Increasing tax revenue without hiking tax burden

Taxes are certainly essential to fund public services and infrastructure, but a disproportionately high tax burden can backfire

No one willingly parts what they own, unless the return is of equal or greater value, regardless of its tangibility – and this applies to taxes as well. The million-dollar question for Sri Lankan taxpayers is: what do we really get in return for the taxes we pay?

Spoiled by policy failures

Despite the Government’s efforts to promote taxation as a civic duty, flawed tax policies are undermining public trust. The fundamental principle of taxation is fairness, which means taxation should be based on ability to pay.

However, the previous Government’s decision to reduce VAT and income tax thresholds and to increase their tax rates, amid inflation that has risen from 9% to an unprecedented 70% in 2022, was anything but prudent. Such a move contradicted the fundamental principle of easing the tax burden during an economic downturn.

Although these policies raised revenues, they also deepened the public’s perception of taxation as legalised robbery, threatening long-term compliance with and trust in the tax system.

The public vented its anger and frustration unmistakably at political authorities who implemented unprincipled and unfriendly tax measures in the last Presidential and General elections.

Beyond hiking tax burden

Taxes are certainly essential to fund public services and infrastructure, but a disproportionately high tax burden can backfire, fuel capital flight, discourage investment, and foster tax evasion and avoidance.

Public trust and confidence in the tax system and its efficient management are more important for tax revenue collection than being threatened by legal and penal provisions.

The most effective ways to increase tax revenue without further burdening existing taxpayers are:

• Broadening the tax base and
• Combating tax evasion.

Broadening the tax base

Broadening the tax base means increasing the number of tax files qualitatively, not quantitatively. More than 72% of total tax revenue is contributed by the nearly 600 largest taxpayers, which represents less than 0.5% of the approximately 1.1 million tax files maintained by the IRD.

In a desperate and frantic attempt to boost Government revenue and appease international funding agencies, the previous Government implemented the futile and illogical measure of making it mandatory for all individuals over the age of 18 to open tax files, regardless of their income status.

The then Finance Minister issued an extraordinary gazette notification in this regard, violating the provisions of the Inland Revenue Act, which focuses on registering individuals based on income and not age.

Fortunately, the Commissioner General of Inland Revenue (CGIR) did not strictly enforce this order and refrained from taking punitive action against more than 99% of non-compliant individuals. Instead, the Inland Revenue Department (IRD) has correctly registered over 600,000 individuals for tax purposes based on their income status.

Known for being task- and result-oriented, the CGIR has shifted its focus from the symbolic expansion of the tax net to the collection of due taxes from defaulters and evaders. This approach has reportedly led to the highest tax revenue collected by the IRD ever.

Combating tax evasion

Tax evasion is a challenge facing global tax agencies. This tax evasion challenge is particularly acute in emerging economies due to a variety of reasons, including the lack of deterrent laws, loopholes in existing laws, non-adherence to global tax treaties, and corruption among the public and officials.

Tax evasion can be broadly divided into two categories based on the entity and individual (hereinafter referred to as person) involved.

1. Tax evasion by resident person, and

2. Tax avoidance by non-resident person.

1. Tax evasion by resident person through cross-border transactions

I do not here address the widespread tax evasion by resident person made through underreporting income and/or over reporting expenses. My focus is on the multi-billion dollar tax evasion schemes that resident taxpayers have been implementing through cross-border transactions.

The Tax Justice Network (TJN) is an internationally recognised independent organisation dedicated to researching global tax issues and tax evasion. According to its findings, the international community loses $ 480 billion in tax revenue annually due to cross-border tax evasion by multinational enterprises (MNEs) and high-net-worth individuals. (Countries warned that $ 4.8 trillion could be lost to tax havens over the next decade if the preventive measures were not adopted – Tax Justice Network).

TJN has identified the tax loss attributable to Sri Lanka’s tax jurisdiction for 2022 at $ 413.25 million. Of this, Sri Lankan MNEs evaded $ 406.56 million, while wealthy Sri Lankan individuals evade $ 6.69 million. The total annual tax loss in LKR is around 125 billion.

Modes operandi of cross-border tax avoidance

Cross-border tax avoidance practices are specific methods or schemes used by individuals or businesses to illegally reduce or avoid taxes in different jurisdictions. In the context of cross-border activities, these tactics often exploit the complexities of international tax systems to their advantage. Some such tactics include:

Transfer pricing: Multinational corporations manipulate transfer prices for intercompany transactions to shift profits to low-tax or no-tax jurisdictions, thereby reducing overall tax liability.

Offshore accounts: Individuals or entities hide income or assets in offshore bank accounts located in countries with strict banking secrecy laws.

Use of shell companies: The establishment of shell companies or trusts in tax havens to conceal the true ownership of assets or income, thereby avoiding taxation in their home country.

Artificial transactions: Engaging in fictitious or artificial transactions, without any real economic purpose, solely to exploit tax loopholes or for deductions.

Tax treaty abuse: The misuse of double taxation treaties between countries to claim unnecessary tax exemptions or deductions, often through treaty shopping (choosing jurisdictions for their favourable treaty terms).

Round tripping: Local funds are sent abroad, disguised as foreign investments, and brought back to benefit from tax exemptions or incentives.

Game changer

As this tax evasion poses a global challenge to international tax agencies, the Global Forum of the Organization for Economic Cooperation and Development (OECD) has developed an effective framework called Automatic Exchange of Information (AEoI) to combat tax evasion, particularly in the context of cross-border transactions by MNEs.

AEoI is a mechanism through which tax jurisdictions automatically share financial account information with their home country authorities on an annual basis. It operates under the Common Reporting Standard (CRS) developed by the OECD.

