New withholding tax could sink Maldives

Sri Lanka accounts for a substantial volume of investment in Maldives on an annual basis. It was recently estimated that the outward direct investment from Sri Lanka to Maldives in 2020 alone stood at around $ 100 million. Much of the investment comes in conjunction with large-scale construction projects

By A Special Correspondent

Last Thursday’s deplorable bomb attack on Maldives’ former President and current Speaker Mohamed Nasheed sent shockwaves across the region. Sri Lankans, having endured years of heinous terror attacks, are sure to empathise with their Indian Ocean neighbours, and wish Nasheed a swift recovery.

The Sri Lankan experience since 2019 in particular has demonstrated how vulnerable economies can be to international perceptions of security risks. Coupled with an increase in COVID-19 cases in the region, last week’s events could present a serious setback to the revival of the Maldivian economy. Yet, from the perspective of foreign investors in particular, country risks can take subtler forms.

In January 2020, Maldives introduced a new Income Tax Act (Law No. 25/2019). This Act specifies that any payment to a non-resident company would be subject to a 10% withholding tax (WHT). It applies to a range of foreign companies that already pay income tax and Goods and Services Tax (GST) in Maldives. The new Income Tax Act is, therefore, not in line with international standards of taxation practiced around the world.

The full effects of this new law is now being felt across the Indian Ocean, and Sri Lankan companies may be the worst affected. A closer look at the law suggests that the new policy may have an adverse impact on investor confidence, tourism, and local housing costs.

Impact on Sri Lankan companies

As a result of the 2020 Maldivian Act, Sri Lankan construction companies that are already registered with the Maldives Inland Revenue Authority will be double taxed. These companies already pay income tax and GST in Maldives, but will be subjected to an additional 10% non-resident WHT when receiving payments for projects carried out in Maldives. 

WHT would retrospectively apply to construction contracts that were entered into before the law was introduced in 2020. This change places a serious financial strain on these companies, and makes continued work on large scale construction projects, on pre-agreed project cost, unfeasible. 

International construction companies often maintain profit margins of well under 10% of the overall project estimate. Therefore, sustaining a 10% WHT on all receivables, which includes the sale of material would constrict existing cash inflows, thereby severely disrupting large-scale construction projects, and discourage investors from continuing to support such projects. 

According to industry insiders, the Government of Sri Lanka is aware of this issue and has reached out to the Maldivian High Commission. The High Commission has assured the Sri Lankan Government that it will secure a reasonable solution to this problem. The two SAARC nations have enjoyed decades of positive diplomatic relations and cross-country economic engagement. However, this new issue could very well place a strain on the relationship.

Consequences of a non-resident WHT

There are three sound reasons for avoiding a non-resident WHT on construction projects. The implications of the Maldivian tax policy are yet to be fully felt or understood by the various stakeholders who stand to be affected by it. In this sense, it is very much a disaster waiting to materialise. These reasons need to be highlighted, as they offer important lessons for Sri Lanka.

Foreign investors will flee

The new tax law applies to even construction contracts entered into before January 2020. Therefore, it has retrospective effect with little to no warning, and would result in substantial cashflow problems for existing construction projects. 

For example, a developer who would have expected $ 100 as a payment on a planned transaction when signing the contract prior to 2020, would now receive only $ 90. The reduction in cashflow would be due to the fact that under the new law, the resident party to the transaction would be compelled to retain 10% WHT. Even if the $ 10 can be set-off against the final corporate tax liability of the company, the unplanned cash outflow at the point of the transaction would severely impede the on-going project. 

Furthermore, the extent of such setting off is also questionable because corporate tax is applied on eventual profits rather than revenue. Therefore, the withheld amounts under WHT would generally be seven to eight times the actual payable amount of corporate tax.

Such arbitrariness and uncertainty would strike considerable fear into the hearts of potential foreign investors. Foreign investors from around the world will view this policy as signalling the general character of the investment climate in Maldives. Arbitrariness and uncertainty, particularly in tax policy, and the inability to estimate returns on investment, are massive disincentives to any potential foreign investor. Moreover, scores of studies, including one published in 2014 by the Oxford Centre for Business Taxation, clearly note that high WHT disincentivises foreign investors.

The continued application of this policy would dissuade many future investors – including those from Sri Lanka – from supporting development projects in Maldives. Sri Lanka in fact accounts for a substantial volume of investment in Maldives on an annual basis. It was recently estimated that the outward direct investment from Sri Lanka to Maldives in 2020 alone stood at around $ 100 million. Much of the investment comes in conjunction with large-scale construction projects. 

Tourism will tank

Maldives, like Sri Lanka, has an economy that is heavily dependent on tourism. It constitutes more than 30% of the country’s GDP, and roughly 60% of the country’s foreign exchange receipts. 

A large proportion of the development projects affected by the new tax policy involves the construction of tourist resorts and related infrastructure. The disruption of these ongoing projects, due to an unforeseen tax burden and unexpected cash outflows, will hurt the tourism industry in Maldives in two ways. 

First, delays in the completion of these projects will deprive Maldives of hundreds of thousands of dollars in tourism income. The local construction sector in Maldives would not have the capacity to meet the demands of large-scale construction projects in the tourism sector. The Maldivian tourism industry is heavily dependent on foreign investment, and the involvement of foreign construction companies. In a context where COVID-19 has adversely affected the tourism industry and ongoing tourism projects in Maldives, the major disruptions that this tax law brings will further harm an already vulnerable sector.

Second, the tax policy will have ripple effects in terms of the willingness of investors to support the tourism industry in Maldives. Mid-stream disruptions to existing projects will eventually adversely affect investor confidence in the tourism sector. The high volume of investment – particularly into tourism – that many foreign construction companies bring into Maldives is unlikely to continue if taxes of this nature are retained. Consequently, hundreds if not thousands of jobs in the tourism sector stand to be lost.

Consumer bears the cost

The new tax policy will have a significant trickle-down effect on the average Maldivian consumer by driving  up the cost of construction and housing. This inevitability presents a good reason for Maldivian nationals to look more closely at a law that is presented as affecting only foreigners. Sri Lankan policymakers should meanwhile note these consequences and avoid replicating such policies.

The consequences of a new and arbitrary tax policy can eventually impact the average consumer. For instance, it is bound to increase the price of housing. Maldivians are in fact already facing a housing crisis both in terms of supply and cost. The crisis in Male, which is recorded as the fifth most congested city in the world, has been described as ‘acute’ by policymakers. 

On the one hand, the presence of foreign companies in the construction market tends to stabilise prices of materials due to the scale of their development projects. However, an arbitrary tax targeting foreign construction companies may force such companies to withdraw from the market. This exit will eventually enable the remaining domestic players to control and drive up prices of construction and housing. 

On the other hand, since the Act is enforced retrospectively, domestic contractors would also face an immediate issue in settling WHT payments for pre-2020 contracts signed with non-resident suppliers for material, and a range of specialised items such as generators, and water and sewage treatment facilities. A non-resident WHT would still apply to these transactions, and would eventually drive up the price of materials and specialist equipment. Consequently, the real burden of this new tax policy would be borne by consumers.

Conclusion

Maldives’ Parliament – the People’s Majlis of Maldives – must take steps to rectify the problems associated with the current Income Tax Act. The leadership in Maldives would do well to address these problems without delay, and Sri Lankan counterparts should do what they can to support decisive reform.

If this opportunity is missed, the dire consequences of the current tax policy would begin to materialise. Foreign investors would flee, tourism would tank, and worst of all, the consumer would bear the cost while a few domestic players benefit.