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Cablegate: New Tax Squeeze Prior to Unveiling Sri

This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 04 COLOMBO 001858

SIPDIS

SENSITIVE

MANILA FOR USADB; DEPT PLEASE PASS TO MCC:SGROFF

E.O 12958: N/A
TAGS: ECON EFIN ETRD CE ECONOMICS
SUBJECT: NEW TAX SQUEEZE PRIOR TO UNVEILING SRI
LANKAN BUDGET

1. (SBU) Summary: The Government of Sri Lanka has
introduced a series of politically motivated taxes
just prior to its presentation of the 2005 budget.
Most of the taxes attempt to satisfy the Marxist
elements in the current government, who want to be
seen as protectors of the national heritage, rural
farmers and local businessmen. The Finance Ministry
says the measures are needed to protect the fast-
depleting foreign reserves and protect industries
from dumping. Some of the taxes have come into
effect with retroactive charges to 2002. These
taxes are indicative of the cash flow problem faced
by the GSL. The timing of the tax announcement,
just prior to the new budget, may be an attempt to
make the new budget appear less of a burden and more
generous. End Summary.

2. (U) Below is a list of recent tax measures
followed by detailed information on each tax:

-- 100% tax on sale of land and property to foreign
nationals (including companies with over 25 percent
foreign equity)
-- Repeal of 2002-tax amnesty
-- Hike in duty on motor vehicle imports
-- New duty on non-essential imports
-- A tax on Government securities transaction with
retroactive effect to 2002
-- Economic Service Charge on turnover of companies

Tax on property
---------------

3. (SBU) The first tax to be introduced by this
Government was a 100 percent transfer tax on
property sales to foreign nationals and companies.
This tax was mooted by the Janatha Vimukthi Peramuna
(JVP), a key element of the current ruling
coalition, following extensive press coverage of
property purchases by foreigners, after the
abolition of a 100 percent transfer tax in 2002.

4. (U) In particular, significant negative
publicity was focused on real estate purchases
inside the historic Dutch fort in Galle, and along
the southern coastal belt, both JVP strongholds.
Foreign land ownership was a hot issue in the April
2004 election campaign, with the UPFA promising to
stop foreign land purchases if elected. The new
law, however, goes beyond the previous property tax
as it also covers local companies with more than 25
percent foreign equity. It also requires a
government assessment of land value for land sold to
foreigners. For these reasons it has been heavily
criticized by the business community.

5. (SBU) According to a partner at a leading law
firm, his firm is recommending against land
purchases by foreign clients as a result of the tax
and uncertainties surrounding implementation of the
value assessment requirement. A Finance Ministry
official told EconFSN that the Ministry is seeking
to amend that requirement and also to give power to
the Finance Minister to exempt companies from the
tax on a case-by-case basis. Contacts at the Colombo
Stock Exchange indicate they have not heard many
complaints from listed companies with over 25%
foreign holding, but that most firms could
circumvent the tax by creating a new, wholly-Sri
Lankan-owned corporation for property holdings.

Repeal of Tax Amnesty
---------------------

6. (U) The Government has also moved to repeal
(parts of) a controversial tax amnesty granted by
the previous government. The amnesty was declared
in 2003, allowing people to declare undisclosed
assets and income, and also obtain waivers from a
range of unpaid taxes. The purpose of the amnesty,
according to the previous Finance Minister, was to
widen the tax net. The amnesty attracted 58,000
applications, all of which would be added to the tax
rolls.

7. (SBU) The President and the new government
criticized the amnesty, saying that it paved the way
for corrupt supporters of the previous Government
and tax dodgers to escape from their tax
liabilities. In addition, the Government has said
that tax collections have decreased due to the
amnesty. The main criticism has been the coverage
of indirect taxes (Goods and Services Tax (GST - a
precursor to the Value Added Tax implemented in
2002), excise tax, import and export duties)
enabling large-scale tax evasion.

8. (U) According to the new legislation, taxpayers
will still be able to qualify for amnesty on income
tax, but not on other indirect taxes. Finance
Ministry officials argue that these indirect taxes
have already been recovered by businesses from
consumers (such as GST on consumer products) and
should be rightly paid back to the Government. The
business community, especially the powerful Ceylon
Chamber of Commerce, has expressed reservations on
the repeal of the tax amnesty, saying it has
compromised the credibility of the government in the
investor community.