The importance of AEoI in addressing tax evasion by MNEs

AEoI enables tax authorities to access detailed financial information about MNEs and their operations across jurisdictions. This includes:

• Income and balances in foreign accounts.
• Cross-border payments and transfers.
• Ownership structures of entities and trusts.

This transparency reduces the opportunities for MNEs to hide profits or assets in offshore accounts or low-tax jurisdictions.

Reduced bank secrecy: In the past, MNEs exploited bank secrecy laws in certain jurisdictions to hide taxable income. The AEoI has eliminated such practices by requiring financial institutions to report account information to the relevant authorities.

Supporting compliance and prevention: Sharing financial information automatically encourages compliance among MNEs and discourages them from engaging in aggressive tax evasion practices.

The AEoI framework is a cornerstone of global efforts to combat tax evasion, particularly by MNEs. By fostering greater transparency and accountability, it not only strengthens the global tax system but also combats money laundering activities too.

More than 170 countries and tax jurisdictions have now joined the Global Forum, and more than 100 countries have joined the AEoI to implement it effectively.

Learning from global success stories

For example, Indonesia, which introduced the AEoI in 2009 and linked it to a tax amnesty in 2015, led to the disclosure of $366 billion in hidden assets by 900,000 declarants and generated $ 8.6 billion in taxes. Similarly, India has collected $ 20 billion in taxes in one year through AEoI mechanisms – three times Sri Lanka’s total 2024 tax revenue target.

Sadly, Sri Lanka has not yet signed up to the AEoI for reasons best known to political authorities. I am not suggesting that the government is not involved in this AEoI at the Global Forum to protect its corrupt politicians and cronies.

2. Tax avoidance by non-resident MNEs through e-commerce

Another major setback for international tax agencies, particularly in emerging economies, has been the avoidance of taxes by non-resident MNEs on profits earned in source countries through the e-commerce.

Internationally accepted law and practice is that a tax jurisdiction cannot impose income tax on a business income if the person does not have a physical presence in that tax jurisdiction.

The OECD and the UN Taxation Committee (UNTC) – global tax standard setters – recommend two different approaches to international taxation to address the challenges of taxing the digital economy by such non-resident entities.

OECD Pillar One-Amount A

The OECD, representing developed economies, has “reluctantly” proposed a Pillar One-Amount A to allocate a portion of the taxing rights – subject to multiple conditions such as minimum global income, minimum PBT, nexus rules, etc. to source countries of large MNEs based on market jurisdictions, regardless of the physical presence of the MNEs.

Sri Lanka was one of only three countries out of 142 members of the OECD-inclusive framework that withheld the consensus in 2021 on the OECD’s two-pillar solution. The growing disagreement among member countries that initially agreed to the solution underscores the wisdom of Sri Lanka’s decision.

Article 12B of the UNTC: Alternative proposal

The UNTC, which is the other global tax standards setter and is largely represented by developing countries, has proposed a simple and flexible framework to allow source countries to tax non-resident MNEs engaged in digital services, regardless of their physical presence. This taxing right is known as the Article 12B Amount.

This proposal of Article 12B of UNTC is based on the existing Article 12 of Double Tax Avoidance Agreements (DTAA) which deals with passive income of such as royalty and service income.

Article 12B of the UNTC empowers source countries to tax the income of such non-resident MNEs through a bilateral or unilateral withholding tax mechanism with other resident countries.

Currently, some countries use the equivalent of 12B to tax the digital services income of non-resident MNEs through the withholding mechanism of Digital Services Tax (DST). These include Austria, Italy, France, the United Kingdom, Kenya, India, etc.

“Levy on Foreign Commercial Transactions” and Sri Lanka

Sri Lanka enacted an Act in 2019 to impose DST on the digital economy with effect from the date of gazette notification to be issued by the Minister of Finance. The gazette notification is yet to be published.

Section 7 of the Finance Act No. 21 of 2019 imposes a tax of 3.5%, known as Levy on Foreign Commercial Transactions, on the purchase of goods or services made from a person outside Sri Lanka through a debit or credit card.

Section 7 of the relevant Finance Act states:

1) From and after the appointed date, there shall be charged, a levy to be called the “Levy on Foreign Commercial Transactions” (hereinafter in this Part referred to as the “Levy”) from every person who has completed a transaction through a payment card with a person outside Sri Lanka, to purchase any goods or services from such person outside Sri Lanka.

2) The rate of the Levy shall be 3.5 per centum on the sum remitted outside Sri Lanka for any transaction under subsection (1).

The folly of this Section of the Act was that the levy is to be deducted from the consumer, not from the foreign supplier of the commercial goods or services. 

My suggestion is that the financial institutions issuing debit/credit cards through which such digital business transacted should be required to deduct the withholding tax (preferably 04% or 05%) from the amount due to be remitted to such non-resident person (not from the consumer) supplying the digital goods or services.

Sri Lanka should adopt a withholding tax mechanism for non-resident digital service providers. For example, a financial institution making a payment of $ 100 to a digital platform would remit $ 95 to the provider and $ 5 as withholding tax to the IRD. According to UNTC’s research, this approach could fetch over $ 104.5 million annually.

Sri Lanka can increase tax revenue by focusing on fairness, broadening the tax base, and tackling evasion. Implementing global mechanisms such as the AEoI of OECD to tackle the cross-border tax evasion and adopting Amount 12B of UNTC to tax digital services are key steps. By learning from successful international practices and reforming domestic policies, the country can build a transparent, fair tax system that builds public trust and sustainable growth.

(The writer is a retired Deputy Commissioner General of IRD. He can be contacted via [email protected].)