing investments in backward integration and overall global competitiveness.
With comparisons drawn to more favourable VAT treatments in countries like Taiwan and Vietnam, and ongoing dialogue with the Inland Revenue Department, there is a concerted effort to find a resolution. The situation highlights the delicate balance between fiscal necessity and the imperative to support export-oriented industries in maintaining their international standing.