Duty on motor vehicle imports
-----------------------------

9. (U) The government has also begun to increase
taxes on imported items. The first in line were
motor vehicles. The excise duty on gasoline-powered
cars was increased from 25 percent to 30-60 percent,
based on engine capacity. Smaller vehicles will be
assessed a lower duty and bigger vehicles at a
higher duty (at the lower duty range -- cars under
1000 cc -- the market consists mostly of the Indian
made "Maruti" and the locally produced "Micron").

10. (U) Excise duty on diesel cars have been
increased from 60 percent to 115 percent. The
excise duty on gasoline powered vans has been
increased from about 15 percent to 30% and diesel
powered from about 48 percent to 84 percent.

11. (U) In addition to increased duty, importers of
motor vehicles are now required to pay up front when
opening letters of credit. The Central Bank said
these steps should help to reduce vehicle imports,
curb high credit growth to the private sector,
reduce the burden on the fuel bill and reduce road
congestion. The increased duty on motor vehicles
has come under sharp criticism by vehicle importers,
who say they are unable to pay higher prices for
imports already made. At least one importer has
obtained an order restraining the government from
implementing the new tax.

Import duty on non-essentials
-----------------------------

12. (U) The Government has also introduced a tariff
on a range of "non-essential" imports including
fruits, vegetables, processed and unprocessed food,
shoes, bags, rubber and plastic products, textile
products (other than fabric), consumer items such as
toiletries and perfumes, ceramic ware, glass ware,
pens and electrical goods. The tax is three tiered:
10, 15 and 20 percent, with most of the items also
carrying a specific (piece rate) duty. The higher
of the two rates will be charged. Some of the
specific duties would amount to a 100 percent tax as
in the case of ballpoint pens, which are charged a
duty of 10 rupees (about 9 US cents) per item. The
tariff, ostensibly imposed for Sri Lanka's Export
Development Board, will be in addition to normal
import duty and the 10 percent duty surcharge
currently in effect. The tax will send Sri Lanka's
import duty structure sharply upwards.

13. (SBU) The Finance Ministry in a press release
said that this measure intends to "discourage the
importation of nonessentials in view of the foreign
exchange crises faced by the government due to the
escalation of world oil prices". However, the real
reason appears to be a politically motivated move to
protect the local industry as indicated previously
in the July 2004 Economic Policy Framework (EPF),
which declared that SME's must be offered protection
from being displaced by unfair import competition.
The Finance Ministry Statement also said that the
government has been informed of severe competition
faced by the farmers and local industries due to
dumping. Further, the statement indicated that the
Customs Department finds it difficult to ascertain
the true value of imports. Although the release
said the income would be used for export
development, it is most likely that proceeds will go
to the treasury.

14. (SBU) The Department of Commerce has not yet
carried out a study of the impact of these measures
on Sri Lanka's WTO obligations. Since Sri Lanka's
bound duty on agriculture is around 50 percent (for
import tariff) and 10 percent (for other charges),
and most non-agricultural products (except for
textiles) are not bound, they hope these measures
will not cause serious problems for Sri Lanka at the
WTO.

Taxes with retroactive effect
-----------------------------

15. (U) Two other taxes have been introduced with
retroactive effect. They include taxation of
trading profits and interest income of secondary
market transaction of securities, treasury bills and
other government bonds with retroactive effect, from
April 2002. Financial institutions have complained
about this move, especially as profits attributable
to the past years have been already paid to
shareholders.

Economic Service Charge (ESC)
-----------------------------

16. (U) The Government has also taken steps to
implement a 1 percent ESC proposed by the last
government. ESC can be set off against income tax
payable during the year. While the ESC was proposed
on either a turnover or asset basis, the current
government has implemented the tax on the basis of
turnover.

Comment
-------

17. (SBU) The current state of the GSL's fiscal
situation is troubled. Retroactive taxes appear
indicative of how low cash reserves have fallen.
Oil prices, a general lack of business confidence
and a surge in intermediate goods imports have put
pressure on the rupee, and the Central Bank has
intervened heavily to smooth its depreciation
(approximately 7 percent since January 1). While
few expect these taxes to be major revenue earners,
the Government hopes that they will help slow the
outflow of foreign reserves.

18. (SBU) By imposing these measures through
gazette notification, rather than the budget
process, however, some believe the GSL is setting
itself up to unveil a budget that is filled with
benefits (higher public sector salaries, possibly
increased agricultural subsidies), but that does not
impose serious revenue or belt-tightening
initiatives. These taxes are also indicative,
though, of the current GSL's general leanings toward
import-substitution and protectionist policies, as
promised in its Economic Policy Framework. End
comment.

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